10-K 1 a19-30043_110k.htm 10-K

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

 

FORM 10-K

 

x      Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

for the fiscal year ended December 31, 2018

 

OR

 

o         Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

for the transition period from            to           

 

NORTECH SYSTEMS INCORPORATED

(Exact name of registrant as specified in its charter)

 

Commission file number 0-13257

 

State of Incorporation: Minnesota

 

IRS Employer Identification No. 41-1681094

 

Executive Offices: 7550 Meridian Circle N #150, Maple Grove, MN 55369

 

Telephone number: (952) 345-2244

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange on which registered

Common Stock, par value $.01 per share

 

NASDAQ Capital Market

 

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o No x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.  Yes o No x

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes x No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer o

 

Accelerated filer o

 

 

 

Non-accelerated filer x 

 

Smaller reporting company x

 

 

 

 

 

Emerging growth company o

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o No x

 

The aggregate market value of voting stock held by non-affiliates of the registrant, based on the closing price of $3.42 per share, was $3,520,018 on June 30, 2018.

 

Shares of common stock outstanding at March 26, 2019: 2,684,672.

 

(The remainder of this page was intentionally left blank.)

 

 

 


Table of Contents

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s Proxy Statement for the 2019 Annual Shareholders’ Meeting have been incorporated by reference into Part III of this Form 10-K. The Proxy Statement is expected to be filed with the Securities and Exchange Commission (the SEC) within 120 days after December 31, 2018, the end of our fiscal year.

 

(The remainder of this page was intentionally left blank)

 

2


Table of Contents

 

NORTECH SYSTEMS INCORPORATED

ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

 

 

 

PAGE

PART I

 

 

 

 

 

Item 1.

Business

5-7

 

 

 

Item 1A.

Risk Factors

7-12

 

 

 

Item 1B.

Unresolved Staff Comments

12

 

 

 

Item 2.

Properties

12-13

 

 

 

Item 3.

Legal Proceedings

13

 

 

 

Item 4.

Mine Safety Disclosures

13

 

 

 

PART II

 

 

 

 

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

14

 

 

 

Item 6.

Selected Financial Data

15

 

 

 

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

15-24

 

 

 

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

24

 

 

 

Item 8.

Financial Statements and Supplementary Data

25-54

 

 

 

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

55

 

 

 

Item 9A.

Controls and Procedures

55

 

 

 

Item 9B.

Other Information

55

 

 

 

PART III

 

 

 

 

 

Item 10.

Directors, Executive Officers and Corporate Governance

56

 

 

 

Item 11.

Executive Compensation

56

 

 

 

Item 12.

Security Ownership of Certain Beneficial Owners, Management and Related Stockholder Matters

56-57

 

 

 

Item 13.

Certain Relationships and Related Transactions, and Director Independence

57

 

 

 

Item 14.

Principal Accountant Fees and Services

57

 

 

 

PART IV

 

 

 

 

 

Item 15.

Exhibits and Financial Statement Schedules

58-60

 

 

 

 

Signatures

61

 

3


Table of Contents

 

NORTECH SYSTEMS INCORPORATED

FORM 10-K

For the Year Ended December 31, 2018

 

PART   I

 

Item 1.   Business

 

General

 

Nortech Systems, Inc., (“the Company”, “we”, “our”) organized in December 1990, is an Electronic Manufacturing Services (“EMS”) company headquartered in Maple Grove, Minnesota, a suburb of Minneapolis, Minnesota. We maintain facilities and operations in Minnesota in the United States; Monterrey, Mexico; and Suzhou, China. We offer a full range of value-added engineering, technical and manufacturing services and support including project management, designing, testing, prototyping, manufacturing, supply chain management and post-market services. Our manufacturing and engineering services include complete medical devices, printed circuit board assemblies, wire and cable assemblies, and complex higher level electromechanical assemblies. The majority of our revenue is derived from products built to the customer’s design specifications.

 

Our breadth of manufacturing, technical expertise and experience make us attractive to our broad customer base. Our customers are original equipment manufacturers (“OEMs”) in the Aerospace and Defense, Medical and Industrial markets. The diversity in the markets we serve is an advantage in dealing with the effects of fluctuations from the economy and competition. In the design phase, we provide technical support, subject matter expertise in design for manufacturing and testing capabilities that allow our customer programs to get to production faster while meeting both their quality and cost requirements. Our customers rely on our experience and capabilities in manufacturing and supply chain to manage and reduce cost over the life cycle of their products. This requires a strong relationship with our customers based on a trusting partnership as we perform as an extension of their operations.

 

All of our facilities are certified to one or more of the industry standards, including International Standards Organization (“ISO”) 9001, ISO 13485, and Aerospace Systems (“AS”) 9100, with most having additional certifications based on the needs of the customers they serve. In addition to industry standard certifications we actively manage quality metrics throughout product life-cycle at all levels of the organization to provide real-time, pro-active support to our customers and their projects. Process validation is performed through the strict phases of installation qualification, operation qualification and performance qualification.

 

Business Segment

 

All of our operations fall under the Contract Manufacturing segment within the EMS industry. We strategically direct production between our various manufacturing facilities based on a number of considerations to best meet our customers’ needs. We share resources for sales, marketing, engineering, supply chain, information services, human resources, payroll, and all corporate accounting functions. Our financial information is consolidated and evaluated regularly by the chief operating decision maker in assessing performance and allocating resources.

 

Business Strategy

 

The EMS industry has evolved into a dynamic, high-tech, regulated global electronics contract services industry. We continue to expand our capabilities and footprint to better meet these changing market requirements. Along with offering technical expertise in our quality processes, engineering design applications and testing, we are also increasing our focus on supplier-managed inventory services and the cost drivers throughout the global supply chain. We continue to transform our business model from one that is less transactional and price/commodity driven to a solution based model focused on value added

 

4


Table of Contents

 

services. We continue to pursue acquisitions, mergers, and/or joint ventures of companies in the EMS industry to expand our service offering, advance our competitive edge, grow our customer base and increase revenues. Our strategic objectives and our history have been based on both organic and acquired growth.

 

Our quality systems and processes are based on ISO standards with all facilities certified to ISO 9001 and/or AS9100 standards. We also have ISO 13485 certification which recognizes our quality management systems applicable to contract design, manufacture and repair of assemblies for the medical industry. Our Milaca operation is a U.S. Food and Drug Administration (“FDA”) registered facility. These certifications and registrations provide our customers assurance of our capabilities and proven processes.

 

We are committed to quality, cost effectiveness and responsiveness to customer requirements. To achieve these objectives we have invested in Restriction of Hazardous Substances (lead free) processing, equipment, plant capacity studies, people, enterprise resource planning systems, lean manufacturing and supply chain management techniques at our facilities. We are committed to continuous improvement and have invested in training our people to identify and act on improvement opportunities. We maintain a diversified customer base and expand into other capabilities and services when there is a fit with our core competencies and strategic vision.

 

Marketing

 

We concentrate our marketing efforts in the Aerospace and Defense, Medical and Industrial markets. Our marketing strategy emphasizes our breadth, expertise and experience in each of our markets. Our expertise helps our customers save time and money and also reduces their risks. The breadth of our manufacturing, supply chain, engineering services and complete turnkey solutions assist our customers in getting their products to market quickly while managing the total cost solution. Our strength is managing low to moderate volume components and assemblies with high mix customer demand. This requires us to have close customer relationships and operational flexibility to manage the variation of product demands.

 

Our customer emphasis continues to be on companies that require an electronic manufacturing partner with a high degree of manufacturing and quality sophistication, including statistical process control, statistical quality control, ISO standards, Military Specifications, AS9100 and FDA facility registration. We continue efforts to penetrate our existing customer base and expand market opportunities with participation in industry forums and selected trade shows. We target customers who value proven manufacturing performance, design, project management and application engineering expertise and who value the flexibility to manage the supply chain of a high mix of products and services. We market our services through a mix of traditional marketing outreach, a specialized business development team and independent manufacturers’ representatives. For more information on our marketing and service offerings see our web site at nortechsys.com. The information on our company’s website is not part of this filing.

 

Sources and Availability of Materials

 

We currently purchase the majority of our electronic components globally and directly from electronic component manufacturers and large electronic distributors. On occasion, some of our components may be placed on a stringent allocation basis; however, we are not currently experiencing any major material purchasing or availability problems.

 

Major Customers

 

Our largest customer has two divisions that together accounted for approximately 23.2% and 24.9% of net sales for the years ended December 31, 2018 and 2017, respectively. One division accounted for approximately 20.8% and 23.5% of net sales for the years ended December 31, 2018 and 2017, respectively. The second division accounted for approximately 2.4% and 1.4% of net sales for the years ended December 31, 2018 and 2017, respectively.

 

5


Table of Contents

 

Patents and Licenses

 

Our success depends on our technical expertise, trade secrets, supply chain and manufacturing skills. However, during the normal course of business we have obtained or developed proprietary product requiring licensing, patent, copyright or trademark protection. During 2017, we acquired intellectual property (“IP”) related to a mobile medical device platform that has the capability to transmit and record data which has not been significant to our revenue or operations.

 

Competition

 

The contract manufacturing EMS industry’s competitive makeup includes small closely held contract manufacturing companies, large global full-service contract manufacturers, company-owned in-house manufacturing facilities and foreign contract manufacturers. We do not believe that the small closely held operations pose a significant competitive threat in the markets and customers we serve, as they generally do not have the complete manufacturing and engineering services or capabilities required by our target customers. We do believe the larger global full service and foreign manufacturers are more focused on higher volume customer engagements and we do not see them as our primary competition. We continue to see opportunities with OEM companies that have their own in-house electronic manufacturing capabilities as they evaluate their internal costs and investments against outsourcing to contract manufacturers like us. We do see trends of the low volume, high mix customer demand going to a regional supply base. This is a good fit with our operations in US, Mexico and Asia. We continue to study and investigate other regions and global alternatives to meet our competitive challenges and customer requirements.

 

Research and Development

 

We perform research and development for customers on an as requested, project and program basis for development of conceptual engineering and design activities as well as products moving into production. While we did not expend significant dollars in 2018 or 2017 on company-sponsored product research and development, we continue to explore opportunities for developing proprietary manufacturing methods or products.

 

Environmental Law Compliance

 

We believe that our manufacturing facilities are currently operating under compliance with local, state, and federal environmental laws. We plan to continue acquiring environmental-oriented equipment and incurring the expenditures we deem necessary for compliance with applicable laws. Expenditures relating to compliance for operating facilities incurred in the past have not significantly affected our capital expenditures, earnings or competitive position.

 

Government Regulation

 

As a medical device manufacturer, we have additional compliance requirements. We are required to register with the FDA and are subject to periodic inspection by the FDA for compliance with the FDA’s Quality System Regulation (“QSR”) requirements, which require manufacturers of medical devices to adhere to certain regulations, including testing, quality control and documentation procedures. Compliance with applicable regulatory requirements is subject to continual review and is rigorously monitored through periodic inspections and product field monitoring by the FDA. To support the quality requirements of our Aerospace and Defense market customers, our Blue Earth facility is International Traffic in Arms Regulations (“ITAR”) registered.

 

Employees

 

We have 728 full-time and 91 part-time/temporary employees as of December 31, 2018. Manufacturing personnel, including direct, indirect support and sales functions, comprise 778 employees, while general administrative employees total 41.

 

6


Table of Contents

 

Foreign Operations and Export Sales from Our Domestic Operations

 

We have leased manufacturing facilities in Monterrey, Mexico and Suzhou, China with approximately $821,000 and $630,000 in long-term assets at December 31, 2018, respectively. Export sales from our domestic operations represented 4.8% and 4.5% of net sales the years ended December 31, 2018 and 2017, respectively.

 

Available Information

 

Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to those reports are available free of charge, as soon as reasonably practicable, after we electronically file such material with, or furnish it to, the United States Securities and Exchange Commission (“SEC”). These reports are available on our website at http://www.nortechsys.com and on the SEC’s website at http://www.sec.gov. Information included on our website is not deemed to be incorporated into this Annual Report on Form 10-K.

 

Item 1A. Risk Factors

 

In evaluating our Company, careful consideration should be given to the following risk factors, in addition to the other information included in this Annual Report on Form 10-K. Each of these risk factors could adversely affect our business, operating results and/or financial condition, as well as adversely affect the value of an investment in our common stock. In addition to the following disclosures, please refer to the other information contained in this report, including our consolidated financial statements and the related notes.

 

The economic conditions around the world could adversely affect demand for our products and services and the financial health of our customers.

 

Demand for our products and services depends upon worldwide economic conditions, including but not limited to overall economic growth rates, construction, consumer spending, financing availability, employment rates, interest rates, inflation, consumer confidence, defense spending levels, and the profits, capital spending, and liquidity of industrial companies.

 

An economic downturn or financial market turmoil may depress demand for our equipment in all major geographies and markets. If our original equipment manufacturers are unable to purchase our products because of unavailable credit or unfavorable credit terms, depressed end-user demand, or are simply unwilling to purchase our products, our net sales and earnings will be adversely affected. Also, we are subject to the risk that our customers will have financial difficulties, which could harm their ability to satisfy their obligation to pay accounts receivable. Further, an economic downturn may affect our ability to satisfy the financial covenants in the terms of our financing arrangements.

 

Operating in foreign countries exposes our operations to risks that could adversely affect our operating results.

 

We operate manufacturing facilities in Mexico and China. Our operations in those countries are subject to risks that could adversely impact our financial results, such as economic or political volatility, foreign legal and regulatory requirements, international trade factors (export controls, trade sanctions, duties, tariff barriers and other restrictions), protection of our proprietary technology in certain countries, potentially burdensome taxes, crime, employee turnover, staffing, managing personnel in diverse culture, labor instability, transportation delays, and foreign currency fluctuations.

 

We operate in the highly competitive EMS industry and we depend on continuing outsourcing by OEMs.

 

We compete against many EMS companies. The larger global competitors have more resources and greater economies of scale and have more geographically diversified international operations. We also compete with OEM operations that are continually evaluating manufacturing products internally against the advantages of outsourcing or delaying their decision to outsource. We may also be at a competitive disadvantage with respect to price when compared to manufacturers with excess capacity, lower cost structures and availability of lower cost labor.

 

Competitive factors in our targeted markets are believed to be quality, the ability to meet delivery schedules, customer service, value-added engineering, technology solutions, geographic location and price. We also expect that our competitors will continue to improve the performance of their current products or services, to reduce their current products or service sales prices and improve services that maybe offered. Any of these could cause a decline in sales, loss of market share, or lower profit margin.

 

7


Table of Contents

 

The availability of excess manufacturing capacity of our competitors also creates competitive pressure on price and winning new business. We must continue to provide a quality product, be responsive and flexible to customers’ requirements, and deliver to customers’ expectations. Our lack of execution could have an adverse effect on our results of operations and financial condition.

 

We offer a full range of value-added engineering, technical and manufacturing services and support including project management, designing, testing, prototyping, manufacturing, supply chain management and post-market services.

 

We are dependent on suppliers for electronic components and may experience shortages, extended lead times, cost premiums and shipment delays that would adversely affect our customers and us.

 

We purchase raw materials, commodities and components for use in our production. Increased costs of these materials could have an adverse effect on our production costs if we are unable to pass along price increases or reduce the other cost of goods produced through cost improvement initiatives. Fuel and energy cost increases, as well as unforeseen tariffs, could also adversely affect our freight and operating costs. Due to customer specifications and requirements, we are dependent on suppliers to provide critical electronic components and materials for our operations that could result in shortages of some of the electronic components needed for their production. Component shortages may result in expedited freight, overtime premiums and increased component costs. In addition to the financial impact on operations from lost revenue and increased cost, there could potentially be harm to our customer relationships.

 

We depend heavily on our people and may from time to time have difficulty attracting and retaining skilled employees.

 

Our operations depend upon the continued contributions of our key management, marketing, technical, financial, accounting, product development engineers, sales people and operational personnel. We also believe that our continued success will depend upon our ability to attract, retain and develop highly skilled managerial and technical resources within the highly competitive EMS industry. Not being able to attract or retain these employees could have a material adverse effect on revenues and earnings.

 

Our engineering revenue depends on our ability to deliver quality value-added engineering services required by our customers in the future.

 

The markets for our engineering services are characterized by rapidly changing technology and evolving process development. The continued success of our business will depend upon our ability to hire and retain qualified engineering personnel and maintain and enhance our technological leadership. Although we believe that we currently have the ability to provide the value-added engineering services that is required by our customers, there is no certainty that we will develop the capabilities required by our customers in the future. The emergence of new technology, industry standards or customer requirements may render the engineering services we currently provide obsolete or uncompetitive.  The acquisition and implementation of new engineering knowledge and technical skills may require significant expense that could adversely affect our operating results, as could our failure to anticipate and adapt to our customers’ changing technological requirements.

 

We may not meet regulatory quality standards applicable to our manufacturing and quality processes which could have an adverse effect on our business.

 

We are registered with the FDA and are subject to periodic inspection by the FDA for compliance with the FDA’s QSR requirements, which require manufacturers of medical devices to adhere to certain regulations, including testing, quality control and documentation procedures. We are also ITAR registered which is required for our manufacturing of defense related products. Compliance with applicable regulatory requirements is subject to continual review and is rigorously monitored through periodic inspections and product field monitoring. If any inspection reveals noncompliance with these regulations, it could adversely affect our operations.

 

A large percentage of our sales have been made to a small number of customers, and the loss of a major customer, if not replaced, would adversely affect us.

 

Our largest customer has two divisions that account for 23.2% and 24.9% of net sales for the years ended December 31, 2018 and 2017, respectively. The loss of a substantial portion of net sales to our largest customers could have a material adverse effect on us.

 

8


Table of Contents

 

Our customers cancel orders, change order quantity, timing and specifications that if not managed would have an adverse effect on inventory carrying costs.

 

We face, through the normal course of business, customer cancellations and rescheduled orders and are not always successful in recovering the costs of such cancellations or rescheduling. In addition, excess and obsolete inventory losses as a result of customer order changes, cancellations, product changes and contract termination could have an adverse effect on our operations. We estimate and reserve for any known or potential impact from these possibilities.

 

Our exposure to financially troubled customers or suppliers may adversely affect our financial results.

 

We provide manufacturing services to companies and industries that have in the past, and may in the future, experience financial difficulty. If our customers experience financial difficulty, we could have difficulty recovering amounts owed to us from these customers, or demand for our products from these customers could decline. Additionally, if our suppliers experience financial difficulty we could have difficulty sourcing supply necessary to fulfill production requirements and meet scheduled shipments. If one or more of our customers were to become insolvent or otherwise were unable to pay for the services provided by us on a timely basis, or at all, our operating results and financial condition could be adversely affected. Such adverse effects could include one or more of the following: an increase in our provision for doubtful accounts, a charge for inventory write-offs, a reduction in revenue, and an increase in our working capital requirements due to higher inventory levels and increases in days our accounts receivables are outstanding.

 

Some shareholders may be able to take actions that do not reflect the will or best interests of other shareholders.

 

Our officers and directors control a majority share of our outstanding common stock and could individually or together exert a significant degree of influence over our affairs.

 

The manufacture and sale of our products carries potential risk for product liability claims.

 

We represent and warrant the goods and services we deliver are free from defects in material and workmanship for one year from ship date. We make no other guarantees or warranties, expressed or implied, of any nature whatsoever as to the goods including without limitation, warranties to merchantability, fit for a particular purpose, non-infringement of patent or the like unless agreed upon in writing. If a product liability claim results in our being liable and the amount is in excess of our insurance coverage or there is no insurance coverage for the claim then it could have an adverse effect on our business and financial position.

 

Complying with securities laws, tax laws, accounting policies and regulations, and subsequent changes, may be costly for us and adversely affect our financial statements.

 

New or changing laws, regulations, policy and standards relating to corporate governance and public disclosure, including SEC and Nasdaq regulations, tax legislation and the implementation of significant changes in the United States Generally Accepted Accounting Principles (“GAAP”), present challenges due to complexities, assumptions and judgements required to implement. We apply judgments based on our understanding, interpretation and analysis of the relevant facts, circumstances, historical experience and valuations, as appropriate. As a result, actual amounts could differ from those estimated at the time the financial statements are issued. In addition, implementation may change the financial accounting or reporting standards that govern the preparation of our financial statements or authoritative entities could reverse their previous interpretations or positions on how various financial accounting or reporting standards should be applied. These changes may be difficult to predict and implement and could materially or otherwise impact how we prepare and report our estimates, uncertainties, financial statements, operating results and financial condition. Our efforts to comply with evolving laws, regulations, accounting policies and standards have resulted in, and are likely to continue to result in, increased general and administrative expenses and management time and attention from revenue-generating activities to compliance activities and may have an adverse affect on our financial statements, including cash flows.

 

9


Table of Contents

 

Anti-Corruption and Trade Laws - We may incur costs and suffer damages if our employees, agents, or suppliers violate anti-bribery, anti-corruption or trade laws and regulations.

 

Laws and regulations related to bribery, corruption and trade, and enforcement thereof, are increasing in frequency, complexity and severity on a global basis. The continued geographic expansion of our business into China increases our exposure to, and cost of complying with, these laws and regulations. If our internal controls and compliance program do not adequately prevent or deter our employees, agents, suppliers and other third parties with whom we do business from violating anti-corruption laws, we may incur defense costs, fines, penalties, reputational damage and business disruptions.

 

Changes in currency translation rates could adversely impact our revenue and earnings.

 

Changes in exchange rates will impact our reported sales and earnings. A majority of our manufacturing and cost structure is based in the United States. In addition, decreased value of local currency may adversely affect demand for our products and may adversely affect the profitability of our products in U.S. dollars in foreign markets where payments are made in the local currency.

 

Non-compliance with environmental laws may result in restrictions and could adversely affect operations.

 

Our operations are regulated under a number of federal, state, and foreign environmental and safety laws and regulations that govern the discharge of hazardous materials into the air and water, as well as the handling, storage, and disposal of such materials. These laws and regulations include the Clean Air Act; the Clean Water Act; the Resource Conservation and Recovery Act; and the Comprehensive Environmental Response, Compensation, and Liability Act; as well as analogous state and foreign laws. Compliance with these environmental laws is a major consideration for us due to our manufacturing processes and materials. It is possible we may be subject to potential financial liability for costs associated with the investigation and remediation at our sites; this may have an adverse effect on operations. We have not incurred significant costs related to compliance with environmental laws and regulations and we believe that our operations comply with all applicable environmental laws.

 

Environmental laws could also become more stringent over time, imposing greater compliance costs and increasing risks and penalties associated with violation. We operate in environmentally sensitive locations and are subject to potentially conflicting and changing regulatory agendas of political, business, and environmental groups. Changes or restrictions on discharge limits; emissions levels; or material storage, handling, or disposal might require a high level of unplanned capital investment or relocation. It is possible that environmental compliance costs and penalties from new or existing regulations may harm our business, financial condition, and results of operations.

 

10


Table of Contents

 

We may be subject to risks associated with our prior acquisitions, and the risks could adversely affect our operating results.

 

The success of our prior acquisitions depend on our ability to integrate the new operations with the existing operations. The Company cannot ensure that the expected benefits of any acquisition will be realized. Additionally, unforeseen issues could arise which adversely affect the anticipated returns or which are otherwise not recoverable as an adjustment to the purchase price. Other acquisition risks include delays in realizing benefits from the acquired companies or products; difficulties due to lack of or limited prior experience in any new product or geographic markets we enter; unforeseen losses of customers of, or suppliers to, acquired businesses; difficulties in retaining key employees of the acquired businesses; or challenges arising from increased geographic diversity and complexity of our operations and our information technology systems. The price we pay for a business may exceed the value we realize and we cannot assure you that we will achieve the expected synergies and benefits of any prior acquisition. Acquisitions have resulted in the recognition of goodwill and other intangible assets which are subject to potential impairments in the future that could harm our financial results.

 

If we fail to comply with the covenants contained in our credit agreement we may be unable to secure additional financing and repayment obligations on our outstanding indebtedness may be accelerated.

 

Our credit agreement contains financial and operating covenants with which we must comply. As of December 31, 2018, we were in compliance with these covenants. However, our continued compliance with these covenants is dependent on our financial results, which are subject to fluctuation as described elsewhere in these risk factors. If we fail to comply with the covenants in the future or if our lender does not agree to waive any future non-compliance, we may be unable to borrow funds and any outstanding indebtedness could become immediately due and payable, which could materially harm our business.

 

We are dependent on our information technology systems for order, inventory and production management, financial reporting, communications and other functions. If our information systems fail or experience major interruptions due to physical damage or loss of power on our business and our financial results could be adversely affected.

 

We rely on our information technology systems to effectively manage our operational and financial functions. Our computer systems, Internet web sites, telecommunications, and data networks are vulnerable to damage or interruption from power loss, natural disasters and other sources of physical damage or disruption to the equipment which maintains, stores and hosts our information technology systems. We have taken steps to protect and create redundancies for the equipment that facilitates the use of our management information systems, but these steps may not be adequate to ensure that our operations are not disrupted by events within and outside of our control.

 

If our information technology systems fail or experience major interruptions, or the information technology systems of third parties that we rely upon fail or experience major interruptions, due to cyber-attacks or other activities designed to disrupt global information systems, our business and our financial results could be adversely affected.

 

We rely on information technology systems to effectively manage our operational and financial functions and our day-to-day functions. We increasingly rely on information technology systems to process, transmit, and store electronic information. In addition, a significant portion of internal communications, as well as communication with customers and suppliers, depends on information technology. We are exposed to the risk of cyber incidents in the normal course of business. Cyber incidents

 

11


Table of Contents

 

may be deliberate attacks for the theft of intellectual property or other sensitive information or may be the result of unintentional events. Like most companies, our information technology systems may be vulnerable to interruption due to a variety of events beyond our control, including, but not limited to, terrorist attacks, telecommunications failures, computer viruses, hackers, foreign governments, and other security issues. We have technology security initiatives and data recovery plans in place to mitigate our risk to these vulnerabilities, but these measures may not be adequate, or implemented properly, or executed timely to ensure that our operations are not disrupted. Potential consequences of a material cyber incident include damage to our reputation, litigation, and increased cyber security protection and remediation costs. Such consequences could adversely affect our results of operations.

 

We may experience difficulties implementing our new global enterprise resource planning system.

 

We are engaged in an implementation of a new global enterprise resource planning system (ERP). The ERP is designed to efficiently maintain our books and records and provide information important to the operation of our business to our management team. The ERP implementation has and will continue to require significant investment of human and financial resources. In implementing the ERP, we may experience significant delays, increased costs and other difficulties. Any significant disruption or deficiency in the design and implementation of the ERP could adversely affect our ability to process orders, ship product, send invoices and track payments, fulfill contractual obligations or otherwise operate our business. While we have invested significant resources in planning, project management and training, additional and significant implementation issues may arise. In addition, our efforts to adjust and centralize various business processes and functions within our organization in connection with our ERP implementation may disrupt our operations and negatively impact our business, results of operations and financial condition.

 

Our business may be impacted by natural disasters or future climate change.

 

Natural disasters, such as tornadoes and earthquakes, and possible future changes in climate could negatively impact our business and supply chain. Our properties may be exposed to rare catastrophic weather events, such as severe storms and/or floods. If the frequency of extreme weather events increases due to climate change, our exposure to these events could increase. In countries that we rely on for operations and materials, such as Mexico and China, potential natural disasters or future climate changes could disrupt our manufacturing operations, reduce demand for our customers’ products and increase supply chain costs.

 

Item 1B.   Unresolved Staff Comments

 

As a smaller reporting company, we are not required to provide the information required by this Item.

 

Item 2.   Properties

 

Administration

 

Our corporate headquarters consists of an approximately 19,000 square feet building located in Maple Grove, Minnesota, a northwestern suburb of Minneapolis, Minnesota, and its lease expires January 2025.

 

Manufacturing facilities

 

Our manufacturing facilities are in good operating condition and we believe our overall production capacity is sufficient to handle our foreseeable manufacturing needs and customer requirements. The following are our manufacturing facilities as of December 31, 2018:

 

12


Table of Contents

 

 

 

 

 

 

 

Manufacturing

 

 

 

 

 

 

 

 

 

 

 

Space

 

Office Space

 

Total

 

Location

 

Own/Lease

 

Lease End Date

 

Square Feet

 

Square Feet

 

Square Feet

 

Bemidji, MN

 

Own

 

 

 

56,000

 

13,000

 

69,000

 

Blue Earth, MN

 

Own

 

 

 

92,000

 

48,000

 

140,000

 

Merrifield, MN

 

Own

 

 

 

34,000

 

12,000

 

46,000

 

Milaca, MN

 

Lease

 

June 30, 2020

 

15,000

 

5,000

 

20,000

 

Mankato, MN

 

Own

 

 

 

43,000

 

15,000

 

58,000

 

Monterrey, Mexico

 

Lease

 

January 31, 2019

 

45,000

 

1,000

 

46,000

 

Monterrey, Mexico

 

Lease

 

January 24, 2029

 

76,000

 

1,000

 

77,000

 

Suzhou, China

 

Lease

 

December 31, 2021

 

27,000

 

3,000

 

30,000

 

 

On February 21, 2018, we entered into a ten-year lease agreement for a 77,000 square foot manufacturing facility in Nuevo Leon, Mexico which we took occupancy during the fourth quarter of 2018.  This facility replaced the Monterrey, Mexico facility lease which expired January 31, 2019.

 

Item 3.   Legal Proceedings

 

From time to time, we are involved in ordinary, routine or regulatory legal proceedings incidental to the business. When a loss is deemed probable and reasonably estimable an amount is recorded in our consolidated financial statements.

 

Item 4.   Mine Safety Disclosures

 

Not applicable.

 

13


Table of Contents

 

PART II

 

Item 5.   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

As of March 26, 2019, there were 656 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 2018 or 2017. 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, 2018

 

$

2.87

 

$

4.85

 

June 30, 2018

 

$

2.77

 

$

3.67

 

September 30, 2018

 

$

3.21

 

$

8.08

 

December 31, 2018

 

$

3.51

 

$

5.50

 

 

 

 

 

 

 

March 31, 2017

 

$

3.35

 

$

4.60

 

June 30, 2017

 

$

3.13

 

$

3.89

 

September 30, 2017

 

$

3.16

 

$

3.75

 

December 31, 2017

 

$

3.36

 

$

6.24

 

 

Issuer Purchase of Equity Securities

 

As of December 31, 2017, we had a $250,000 share repurchase program which was authorized by our Board of Directors in August 2017 and expired in July 2018 with no authorized repurchases remaining under this program. Under this repurchase program, we repurchased 55,199 shares totaling $194,420 during the year ended December 31, 2018. In August 2018, the Board of Directors approved an additional $250,000 share repurchase program. Under this repurchase program, we repurchased 21,002 shares totaling $81,329 during the year ended December 31, 2018.

 

The table below sets forth information regarding repurchases we made of our common stock under the $250,000 share repurchase program authorized in August 2018 during the periods indicated.

 

Period

 

Total Number
of Shares
Purchased

 

Average
Price Paid
Per Share

 

Total Number of
Shares Purchased as
Part of Publicly
Announced Plan

 

Maximum Dollar
Value of Shares that
May Yet Be
Purchased Under the
Plan

 

Balance at December 31, 2017

 

 

$

 

 

$

 

Stock repurchases

 

21,002

 

3.87

 

21,002

 

166,571

 

Balance at December 31, 2018

 

21,002

 

$

3.87

 

21,002

 

$

166,571

 

 

14


Table of Contents

 

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

 

As a smaller reporting company, we are not required to provide the information required by this Item.

 

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 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 wire and cable assemblies, printed circuit board assemblies, higher-level assemblies, medical devices 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, 2018, we have the following facilities in Minnesota; Bemidji, Blue Earth, Eden Prairie, Mankato, Merrifield, Milaca and Maple Grove. We also have facilities in Monterrey, Mexico and Suzhou, China. On January 31, 2017, we closed our manufacturing operations in Augusta, Wisconsin (see Note 9, of “Notes to Consolidated Financial Statements”).

 

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

 

Our significant accounting policies and estimates are summarized in “Notes to Consolidated Financial Statements”. Some of the 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 historical experience, known trends in the industry, terms of existing contracts and other information from outside sources, as appropriate. Actual results may differ from these estimates under different assumptions and conditions.

 

Certain of the most critical estimates that require significant judgment are as follows:

 

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

 

15


Table of Contents

 

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.

 

Effective January 1, 2018, we adopted the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers (Topic 606)” (“ASU 2014-09”), which supersedes the revenue recognition requirements in ASC 605, “Revenue Recognition.” ASU 2014-09 is based on the principle that revenue is recognized to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. It also requires additional disclosure about the nature, amount, timing, and uncertainty of revenue, cash flows arising from customer contracts, including significant judgments and changes in judgments, and assets recognized from costs incurred to obtain or fulfill a contract. The Company adopted the provisions of ASU 2014-09 using the modified retrospective approach with application to contracts that were not completed as of January 1, 2018. The adoption of ASU 2014-09 had a significant impact to the Company’s results of operations, cash flows and financial position, and as a result we now recognize the majority of our revenue over time rather than upon shipment resulting in an adjustment to retained earnings of $1,381,000 on January 1, 2018. The Company has presented the disclosures required by this new standard, refer to Note 3.

 

Goodwill and Other Intangible Assets

 

In accordance with ASC 350, Goodwill and Other Intangible Assets, goodwill is not amortized but is required to be reviewed for impairment at least annually or when events or circumstances indicate that carrying value may exceed fair value. We test impairment annually as of October 1st. In testing goodwill for impairment we perform a quantitative impairment test, including computing the fair value of the reporting unit and comparing that value to its carrying value. If the fair value is less than its carrying value, then the goodwill is determined to be impaired. In the event that goodwill is impaired, an impairment charge to earnings would become necessary. Based upon our annual goodwill impairment test we concluded that goodwill was impaired due to a significant reduction of results from operations during the fourth quarter of 2017. As described in Note 1 to the consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K, in 2017 we adopted Accounting Standards Update No, 2017-04, Simplifying the Test for Goodwill Impairment, and performed a single step in performing our impairment analysis, which is to determine the estimated fair value of our reporting unit and compare it to the carrying value of the reporting unit, including goodwill. To the extent the carrying amount of goodwill exceeds the implied goodwill, the difference is the amount of the goodwill impairment. Our annual impairment test as of October 1, 2017, resulted in $0.9 million of impairment charges related to our goodwill. The impairment charge was based on a combined approach using both the income approach which is based on discounted cash flows and the market approach which is based on the guideline public company method. Discounted cash flow models include assumptions related to our product revenue, gross margins, operating margins and other assumptions. There was no impairment of goodwill recorded in 2018.

 

We recognize the assets acquired and liabilities assumed in business combinations on the basis of their fair values at the date of acquisition. We assess the fair value of assets, including intangible assets, using a variety of methods and each asset is measured at fair value from the perspective of a market participant. The method used to estimate the fair values of intangible assets incorporates significant assumptions regarding the estimates a market participant would make in order to evaluate an asset, including a market

 

16


Table of Contents

 

participant’s use of the asset and the appropriate discount rates for a market participant. Any excess purchase price over the fair value of the net tangible and intangible assets acquired is allocated to goodwill.

 

On July 1, 2015, we completed the acquisition of substantially all of the assets of Devicix, LLC upon the terms and conditions contained in an Asset Purchase Agreement entered into on June 17, 2015. The Devicix acquisition resulted in $3.2 million of goodwill, which is deductible for tax purposes.  We recorded an impairment charge of $908,000 on the goodwill related to the Devicix, LLC purchase as of December 31, 2017.

 

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. We determined there was a triggering event during the fourth quarter of 2017 and determined the undiscounted cash flows exceeded the carrying amounts of long-lived assets.  We did not have a triggering event in 2018.

 

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. We believe the reserve is adequate for any exposure to loss in the December 31, 2018 accounts receivable. At December 31, 2018, our allowance for doubtful accounts was $0.2 million.

 

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. We believe the total reserve at December 31, 2018 of $1.1 million is adequate.

 

17


Table of Contents

 

Operating Results

 

The following table presents our statements of operations data as percentages of total net sales for the years indicated:

 

 

 

2018

 

2017

 

Net Sales

 

100.0

%

100.0

%

Cost of Goods Sold

 

88.3

 

89.2

 

Gross Profit

 

11.7

 

10.8

 

 

 

 

 

 

 

Selling Expenses

 

3.2

 

4.2

 

General and Administrative Expenses

 

7.4

 

7.2

 

Impairment of Goodwill

 

0.0

 

0.8

 

Gain on Sale of Property and Equipment

 

0.0

 

(0.3

)

Income (Loss) from Operations

 

1.1

 

(1.1

)

 

 

 

 

 

 

Other Expense

 

(0.7

)

(0.7

)

Income (Loss) Before Income Taxes

 

0.4

 

(1.8

)

 

 

 

 

 

 

Income Tax Expense

 

0.3

 

0.4

 

Net Income (Loss)

 

0.1

%

(2.2

)%

 

Net Sales

 

Our net sales in 2018 were $113.4 million, compared to $112.3 million in 2017, an increase of 0.9%. Our 2018 amounts include $4.8 million of additional sales related to the change in the revenue recognition policy. Net sales results were varied by markets. The medical market decreased by $1.8 million or 3.5% with medical component products accounting for 30% of the decrease and medical devices the remaining 70%. The industrial market increased by $0.2 million or 0.4% in 2018 as compared to 2017. Net sales from the aerospace and defense markets increased by $2.7 million or 17.2% in 2018 as compared to 2017.

 

Net sales by our major EMS industry markets for the years ended December 31, 2018 and 2017 were as follows:

 

 

 

 

 

 

 

%

 

(in millions)

 

2018

 

2017

 

Change

 

Aerospace and Defense

 

$

18.3

 

$

15.7

 

16.6

 

Medical

 

45.1

 

51.4

 

(12.3

)

Industrial

 

50.0

 

45.2

 

10.6

 

Total Net Sales

 

$

113.4

 

$

112.3

 

1.0

 

 

18


Table of Contents

 

Net sales by our major EMS industry markets for the year ended December 31, 2018, to the pro-forma amounts for the same period had the previous guidance been in effect (in millions):

 

 

 

As Reported
2018

 

Pro forma as
if
the previous
accounting
guidance was
in effect

 

% Change

 

Aerospace and Defense

 

$

18.3

 

$

17.6

 

2.8

 

Medical

 

45.1

 

47.5

 

-5.1

 

Industrial

 

50.0

 

43.4

 

15.2

 

Total Net Sales

 

$

113.4

 

$

108.5

 

4.5

 

 

Net sales by timing of transfer of goods and services for year ended December 31, 2018 is as follows (in millions):

 

 

 

Product/ Service
Transferred Over
Time

 

Product
Transferred
at
Point in Time

 

Noncash
Consideration

 

Total Net Sales
by Market

 

Aerospace and Defense

 

$

17.3

 

$

0.2

 

$

0.8

 

$

18.3

 

Medical

 

39.0

 

4.2

 

1.9

 

45.1

 

Industrial

 

47.0

 

0.8

 

2.2

 

50.0

 

Total net sales

 

$

103.3

 

$

5.2

 

$

4.9

 

$

113.4

 

 

Backlog

 

Our 90-day backlog at December 31, 2018 was $27.4 million, compared to $19.4 million at the end of 2017. Our medical customers 90-day backlog increased 126.7% compared to the prior year end. The medical increase was augmented by an increase in backlog to our defense customers of 20.6%, and partially offset by a decrease in backlog for our industrial customers of 13.2%.

 

90-day backlog by our major EMS industry markets are as follows:

 

 

 

Backlog as of the Year Ended

 

 

 

 

 

December 31,

 

%

 

(in millions)

 

2018

 

2017

 

Change

 

Aerospace and Defense

 

$

6.0

 

$

5.0

 

20.6

 

Medical

 

14.3

 

6.3

 

126.7

 

Industrial

 

7.1

 

8.2

 

(13.2

)

Total Backlog

 

$

27.4

 

$

19.4

 

40.8

 

 

Our 90-day backlog varies due to order size, manufacturing delays, inventory programs, contract terms and conditions and changes in timing of customer delivery schedules and releases. These variables cause inconsistencies in comparing the backlog from one period to the next.

 

Gross Profit

 

Our gross profit as a percentage of net sales was 11.7% and 10.8% for the years ended December 31, 2018 and 2017, respectively. The increase in gross profit for the year was driven by customer and product

 

19


Table of Contents

 

mix, operational efficiencies and cost improvements as we adjusted to current revenue levels. We recognized revenue of $4.9 million related to the noncash consideration recorded at zero margin as a result of implementing revenue recognition, partially offsetting this increase.

 

Selling

 

Selling expenses were $3.6 million, or 3.2% of net sales, for the year ended December 31, 2018 and $4.7 million, or 4.2% of net sales, for the year ended December 31, 2017. The decrease in selling expenses for 2018 is due to reductions in volume dependent expenses.

 

General and Administrative

 

General and administrative expenses were $8.4 million, or 7.4% of net sales, for the year ended December 31, 2018 and $8.1 million, or 7.2% of net sales, for the year ended 2017. The year over year comparison is consistent due to our adjustment of spending based on customer demands.

 

Gain from Sale of Property and Equipment

 

Net gain from sale of property and equipment for the year ended December 31, 2017 was $0.4 million from the sale of the Augusta building and building improvements (see Note 9, of “Notes to Consolidated Financial Statements”). There was no gain from sale of property and equipment recorded in 2018.

 

Income (Loss) from Operations

 

Our income from operations for the 2018 fiscal year was $1.2 million, an increase of $2.5 million over our loss from operations for the 2017 fiscal year of $1.3 million, resulting from our improvement in gross profit as a percent of sales and the impairment charge taken in 2017.

 

Loss on Extinguishment of Debt

 

Loss on the extinguishment of debt for the year ended December 31, 2017 was $0.2 million, primarily related to legal and terminations fees (see Note 4, of “Notes to Consolidated Financial Statements”).  There was no loss on extinguishment of debt recorded in 2018.

 

20


Table of Contents

 

Interest Expense

 

Interest expense for the year ended December 31, 2018 was $0.8 million, compared with $0.6 million for the year ended December 31, 2017 due largely to higher interest rates.

 

Income Taxes

 

Income tax expense for the year ended December 31, 2018 was $0.3 million. Income tax expense for the year ended December 31, 2017 was $0.4 million. The effective tax rate for fiscal 2018 and 2017 was 66.3% and (18.1%), respectively. Our 2018 tax rate was driven by the tax on global intangible low-taxed income provisions that was enacted in 2018 and onward. Our 2017 tax rate was impacted by federal tax reform, which saw a significant change in valuation allowance. The Company was in a loss position and could not avail itself of a domestic production activities deduction credit.

 

The statutory reconciliation for the years ended December 31, 2018 and 2017 is as follows:

 

(in thousands)

 

2018

 

2017

 

Statutory federal tax provision (benefit)

 

$

107

 

$

(704

)

State income tax benefit

 

(36

)

(117

)

Effect of foreign operations

 

52

 

(88

)

Uncertain tax positions

 

(19

)

 

Income tax credits

 

 

(112

)

Valuation allowance

 

(199

)

1,011

 

Permanent differences

 

15

 

8

 

Global Intangile Low-Taxed Income Effect

 

296

 

 

Return to Provision - Credits and NOL

 

176

 

 

Deferred adjustments

 

(62

)

 

Loss of Section 199 due to carryback claim

 

 

46

 

Effects of tax reform

 

 

280

 

Other

 

(4

)

51

 

Income tax expense

 

$

326

 

$

375

 

 

Net Income (Loss)

 

Our net income in 2018 was $0.2 million or $0.06 per diluted common share. Net loss in 2017 was $2.4 million or $0.89 per diluted common share.

 

Liquidity and Capital Resources

 

We believe that our existing financing arrangements and anticipated cash flows from operations will be sufficient to satisfy our working capital needs, capital expenditures and debt repayments for at least the next 12 months.

 

Credit Facility

 

We have a credit agreement with Bank of America which was entered into on June 15, 2017 (as amended effective December 29, 2017, the “Bank of America Credit Agreement”), and provides for a line of credit arrangement of $16 million that expires on June 15, 2022. The credit arrangement also has a $5 million real estate term note outstanding with a maturity date of June 15, 2022. The Bank of America Credit Agreement replaced our previous credit agreement with Wells Fargo Bank (the “Wells Fargo Credit Agreement”),

 

21


Table of Contents

 

which terminated on June 20, 2017, resulting in a loss on the extinguishment of debt of $175,000 primarily related to legal and terminations fees.

 

Under the Bank of America Credit Agreement, both the line of credit and real estate term notes are subject to variations in the LIBOR rate. Our Bank of America Credit Agreement bears interest at the combined weighted-average interest rate of 4.80% as of December 31, 2018, compared with 3.74% as of December 31, 2017. We had borrowings on our Bank of America Credit Agreement of $ $9.3 million outstanding, compared with $8.5 million outstanding as of December 31, 2017. There are no acceleration clauses under the Bank of America Credit Agreement that would accelerate the maturity of our outstanding line of credit borrowings.

 

The line of credit and real estate term notes with Bank of America 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.

 

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 each period of four fiscal quarters, commencing with the period of four fiscal quarters ending December 31, 2018. In addition, the Bank of America Credit Agreement requires that we comply with certain minimum levels of cumulative EBITDA for measurement periods during fiscal 2018, including cumulative EBITDA of $1,970,000 for the twelve months ended December 31, 2018.

 

The availability under the line is subject to borrowing base requirements, and advances are at the discretion of the lender. At December 31, 2017, we had unused availability under our line of credit of $4.2 million, supported by our borrowing base. The line is secured by substantially all of our assets.

 

The Wells Fargo Bank Credit Agreement, which terminated on June 20, 2017, provided for a line of credit arrangement of $15.0 million, of which $7.3 million was outstanding at December 31, 2016. This credit arrangement also had a $3.5 million of real estate term notes with a maturity in 2027, an equipment loan for $2.7 million and a term loan facility of up to $1.0 million for capital expenditures. As of December 31, 2016, there was $0.7 million outstanding against the $1.0 million capital term note.

 

As part of the July 1, 2015, Devicix acquisition, we entered into two unsecured subordinated promissory notes payable to the seller in the principal amounts of $1.0 million and $1.3 million. The $1.0 million promissory note has a four-year term, bearing interest at 4.0% per annum, requiring monthly principal and interest payments of $22,579 and is subject to offsets if certain revenue levels are not met. The $1.3 million promissory note has a four-year term and bears interest at 4.0% per annum, requiring monthly principal and interest payments of $29,353 and is not subject to offset.

 

22


Table of Contents

 

Cash flows for the years ended December 31, 2018 and 2017 are summarized as follows:

 

(in thousands)

 

2018

 

2017

 

Cash flows provided by (used in):

 

 

 

 

 

Operating activities

 

$

2,444

 

$

806

 

Investing activities

 

(1,390

)

(258

)

Financing activities

 

(889

)

(38

)

Effect of exchange rate changes on cash

 

3

 

1

 

Net change in cash

 

$

168

 

$

511

 

 

Cash provided by operating activities for the year ended December 31, 2018 was $2.4 million, comprised primarily of net earnings and the noncash add back of depreciation and amortization. Cash provided by operating activities for the year ended December 31, 2017 was $0.8 million comprised of the noncash add back of depreciation, amortization and impairment of goodwill, offset by changes in account receivable, contingent liability and gain on disposal of August facility (see Note 9, of “Notes to Consolidated Financial Statements”). The year-over-year increase in cash provided by operating activities is due to the improvement in net earnings partially offset by net decrease in working capital.

 

Net cash used in investing activities was $1.4 million and $0.3 million for the years ended December 31, 2018 and 2017, respectively. Cash used in investing activities in 2018 was primarily reinvestments in the business to purchase property and equipment. Cash used in investing activities in 2017, was primarily due to purchases of property and equipment offset by net proceeds from the sale of the August facility (see Note 9, of “Notes to Consolidated Financial Statements”).

 

Net cash used in financing activities in 2018 of $0.9 million consisted of payments on long-term debt and capital leases. Net cash used in financing activities in 2017 of less than $0.1 million consisted of borrowings on the line of credit of $1.2 million and proceeds from long-term debt of $5.1 million offset by payments of long-term debt of $5.9 million, debt issuance costs of $0.3 million, loss on extinguishment of debt of $0.2 million and share repurchases of $30,340.

 

Cash conversion cycle:

 

 

 

Years Ended ended December 31,

 

 

 

2018

 

2017

 

Days in trade accounts receivable

 

65

 

60

 

Days in inventory

 

62

 

78

 

Days in accounts payable

 

(66

)

(52

)

Cash conversion cycle

 

61

 

86

 

 

We calculate days in accounts receivable as accounts receivable for the respective year-to-date period divided by annual sales for the respective year-to-date period by day. We calculate days in inventory and accounts payable as each balance sheet line item for the respective year-to-date period divided by annual cost of goods sold for the respective year-to-date period by day. We calculate cash conversion cycle as the sum of days in receivable and inventory less days in accounts payable. The decrease in our cash conversion cycle in 2018 is due largely to the impact of the adoption of ASU 2014-09 and timing of payments.

 

23


Table of Contents

 

Off-Balance Sheet Arrangements

 

We do not have any off-balance sheet arrangements, other than our outstanding operating leases for production and office equipment, office space, and buildings with contractual obligations totaling $7.4 million (see Note 8 of “Notes to Consolidated Financial Statements”).

 

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;

 

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.

 

24


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

TABLE OF CONTENTS

FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

 

Item 8. Financial Statements and Supplementary Data

 

 

PAGE

 

 

Report of Independent Registered Public Accounting Firm

26

 

 

Consolidated Financial Statements:

 

 

 

Consolidated Statements of Operations and Comprehensive Income (Loss) for the years ended December 31, 2018 and 2017

27

 

 

Consolidated Balance Sheets as of December 31, 2018 and 2017

28

 

 

Consolidated Statements of Cash Flows for the years ended December 31, 2018 and 2017

29

 

 

Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2018 and 2017

30

 

 

Notes to Consolidated Financial Statements

31-51

 

(The remainder of this page was intentionally left blank.)

 

25


Table of Contents

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the shareholders and the board of directors of Nortech Systems Incorporated:

 

Opinion on the Consolidated Financial Statements

 

We have audited the accompanying consolidated balance sheets of Nortech Systems Incorporated and subsidiaries (the “Company”) as of December 31, 2018 and 2017, the related consolidated statements of operations and comprehensive income (loss), shareholders’ equity and cash flows, for the year then ended, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of their operations and their cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

 

Basis for Opinion

 

These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

 

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.

 

Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.

 

/s/ Baker Tilly Virchow Krause, LLP

 

We have served as the Company’s auditor since 2017.

 

Minneapolis, Minnesota

 

April 1, 2019

 

26


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS AND

COMPREHENSIVE INCOME (LOSS)

FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE DATA)

 

 

 

2018

 

2017

 

 

 

 

 

 

 

Net Sales

 

$

113,370

 

$

112,335

 

 

 

 

 

 

 

Cost of Goods Sold

 

100,059

 

100,217

 

 

 

 

 

 

 

Gross Profit

 

13,311

 

12,118

 

 

 

 

 

 

 

Operating Expenses:

 

 

 

 

 

Selling Expenses

 

3,629

 

4,747

 

General and Administrative Expenses

 

8,433

 

8,086

 

Impairment of Goodwill

 

 

908

 

Gain on Sale of Property and Equipment

 

 

(355

)

Total Operating Expenses

 

12,062

 

13,386

 

 

 

 

 

 

 

Income (Loss) From Operations

 

1,249

 

(1,268

)

 

 

 

 

 

 

Other Expense

 

 

 

 

 

Loss on Extinguishment of Debt

 

 

(175

)

Interest Expense

 

(757

)

(628

)

 

 

 

 

 

 

Income (Loss) Before Income Taxes

 

492

 

(2,071

)

 

 

 

 

 

 

Income Tax Expense

 

326

 

375

 

 

 

 

 

 

 

Net Income (Loss)

 

$

166

 

$

(2,446

)

 

 

 

 

 

 

Earnings (Loss) Per Common Share:

 

 

 

 

 

Basic

 

$

0.06

 

$

(0.89

)

Weighted Average Number of Common Shares Outstanding - Basic

 

2,692,382

 

2,745,602

 

 

 

 

 

 

 

Diluted

 

$

0.06

 

$

(0.89

)

Weighted Average Number of Common Shares Outstanding - Dilutive

 

2,699,614

 

2,745,602

 

 

 

 

 

 

 

Other comprehensive income (loss)

 

 

 

 

 

Foreign currency translation

 

(132

)

(57

)

Comprehensive income (loss), net of tax

 

$

34

 

$

(2,503

)

 

See accompanying notes to consolidated financial statements

 

27


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE DATA)

 

 

 

2018

 

2017

 

ASSETS

 

 

 

 

 

Current Assets

 

 

 

 

 

Cash

 

$

480

 

$

473

 

Restricted Cash

 

467

 

306

 

Accounts Receivable, less allowances of $222 and $209

 

20,093

 

17,417

 

Inventories

 

17,004

 

18,527

 

Contract Assets

 

6,431

 

 

Prepaid Assets and Other Current Assets

 

1,381

 

1,044

 

Total Current Assets

 

45,856

 

37,767

 

 

 

 

 

 

 

Property and Equipment, Net

 

10,178

 

10,176

 

Goodwill

 

2,375

 

2,375

 

Other Intangible Assets, Net

 

1,523

 

1,739

 

Other Non Current Assets

 

28

 

28

 

Total Assets

 

$

59,960

 

$

52,085

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

 

Current Liabilities

 

 

 

 

 

Current Maturities of Long-Term Debt

 

$

780

 

$

1,003

 

Current Portion of Capital Lease Obligation

 

337

 

295

 

Accounts Payable

 

18,142

 

11,699

 

Accrued Payroll and Commissions

 

2,747

 

2,900

 

Other Accrued Liabilities

 

2,886

 

2,148

 

Total Current Liabilities

 

24,892

 

18,045

 

 

 

 

 

 

 

Long-Term Liabilities

 

 

 

 

 

Long-term Line of Credit

 

9,264

 

8,503

 

Long-Term Debt, Net of Current Maturities

 

3,624

 

4,353

 

Long-Term Capital Lease Obligation, Net of Current Portion

 

951

 

1,222

 

Other Long-Term Liabilities

 

139

 

137

 

Total Long-Term Liabilities

 

13,978

 

14,215

 

Total Liabilities

 

38,870

 

32,260

 

 

 

 

 

 

 

Commitments and Contingencies

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ Equity

 

 

 

 

 

Preferred Stock, $1 par value; 1,000,000 Shares Authorized; 250,000 Shares Issued and Outstanding

 

250

 

250

 

Common Stock - $0.01 par value; 9,000,000 Shares Authorized; 2,663,049 and 2,739,250 Shares Issued and Outstanding, respectively

 

27

 

27

 

Additional Paid-In Capital

 

15,610

 

15,760

 

Accumulated Other Comprehensive Loss

 

(233

)

(101

)

Retained Earnings

 

5,436

 

3,889

 

Total Shareholders’ Equity

 

21,090

 

19,825

 

Total Liabilities and Shareholders’ Equity

 

$

59,960

 

$

52,085

 

 

See accompanying notes to consolidated financial statements

 

28


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS)

 

 

 

2018

 

2017

 

CASH FLOWS FROM OPERATING ACTIVITIES

 

 

 

 

 

Net Income (Loss)

 

$

166

 

$

(2,446

)

Adjustments to Reconcile Net Income (Loss) to Net Cash

 

 

 

 

 

Provided by Operating Activities:

 

 

 

 

 

Depreciation

 

1,877

 

2,186

 

Amortization

 

312

 

315

 

Compensation on Stock-Based Awards

 

126

 

43

 

Loss on Extinguishment of Debt

 

 

17

 

Compensation on Equity Appreciation Rights

 

 

(22

)

Deferred Taxes

 

1

 

439

 

Change in Contingent Consideration

 

 

(486

)

Change in Accounts Receivable Allowance

 

13

 

(674

)

Change in Inventory Reserves

 

268

 

171

 

Impairment of Goodwill

 

 

908

 

Gain on Disposal of Property and Equipment

 

 

(355

)

Changes in Current Operating Items

 

 

 

 

 

Accounts Receivable

 

(2,746

)

578

 

Inventories and Contract Assets

 

(3,875

)

1,956

 

Prepaid Expenses

 

(302

)

233

 

Income Taxes Receivable

 

(37

)

(31

)

Income Taxes Payable

 

(39

)

39

 

Accounts Payable

 

6,028

 

(2,115

)

Accrued Payroll and Commissions

 

(154

)

(411

)

Other Accrued Liabilities

 

806

 

461

 

Net Cash Provided by Operating Activities

 

2,444

 

806

 

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES

 

 

 

 

 

Proceeds from Sale of Property and Equipment

 

14

 

669

 

Purchase of Intangible Asset

 

(4

)

(114

)

Purchases of Property and Equipment

 

(1,400

)

(813

)

Net Cash Used in Investing Activities

 

(1,390

)

(258

)

 

 

 

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES

 

 

 

 

 

Net Change in Line of Credit

 

761

 

1,187

 

Proceeds from Long-Term Debt

 

 

5,123

 

Principal Payments on Long-Term Debt

 

(1,044

)

(5,893

)

Payments on Capital Lease Obligation

 

(330

)

 

Loss on Extinguishment of Debt

 

 

(158

)

Debt Issuance Costs

 

 

(267

)

Share Repurchases

 

(276

)

(30

)

Net Cash used in Financing Activities

 

(889

)

(38

)

 

 

 

 

 

 

Effect of Exchange Rate Changes on Cash

 

3

 

1

 

 

 

 

 

 

 

Net Change in Cash

 

168

 

511

 

Cash - Beginning of Year

 

779

 

268

 

Cash - End of Year

 

$

947

 

$

779

 

 

 

 

 

 

 

Reconciliation of cash and restricted cash reported within the consolidated balance sheets

 

 

 

 

 

Cash

 

$

480

 

$

473

 

Restricted Cash

 

467

 

306

 

Total Cash and restricted cash reported in the consolidated statements of cash flows

 

$

947

 

$

779

 

 

 

 

 

 

 

Supplemental Disclosure of Cash Flow Information:

 

 

 

 

 

Cash Paid for Interest

 

$

719

 

$

538

 

Cash Paid for Income Taxes

 

335

 

20

 

 

 

 

 

 

 

Supplemental Noncash Investing and Financing Activities:

 

 

 

 

 

Property and Equipment Purchases in Accounts Payable

 

445

 

29

 

Equipment Acquired under Capital Lease

 

100

 

1,517

 

 

See accompanying notes to consolidated financial statements

 

29


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS)

 

 

 

Preferred

 

Common

 

Additional
Paid-In

 

Accumulated
Other
Comprehensive

 

Retained Income

 

Total
Shareholders’

 

BALANCE DECEMBER 31, 2016

 

$

250

 

$

27

 

$

15,747

 

$

(44

)

$

6,335

 

22,315

 

Net Loss

 

 

 

 

 

(2,446

)

(2,446

)

Foreign Currency Translation Adjustment

 

 

 

 

(57

)

 

(57

)

Compensation on Stock-based awards

 

 

 

43

 

 

 

43

 

Issuance of common stock

 

 

 

 

 

 

 

Share repurchases

 

 

 

(30

)

 

 

(30

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE DECEMBER 31, 2017

 

250

 

27

 

15,760

 

(101

)

3,889

 

19,825

 

Net Income

 

 

 

 

 

166

 

166

 

Cumulative Adjustment

 

 

 

 

 

1,381

 

1,381

 

Foreign currency translation adjustment

 

 

 

 

(132

)

 

(132

)

Compensation on stock-based awards

 

 

 

126

 

 

 

126

 

Issuance of common stock

 

 

 

 

 

 

 

Share repurchases

 

 

 

(276

)

 

 

(276

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE DECEMBER 31, 2018

 

$

250

 

$

27

 

$

15,610

 

$

(233

)

$

5,436

 

$

21,090

 

 

See accompanying notes to consolidated financial statements

 

30


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation

 

The accompanying consolidated financial statements have been prepared in accordance with Generally Accepted Accounting Principles in the United States of America (“GAAP”) for financial information and pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).

 

Nature of Business

 

Our manufacturing services include complete medical devices, printed circuit board assemblies, wire and cable assemblies, and complex higher level electromechanical assemblies for a wide range of medical, industrial and defense and aerospace industries. We provide a full “turn-key” contract manufacturing service to our customers. All products are built to the customer’s design specifications. We also provide engineering services and repair services.

 

Our manufacturing facilities are located in Bemidji, Blue Earth, Merrifield, Milaca and Mankato, Minnesota as well as, Monterrey, Mexico and Suzhou, China. Products are sold to customers both domestically and internationally.

 

Principles of Consolidation

 

The consolidated financial statements include the accounts of Nortech Systems Incorporated and its wholly-owned subsidiaries, Manufacturing Assembly Solutions of Monterrey, Inc. and Nortech Systems Hong Kong Company, Limited and its subsidiary, Nortech Systems Suzhou Company, Limited. All significant intercompany accounts and transactions have been eliminated in consolidation.

 

Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of our consolidated financial statements. Estimates also affect the reported amounts of revenue and expense during the reporting period. Significant items subject to estimates and assumptions include the valuation allowance for inventories, allowance for doubtful accounts, accrued warranties, realizability of deferred tax assets, goodwill impairment and long-lived asset impairment testing. Actual results could differ from those estimates.

 

Restricted Cash

 

Cash and cash equivalents classified as restricted cash on our consolidated balance sheets are restricted as to withdrawal or use under the terms of certain contractual agreements. The December 31, 2018 balance included cash collateral required to be held against our corporate employee purchasing card program and lockbox deposits that are temporarily restricted due to timing at the period end. The lockbox deposits are applied against our line of credit the next business day. As of December 31, 2018, we had no outstanding letters of credit. Restricted cash as of December 31, 2018 and December 31, 2017 was $467 and $306, respectively.

 

Accounts Receivable and Allowance for Doubtful Accounts

 

We grant credit to customers in the normal course of business. Accounts receivable are unsecured and are presented net of an allowance for doubtful accounts. The allowance for doubtful accounts was $222 and

 

31


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

$209 at December 31, 2018 and 2017, respectively. We determine our allowance by considering a number of factors, including the length of time accounts receivable are past due, our previous loss history, the customers’ current ability to pay their obligations to us, and the condition of the general economy and the industry as a whole. We write-off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts.

 

Inventories

 

Inventories are stated at the lower of cost (first-in, first-out method) or market (based on the lower of replacement cost or net realizable value). Costs include material, labor, and overhead required in the production of our products. Inventory reserves are maintained for inventories that may have a lower value than stated or quantities in excess of future production needs.

 

Inventories are as follows:

 

(in thousands)

 

2018

 

2017

 

Raw materials

 

$

16,769

 

$

13,870

 

Work in process

 

1,015

 

3,112

 

Finished goods

 

332

 

2,389

 

Reserves

 

(1,112

)

(844

)

Total

 

$

17,004

 

$

18,527

 

 

Property and Equipment

 

Property and equipment are stated at cost less accumulated depreciation. Additions, improvements and major renewals are capitalized, while maintenance and minor repairs are expensed as incurred. When assets are retired or disposed of, the assets and related accumulated depreciation are removed from the accounts and the resulting gain or loss is reflected in operations. Leasehold improvements are depreciated over the shorter of their estimated useful lives or their remaining lease terms. All other property and equipment are depreciated by the straight-line method over their estimated useful lives, as follows:

 

Buildings

 

39 Years

 

Leasehold improvements

 

3-15 Years

 

Manufacturing equipment

 

3-7 Years

 

Office and other equipment

 

3-7 Years

 

 

Property and equipment at December 31, 2018 and 2017:

 

(in thousands)

 

2018

 

2017

 

Land

 

$

360

 

$

360

 

Building and Leasehold Improvements

 

9,184

 

8,827

 

Manufacturing Equipment

 

21,260

 

21,267

 

Office and Other Equipment

 

7,074

 

6,035

 

Accumulated Depreciation

 

(27,700

)

(26,313

)

Total Property and Equipment, net

 

$

10,178

 

$

10,176

 

 

32


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

Other Intangible Assets

 

Finite life intangible assets at December 31, 2018 and 2017 are as follows:

 

 

 

December 31, 2018

 

 

 

 

 

Gross

 

Accumulated

 

Net Book

 

 

 

 

 

Carrying

 

Amortization

 

Value

 

(in thousands)

 

Years

 

Amount

 

Amount

 

Amount

 

Customer Relationships

 

9

 

1,302

 

506

 

796

 

Intellectual Property

 

3

 

100

 

61

 

39

 

Trade Names

 

20

 

814

 

143

 

671

 

Other

 

7

 

17

 

 

17

 

Totals

 

 

 

$

2,233

 

$

710

 

$

1,523

 

 

 

 

December 31, 2017

 

 

 

 

 

Gross

 

Accumulated

 

Net Book

 

 

 

 

 

Carrying

 

Amortization

 

Value

 

 

 

Years

 

Amount

 

Amount

 

Amount

 

Customer Relationships

 

9

 

1,302

 

361

 

941

 

Intellectual Property

 

3

 

100

 

28

 

72

 

Trade Names

 

20

 

814

 

102

 

712

 

Other

 

7

 

14

 

 

14

 

Totals

 

 

 

$

2,230

 

$

491

 

$

1,739

 

 

Amortization of finite life intangible assets was $219 and $237 for the years ended December 31, 2018 and 2017, respectively.

 

Estimated future annual amortization expense (except projects in process) related to these assets is approximately as follows:

 

Year

 

Amount

 

2019

 

$

219

 

2020

 

191

 

2021

 

185

 

2022

 

185

 

2023

 

185

 

Thereafter

 

541

 

 

 

$

1,506

 

 

Goodwill and Other Intangible Assets

 

In accordance with ASC 350, Goodwill and Other Intangible Assets, goodwill is not amortized but is required to be reviewed for impairment at least annually or when events or circumstances indicate that carrying value may exceed fair value. We test impairment annually as of October 1st. In testing goodwill for impairment we perform a quantitative impairment test, including computing the fair value of the reporting unit and comparing that value to its carrying value. If the fair value is less than its carrying value, then the goodwill is determined to be impaired. In the event that goodwill is impaired, an impairment charge

 

33


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

to earnings would become necessary. Based upon our annual goodwill impairment test we concluded that goodwill was impaired due to a significant reduction of results from operations during the fourth quarter of 2017. We adopted Accounting Standards Update No, 2017-04, Simplifying the Test for Goodwill Impairment, and performed a single step in performing our impairment analysis, which is to determine the estimated fair value of our reporting unit and compare it to the carrying value of the reporting unit, including goodwill. To the extent the carrying amount of goodwill exceeds the implied goodwill, the difference is the amount of the goodwill impairment. Our annual impairment test as of October 1, 2017, resulted in $908 of impairment charges related to our goodwill. The impairment charge was based on a combined approach using both the income approach which is based on discounted cash flows and the market approach which is based on the guideline public company method. Discounted cash flow models include assumptions related to our product revenue, gross margins, operating margins and other assumptions. There was no impairment of goodwill recorded in 2018.

 

We recognize the assets acquired and liabilities assumed in business combinations on the basis of their fair values at the date of acquisition. We assess the fair value of assets, including intangible assets, using a variety of methods and each asset is measured at fair value from the perspective of a market participant. The method used to estimate the fair values of intangible assets incorporates significant assumptions regarding the estimates a market participant would make in order to evaluate an asset, including a market participant’s use of the asset and the appropriate discount rates for a market participant. Any excess purchase price over the fair value of the net tangible and intangible assets acquired is allocated to goodwill.

 

On July 1, 2015, we completed the acquisition of substantially all of the assets of Devicix, LLC upon the terms and conditions contained in an Asset Purchase Agreement entered into on June 17, 2015. The Devicix acquisition resulted in $3,200 of goodwill, which is deductible for tax purposes. We recorded an impairment charge of $908 on the goodwill related to the Devicix, LLC purchase as of December 31, 2017. There was no impairment of goodwill recorded in 2018.

 

Long-Lived Asset Impairment

 

We evaluate long-lived assets, primarily property and equipment, as well as the related depreciation periods, 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 or asset group. 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. Assets held for sale are reported at the lower of the carrying amount or fair value less costs to dispose. We determined there was a triggering event during the fourth quarter of 2017 and determined the undiscounted cash flows exceeded the carrying amounts of long-lived assets.  We determined there were no triggering events in 2018.

 

Preferred Stock

 

Preferred stock issued is non-cumulative and nonconvertible. The holders of the preferred stock are entitled to a non-cumulative dividend of 12% when and if declared. In liquidation, holders of preferred stock have preference to the extent of $1.00 per share plus dividends accrued but unpaid. No preferred stock dividends were declared or paid during the years ended December 31, 2018 and 2017.

 

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

 

34


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

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 Consolidated Statements of Operations and Comprehensive Income (Loss). 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.

 

Effective January 1, 2018, we adopted the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers (Topic 606)” (“ASU 2014-09”), which supersedes the revenue recognition requirements in ASC 605, “Revenue Recognition.” ASU 2014-09 is based on the principle that revenue is recognized to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. It also requires additional disclosure about the nature, amount, timing, and uncertainty of revenue, cash flows arising from customer contracts, including significant judgments and changes in judgments, and assets recognized from costs incurred to obtain or fulfill a contract. The Company adopted the provisions of ASU 2014-09 using the modified retrospective approach with application to contracts that were not completed as of January 1, 2018. The adoption of ASU 2014-09 had a significant impact to the Company’s results of operations, cash flow and financial position, and as a result we now recognize the majority of our revenue over time rather than upon shipment resulting in an adjustment to retained earnings of $1,381 on January 1, 2018. The Company has presented the disclosures required by this new standard, refer to Note 3.

 

Product Warranties

 

We provide limited warranty for the replacement or repair of defective product within a specified time period after the sale at no cost to our customers. We make no other guarantees or warranties, expressed or implied, of any nature whatsoever as to the goods including, without limitation, warranties to merchantability, fit for a particular purpose or non-infringement of patent or the like unless agreed upon in writing. We estimate the costs that may be incurred under our limited warranty and provide a reserve based on actual historical warranty claims coupled with an analysis of unfulfilled claims at the balance sheet date. Our warranty claim costs are not material given the nature of our products and services.

 

Advertising

 

Advertising costs are charged to operations as incurred. The total amount charged to expense was $132 and $68 for the years ended December 31, 2018 and 2017, respectively.

 

Income Taxes

 

We account for income taxes under the asset and liability method. Deferred income tax assets and liabilities are recognized annually for differences between the financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. The company recognizes interest and penalties accrued on any unrecognized tax benefits as a component on income tax expense.

 

We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the

 

35


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

position. The tax benefits recognized in the consolidated financial statements from such positions are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate resolution. Management must also assess whether uncertain tax positions as filed could result in the recognition of a liability for possible interest and penalties if any. Our estimates are based on the information available to us at the time we prepare the income tax provisions. Our income tax returns are subject to audit by federal, state, and local governments, generally three years after the returns are filed. These returns could be subject to material adjustments or differing interpretations of the tax laws.

 

Incentive Compensation

 

We use a Black-Scholes option-pricing model to determine the grant date fair value of our incentive awards and recognize the expense on a straight-line basis over the vesting period less awards expected to be forfeited using estimated forfeiture rates. See Note 7 for additional information.

 

Net Income (Loss) Per Common Share

 

Basic net income (loss) per common share is computed by dividing net income (loss) by the weighted-average number of common shares outstanding. Dilutive net income (loss) per common share assumes the exercise and issuance of all potential common stock equivalents in computing the weighted-average number of common shares outstanding, unless their effect is antidilutive.

 

A reconciliation of basic and diluted share amounts for the years ended December 31, 2018 and 2017 is as follows:

 

 

 

2018

 

2017

 

Basic weighted average common shares outstanding

 

2,692,382

 

2,745,602

 

Weighted average common stock equivalents from assumed exercise of stock options

 

7,232

 

 

Diluted weighted average common shares outstanding

 

2,699,614

 

2,745,602

 

 

Fair Value of Financial Instruments

 

The carrying amounts of all financial instruments approximate their fair values. The carrying amounts for cash and cash equivalents, accounts receivable, accounts payable, and accrued liabilities approximate fair value because of the short maturity of these instruments. Based on the borrowing rates currently available to us for bank loans with similar terms and average maturities, the carrying value of our long-term debt and line of credit approximates its fair value.

 

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Valuation techniques used to measure fair value maximize the use of observable inputs and minimize the use of unobservable inputs.

 

36


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

The fair value framework requires the categorization of assets and liabilities into one of three levels based on the assumptions (inputs) used in valuing the asset or liability. Level 1 provides the most reliable measure of fair value, while Level 3 generally requires significant management judgment. The three levels are defined as follows:

 

Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities.

 

Level 2: Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

 

Level 3: Unobservable inputs for the asset or liability, reflecting the reporting entity’s own assumptions about the assumptions that market participants would use in pricing

 

Our assessment of the significance of a particular input to the fair value measurements requires judgment, and may affect the valuation of the assets and liabilities being measured and their placement within the fair value hierarchy. We endeavor to use the best available information in measuring fair value. Assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

 

Acquisition-Related Contingent Consideration

 

The Company acquired Devicix on July 1, 2015. The aggregate consideration paid to Devicix shareholders includes up to $2,500 of contingent consideration to be paid based on the achievement of certain performance-based milestones. The fair value of the contingent consideration was measured using an expected present value approach to estimate an expected value. This fair value measurement is based on significant inputs not observable in the market and thus represents a Level 3 measurement within the fair value hierarchy. The fair value of this Level 3 measured liability was $34 and $70 at December 31, 2018 and 2017, respectively.

 

Goodwill

 

The changes in the carrying amount of goodwill for the years presented are as follows:

 

Carrying amount at December 31, 2016

 

$

3,283

 

Impairment of goodwill

 

(908

)

Carrying amount at December 31, 2017

 

2,375

 

Impairment of goodwill

 

 

Carrying amount at December 31,2018

 

$

2,375

 

 

In determining the nonrecurring fair value measurements of impairment of goodwill we utilized a blend of the market value and discounted cash flow approach.  We determined there was no impairment of goodwill during the year ended December 31, 2018. During the year ended December 31, 2017, we determined fair values for the identified assets and recorded an impairment charge of goodwill, set forth in the table below:

 

37


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

 

 

Fair value as
of
mesurement
date

 

Quoted prices
in active
markets for
identical assets
(Level 1)

 

Significant
other
observable
inputs
(Level 2)

 

Significant
unobservable
inputs
(Level 3)

 

Impairment
Charge

 

December 31, 2017

 

 

 

 

 

 

 

 

 

 

 

Goodwill

 

$

2,375

 

 

 

$

2,375

 

$

908

 

 

Enterprise-Wide Disclosures

 

Our results of operations for the years ended December 31, 2018 and 2017 represent a single operating and reporting segment referred to as Contract Manufacturing within the EMS industry. We strategically direct production between our various manufacturing facilities based on a number of considerations to best meet our customers’ requirements. We share resources for sales, marketing, engineering, supply chain, information services, human resources, payroll and all corporate accounting functions. Consolidated financial information is available that is evaluated regularly by the chief operating decision maker in assessing performance and allocating resources.

 

Export sales from our domestic operations represent approximately 4.8% and 4.5% of consolidated net sales for the years ended December 31, 2018 and 2017, respectively.

 

Net sales by our major EMS industry markets for the years ended December 31, 2018 and 2017 are as follows:

 

(in thousands)

 

2018

 

2017

 

Aerospace and Defense

 

$

18,314

 

$

15,683

 

Medical

 

45,082

 

51,449

 

Industrial

 

49,974

 

45,203

 

Total Net Sales

 

$

113,370

 

$

112,335

 

 

Noncurrent assets, excluding deferred taxes, by country are as follows:

 

(in thousands)

 

United States

 

Mexico

 

China

 

Total

 

December 31, 2018

 

 

 

 

 

 

 

 

 

Property and equipment, net

 

$

8,687

 

$

821

 

$

670

 

$

10,178

 

Other assets

 

3,898

 

8

 

 

3,906

 

 

 

 

 

 

 

 

 

 

 

December 31, 2017

 

 

 

 

 

 

 

 

 

Property and equipment, net

 

$

8,713

 

$

1,003

 

$

460

 

$

10,176

 

Other assets

 

4,114

 

8

 

 

4,122

 

 

Foreign Currency Transactions

 

The functional currency for our Mexico subsidiary is the US dollar. Foreign exchange transaction gains and losses attributable to exchange rate movements related to transactions made in the local currency and on

 

38


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

intercompany receivables and payables not deemed to be of a long-term investment nature are recorded in other income (expense). The functional currency for our China subsidiary is the Renminbi (“RMB”). Assets and liabilities of the China operation are translated from RMB into U.S. dollars at period-end rates, while income and expense are translated at the weighted-average exchange rates for the period. The related translation adjustments are reflected as a foreign currency translation adjustment in accumulated other comprehensive income (loss) within shareholders’ equity. The total foreign currency translation adjustment decreased shareholders’ equity by $132, from an accumulated foreign currency translation loss of $101 as of December 31, 2017 to an accumulated foreign currency translation loss of $233 as of December 31, 2018.

 

Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the consolidated statements of income. Net foreign currency transaction losses included in the determination of net earnings was $170 and $192 for the years ended December 31, 2018 and 2017, respectively.

 

Recently Issued and Adopted Accounting Pronouncements

 

In February 2016, the FASB issued ASU No. 2016-02, “Leases” (Topic 842), which supersedes the existing guidance for lease accounting, “Leases” (Topic 840). ASU No. 2016-02 requires lessees to recognize a lease liability and a right-of-use asset for all leases that extend beyond one year. The amendments in this ASU will be effective for us for interim and annual periods beginning after December 15, 2018. The original guidance required application on a modified retrospective basis with the earliest period presented in the financial statements. In August 2018, the FASB issued ASU 2018-11, “Targeted Improvements” to ASC 842, which includes an option to not restate comparative periods in transition and instead to elect to use the effective date of ASC 842, “Leases”, as the date of initial application of transition. Based on the effective date, this guidance will apply and the Company will adopt this ASU beginning on January 1, 2019, and the Company plans to elect the transition option provided under ASU 2018-11. We have completed the qualitative analysis from the lessee perspective. As part of our process, we elected to utilize certain practical expedients that were provided for transition relief. Accordingly, we are not reassessing expired or existing contracts, lease classifications or related initial direct costs as part of our assessment process. Additionally, we elected the practical expedient to treat lease and non-lease components of fixed payments due to the lessor as one, and therefore no separate allocation is required on the initial implementation date of January 1, 2019, and thereafter. We anticipate the adoption of this standard will result in an increase in our right of use assets and lease liabilities in the range of $5,500 to $6,500 recorded on our consolidated balance sheets on January 1, 2019; however, these estimates are subject to change as the Company finalizes its implementation. In 2019, the Company will also implement additional internal controls to comply with the requirements of the standard. The Company does not believe the adoption of this guidance will have a material impact on its consolidated results of operations or cash flows.

 

In March 2018, we adopted FASB ASU 2018-05, Income Taxes (Topic 740): Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118, which updates the income tax accounting in U.S. GAAP to reflect the Securities and Exchange Commission (“SEC”) interpretive guidance released on December 22, 2017, when the Tax Cuts and Jobs Act (the “Tax Act”) was signed into law. Additional information regarding the adoption of this standard is contained in Note 5, ‘Income Taxes’.

 

39


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

NOTE 2. CONCENTRATION OF CREDIT RISK AND MAJOR CUSTOMERS

 

Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash and accounts receivable. With regard to cash, we maintain our excess cash balances in checking accounts at two high-credit quality financial institutions. These accounts may at times exceed federally insured limits. We grant credit to customers in the normal course of business and do not require collateral on our accounts receivable.

 

Our largest customer has two divisions that together accounted for 10% or more of our net sales during the year ended December 31, 2018 and 2017. One division accounted for approximately 20.8% and 23.5% of net sales for the years ended December 31, 2018 and 2017, respectively. The second division accounted for approximately 2.4% and 1.4% of net sales for the years ended December 31, 2018 and 2017, respectively. Together they accounted for approximately for 23.2% and 24.9% of net sales for the years ended December 31, 2018 and 2017, respectively. Accounts receivable from the customer at December 31, 2018 and 2017 represented 16.3% and 16.4% of our total accounts receivable, respectively.

 

NOTE 3. REVENUE

 

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, as the promise to transfer products or services is not separately identifiable from other promises in the contract and, therefore, not distinct.

 

Revenue is measured as the amount of consideration we expect to receive in exchange for transferring products or providing services. As such, revenue is recorded net of returns, allowances and customer discounts. 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 are included in cost of goods sold.

 

The majority of our revenue is derived from the transfer of goods produced under contract manufacturing agreements which have no alternative use and we have an enforceable right to payment for our performance completed to date. Our performance obligations within our contract manufacturing agreements are generally satisfied over time as the goods are produced based on customer specifications and we have an enforceable right to payment for the goods produced.  If these requirements are not met, the revenue is recognized at a point in time, generally upon shipment. Revenue under contract manufacturing agreements that was recognized over time accounted for approximately 91% of our revenue for the twelve months ended December 31, 2018. Revenues under these agreements are generally recognized over time using an input measure based upon the proportion of actual costs incurred.

 

Accounting for contract manufacturing agreements involves the use of various techniques to estimate total revenue and costs. We estimate profit on these agreements as the difference between total estimated revenue and expected costs to complete the performance obligation within the terms of the agreement and recognize the respective profit as the goods are produced. The estimates to determine the profit earned on

 

40


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

the performance obligation are based on anticipated selling prices and historical cost of goods sold and represent our best judgement at the time. Changes in judgements on these above estimates could impact the timing and amount of revenue recognized with a resulting impact on the timing and amount of associated profit.

 

On occasion our customers provide materials to be used in the manufacturing process and the fair value of the materials is included in revenue as noncash consideration at the point in time when the manufacturing process commences along with the same corresponding amount recorded as cost of goods sold. The inclusion of noncash consideration has no impact on overall profitability.

 

Contract Assets

 

Contract assets, recorded as such in the consolidated balance sheet, consist of unbilled amounts related to revenue recognized over time. Significant changes in the contract assets balance during the year ended December 31, 2018 was as follows:

 

Year Ended December 31, 2018

 

 

 

Outstanding at January 1, 2018

 

$

6,459

 

Increase (decrease) attributed to:

 

 

 

Transferred to receivables from contract assets recognized

 

(5,932

)

Product transferred over time

 

5,904

 

Outstanding at December 31, 2018

 

$

6,431

 

 

We expect substantially all of the remaining performance obligations for the contract assets recorded as of December 31, 2018, to be transferred to receivables within 90 days, with any remaining amounts to be transferred within 180 days. We bill our customers upon shipment with payment terms of up to 120 days.

 

The following tables summarize our net sales by market for the year ended December 31, 2018:

 

 

 

Year Ending December 31, 2018

 

(in thousands)

 

Product/ Service
Transferred Over
Time

 

Product
Transferred at
Point in Time

 

Noncash
Consideration

 

Total Net Sales
by Market

 

Aerospace and Defense

 

$

17,263

 

$

232

 

$

819

 

$

18,314

 

Medical

 

39,071

 

4,157

 

1,854

 

45,082

 

Industrial

 

46,950

 

821

 

2,203

 

49,974

 

Total net sales

 

$

103,284

 

$

5,210

 

$

4,876

 

$

113,370

 

 

41


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

Impact of New Revenue Guidance on Financial Statement Line Items

 

The following table compares the reported consolidated statement of operations and comprehensive loss, balance sheet and cash flows, as of and for the year ended December 31, 2018, to the pro-forma amounts had the previous guidance been in effect:

 

 

 

Year Ending December 31, 2018

 

Consolidated Statement of Operations

 

As Reported

 

Pro forma as if the
previous accounting
guidance was in
effect

 

 

 

 

 

 

 

Net Sales

 

$

113,370

 

$

108,522

 

Cost of Goods Sold

 

100,059

 

95,249

 

Gross Profit

 

13,311

 

13,273

 

 

 

 

 

 

 

Income from Operations

 

1,249

 

1,211

 

 

 

 

 

 

 

Income Before Income Taxes

 

492

 

454

 

 

 

 

 

 

 

Income Tax Expense

 

326

 

326

 

 

 

 

 

 

 

Net Income

 

$

166

 

$

128

 

 

 

 

 

 

 

Net Income Per Common Share - Diluted

 

$

0.06

 

$

0.05

 

 

 

 

As of December 31, 2018

 

Consolidated Balance Sheet

 

As Reported

 

Pro forma as if the
previous accounting
guidance was in
effect

 

 

 

 

 

 

 

Assets

 

 

 

 

 

Inventories

 

$

17,004

 

$

22,015

 

Contract Assets

 

$

6,431

 

$

 

 

 

 

 

 

 

Shareholders’ Equity

 

 

 

 

 

Retained Earnings

 

$

21,090

 

$

19,671

 

 

 

 

Year Ending December 31, 2018

 

Consolidated Statement of Cash Flows

 

As Reported

 

Pro forma as if the
previous accounting
guidance was in
effect

 

 

 

 

 

 

 

Net Income

 

$

166

 

$

128

 

Adjustments to Reconcile Net Loss to Net Cash Provided by Operating Activities

 

 

 

 

 

Change in Current Operating Items

 

 

 

 

 

Inventories

 

(3,875

)

(3,809

)

Contract Asset

 

28

 

 

 

 

 

 

 

 

Net Cash Provided by Operating Activities

 

$

2,444

 

$

2,444

 

 

42


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

NOTE 4. FINANCING ARRANGEMENTS

 

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 $16,000 that expires on June 15, 2022. The credit arrangement also has a $5,000 real estate term note outstanding with a maturity date of June 15, 2022. The Bank of America credit agreement replaces our previous credit agreement with Wells Fargo Bank which terminated on June 20, 2017 and resulted in a loss on the extinguishment of debt of $175 primarily related to legal and terminations fees.

 

Under the Bank of America credit agreement, both the line of credit and real estate term notes are subject to variations in the LIBOR rate. Our line of credit bears interest at a weighted-average interest rate of 4.8% as of December 31, 2018. We had borrowings on our line of credit of $9,264 and $8,503 outstanding as of December 31, 2018 and December 31, 2017, respectively. There are no subjective acceleration clauses under the credit agreement that would accelerate the maturity of our outstanding borrowings.

 

The line of credit and real estate term notes with Bank of America 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.

 

The Bank of America credit agreement as amended provides for, among other things, a fixed charge coverage ratio of not less than (i) 1.0 to 1.0 for each period of four fiscal quarters, commencing with the period of four fiscal quarters ending December 31, 2018. In addition, the agreement requires that the Company comply with certain minimum levels of cumulative EBITDA for measurement periods during fiscal 2018, including cumulative EBITDA of $1,970 for the twelve months ending December 31, 2018.

 

The availability under the line is subject to borrowing base requirements, and advances are at the discretion of the lender. At December 31, 2018 and 2017, we had unused availability under our line of credit of $6,137 and $4,231, respectively, supported by our borrowing base. The line is secured by substantially all of our assets.

 

As part of the July 1, 2015 Devicix acquisition we entered into two unsecured subordinated promissory notes payable to the seller in the principal amounts of $1,000 and $1,300. The $1,000 promissory note has a four-year term, bearing interest at 4% per annum, requiring monthly principal and interest payments of $23 and is subject to offsets if certain revenue levels are not met. The $1,300 promissory note has a four-year term and bears interest at 4% per annum, requiring monthly principal and interest payments of $29 and is not subject to offset.

 

43


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

Long-term debt balances at December 31, 2018 and 2017 consisted of the following (in thousands):

 

 

 

December 31,

 

December 31,

 

(in thousands)

 

2018

 

2017

 

Term note payable - Bank of America

 

 

 

 

 

 

 

 

 

 

 

 

 

Real estate term note bearing interest at one-month LIBOR + 2.25% (4.8% and 4.5% as of December 31, 2018 and 2017, respectively) maturing June 15, 2022 with monthly payments of approximately $41,000 plus interest secured by substantially all assets.

 

$

4,253

 

$

4,751

 

 

 

 

 

 

 

Devicix Acquistion Note 1 payable to DeLange Holdings bears interest rate of 4.0% per annum, maturing July 1, 2019.

 

156

 

394

 

 

 

 

 

 

 

Devicix Acquistion Note 2 payable to DeLange Holdings bears interest rate of 4.0% per annum, maturing July 1, 2019.

 

203

 

512

 

 

 

4,612

 

5,657

 

Discount on Devicix Notes Payable

 

(23

)

(63

)

Debt issuance Costs

 

(185

)

(238

)

Total long-term debt

 

4,404

 

5,356

 

Current maturities of long-term debt

 

(780

)

(1,003

)

Long-term debt - net of current maturities

 

$

3,624

 

$

4,353

 

 

Future maturity requirements for long-term debt outstanding as of December 31, 2018, are as follows:

 

Years Ending December 31,

 

Amount

 

2019

 

$

857

 

2020

 

498

 

2021

 

498

 

2022

 

2,759

 

 

 

$

4,612

 

 

During the third quarter of fiscal year 2017, the Company entered into a five-year lease of equipment used in the normal course of business with a principal borrowing amount of $1,096. The lease qualified as a capital lease and is accounted for accordingly, based on an effective interest rate of 4.97%. As of December 31, 2017, the property held under the capital lease was $1,103.

 

The Company entered into a second lease in September 2017, with a four year, six-month term used in the normal course of business with a principal borrowing amount of $502. The lease qualified as a capital lease and is accounted for accordingly, based on an effective interest rate of 6.22%. As of December 31, 2017, the property held under the capital lease was $421.  As of December 31, 2018, the Company had no depreciation expense related to the leased assets as it was not in operational use and related implementation costs were not complete.

 

44


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

The Company has lease financing facilities for property and equipment. The obligations are collateralized by the property underlying lease. Total cost of the leased equipment was $1,624 at December 31, 2018 and $1,524 at December 31, 2017.

 

Current maturities of capital leases were $337 at December 31, 2018 and $295 at December 31, 2017.

 

Interest expense related to the leased assets was $91 and $9 for the years ended December 31, 2018 and 2017, respectively. Depreciation expense related to the leased assets was $201 and $0 for the years ended December 31, 2018 and 2017, respectively.

 

Approximate future minimum lease payments under non-cancelable capital leases subsequent to December 31, 2018 are as follows:

 

Years Ending

 

 

 

December 31,

 

Amount

 

2019

 

$

398

 

2020

 

398

 

2021

 

398

 

2022

 

211

 

2023

 

2

 

Total noncancelable future lease commitments

 

$

1,407

 

Less: interest

 

(119

)

Present value of obligations under capital leases

 

$

1,288

 

 

NOTE 5. INCOME TAXES

 

On December 22, 2017, the Tax Cuts and Jobs Act (“U.S. Tax Reform”) was enacted. The legislation significantly changed U.S. tax law by lowering the federal corporate tax rate from 34.0% to 21.0%, effective January 1, 2018, modifying the foreign earnings deferral provisions, and imposing a one-time toll charge on deemed repatriated earnings of foreign subsidiaries as of December 31, 2017. Effective for 2018 and forward, there is a tax on global intangible low-taxed income provisions (“GILTI”). As of December 31, 2017, two provisions that affected the consolidated financial statements were the corporate tax rate reduction and the one-time toll charge. As the corporate tax rate reduction was enacted in 2017 and effective January 1, 2018, we appropriately accounted for the tax rate change in the valuation of our deferred taxes. As a result of GILTI, we recorded a tax expense of $296 in 2018.

 

Global Intangible Low Taxed Income (GILTI): The Tax Act creates a new requirement that certain income (i.e. GILTI) earned by controlled foreign corporations (CFCs) must be included currently in the gross income of the CFCs’ U.S. Shareholder. GILTI is the excess of the shareholder’s “net CFC tested income” over the net deemed tangible income return, which is currently defined as the excess of 1) 10 percent of the aggregate of the U.S. shareholder’s pro rata share of the qualified business asset investment of each CFC with respect to which it is a U.S. shareholder over 2) the amount of certain interest expense taken into

 

45


Table of Contents

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2018 AND 2017

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

 

account in the determination of net CFC-tested income. Under U.S. GAAP, we are allowed to make an accounting policy choice of either 1) treating taxes due on future U.S. inclusions in taxable income related to GILTI as a current-period expense when incurred (the “period cost method”) or 2) factoring such amounts into a company’s measurement of its deferred taxes (the “deferred method”). We have selected the period cost method. As a result, we have not provided deferred taxes related to the temporary differences that upon reversal will affect the amount of income subject to GILTI in the period.

 

The SEC issued Staff Accounting Bulletin No. 118 (“SAB 118”), which provides us with up to one year to finalize accounting for the impacts of U.S. Tax Reform. In 2017, we estimated the provisional tax impacts related to the toll charge, deferred income taxes, including the impacts of the change in corporate tax rate, and out indefinite reinvestment assertion. As of the fourth quarter of 2018, we have completed our accounting for the tax effects of U.S. Tax Reform and determined we would not be subject to the one-time transition tax. The total impact was calculated to be $223.

 

The income tax expense for the years ended December 31, 2018 and 2017 consists of the following:

 

(in thousands)

 

2018

 

2017

 

 

 

 

 

 

 

Current taxes - Federal

 

$

(38

)

$

(124

)

Current taxes - State

 

10

 

10

 

Current taxes - Foreign

 

334

 

49

 

Deferred taxes - Federal

 

 

176

 

Deferred taxes - State