Nortech Systems Inc Q4 FY2022 Earnings Call

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

Good morning and thanks, operator, and Happy St. Patrick’s Day to everybody. I want to welcome everyone to our conference call today. First, Jay will begin with a review of our industry, our value proposition for customers, and operational performance. Then I will review Nortech’s Q4 and full year financial results, and then turn it back over to Jay for his closing comments. After that, we will open up the call for your questions. Before we continue though, please note that statements made during this call and the Q&A session may be forward-looking regarding expected revenue, earnings, future plans, opportunities, and other company expectations. These estimates, plans, and other forward-looking statements involve unknown and known risks and uncertainties that may cause actual results to differ materially from those expressed or implied on this call. These risks, including those that are detailed in our most recent Form 10-K, may be amended or supplemented. The statements made during this conference call are based upon information known by Nortech as of the date and time of this call, and we assume no obligation to update the information in today’s call. You can find Nortech’s complete Safe Harbor statements in our SEC filings. And with that, I will turn it over to Jay for his opening comments.

Thank you, Chris, and happy St. Patrick’s Day everyone. We are excited to discuss our 2022 results and we will do so shortly. But today, I want to take a little bit of time to reflect on a simple question: What is Nortech’s value proposition? Though what we do here at Nortech is complex, the answer to this question is relatively simple. We engineer and manufacture complex, low-volume, high-mix electromechanical systems, assemblies, and components for medical, industrial, and defense customers, and we do so globally, with plants in Minnesota, Monterrey, Mexico and Suzhou, China. Notably, we do not compete in the high volume, low mix space, which is dominated by larger companies like Benchmark and Plexus, admirable companies in their own right, whose factories churn off thousands of identical products every day running multiple shifts. In contrast to those huge firms, Nortech will set up production lines that might run for a week or two, or maybe a month. We constantly take down lines and set up different lines. It’s a fundamentally different business. While we leverage some very sophisticated capital equipment in the production and testing, we primarily rely on our experienced, high-skilled workforce to produce these very complex technical solutions. A $2 million to $5 million order is significant for us. Larger contract manufacturers won’t take that business; it’s perfect for Nortech. Our largest customer accounts for roughly 25% of our revenue, but after that, our next largest customer is about 7%. We can effectively serve customers of any size that fit our global low volume, high mix, mission-critical business model. While Wall Street analysts may group all large and small EMS firms together, we do things that those larger firms cannot or will not do, and candidly, they do things that we will not do. Occasionally, customers learn this fundamental difference in business philosophy the hard way. We are currently negotiating with a medical customer that had first awarded their business to a large EMS firm. It was a relatively small contract for the large EMS firm and the customer was neglected. Consequently, quality and communication both suffered. The complicated, complex manufacturing process and supply chain was a poor fit for that large company’s high-volume, low-mix model. Frustrated, that customer then pulled its manufacturing back in-house, but quickly recognized and managed all the suppliers they have taken on, the cash implications of managing a lot of new inventory and the complexity of their manufacturing process. That customer is now talking to us, and this situation fits Nortech perfectly. This simple story reflects what happens somewhat frequently. The Nortech team is very proud of what we do daily for our customers and we feel we do it very well. It starts with taking great care of each other as Nortech employees and taking great care of our families. It’s also very important to us that we take very good care of our supplier partners by communicating with them openly and honestly and paying them on time 100% of the time. It also means that we strive to be good corporate citizens locally, nationally, and globally. We know that if we take great care of all these critical stakeholders—employees and our families, customers, supplier partners, and our communities—we will also take great care of our shareholders. If there is a secret to our strong results in 2022, this is it. Now to explain our financials in more depth, I will turn it over to Chris.

Thanks, Jay. So I will begin with the top line. In Q4 2022, revenue totaled $35.6 million. This represents a 6.4% increase from revenue of $32.5 million in the fourth quarter of 2021 and it’s slightly up from the prior quarter, with increases year-over-year coming from both higher volume and previous pricing actions. For the full year 2022, revenue totaled $134 million, a nearly 17% increase from revenue of $115 million in the full year of 2021. Nortech’s revenue performance was driven by growth in net sales across all the markets that we serve. The medical market was up by about $13 million or 20% compared to 2021, with the majority of the increase coming from medical component products. In 2022, revenue from the industrial market was up $3 million or 9% from the prior year. Last, our aerospace and defense markets were also up from prior year levels by 17.5% or $3 million. So as I mentioned earlier, the overall year-over-year revenue improvement across all our markets was primarily due to a combination of higher production volume and pricing adjustments. Q4 gross profit totaled $5.1 million or 14.3% compared to a gross profit of $2.7 million or 8% from the prior year quarter. The fourth-quarter margin was down on a sequential basis, but we believe that over the long run, we are in a more stable gross margin position. For the full year 2022, gross profit of $20.5 million or 15.3% gross margin was up from adjusted gross profit of $11.2 million or 9.7% in the prior year. Notable in 2021 is that GAAP gross profit included the $4.7 million employee retention credit, and so our adjusted gross profit excludes that non-recurring item. The 83% year-over-year gross profit improvement and resulting 560 basis point improvement in year-over-year gross margin relates primarily to pricing actions to overcome inflationary cost pressures. Fourth quarter operating expenses totaled $4.4 million, a 23% increase from the fourth quarter 2021 operating expenses of $3.6 million and it was flat on a sequential quarter basis. The $800,000 increase in year-over-year operating expenses was driven primarily by a $347,000 increase in selling expenses related to engineering and marketing to drive new business bookings for future quarters. Next, the majority of the $382,000 increase in year-over-year G&A costs was due to necessary investments in IT, HR, and analytical capabilities. Lastly, a $174,000 increase in year-over-year research and development cost reflects continued investment in new technologies such as the Active Optical Xtreme cable platform. For the full year 2022, income tax expense was $1.5 million compared to $900,000 in 2021. The effective tax rate in fiscal 2022 was 42%, up from 12% in 2021. So, that’s a large change in the tax rate. In 2022, the tax rate was driven by a valuation allowance from the Tax Cuts and Jobs Act requirement to capitalize and amortize research and experimental expenditures in 2022. In 2021, our tax rate was driven by the non-taxable PPP loan forgiveness. Fourth quarter EBITDA totaled $1.2 million, significantly increasing over an EBITDA loss of $400,000 in the fourth quarter of 2021. For the full year, EBITDA totaled $5.8 million, which is a $6 million improvement on an EBITDA loss of $200,000 in 2021. Both the fourth quarter and full year increases resulted primarily from previously discussed revenue and gross profit increases offset by investments in operating capabilities. Now moving on to the balance sheet and cash flow statement. In 2022, cash provided by operating activities was $5.4 million compared to cash used by operations of $4.5 million in 2021. Also notable in 2022, operating cash flow included the first of two $2.6 million payments from the IRS for the employee retention credit. The IRS is still processing Nortech’s second ERC application and we hope to receive that payment at any time, but we have no visibility to when we will receive that payment. We also have $1.2 million of deferred social security tax payments that will offset the final $2.6 million ERC payment. During the fourth quarter, net working capital improved by about $1 million as inventory levels of $22.4 million declined slightly from the prior quarter. Throughout 2022, we saw a gradual improvement in supply chain bottlenecks and component lead times. Nortech’s supply chain team is working very closely with our customers and suppliers to ensure that the entire end-to-end supply chain is optimized for on-time delivery and working capital efficiency. We ended 2022 with $6.9 million of borrowings on our $16 million line of credit with Bank of America, and we had unused borrowing availability of $8.4 million. We believe that our...

Apologies, ladies and gentlemen, we seem to have lost volume from our speakers. Please wait one moment while we try to reconnect, and please bear with us. Thank you. Ladies and gentlemen, please bear with us one moment while we fix this slight technical issue. In the meantime, I will reactivate the hold music until we have our speakers. Thank you. Thank you for your patience ladies and gentlemen. We are still trying to fix this issue. Thank you for your patience. We are still trying to fix this issue. Ladies and gentlemen, to apologize, we appear to be having an issue to reconnect to our speakers. So you can please bear with us. We will try and recheck, and see if we can get them back on the line. Thank you for your patience and please bear with us. Once again, ladies and gentlemen, thank you for your patience, we are still trying to reconnect to our speakers for today’s call. Thank you for your patience. And I will update you again, shortly. Thank you for your patience, ladies and gentlemen. We are still trying to contact our speakers. Hopefully, they will be with us shortly. And we can resume the conference. Thank you again for your patience. Hello, is that, Chris?

Yes, this is Chris.

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

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

Thanks, Chris. Again, we sincerely apologize for this. We’re trying to figure out what the root cause was exactly. But before we open the call up for questions, I want to touch on three topics: our strategic planning process, our investments in new technologies, and our ESG journey. Strategic planning is an ongoing process at Nortech rather than just a once-a-year exercise. Our management team and Board are always thinking ahead beyond the next quarter or even fiscal year. For example, our current Nortech strategic plan covers 2023 to 2028, effectively 6 years ahead. Effective strategic planning for the future requires comprehensive, reliable information. This effort is aided by our enterprise-wide ERP system that connects our entire organization and enables us to quickly adjust to demand fluctuations this past year and will do so in the future while providing other vital insights. We implemented a new ERP a few years ago and today it’s a vital tool for the whole leadership team as we run the business. Our strategic planning process also recognizes Nortech’s growth history as a company. It’s encouraging to look back 4 years, the span of my tenure as President and CEO, to see that we’re a much healthier business today. We are much more financially stable, including our balance sheet and cash flows. Our internal team is significantly stronger at headquarters here in the Twin Cities and in all of our plants around Minnesota, Mexico, and China. We have better customer relationships, more true partnerships today. Our supplier partnerships have also improved dramatically. We are also better corporate citizens. We take better care of each other as employees, including our families. In each of the locations where we operate, Nortech is working to become a better community partner and a better place to work. This helps us attract and retain employees. Today, our staffing levels are sufficient and stable. To stay on top of technologies that can help further distinguish us in the marketplace, we will continue leveraging our engineering expertise in new areas. Last year, we announced two exciting developments, launching our Active Optical Xtreme cable platform for machine vision and factory automation and receiving a U.S. patent for the Flex Faraday Xtreme flexible printed circuit for high-frequency signals. Both are future-oriented technologies with exciting potential. They are also critical stepping stones to even better innovations that will help our customers in many ways, making their products more competitive, higher-performance, lighter, more cybersecure, all while lowering overall costs. These innovations will make our products and therefore our customers’ products cleaner environmentally and more sustainable. While we work to develop future technologies for our customers, we also must help them prepare for other challenges on the horizon. These include issues of sustainability within the context of ESG: environmental, social, and governance priorities. ESG may not be front and center on everyone’s radar now, but it’s only a matter of time, and Nortech will be a proactive leader, not a follower. Note this: our R&D efforts are intimately tied to our ESG priorities. Tied directly to creating shareholder value, Nortech’s Board and management team are committed to helping our customers and suppliers achieve these critically important ESG goals. We are in the initial stages of this journey, establishing baselines and developing plans. But relatively soon, we will begin to publicly report and track Nortech’s ongoing ESG performance and progress in key areas. No business operates in a vacuum, and this effort demonstrates another way Nortech is committed to our employees, our families, customers, supplier partners, and shareholders, along with a greater world around us. With that, we will open things up for questions.

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

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

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

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

Can you provide a pinch of color on the comment of headwinds and tailwinds, more importantly on the headwinds? I know there are labor and inflationary pressures, and material pressures. But is that the driver, or is it competitive market conditions at the customer level, or the need to be extra competitive to win new business?

One significant headwind is that as the global supply chain starts to ease, looking back 12 to 18 months, it is quite a bit better now than it was before. Our customers are more comfortable with their inventory and, in some cases, have pushed orders out because they are not as concerned about the inventory, as we are performing better. This creates an interesting dynamic in the market. Of course, there are concerns as the Fed has aggressively raised interest rates about whether we will see a hard landing or a softer landing. We kind of anticipate that pendulum going back, and we have seen business pushed out, expecting it will come back and normalize our run rates. Our customers, for the most part, tend to be somewhat independent of a lot of the regular market or economic fluctuations because they are in the defense or medical space. So, we expect things to normalize out a little bit this year, and we are all planning for a harder landing while hoping for a softer landing.

Would you give us a little sense of how Q1 is tracking at year-end? And maybe relative to Q4 top line run rate and margin and the like?

We won’t comment specifically on Q1 at this point, partly because we are in the middle of it. The last month of each quarter is pretty busy. We do expect to have a solid year this year overall, and we really like our strategic plan going forward over the next 6 years.

Thank you, Paul. Appreciate it.

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

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

This is Chris, and I will go through our Safe Harbor statement again. As a reminder, statements made during this call and the Q&A session were forward-looking regarding expected revenue, earnings, future plans, and opportunities. These estimates, plans, and other forward-looking statements involve unknown and known risks and uncertainties that may cause the actual results to differ materially from those expressed or implied on this call. These risks, including those that are detailed in our most recent Form 10-K, may be amended or supplemented. The statements made during this conference call are based on information known by Nortech as of the date and time of this call, and we assume no obligation to update the information in today’s call. You can find Nortech’s complete Safe Harbor statements in our SEC filings. With that, I will end the call. Thank you, and we will talk again in May.

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