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TMCNet:  NORTECH SYSTEMS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

[August 06, 2014]

NORTECH SYSTEMS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) Overview: We are a Wayzata, Minnesota based full-service electronics manufacturing services (EMS) contract manufacturer of wire and cable assemblies, printed circuit board assemblies, higher-level assemblies and box builds for a wide range of industries. We provide value added engineering services and technical support including design, testing, prototyping and supply chain management to customers mainly in the aerospace and defense, medical, and industrial equipment markets. We maintain manufacturing facilities in Baxter, Bemidji, Blue Earth, Mankato, Merrifield, and Milaca, Minnesota; Augusta, Wisconsin; and Monterrey, Mexico. All of the Company's facilities are certified to one or more of the ISO standards, including 9001 and 13485, with most having additional certifications based on the needs of the customers they serve.


Summary of Results: The second quarter of 2014 was stronger than the first in both revenue and net income and our quarter end backlog increased 13% from the beginning of the quarter led by medical and industrial customers. We continue to see increased activity in quoting and pipeline opportunities from our industrial customers which were lagging during most of the economic recovery. Orders from our defense customers continue to be impacted by funding delays and program cancellations.

For the quarter ended June 30, 2014, we reported net sales of $27.4 million compared to $28.5 million reported in the same quarter of 2013. Increases to our medical customers were offset by decreases to our aerospace and defense and industrial customers.

Our gross profit percentage for the three months ended June 30, 2014 was 12.0% compared to 11.8% for the three months ended June 30, 2013. Favorable changes in product mix and continued process improvements in the second quarter of 2014 positively impacted gross margin. Gross profit percentage for the six months ended June 30, 2014 and 2013 was 11.9% and 12.1%, respectively.

Gross profit is affected by a number of factors, including product mix, component costs and availability, product life cycles, unit volumes, pricing, competition, new product introductions, and capacity utilization. Our manufacturing processes allow us to build a broad range of products in our facilities and better utilize our manufacturing capacity. In the case of new product introductions, profitability normally lags revenue growth due to product start-up costs, operational inefficiencies, and under-absorbed overhead. Gross margin for these programs often improves over time as manufacturing volumes increase and as our utilization rates and overhead absorption improve, As a result of these various factors, our gross margin varies from period to period.

13 -------------------------------------------------------------------------------- Table of Contents Income from operations was approximately $347,000 and $583,000 for the three and six months ended June 30, 2014, respectively and $373,000 and $597,000 for the three and six months ended June 30, 2013, respectively.

Net income for the second quarter of 2014 was $246,701 or $0.09 per diluted common share, compared to net income of $187,219 or $0.07 per diluted common share for the same period in 2013. Net income for the six months ended June 30, 2014 was $332,858 or $0.12 per diluted common share, while net income from the same period in 2013 totaled $328,308 or $0.12 per diluted common share.

Cash provided by operating activities in the first six months of 2014 was $1.3 million. Cash provided in the first six months of 2014 came primarily from profits, noncash addback of depreciation and the timing of collections on our accounts receivable, offset by increased inventories and accounts payable. Cash used by operating activities in the first six months of 2013 was $1.4 million due to increased inventories and slower than expected collections on our accounts receivable.

Results of Operations: The following table presents statements of income data as percentages of total net sales for the periods indicated: Three Months Ended Six Months Ended June 30 June 30 2014 2013 2014 2013 Net Sales 100.0 % 100.0 % 100.0 % 100.0 % Cost of Goods Sold 88.0 88.2 88.1 87.9 Gross Profit 12.0 11.8 11.9 12.1 Selling Expenses 4.2 4.2 4.2 4.4 General and Administrative Expenses 6.5 6.3 6.6 6.5 Restructuring and Impairment Charges 0.0 0.0 0.0 0.1 Income from Operations 1.3 1.3 1.1 1.1 Other Expenses, Net (0.4 ) (0.3 ) (0.4 ) (0.4 ) Income Before Income Taxes 0.9 1.0 0.7 0.7 Income Tax Expense 0.0 0.3 0.1 0.1 Net Income 0.9 % 0.7 % 0.6 % 0.6 % Net Sales: We reported net sales of $27.4 million and $28.5 for the three months ended June 30, 2014 and 2013, respectively. Net sales for the six months ended June 30, 2014 and 2013 were $53.6 million and $54.4 million, respectively. Revenue increased to our existing medical customers, but was offset by a decline in revenue to our industrial customers who continue to be impacted by the sluggish 14 -------------------------------------------------------------------------------- Table of Contents economic recovery. Sales to our aerospace and defense customers decreased as a result of lower Department of Defense program funding. Defense contract length and size continue to decrease in this post war environment with several large programs eliminated or substantially reduced.

Net sales by our major EMS industry markets for the three and six month periods ended June 30, 2014 and 2013 are as follows: Three Months Ended Six Months Ended June 30 June 30 2014 2013 % 2014 2013 % (in thousands) $ $ Change $ $ Change Aerospace and Defense 3,633 5,035 (28 ) 8,032 9,701 (17 ) Medical 10,787 8,100 33 20,645 15,877 30 Industrial 12,989 15,316 (15 ) 24,881 28,798 (14 ) Total Sales 27,409 28,451 (4 ) 53,558 54,376 (2 ) Backlog: Our 90-day order backlog as of June 30, 2014 was approximately $19.2 million, a 13% increase compared to approximately $17.0 million at the beginning of the quarter. Our medical customers backlog increased nicely from the beginning of the quarter and last year and we are encouraged by the increase in backlog and sales activity coming from our industrial customers. Aerospace and defense backlog increased from the start of the quarter but decreased from the prior year due to lower Department of Defense funding and the post war transition. Our backlog consists of firm purchase orders and we expect a major portion of the current 90 day backlog to be realized as revenue during the following quarter.

90 Day backlog by our major EMS industry markets are as follows: Backlog as of the Quarter Ended June 30 March 31 June 30 (in thousands) 2014 2014 2013 Aerospace and Defense $ 3,647 $ 2,921 $ 5,117 Medical 8,638 8,014 7,366 Industrial 6,917 6,084 6,768 Total Backlog $ 19,202 $ 17,019 $ 19,251 15 -------------------------------------------------------------------------------- Table of Contents Our 90 day backlog varies due to order size, manufacturing delays, contract terms and conditions and timing from customer delivery schedules and releases.

These variables cause inconsistencies in comparing the backlog from one period to the next.

Gross Profit: Gross profit as a percent of net sales for the three months ended June 30, 2014 and 2013 was 12.0% and 11.8% of net sales. Favorable changes in product mix and continued process improvements in the second quarter of 2014 positively impacted gross margin. Gross profit percentage for the six months ended June 30, 2014 and 2013 was 11.9% and 12.1%, respectively.

Selling Expense: Our selling expenses were $1.1 million or 4.2% of net sales and $1.2 million or 4.2% of net sales for the three months ended June 30, 2014 and 2013, respectively. Selling expenses were $2.3 million or 4.2% of net sales and $2.4 million or 4.4% of net sales for the six months ended June 30, 2014 and 2013, respectively.

General and Administrative Expense: Our general and administrative expenses were $1.8 million or 6.5% of net sales and $1.8 million or 6.3% of net sales for the three months ended June 30, 2014 and 2013, respectively. General and administrative expenses were $3.5 million or 6.6% of net sales and $3.6 million or 6.5% of net sales for the six months ended June 30, 2014 and 2013, respectively.

Income Taxes: Our effective tax rate for the three months ended June 30, 2014 was (6%) compared with 34% for the three months ended June 30, 2013. The tax benefit in the second quarter of 2014 was the result of a favorable audit settlement with the Minnesota Department of Revenue which included the acceptance of the Company's research and development credits of $100,000 which were previously reserved for as an uncertain position. The differences between federal income taxes computed at the federal statutory rate and reported income taxes for the three and six months ended June 30, 2014 and 2013 are as follows: Three Months Ended Six Months Ended June 30 June 30 2014 2013 2014 2013Statutory federal tax provision $ 79,000 $ 97,000 $ 130,000 $ 140,000 State income taxes 12,000 13,000 19,000 23,000 Income tax credits (6,000 ) (17,000 ) (14,000 ) (103,000 ) Change in uncertain tax positions (100,000 ) 8,000 (100,000 ) 22,000 Other - (3,000 ) - (5,000 ) Income tax expense (benefit) $ (15,000 ) $ 98,000 $ 35,000 $ 77,000 16 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources: We have satisfied our liquidity needs over the past several years with cash flows generated from operations and an operating line of credit through WFB. We also have real estate and equipment term loans. Both the line of credit and real estate term notes are subject to fluctuations in the LIBOR rates. The line of credit, real estate term notes, and equipment loans with WFB 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.

On June 30, 2014, we had outstanding advances of $7.2 million under the line of credit and unused availability of $4.2 million supported by our borrowing base.

We believe our financing arrangements and cash flows to be provided by operations will be sufficient to satisfy our future working capital needs. Our working capital was $23.0 million and $15.5 million as of June 30, 2014 and December 31, 2013, respectively. The increase in working capital relates primarily to the reclassification of our line of credit from current to long term. We have reclassified to long term on our balance sheet at June 30, 2014 because we have the ability and intent to refinance the debt on a long term basis.

Net cash provided by operating activities for the six months ended June 30, 2014 was $1.3 million. Cash provided in the first six months of 2014 came primarily from profits, noncash addback of depreciation and the timing of collections on our accounts receivable, offset by increased inventories and accounts payable purchases to support the increase in our 90 day backlog.

Net cash used in investing activities of $1.1 million for the six months ended June 30, 2014 is comprised of property and equipment purchases to support the business.

Critical Accounting Policies and Estimates: Our significant accounting policies and estimates are summarized in Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2013. There have been no significant changes in these critical accounting policies since December 31, 2013. Some of our 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 our historical experience, known trends in our industry, terms of existing contracts and other information from outside sources, as appropriate. Actual results could differ from these estimates.

Recent Accounting Pronouncements In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update ("ASU") 2014-09, Revenue from Contracts with Customers (Topic 606). This standard outlines a single comprehensive model for companies to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance.

The core principle of the revenue model is that revenue is recognized 17 -------------------------------------------------------------------------------- Table of Contents when a customer obtains control of a good or service. A customer obtains control when it has the ability to direct the use of and obtain the benefits from the good or service. Transfer of control is not the same as transfer of risks and rewards, as it is considered in current guidance. The Company will also need to apply new guidance to determine whether revenue should be recognized over time or at a point in time. This standard will be effective for the first interim period within annual reporting periods beginning after December 15, 2016, with no early adoption permitted, using either of two methods: (a) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within ASU 2014-09; or (b) retrospective with the cumulative effect of initially applying ASU 2014-09 recognized at the date of initial application and providing certain additional disclosures as defined in ASU 2014-09. The Company has not yet selected a transition method and is currently evaluating the impact of the pending adoption of ASU 2014-09 on the consolidated financial statements.

Forward-Looking Statements: Those statements in the foregoing report that are not historical facts are forward-looking statements made pursuant to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995. 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 and demand for our products; † Increased competition; † Changes in the reliability and efficiency of operating facilities or those of third parties; † Risks related to availability of labor; † Increase in certain raw material costs such as copper; † Commodity and energy cost instability; † General economic, financial and business conditions that could affect our financial condition and results of operations; and † Availability of raw material components.

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. 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-Q are expressly qualified in their entirety by the forgoing cautionary statements. We undertake no obligations to update publicly any forward-looking 18 -------------------------------------------------------------------------------- Table of Contents statement (or its associated cautionary language) whether as a result of new information or future events.

Please refer to forward-looking statements and risks as previously disclosed in our report on Form 10-K for the fiscal year ended December 31, 2013.

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