Q3 2023 Nortech Systems Inc Earnings Call

Participants

Alan Nordstrom; Interim CFO; Nortech Systems, Inc.

Jay Miller; President & CEO; Nortech Systems, Inc.

Presentation

Operator

Greetings. Welcome to Nortech's third quarter 2023 earnings call. (Operator Instructions) Please note this conference is being recorded.
I will now turn the conference over to your host, Alan Nordstrom, acting CFO at Nortech. Alan, you may begin.

Alan Nordstrom

All right. Thank you, Paul. I'd like to welcome everyone to today's conference call. Jay will begin today's call with a review of our operations, recent developments, and business outlook, then I'll review Nortech's third quarter 2023 financial results before I hand it back over to Jay for his closing comments. Then we'll open up the call for your questions.
Please note that we're still working through the final steps with our independent auditors, and we will file the Form 10 Q-when those steps have been completed. But before we continue, please note that statements made during this call and 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-Q, will 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 statement in our SEC filings.
And with that, I'll turn it over to you, Jay, for your opening comments.

Jay Miller

Thank you, Alan, and good afternoon, everyone. We're glad you could join us today. As usual, I'd like to start by thanking our more than 750 employees worldwide for their dedicated efforts. These people are truly Nortech's most important competitive advantage. Our team members work hard every day to deliver the mission-critical electrical components, higher-level assemblies, complete finished products, and engineering services our customers rely on.
Today, I'd like to especially recognize team members at our two international facilities. Alan and I are speaking to you from Nortech's facility in Monterrey, Mexico, about 1,500 miles south of our Minneapolis headquarters. This week, we held our quarterly Board of Directors meetings here and it's been a great opportunity for our Board to see our Monterrey team in action.
Our 77,000 square foot facility here opened in 2018, newly built and outfitted to our specifications for additional engineering resources and enhanced manufacturing workflow. Nortech is operating in Mexico since 2002.
Our other international team members are in Suzhou, just west of Shanghai on the eastern coast of China, what's already Thursday morning. They're about 6,800 miles away from Nortech's headquarters. This facility opened in 2016 and encompasses 60,000 square feet. By the way, Nortech first started in China in 1999 with an operating partnership.
We were very proud to announce last month that our Suzhou facility recently received Class II Medical Device certification from China's National Medical Products Administration for serving the Asian market. Our Suzhou team members worked very hard to achieve this prestigious certification, which ensures the highest level of safety and effectiveness. This is a shining example of how Nortech's reputation for superior quality and customer service continues to grow around the world, thanks to our employees' efforts.
This is a significant achievement for Nortech and our medical customers in the Asia Pacific region, both existing and potential, with China as the largest market. According to a McKinsey report published earlier this year, China's growing medtech market could more than double by 2030, with 9% annual spending increases expected this decade under the government's Healthy China 2030 Plan. Healthcare spending as a percentage of GDP in China is on track to match that of some developed European countries.
For Nortech, I should add the medical market is our largest and fastest growing. Over the past five years, our medical revenue rose nearly 70% to $76 million in 2022, accounting for 57% of our total revenue last year, this was up from $45 million or 40% of total revenue in 2018. Meanwhile, we continue to see steady long-term growth with our defense and industrial customers.
Turning next to our third-quarter results. Our team's focused execution across China, Mexico, and the US helped Nortech increase our gross margin sequentially and maintain EBITDA levels in the third quarter.
As previously discussed on these calls, we anticipate customer demand levels will sometimes fluctuate based on factors like inventory adjustments and other timing issues. We saw this influenced third-quarter revenue as a few customers requested that we delay shipments to them while they were working through inventory they built up during the COVID pandemic. From our ongoing dialogue with these customers, we expect the issue to be resolved in the near term.
In the third quarter, year-over-year comparisons were also challenging because the prior-year period set all-time quarterly margin records as we saw the benefits of implementing significant pricing actions ahead of material cost increases. However, that situation has since normalized a bit with gross margins consistently running in the mid-teens.
For this recent third quarter, our backlog levels remain healthy. We continue to find promising opportunities with a diverse array of medical, industrial, and defense customers, including many Fortune 500 companies. One indicator of this positive momentum is the fact that our trailing 12-month revenue increased more than 5% from the prior trailing 12-month period. Given all these factors, we expect to finish 2023 strong.
The US economy seems to be gradually improving. Economists recently surveyed by the Wall Street Journal lowered their forecasted probability of a recession within the next year and raised GDP outlook. Consequently, we remain guardedly optimistic about the end of 2023, our 2024 business outlook, and long-term prospects beyond 2024.
We believe that Nortech's future is bright. This confidence comes from the combination of our diverse customer base, solid financial platform, and hard-working team members.
Now I'll turn it over to Alan for a more in-depth look at our third quarter and nine-months financials. Alan?

Alan Nordstrom

Thank you, Jay. In the next few minutes, I'll provide some details of our financial performance in the 2023 third quarter, but I also encourage you to review our latest Form 10-Q when filed as it contains far more information about our business operations and financial performance than we will cover on this call.
As we pointed out in the past, we believe that our individual quarters can be affected by outside factors. These might include timing fluctuations, customer shipments, and supply chain issues. Any of these, during a given reporting cycle, could temporarily disrupt our momentum. Consequently, we believe it's more appropriate to review our business on a 12-month basis rather than a strict calendar fiscal year. This approach will help normalize these potential anomalies and offer a better gauge of our strategies for long-term success.
So switching to our third quarter financial performance. As Jay noted earlier, we have anticipated the demand levels to fluctuate as customers work through inventory. We saw this includes third-quarter revenue levels. However, we expect this issue to get resolved in the near term.
Also, the year-over-year decline largely results from last year's record high third-quarter revenue levels that were boosted by significant pricing actions in the period ahead of material cost increases, yet we see sustained year-over-year backlog levels, sequential gross margin expansion, and solid levels of net income and EBITDA.
In the balance of my comments, I will review key areas which drove our third-quarter financial performance, may include, first, a review of certain factors impacting our income statement; second, selected items, which includes Nortech's cash flow statement; and lastly, a brief review of the balance sheet. As usual, if you have specific questions about these items or any of our quarterly financial results, I'll be happy to address them during the Q&A portion of this afternoon's call.
In Q3 2023, revenue totaled $33.4 million, this represent a 5.4% decline from revenue of $35.3 million in the third quarter of 2022, yet it's still up nearly 5% on a year-to-date basis. This performance is particularly noteworthy as it compares to strong results in the respective prior-year period. In fact, we've been able to achieve substantial revenue growth over the trailing 12-month period despite some stronger historical comparison.
Nortech's year-to-date 2023 revenue performance was driven by growth in our medical category, while our industrial and aerospace and defense categories remained relatively consistent over the period. For the first nine months of 2023, the medical market was up $5.5 million, or 10.1%, as compared to the first nine months of 2022, with the majority of the increase coming from medical component products.
For the year-to-date period, revenue from the industrial category was $29 million, unchanged from the prior year, while the aerospace and defense market totaled $14.5 million, down slightly from $15.2 million in the prior year. Included in the financial performance for the year-to-date period of 2023, gross profit totaled $16.3 million, or 15.8%, compared to gross profit of $15.4 million, or 15.6%, in the prior-year period.
Third quarter 2023 operating expenses totaled $4.2 million, a 4.3% decrease from the third quarter of '22 operating expense of $4.4 million. The $188,000 decrease in year-over-year operating expenses, driven primarily by a $161,000 reduction in third-quarter product research and development expenses. Despite the declining year-over-year R&D expenses, we believe that this level of investment is sufficient for new technology.
As a result of performance in the third quarter, net income through the first nine months of 2023 totaled $2.5 million, or $0.87 per diluted share, compared to $2.4 million were $0.83 per diluted share, for the first nine months of 2022.
Moving to the balance sheet and cash flow statements. First, through the first nine months of 2023, net cash provided by operating activities totaled $2.2 million, more than double the level generated for the similar 2022 period. During the third quarter, as a result of previously outlined slowdown in customer demand, inventory level of $21.5 million was up from the prior quarter inventories, yet remain down from inventory of $22.4 million at December 31, 2022.
Receivables at September 30, 2023 were $16 million, down from $17.4 million in the prior quarter and unchanged from $16 million at December 31, 2022. This is in line with the seasonal pattern that we have seen evolve over the past couple of years. The first half of the year has been typically marked by higher receivable levels, while cash collections accelerate during the summer months and second-half receivable levels declined because ultimately, we believe it will generate modest levels of free cash flow going forward.
We ended the third quarter of 2023 with $7.5 million of borrowing capacity and our $16 million line of credit with Bank of America. This credit agreement is important in giving Nortech the flexibility to manage through the headwinds we experienced in the last few years and the previously mentioned seasonal fluctuations we see in our receivables and collections.
At September 30, 2023, cash and equivalents totaled $1.1 million, down from $1.9 million at the end of the prior quarter. We believe that our existing financing arrangements, anticipated cash flows from operations, and cash on hand will be sufficient to satisfy our working capital needs for the remainder of 2023, as well as any capital expenditures and debt repayments.
On a final note, let me reiterate that our top financial priorities for 2023 remain unchanged. First, we're extremely focused on continuing to strengthen our balance sheet and mitigate impacts we may see from changes in the economic environment or seasonality.
Next, we will take further advantage of opportunities to align our operations and infrastructure with the market demand that we are seeing to deliver sustainable free cash flow growth. Our confidence results from growth momentum we saw in 2022 that have sustained thus far in 2023, coupled with disciplined lean operations execution, expense management, and R&D innovation, we believe Nortech can deliver on our objectives.
With that, I'll turn it back over to Jay for his closing comments.

Jay Miller

Thanks again, Alan. Before we open the call up to your questions, there are three topics I'd like to touch on, inflation, ESG, and Nortech's peer comparisons.
First, over the past couple of years, unfortunately, inflation is nothing new. We've been carefully managing through its impact on both wages and raw materials. For wages, our team members received across-the-board pay increases this past April. We feel strongly about taking care of the financial well-being of our team members and their families. By the way, I should add staffing levels are good across all Nortech locations.
As a company, we addressed inflation somewhat early, including the price increases we made during the third quarter of 2022. In calculating these price adjustments, we consider both inflation trends and the fact that our pricing for certain technologies and services was not in line with the market.
Because of timing issues from price increases relative to expense recognition, quarterly margin comparisons were fluctuating. However, if you look at the trailing 12-month chart we include in our press release, it shows a tremendous expansion of gross margin levels over the past two years. Going forward, we expect gross margins will continue to increase through a combination of strategic pricing actions and operational improvements.
Second, our ESG efforts, environmental, social, and governance continue to follow a methodical measured approach. Guided by our long-term vision, we are in the early stage of activities, specifically baseline measurements for Nortech submissions, both direct and indirect, through our supplier partners. We expect to post ESG updates to the Nortech website in early 2024.
Being proactive with ESG positions, Nortech well with our own customers, many of which are already actively engaged in ESG efforts. Early on this call, I mentioned the growing importance in the medical market for Nortech. This market, including the larger life science healthcare sector, is the most engaged in preparing for future ESG disclosure requirements according to a Deloitte survey published late last year. Over 70% of such customers are actively involved.
And finally, for our industry and comparisons with Nortech peers, we've described in our past calls how we operate under a low volume, high-mix business model. We make a wide array of complex, highly technical assemblies, sometimes at relatively low quantities. Most of the large publicly traded electronic manufacturing systems firms like Foxconn and Jabil and Benchmark are the reverse, high volume and low mix, think cellphone, smartwatches, and personal computers. These are very different products from the ones we manufacture that include things like complete medical devices, as well as very complex cable systems with printed circuit boards for the defense and industrial markets.
However, all EMS companies operate in a similar macroeconomic environment and faced related challenges and industry trends. According to data from New Venture Research published by the trade organization of IPC, the global EMS market in 2022 grew by 3.2%. By contrast, Nortech substantially outpaced the industry. Our goal remains to outperform our peer group, both in terms of revenue and profitability.
And finally today, I want to express my sincere gratitude to our dedicated shareholders for their support and loyalty. Many have been with Nortech for decades. I hope all our shareholders share the team's enthusiasm for Nortech's direction and our vision, aspiring to be the global market leader in digital connectivity and data management, engineering, and manufacturing.
Along with delivering on this vision, I can speak for Nortech management team, team members, and Board of Directors in saying that Nortech also remains firmly committed to delivering positive financial value for our shareholders.
That concludes our presentation. And now, we'll open the call up for your questions. Paul, please open the line.

Question and Answer Session

Operator

Thank you. (Operator Instructions) And there were no questions from the lines. I would now like to hand the call back to Jay Miller for closing remarks.

Jay Miller

Thank you, Paul. And thanks, everyone, for joining us today. We look forward to talking to you next March when we present our fourth quarter 2023 results. Thank you again, and goodbye.

Operator

Thank you. This does conclude today's conference. You may disconnect your lines at this time. Thank you for your participation.