Paula Graff - Vice President and Chief Financial Officer Richard Wasielewski - President and Chief Executive Officer.

Jason Herr - Private Investor Sheldon Grodsky - Grodsky Associates, Inc.

Good day everyone and welcome to today's program, the Nortech Systems Second Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen only mode. Later you will have the opportunity to ask questions during the question and answer session. [Operator Instructions]. It is now my pleasure to turn the conference over to Ms.

Paula Graff. Please go ahead..

Thank you. Good morning and welcome to Nortech Systems’ second quarter 2016 conference call. I'm Paula Graff, Vice President and CFO. And with me is Rich Wasielewski, Nortech's President and CEO. Following my introduction, Rich will offer comments on our second quarter results, our industry and the economy and the recent developments.

Then we’ll open up the call for your questions. Before we begin, please be advised that statements made during this call may be forward-looking and are subject to risk factors and uncertainties. Please see the complete Safe Harbor statements in our press release and SEC filings. Now I will now turn the call over to Rich Wasielewski. Rich....

Thank you, Paula, and good morning everyone. Our second quarter results saw revenues increase, led by our medical customers in both manufacturing and engineering services.

Our strategic investment in medical device engineering services helped our growth and we believe our prospects are good for the future growth, with double-digit backlog increases in the quarter.

Our defense business continues to stabilize and shows signs of recovery, with increased activity and opportunities, while our industrial customers lost some momentum that was building over the past several quarters.

Our ‘One Nortech’ messaging and branding that started in 2012 is now in full force, making it much easier to transform our business model to market changes with more earning-engagement opportunities, value-added services, such as engineering design, quick-turn prototyping and additional box-build solutions.

Also, our customers are showing a great appreciation for our competitive global manufacturing options in the U.S., Mexico and now in China, options to fit their markets and regional needs. I’m pleased to report that our China Suzhou project is on time and on budget as it moves into the production phase.

They have recently received ISO certification and are now working with customers on their plant certification and validation of product and production. We are expecting to see our first revenues build in the third quarter if all customer audits and approvals go according to plan.

We made progress in improving our gross margin by 170 basis points in the second quarter, aided by the medical and defense revenue increases, some selective pricing action and a favorable product and service mix.

Including in the cost of goods sold and impacting our gross margin and operating profits in the second quarter was $200,000 in startup costs associated with the new China manufacturing operation. . Let's move to a deeper dive into some of the numbers.

Yesterday we reported net sales of $28.9 million for the second quarter ended June 30, up 8% from the prior year. Quarter-over-quarter results were flat with mixed performance across our top 20 customers and the markets we serve. For the six months, our net sales increased over prior year by 9% to $57.9 million.

Our overall backlog grew nicely at 12% during the quarter and also 12% from the second quarter of 2015, adjusted for taking out the Devicix acquisition. Looking at three key markets, medical sales were up 40%.

This was actually our largest segment in the second quarter at 40% of total revenue, surpassing industrial for the first time since we have been reporting the breakdown. Our medical backlog also increased 28% during the quarter with several new programs ramping up in the second half of the year.

We credit our strategic investment in medical device engineering services for over 50% of the revenue growth. Our Devicix acquisition was not on the books in the second quarter of 2015. Defense results have been encouraging this year with growth returning and more stability among our large defense OEMs.

For the quarter, our sales in this sector were up more than 20% over the prior year and 25% for the six months.

We’re making progress re-establishing long-term relationships with our defense customers through collaboration on new systems and projects now that the activities are increasing, especially with our unique capabilities in ruggedized molded cable technology. Industrial results were mixed, as I said, off 15% for the quarter and 11% for the six months.

After several decent quarters, our industrial customers and transportation, the semiconductor equipment business and the process control sectors continue to face economic headwinds. This market, more than others, moves with the overall economy.

We’re working to successfully boost our efforts with industrial customers through continued investment and resources that support early engagement. This includes design for manufacturability and rapid prototyping for both PCBA assemblies and wire and cable assemblies.

The continued emphasis on our successful “One Nortech” high-level box-build systems integration strategy is also helping to minimize the impact. Moving on to profitability, as I mentioned, our second quarter gross margin improved 170 basis points to 10.8% of sales. Gross margin was 11.2% for the six months, up 130 basis points from the prior year.

Gross margin is still not where it needs to be, but we’re encouraged by the positive direction. And with the China startup costs winding down, we expect to continue to improve this in the second half of the year.

We announced earlier in the week that we will be closing our facility in Augusta, Wisconsin, due to lower demand and changing customer requirements. The shutdown will happen by the end of the year, with operations consolidated and moved to other locations, without interruption to our customer service.

The related costs of consolidation and restructuring are expected to be offset with savings, having minimal impact on our 2016 financial results. When fully consolidated, the annual impact is expected to improve the gross margin annually by roughly $250,000 based on the current production volumes. SG&A expenses increased.

Increases are all related to the Devicix acquisition and the goodwill on the books that were not in the prior period. Overall, we are maintaining our current cost structure and expect further leveraging as we head into the second half of the year. Our operating profits improved $373,000 from the same quarter last year.

The $110,000 reported operating loss includes $200,000 startup costs for our China operation. For the first six months of 2016, the positive impact was greater, nearly $800,000. Our six months operating income stands at $111,000, compared with an operating loss of $685,000 for the prior-year six months.

China's startup cost for the six months stands at $360,000. We reported a net loss of $0.07 per share for the second quarter. This compares with $0.14 per share loss for the same period last year. For the six months, the net loss is $0.04 compared to a net loss of $0.21 for the same time ... for the same six months of 2015.

The profit improvements, again, came from the overall revenue increase, evolving products and service mix and cost-containment efforts for both the second quarter and the six-month period. We now have the majority of the China startup cost behind us and expect to improve our profitability in the second half of the year.

Looking at liquidity, we generated positive operating cash flow in the first six months of $1.1 million from noncash add-backs of depreciation, amortization and working capital changes compared with using $137,000 of cash in the same period of 2015.

There is opportunity to generate more cash in the second half of the year by reducing inventories that crept up almost 7% since the end of 2015, mainly due to customer order push-outs and a buildup of our backlog. We’ve taken action on three fronts to reduce our inventory levels.

The first was increasing the empowerment of our local material managers and master schedulers, doing a better job of matching production and MRP planning with schedules from our customers for orders and forecasts. We are also accelerating our vendor-managed inventory program.

And we hope to double it from 15% of raw materials to 30% of raw materials by the end of the year. None of this is earth shattering. Just good old blocking and tackling and staying true to our SOPs, our standard operating procedures. We ended the second quarter of 2016 with $6.1 million available on our line of credit, up $700,000 in the quarter.

Before I close, I would like to make a few comments on our industry and how it tracks against the overall economy. The trade organization IPC published an EMS market report last month, estimating a 5.7% EMS growth in 2016 in North America, up from 3.3% growth that we experienced last year. An industrial trade publication drilled down to smaller U.S.

EMS firms, like Nortech, expecting this group to outpace the economy, which is projected to post a 2% to 3% GDP growth for the year. This could be aggressive given the poor actual GDP growth for the first and second quarters of 0.8% and 1.2%. If you average these all together, the projections from the industry are just over 4%.

Without our acquisition, taking it out, we’re right on that pace for the first half of the year. And we double that pace if we include the acquisition at the 8% to 9% range. In closing, compared to a year ago, we’re in a better position heading into the second half of the year.

And we expect more progress now that our major investments in medical design engineering, Mexico PCBAs and China expansion are all in the execution stages. The medical design engineering impact is already being felt, as I mentioned earlier. Medical is up high double digits in both sales and backlogs.

This has been our main long-term strategy to increase our medical business mix in the high-profit and the highest-growth market. The focus is now totally on getting the expected returns in growth with these investments and increasing the profitability and asset management on our core contract manufacturing business.

Before I open the call, I want to recognize our loyal and committed Augusta employees for their service over the past 24years. Nortech is totally committed to making their transition as easy as possible. Now we will open up the call for any questions.

Operator?.

[Operator Instructions]. And we will take our first question from Jason Herr, who is a Private Investor. Please go ahead..

Yeah.

So when is China really going to start shipping? Is it early Q3 or end of Q3?.

There is going to be some shipments for first article here in July, but not a lot of revenue. And it will come probably later in the third quarter, into the fourth quarter..

So when do you anticipate being at full capacity then?.

Well, it’s a ramp-up, so full capacity is relative. I think we’re in the 8 to 10 direct labor right now and we expect to be 20 by mid-year of next year on direct labor..

20 as in, what, million?.

20 ... I’m sorry. 20 in people, I’m sorry, direct labor people..

All right.

And how much did Devicix contribute in the quarter for revenue?.

I’m sorry.

Oh, Devicix?.

Yes..

$1.6 million I think was the first quarter and $2 million in the second, $3.6 year-to-date..

So, basically all the revenue gain was from Devicix then..

Yeah. I thought it was about ... all but a million, I think 66% of it probably..

And do you know what the contribution was on that?.

They’re contributing, before goodwill, about 10%, and about 12% to 15% with the goodwill from EBITDA standpoint. There is a schedule in the 10Q that shows the difference..

Okay.

Did Devicix hit the revenue target associated with the transaction that’s on the note?.

They are exceeding right now..

Okay..

At $3.6 for six months. It’s a project business and it’s heavy right now. So I would say that we were expecting a $5 million year and they are doing very well. So it’s exceeding the project..

Got it. But it also means basically if all your growth comes from there, that you’re basically flat on the rest of the business..

That’s correct. At the industrial side. In our top 20 contract manufacturer customers, our number one medical customer on the contract manufacturing side is up this year, but from 25% down a year before. So it’s not quite at 2014 levels yet.

But the industrial -- the transportation, our largest transportation and all our semiconductor customers are down. And that's the majority of the 15% down in industrial. If we ... if, if, if, right? If we didn't have the industrial, if we just were flat in industrial, we would have had a very good quarter.

But I said that last year when the medical side was down. So, we need to adjust to the environment that we’re in. And that's one of the reasons for the plant closing..

And so what are doing then to drive sales within ...

across all the categories so you don’t have such fluctuations?.

Again, we mentioned the “One Nortech”. We mentioned the high-level assembly selling our board capability, our cable capability, our ability to put those all together, earlier engagement projects that take time on early ... on all of those that take time on early engagement, but giving them quicker turns.

That we’re transforming lines at our three strategic locations, someplace in the United States, someplace in Mexico, someplace in China, all three having quick-turn prototype lines. Those are the biggest changes, and cross-selling, again, high-level assemblies..

But have your customers actually given you credit for the whole “One Nortech” strategy? Because you’re at break-even basically on profitability. So it's either they’re not giving you enough credit as far as letting you price for the services, if you’re really giving value-added services, or you’ve got a pretty big cost issue internally..

Well, we do have a capacity issue that we’re working on. We would say that...if we’re at roughly the 11% range, there is 2% available with capacity. It takes time. You don't want to interrupt ...

it takes time to adjust for the capabilities at the different locations and that's what we’re working on right now, to make the strategic locations more compatible for receiving transfers. The capacity by itself is about two points manufacturing variances.

And then there is two points within market mix, the heavier commodity-type contract manufacturing and industrial. That's a good sign that we are moving in that direction. We’re getting tougher with price increases. It bodes well for the future if we can continue to make progress on our defense side. There’s good margins in there as well. So, the last ...

I would say the last four quarters, industrial was growing and the margins are much poorer in that area. So it's good for us to have that growth in medical. It's good to have some stability in the defense business where the margins are better. And then we can take a little bit more action on the capacity and also the ...

what you say, is paying for the value on the different lower-cost locations and not give that away when we do those transfers. So we’re getting a little more aggressive too in that 15% down in the industrial side..

Yeah.

So what is your overall kind of plant or factory capacity or utilization right now? Do you know?.

Can you repeat that?.

So what’s your utilization? So if you’re running a bunch of plants at halfway ... only running at 75% of max capacity and you have a whole bunch of them, that means you’re probably ... as opposed to Augusta, you probably have a couple more plants that you need to streamline or work on getting more business for, or shut down..

Yeah, I think it pertains more to ... I think we’re doing fine in the medical valuations. I think the defense business is looking a lot more like the industrial where it’s very competitive and it’s more commodity-driven. Moving more to the earlier engagement and the value-added and prototyping, that is different than our history.

We’ve been doing that probably diligently for the last 18 to 24 months. It takes time to do that, though. Those are longer ... they’re more projects, more project-based business. To answer your capacity issue, capacity at our locations, most of them run one shift.

There are some I would say 5, 10 people sometimes that run the second shift on the high-volume type stuff. But it’s really one shift. So capacity-wise, we are at one-third, that we’re utilizing two-thirds capacity. That’s not the issue. It’s the capabilities and the talent and expertise.

So it’s the people issues that we’re probably at close to 75 to 80 and some plants are at 110 there, depending on what location. So it takes a balancing between the capabilities at the locations and the people talent that’s there. The defense business, it takes ...

they would tell you, it takes an operator 12 to 18 months to be able to get in through all the training that’s necessary. The Augusta plant had a fine soldering capability and molding capability that isn’t at any other location a year ago. We’ve taken some steps to bridge that gap, but it takes time to do that. Each plant has a little different flavor.

Our main cable ... medical cable plant in Bemidji has a more sophisticated custom cable expertise and a lot of quick-turn engineering support. And our Mexico facility is a manufacturing facility and doesn’t have that engineering support, or it goes to more medium volume. So it has a specialty in it.

So there is not the same capabilities at each location. So I know it’s a long answer, but it’s not a quick turn on and shut off and move those customers around. They really married the location for service. It’s the low-volume/high-mix of product..

Which once again, if it’s truly specialty low-volume stuff, you should be able to charge for it. Or you need to reorganize your factories or plants in order to get to that point. All it takes is a will to do it..

Yes, I can’t disagree with you. I agree with you 100%. We’ve just got to get on with it. And I think that’s where we’re heading. .

Okay. So I’d look at your plant utilization. So I’ve got a question for you. So you say your position’s better for second half of the year and in general. But I’m looking at the financials and you’re basically breakeven. IEC just broke out a 6% margin on the last quarter on a turnaround OI (operating income).

And I guarantee their OI is going to go higher than 6%.

What do you think this business looks like going forward? Is your future a zero breakeven business?.

Well, that’s not why we’re in business and that’s not the issue. We will get ... we could look a little bit better once we get through these three investments that we made in the last 12 months.

And I think they were all solid investments and will return much greater than even our past history has shown when we were doing well because of the mix in the medical side.

And the things that you mentioned, as far as getting value for what we’re doing and transforming into the higher-level assembly valuation, that higher-level assemblies are just taking place now for several major OEMs that only had us buying commodities. So fully agree. I know of all the competitors in the industry.

IEC has had a nice run and they’ve consolidated and done a nice job. Sparton was another one that does well out there and performs. They’re a little different flavor than our complexity in cable and wire and our customer mix. And I think that's what we’re trying to do is hone in.

And I think it really bodes well for us with this growth in medical, stabilization of defense. And now having 60% in industrial now be 40% is going in the right direction. Because there were a lot of that core margin business that either they see the value or we exit, or take pricing action, as you stated..

Yeah. Is Devicix fully integrated now? You’ve had it for a year, so there shouldn't be any issues any more as far as on your platform..

Yeah. I feel that when you buy a ‘going Jenny’ as opposed to distressed, it did exactly what you said. It integrates faster and contributes faster. And that's something that is very evident when you pay. We paid goodwill and we paid a premium for it, but you see the quick turnaround. And we are ... we haven’t ...

even on the production side of the devices, haven't even seen their contribution yet. Because it takes about 18 to 24 months to get through design sometimes to make it into production. But we have several of those programs going. So that ... there’s some device impact in that 28% backlog..

Okay. Oh, so in question, I saw the fixed charge was $121 versus your $115 covenant on the last quarter.

Do you feel you have enough liquidity and are taking steps to make sure you don't break the covenant?.

Yes, we are taking steps. Yes, it did get tighter. It got tighter because of the China capital that came through. We were very close with our bank on that. They gave us, as I think it's in the 10-Q, where they gave us an adjustment for China for this year. They knew that was there.

And I think we have that through the 12 months rolling to the end of the year. We expect to return the profitability. We expect that the startup costs are behind us. And the backlog of 12% going into this is better than like ... I don't recall right now, but it was minus ...

we were down backlog from the start of the year last quarter and it showed up in our numbers. And this quarter we are up 12%. So that bodes well for us going into the third quarter here. And in the fourth quarter, we’re seeing some softness.

Again, the economy and the industrial accounts are a struggle and we need to take the actions that need to be taken and the things that you talked about..

Are you ... I'll ask you a couple more questions and then I’ll drop and go to the back and wait for follow-up.

Are you focusing on paying down debt right now?.

Well, we’re finally, after ... boy, I think it’s been about 18 months of investing in Mexico and Devicix and China. So the major investments are behind us. I’d like to start seeing us start executing on those and start getting the return on those. And I think they’re all positioned to do that.

And it’s just a matter of blocking and tackling and executing, executing and executing against those projects. The Devicix one, again, is much better than those two Greenfield items that we started. .

Okay. And I'll ask you this as a Board member.

What you are doing to increase the stock price?.

Well, the stock price and strategies are pretty much what’s outlined in my 10-Q, as well as the conference call script here. It’s a growth strategy in the medical area, earlier engagement. So the things that you just discussed.. grows that side of the business. The growth is going to come on the top line from the PC boards in Mexico.

China is all incremental. There is no cannibalization on China whatsoever. So, as we go through the next couple of years talking about China, we will talk about what’s the revenue out of there and you can assume those all incremental. The Mexico is the hot region right now. Everybody is moving there.

We have a Kia plant about three miles away from us add 8,000 jobs in the last year. So they’re moving. It’s the next ... like I said, it’s the next hot manufacturing region. So that has to take hold and that’s a growth area for us as well. So growth is definitely a big part of this. We got ...

and on the contract manufacturing, the core business that we have, we need to adjust to the economy in the industrial side and the defense side. The defense business has its own opportunities within the industry now that the budgets have stabilized. So the cost-containment. We have the capacity.

Consolidations are going to continue as fast as we can move to make sure our customers are satisfied and we have the capabilities. And then, if we get ... we’re in pretty decent shape on line of credit availability. But until we can start having some surplus, we wouldn’t be looking at acquisitions out of the operating funds.

We do have a capital structure program that we’re looking at. Because there’s a lot of hidden jewels in the Devicix transaction for IP. And they come across opportunities all the time. We’re not structured right now to take advantage of that. We’re kind of on the contract manufacturing, project engineering basis.

But we could get more into IP and add those capabilities and enhancements to our portfolio so that we can even be more stickier on that side..

So I’m going to stop you there. Because, personally, you need to focus on profitability because if you generate cash, you’ll push the stock price, you can pay off debt, and then you can do acquisitions later. But you’ve got to fix the profitability first..

Well, I think as I talked ... walked you through, this is the third rail. And, like I said, until, if you’re going to take it out of operations, we have to gain some surplus. So we don’t see that as something that’s in the near future. We have the strategic stuff in place..

I understand that and totally hear that. But you have to admit that your history hasn't necessarily proven out that you can have sustained and good profitability..

Yeah. I personally, in my position, am feeling very well of the support from the Board to allow the last 18 months of investments. And it did have an impact on the profitability. But make no mistake about it, what you just said, is where the focus is on profitability.

Because there is none of that other stuff if we don't build that surplus and the cash flow..

I mean you should be looking for at least an OI of 8% ... OI margin of probably 8% to 10%..

Fair enough. We’ll shoot for that..

With that, I’ll drop. Thanks..

Thank you for your comments..

[Operator Instructions] We will take our next question from Sheldon Grodsky with Grodsky Associates. Please go ahead..

Good morning, Sheldon..

Hello everybody. Let me start with a non-operational question.

Do you know what happened to your stock yesterday?.

I was pleasantly surprised at one time during the day and pleasantly disappointed this morning..

But do you have any idea where the buying emanated from?.

What's that?.

Do you know where the buying emanated from?.

No, we don't have access to that. I think we’d know if somebody hits over 5% on it..

Okay. So it could either be some brokerage firm recommendation that wasn't published or it could be someone buying. But ...

and then do you think it was triggered by the announcement that you closed that facility?.

It's possible that somebody says we finally did something. Okay. It's possible. But we’re in it for the long haul. You know, Sheldon you’ve been around awhile. The transformation has been taking place. The recession has been tough on all EMS industries that are tied to the industrial and defense business. And that's a big part of our business.

The transformation has taken hold. It's not happening fast enough, but the growth is there. The regionalization of manufacturing, we’re in a very good position with our customers. I'm telling you, both of our ... that we’re leading with our large OEMs are very excited that we’re there. And we are seeing a lot of quoting activity on that side.

So, yeah, I don't watch it [stock price] that close. I feel for our shareholders and I would sure like to get back to book value of eight bucks as fast as possible. But that's probably my first deal. And then after that we can start doing some accretiveness. .

Let me ask another question please.

What will the total capital expenditures be in China?.

About in the $750,000 range. And if we meet a couple of milestones, we have some incentives from the local governments and the industrial parks to help us out, maybe up to $200,000. So we’d get some refunds there if we meet some milestones, X amount of people and X amount of revenue over a period of time..

And what sort of revenues do you expect to come out of China from that $750,000 investment?.

Ooh, yeah. You’re asking me to start thinking with our crystal ball, Sheldon. We do anywhere between probably per-person sales around the $50,000 per-person range. So 20 people times 50 mid-year, we’re talking about 20 folks.

So...our expectations for that business is probably a million dollars for around this year, about $4 million next year is our expectations..

Thank you..

One other thing, Sheldon, I have to mention on the Asia operation that we’re seeing. And it takes time to work through the inventories. We’re seeing the sourcing. We’ve never been focused on sourcing out of Asia. And it is a golden nugget for us...we should have been there 10 years ago.

Their supply chain and sourcing commodity for electronics has grown so much in the last 10, 15 years. They’re very good. And we’re starting, by having a presence there, we’re reaping some of that value. I think that’s going to be a real winner for us. Much more sometimes than production because we can take that across the whole industry.

So we don’t want to let that one slip. So that’s going to be a helper, kind of little thing in our back pocket here..

Thank you..

Thank you for your questions. Well, if there are no further questions, we thank you for your interest in Nortech and have a great day..