Greetings and welcome to the Nortech Second Quarter 2018 Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Connie Beck, Vice President and Chief Financial Officer..

Thank you, Omer. Good morning and welcome to Nortech Systems’ second quarter 2018 conference call. I am Connie Beck, Vice President and CFO and with me is our President and CEO, Rich Wasielewski. I am going to start today’s call by going over our financial results, which were released yesterday morning.

Then I will turn it over to Rich for additional comments on the second quarter, our market and company developments and then we will open it up for questions.

Before we continue, please note that the statements made during this call and Q&A session maybe forward-looking regarding expected revenue, earnings, future plans, opportunities and other company expectations.

These estimates, plans and other forward-looking statements involve known and unknown risks and uncertainties that may cause actual results to differ materially from those expressed or implied on this call. These risks include those that are detailed in our most recent Annual Report in Form 10-K and maybe amended or supplemented.

The statements made during this conference call are based upon information known to Nortech as of the date and time of this call. 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.

Looking at our second quarter results, our net sales of $28.5 million reflects additional revenue recognized due to our adoption of new FASB accounting standards this fiscal year. We gave more details about this change during our Q1 call in May. Our Form 10-Q also includes more information and disclosures.

The additional revenue recognized this quarter due to the change in accounting standards was $1.6 million. On a pro forma basis to adjust for this accounting change, second quarter sales were $26.9 million. Sequentially, this is up $1.2 million or 5% from Q1 of 2018. Our net sales in the second quarter of 2017 were $30.1 million.

Looking at our three core markets, I will give revenue and backlog results for the quarterly year-over-year and sequential comparison. First on revenue, our industrial sales had a slight decrease of 1% from the prior year quarter. Sequentially, industrial sales were up over 4%. Medical sales decreased by $1.8 million or 13% from the prior year quarter.

The majority of the decline was attributed to medical devices and rest within medical component products. Sequentially, medical sales were up 22% as medical customers began to work through the high level of on-hand inventories as well as program delays. Our aerospace and defense sales increased over the prior year quarter by $400,000 or 10%.

Sequential sales were down 12%. Our defense shipments were hit the hardest by the component parts shortages. Next, on to our backlog, at June 30, 2018, our 90-day shipment backlog was $24 million. This is a 9% increase both year-over-year and sequentially.

Breaking it down further, our industrial backlog increased 10% from the prior year quarter and 5% sequentially. Our medical backlog was steady from the prior year quarter and up 13% sequentially. Aerospace and defense backlog increased 31% from the prior year quarter and 7% sequentially.

Our gross margin percentage for Q2 of 2018 was 15.4%, up 220 basis points from 11.2% in the prior year’s second quarter and up 190 basis points from 11.5% in the first quarter of 2018.

Due to the new revenue recognition policies I have cited earlier we have recognized $1.2 million of revenue related to the non-cash consideration which was recorded at zero margin. This negatively impacted our gross margin by 60 basis points.

The year-over-year gross margin improvement resulted from customer and product mix, operational efficiencies and cost reduction. On to SG&A, we continue to watch our spending and adjust where we can to our current demand levels.

Our selling expense for the second quarter was $1 million or 3.6% of sales versus $1.3 million or 4.4% of sales for the prior year period. G&A expenses for the second quarter, was $2 million or 7.2% of sales versus $1.9 million or 6.5% of sales for the second quarter of 2017.

Our operating income for the second quarter of 2018 was $700,000 compared to $100,000 for the second quarter of 2017. The improvement was mainly due to the gross profit improvement. We reported net income of $400,000 or $0.14 per share for the second quarter of 2018.

This compares with a net loss of $16,000 or $0.01 per share for the same period last year. This was our best quarterly EPS in 7 years. Moving on to the balance sheet, cash provided by operations was $2.7 million for the first six months of 2018 compared to $1.3 million for the first six months of 2017.

Cash flows were again positively impacted by the non-cash add back of depreciation and amortization along with increased accounts payable. This was partially offset by an increase in accounts receivable. Free cash flow was $2.2 million in the second quarter. We ended the second quarter with $6.3 million available on our line of credit.

This compares to $3.9 million at the end of the first quarter. Total debt was $12 million at the end of the second quarter which excluded capital leases of $1.5 million. This compares to debt of $12.6 million for the same period last year that did not have capital leases. This concludes my financial overview.

Now, I will turn it over to Rich for his comments..

Thanks Connie and good morning everyone. Overall, we are pleased with our second quarter results and the progress being made, particularly our sequential improvements in quarterly sales and profits.

It’s been a while since we had across the board all our main revenue and profit generating products and services exceed their projections in the same quarter. We also saw good performance out of our manufacturing operations in the areas of quality, delivery and efficiency.

And our supply chain management did an excellent job of minimizing the impact of the industries electronic part shortages. From an earnings per share standpoint this was our strongest quarter in 7 years. The U.S. and global economies are having a positive impact on our business environment and customers, both domestically and internationally.

We continue to benefit from increased Department of Defense budgets increases and wining new longer term defense programs. We are beginning to see the expected returns from our strategic investments in China and Mexico and the engineering medical device project work is on upward cycle.

In addition as Connie mentioned earlier we have done a decent job of adjusting our cost structure with current demand levels. A closer look at our revenue by markets, our Industrial segment was strong in Q2 with backlog up 5% over Q1. This segment again tracks with the overall U.S. economy, so we have been writing the stronger GDP here in Q2.

Oil and gas, construction equipment, capital equipment continued to see improving demand. All these markets require our custom rugged environmental electronic products. Our global strategy for serving in the region, for region with our multinational customers continues to grow.

Moving on to medical, with medical, we are seeing a robust pipeline of opportunities. Our overall medical backlog is up 70% since the start of the year and 13% from the start of the Q1. Startup funding remains strong and large multinational OEMs are also beginning to increase their investments.

And we are finally seeing several of our large medical customers work through their high on-hand inventory levels that have impact us for over the past four quarters. On to medical device services front, we conducted several studies and surveys in the first half of the year on the branding of Devicix by Nortech.

The findings indicate that the strategic advantage in our ability to accelerate medical device commercialization under Devicix name and reputation. To carry out this marketing message forward, we are assigning more dedicated resources updating marketing collateral and increasing our targeted trade and market presence.

Another milestone is our recent medical capabilities expansion in China, where just last month our Suzhou facility in BioBAY Medical Industrial Park passed its final medical 13485 audit.

We are now open for business for medical device manufacturing building both Class 1 and Class 2 medical devices in the fast-growing Asia market with our first devices scheduled to be produced in the fourth quarter. On the defense side, overall defense budget show an increase in spending both in the U.S.

and globally with the international tensions surrounding Russia and North Korea. For 2019, the Department of Defense budget will rise 5% over 2018 levels and 10% from a continuing resolution level. We are increased quoting activity on both our legacy products and new programs.

We are also seeing our backlog rise seven consecutive quarters and 7% from the start of the first quarter. To better serve the defense market and our projected growth, we are adding government required certification at our Nortech Mankato facility.

We now have 2 AS9100 ITAR facilities that complement each other very nicely, with our Blue Earth operations specializing in custom cable assemblies and in PCB boards in Mankato, with both sides doing higher level assemblies depending on the opportunity.

On the topic of component shortages in tariffs, with defense and other areas, we are seeing electronic component shortages that are causing some shipment delays and move-outs. We estimate that we are unable to ship 600,000 worth of product in Q2 due to these shortages.

From what we are being told by our supply chain partners and our field intelligence, such shortages could persist well into 2019. Many OEMs and EMS manufacturers have been talking about this topic in news for the past year.

We are watching the issue carefully and keeping in close contact with our supply chain and customers to determine the appropriate action. With tariffs, the biggest current impact is uncertainty and questions. We are not expecting any significant charges so far and like the shortages we are keeping a close eye on this as well.

In looking at the economy and the industry and outlook, we are encouraged by strong – the U.S. economy 4.1% GDP growth in the second quarter and we mentioned it in our May call that the industry is expecting a 5% Americas growth in 2018 according to New Venture Research.

These external trends and projections along with our internal indicators, all point up and provide plenty of optimism for us going into the second half of 2018. Now to succession planning, as we announced yesterday, I am planning on retiring. A succession plan has been discussed with the Board for some time.

The timing is right for me and for Nortech to make this transition. The company has started a national wide search with Russell Reynolds Associates. I will continue in my current role and will help in the search and transition for as long as it takes to find the right person.

Because of my faith in all Nortech employees in all locations and in all countries and our long partnership with our customers, I believe and I know our company’s future is bright and the strategic vision is on track.

I am honored to have played a role in the company’s growth and evolution, while maintaining our Nortech culture which values its employees where no one does it alone and we strive to provide a quality place to work in the communities we are in.

Where we are customer focused doing all we can to help them succeed with full awareness of what we produce impacts the patients, the mission and the end users and never forgetting to build shareholders value.

It’s been the highlight of my professional career to serve this company, our shareholders and work alongside our expanding and committed employees. With that, I will conclude our remarks this morning and we will open it up for questions.

Operator?.

At this time we will be conducting a question-and-answer session. [Operator Instructions] Our first question comes from Sheldon Grodsky, Grodsky Associates. Please proceed with your question..

First of all, let me wish you the best of luck in retirement Rich, whenever that happens, I hope things will go very well for you..

Yes. Good morning and thank you, Sheldon..

I think the 800 pound gorilla in the room is in the operations of Nortech this week, but you had a rather unusual surge in activity similar to when you had almost a year ago, does anyone at Nortech know where it came from and why?.

Well, I guess we don’t track it very well and you probably can’t. But it appears to be the same event that happened the year before which is day traders.

There was a blog in analysts for some day traders and a small article written that gave us pretty good grades as far as consistency and longevity and felt that Nortech was going to take off one of these days. And I think all of those things helped to contribute to it, but it wasn’t any major player.

It was a number of day trades is the best as we can tell..

Is there a particular brokerage firm associated with these day traders?.

Not yet we can tell and there was again our intelligence doesn’t show anything..

Okay.

Moving over to operations, you kind of said that all the companies shooting on all cylinders for the first time in a long time, does it look like that’s going to continue or is there anything showing signs of slowing down?.

Right now there is no – there is not a lot of downturn that we can tell. As I stated our backlog is up which as you have tracked us over the years that that’s always a good sign for the next quarter. It’s one of our leading indicators. The economy, the industrial follows the economy and that’s got pent up demand. The medical has always been good to us.

We really took a lot a hits this past four quarters, because of robust maybe too much anticipation of growth and startups in 2017 that has worked its way through, so being up 13% or so in that area is where we want to be. If high single-digits is the medical growth and we are there in 10% to 14% range, we want to exceed the market.

In the defense, that’s just a nice balance in our portfolio. And with the struggling for – a lot of that struggling that we have said for last 7 years has been in the defense arena, the defense market as it’s been depressed. It has now become a good guy for us.

And I would say the last seven quarters, anytime you can keep increasing and there is no at least the next 2 years, the budgets are strong. And I think they are talking about even a stronger 2020.

So really Sheldon, I am generally cost conservative in these, but all our indicators, all the environment, the global economy, the decisions we made are working..

The only negative being the tariffs and the component shortages?.

Yes, but if we are growing double-digits like that, it’s going to have a minor impact at least for the near future. Our supply base is watching it close. We also have triggers.

If it happens, I think it will be inflation and some pricing pressures and that could get us into a downturn, but it’s not in the immediate future and I think that there is enough demand here for 2018 that I think it maybe beyond 2018..

Thank you..

You are welcome. Have a good day..

[Operator Instructions] Our next question comes from Sam Rebotsky from SER Asset Management. Please proceed with your question..

Good luck on your retirement.

Even though I am new to Nortech, the change that’s going on hopefully is beneficial and I guess hopefully you will do well in the future?.

Thank you, Sam and good morning to you..

Thank you. There seems to be difficulty getting thoughts for various companies in your industry and some of them seem to be doing better than others.

Is there any consolidation that’s going on, is there any benefit to you to consolidate with anybody else or how would you look at that? And I guess with somebody new coming on, that’s a difficult problem and of course you want to sort of steer the ship before you make acquisitions or merge, but is there any thoughts on that?.

Well, it’s a thought, but it’s probably 2 or 3 down the road. The first action that we take is always with our supply chain and so far so good with the supply chain. There are shortages, don’t get me wrong, there are shortages, but we will attack our supply chain, we will attack anything we could get through the Internet of Things.

And then we will work with our customers. Because of the custom nature of it in the quality and validation of components that come in, in the certifications makes it very difficult to see that anybody would have the same mix as us other than our customers and they would know where to go.

The third that you are talking about here is that, that card is like I said I think our third or fourth down before we get there. But it is on the table. We thought if we can partner with, we can make kind of a group co-op that for shortage parts, we could get together.

We generally do not have that type of relationship with our competition, but it maybe something for our CEOs to may be have a discussion on. So, it isn’t – your question is right on, it may just be a little bit too soon to answer that for us..

Well, that’s good. And hopefully the day traders have something right and that is the beginning of future growth as we maybe and instead of day trading maybe they should become investors, okay. So let’s see hope that we keep growing the earnings and improving..

Well, thank you, Sam. You have a great day..

Thank you..

[Operator Instructions] Our next question comes from Robert Pagley, Private Investor. Please proceed with your question..

I am curious first of all, I want to congratulate you on your successes and I wanted to get a little more feel for what’s going on in China, are you being affected by these shortages, is that something to do with the issues with the trade with China or is it something totally different, what is the nature of the shortages and what is your thinking actually do in China, by the way I am an electrical engineer, I have a PP license, so I am curious about this and I appreciate giving me a little update on it?.

Well, first of, hello Robert and thanks for your question. China was – we went to China primarily to work with our multi-national customers in the cable and wire complex assembly arena. And we also had this vision with the aging population that are strengthened in medical devices is a nice expansion and we are seeing that today.

We have a great start as we started Greenfield, so we have a great organization being done there, their quality and their delivery performance has been outstanding so far in the last 3 years. So that’s what’s taking place there to follow our multi-nationals that are doing in region production for the region.

The second benefit of Asia is that 55% of this electronic supply chain comes out of Asia and we really were playing until we got there 3 years ago. We are only purchasing about 2% of our electronics here in the United States from Asia.

That particular initiative hasn’t taken full hold yet, we are still in single digits and the part – the particular parts that we have, have not been impacted by the tariffs coming over here on this first phase.

And hopefully they don’t go to Phase 2 and Phase 3 on the tariffs, but right now the type of components have not been impacted by Phase 1 of the government’s tariff program.

The other I guess the benefit that we get out of China today is by making the product in – manufacturing the product in China for China we don’t have to deal with this tariff a lot – most of the parts are sourced there.

There are still some coming from the United States and we are – those parts we will work with the customers to get those possibly transferred to a China source if needed. Hopefully that answers most of what you asked Robert, if not you can expand on it if you want..

Okay.

One other thing I want to tell you, I am 94 years old and I just last week got a pacemaker put into my breast and I am suffering from swollen effect of that, but it works and I am curious about what is the electronic device you make that I am sure it’s not anything like my pacemaker, but what is it that you do in terms of your product?.

Well, first of all, 94 that’s just – you are just a young man right now buddy, as far as I am concerned. So you keep it up, good luck with that pacemaker. We do more Class 2s which are more mechanical devices outside the body. We have done Class 3s that are more evasive. We are planning to do more along the lines of the pacemaker product.

We do have a device of that that does affect a heart that’s on the table today, a project that we are working. We will see how it goes. But right now, the St. Jude’s, St.

Boston size Medtronics, they have a very good supply chain or they are producing for themselves and we are making headway in that arena, but not at this time, so mostly outside mechanical type Class 1 and 2s..

Okay.

It would be a packaging issue then, I don’t think you would do any of the kind of esoteric deposition of stuff on?.

That’s correct..

Well, I thank you very much. You are telling me about this and I guess from what you say the issues of trade with China have – that are now in the headlines that’s not affecting you as far these power shortages is concerned to any extent.

Is that true?.

That is true today. It could change and even here in the third quarter, we are not seeing any kind great changes to it, but there is a lot of uncertainty and a lot of talk. So, the caveat would be not today, there is an expectation and we are watching it very closely..

Okay, that’s good.

Because I think they are starting to I guess there is some Chinese people coming to visit Washington next month or next week, I don’t know they are on our way supposedly to try to resolve some of these issues and that will be good news for all of us not just for your company, but for all of us and it’s made in China and most of it is pretty good.

So, I wish you well and congratulations on all your successes and I wish you a very productive and happy retirement if that’s where you are headed. So, thanks again Rich. Bye-bye now..

Good luck with that pacemaker..

Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would like to turn the call back to Rich Wasielewski for closing remarks..

Well, that concludes our call. Thanks for joining us today and your interest in our Nortech and we will look forward to updating you in the future. Have a great day..

This concludes today’s conference. You may disconnect your lines at this time. Thank you for your participation..