NORTECH SYSTEMS INC - Quarter Report: 2011 September (Form 10-Q)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

 

FORM 10-Q

 

(Mark One)

 

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2011

 

OR

 

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                      to                 

 

NORTECH SYSTEMS INCORPORATED

 

Commission file number  0-13257

 

State of Incorporation: Minnesota

 

IRS Employer Identification No. 41-1681094

 

Executive Offices: 1120 Wayzata Blvd E., Suite 201, Wayzata, MN 55391

 

Telephone number: (952) 345-2244

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulations S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

 

Number of shares of $.01 par value common stock outstanding at November 1, 2011 - 2,742,992

 

(The remainder of this page was intentionally left blank.)

 

 

Table of Contents

 

TABLE OF CONTENTS

 

				PAGE
PART I  — FINANCIAL INFORMATION
	Item 1	—	Financial Statements
			Consolidated Balance Sheets	3 - 4
			Consolidated Statements of Income	5-6
			Consolidated Statements of Cash Flows	7
			Condensed Notes to Consolidated Financial Statements	8-15
	Item 2	—	Management’s Discussion and Analysis of Financial Condition And Results of Operations	15-21
	Item 4	—	Controls and Procedures	21
PART II — OTHER INFORMATION
	Item 1	—	Legal Proceedings	22
	Item 6	—	Exhibits	22
SIGNATURES				23
	Exhibit 31.1
	Exhibit 31.2
	Exhibit 32
	Exhibit 101

 

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PART 1

 

ITEM 1.  FINANCIAL STATEMENTS

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

 

		SEPTEMBER 30			DECEMBER 31
		2011			2010
		(Unaudited)
ASSETS
Current Assets
Cash		$	—		$	230,582
Accounts Receivable, Less Allowance for Uncollectible Accounts		17,638,203			15,562,277
Inventories		21,396,458			16,108,773
Prepaid Expenses		761,379			596,363
Income Taxes Receivable		151,060			376,001
Deferred Income Taxes		625,000			594,000
Total Current Assets		40,572,100			33,467,996
Property and Equipment, Net		8,834,167			7,157,543
Finite Life Intangible Assets, Net of Accumulated Amortization		96,698			202,150
Deferred Income Taxes		3,000			219,000
Other Assets		514,235			514,235
Total Assets		$	50,020,200		$	41,560,924

 

See Accompanying Condensed Notes to Consolidated Financial Statements

 

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

 

		SEPTEMBER 30			DECEMBER 31
		2011			2010
		(Unaudited)
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities
Line of Credit		$	9,263,816		$	5,615,121
Current Maturities of Long-Term Debt		2,127,387			841,760
Accounts Payable		13,721,189			10,727,907
Accrued Payroll and Commissions		2,726,562			2,584,108
Other Accrued Liabilities		916,060			634,655
Total Current Liabilities		28,755,014			20,403,551
Long-Term Liabilities
Long-Term Debt, Net of Current Maturities		836,667			1,731,318
Other Long-Term Liabilities		160,761			137,236
Total Long-Term Liabilities		997,428			1,868,554
Total Liabilities		29,752,442			22,272,105
Shareholders’ Equity
Preferred Stock, $1 par value; 1,000,000 Shares Authorized: 250,000 Shares Issued and Outstanding		250,000			250,000
Common Stock - $0.01 par value; 9,000,000 Shares Authorized: 2,742,992 Shares Issued and Outstanding at both September 30, 2011 and December 31, 2010		27,430			27,430
Additional Paid-In Capital		15,722,140			15,698,348
Accumulated Other Comprehensive Loss		(62,936		)	(62,936		)
Retained Earnings		4,331,124			3,375,977
Total Shareholders’ Equity		20,267,758			19,288,819
Total Liabilities and Shareholders’ Equity		$	50,020,200		$	41,560,924

 

See Accompanying Condensed Notes to Consolidated Financial Statements

 

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)

 

		THREE MONTHS ENDED
		SEPTEMBER 30
		2011			2010
Net Sales		$	28,318,158		$	25,957,327
Cost of Goods Sold		25,029,395			23,064,208
Gross Profit		3,288,763			2,893,119
Operating Expenses:
Selling Expenses		900,849			784,283
General and Administrative Expenses		1,967,776			1,942,646
Total Operating Expenses		2,868,625			2,726,929
Income From Operations		420,138			166,190
Other Income (Expense)
Interest Expense		(130,152		)	(99,434		)
Miscellaneous Income (Expense), net		(9,121		)	153,562
Total Other Income (Expense)		(139,273		)	54,128
Income Before Income Taxes		280,865			220,318
Income Tax Expense		98,000			93,000
Net Income		$	182,865		$	127,318
Earnings Per Common Share:
Basic and Diluted		$	0.07		$	0.05
Weighted Average Number of Common Shares Outstanding Used for Basic and Diluted Earnings Per Common Share		2,742,992			2,742,992

 

See Accompanying Condensed Notes to Consolidated Financial Statements

 

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)

 

		NINE MONTHS ENDED
		SEPTEMBER 30
		2011			2010
Net Sales		$	85,112,931		$	72,393,274
Cost of Goods Sold		75,392,663			63,749,870
Gross Profit		9,720,268			8,643,404
Operating Expenses:
Selling Expenses		2,701,642			2,305,207
General and Administrative Expenses		5,972,692			5,361,255
Total Operating Expenses		8,674,334			7,666,462
Income From Operations		1,045,934			976,942
Other Income (Expense)
Interest Expense		(392,237		)	(325,375		)
Bargain Purchase Gain		791,615			—
Miscellaneous Income (Expense), net		(55,165		)	116,147
Total Other Income (Expense)		344,213			(209,228		)
Income Before Income Taxes		1,390,147			767,714
Income Tax Expense		435,000			398,000
Net Income		$	955,147		$	369,714
Earnings Per Common Share:
Basic and Diluted		$	0.35		$	0.13
Weighted Average Number of Common Shares Outstanding Used for Basic and Diluted Earnings Per Common Share		2,742,992			2,742,186

 

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

 

		NINE MONTHS ENDED
		SEPTEMBER 30
		2011			2010
Cash Flows From Operating Activities
Net Income		$	955,147		$	369,714
Adjustments to Reconcile Net Income to Net Cash
Provided by (Used in) Operating Activities:
Depreciation		1,446,212			1,181,745
Amortization		105,452			106,248
Stock-Based Compensation		23,792			23,796
Interest on Swap Valuation		(18,140		)	(19,492		)
Bargain Purchase Gain		(791,615		)	—
Deferred Income Taxes		185,000			268,000
Loss on Disposal of Property and Equipment		941			901
Foreign Currency Gain		—			(240		)
Changes in Current Operating Items, Net of Effects of Business Acquisitions
Accounts Receivable		(198,970		)	(2,790,649		)
Inventories		(5,287,685		)	(2,241,074		)
Prepaid Expenses and Other Assets		(165,016		)	(61,368		)
Income Taxes Receivable		224,941			2,191,702
Accounts Payable		1,220,948			1,561,006
Accrued Payroll and Commissions		142,454			1,686,377
Other Accrued Liabilities		(50,470		)	(644,437		)
Net Cash Provided by (Used in) Operating Activities		(2,207,009		)	1,632,229
Cash Flows from Investing Activities:
Proceeds from Sale of Property and Equipment		1,400			—
Business Acquisitions		(1,042,389		)	(402,969		)
Purchase of Property and Equipment		(560,022		)	(447,261		)
Net Cash Used in Investing Activities		(1,601,011		)	(850,230		)
Cash Flows from Financing Activities:
Net Borrowings from Line of Credit		3,648,695			768,028
Proceeds from Long-Term Debt		1,380,904			—
Principal Payments on Long-Term Debt		(1,452,161		)	(1,808,408		)
Proceeds from Issuance of Common Stock		—			12,500
Net Cash Provided by (Used in) Financing Activities		3,577,438			(1,027,880		)
Effect of Exchange Rate Changes on Cash		—			500
Net Decrease in Cash		(230,582		)	(245,381		)
Cash - Beginning		230,582			245,381
Cash - Ending		$	—		$	—
Supplemental Disclosure of Cash Flow Information:
Cash Paid During the Period for Interest		$	386,612		$	352,004
Cash Paid During the Period for Income Taxes		—			376,615
Supplemental Noncash Investing and Financing Activities
Due to Seller for Business Acquisition		$	250,000		$	—
Capital Expenditures in Accounts Payable		117,324			—

 

See Accompanying Condensed Notes to Consolidated Financial Statements

 

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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

NOTE 1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation

 

The accompanying unaudited consolidated financial statements for the interim periods have been prepared in accordance with Generally Accepted Accounting Principles in the United States of America (GAAP) for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission.  Accordingly, they do not include all of the financial information and footnotes required by GAAP for complete financial statements, although we believe the disclosures are adequate to make the information presented not misleading.  It is suggested that these consolidated financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in our latest shareholders’ annual report on Form 10-K.  The operating results for the interim periods presented are not necessarily indicative of the results expected for the full year or for any other interim period.  In our opinion, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included.

 

The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  In preparing these consolidated financial statements, we have made our best estimates and judgments of certain amounts included in the consolidated financial statements, giving due consideration to materiality.  Changes in the estimates and assumptions used by us could have a significant impact on our financial results, since actual results could differ from those estimates.

 

Principles of Consolidation

 

The consolidated financial statements include the accounts of Nortech Systems Incorporated and its wholly owned subsidiary, Manufacturing Assembly Solutions of Monterrey, Inc.  All significant intercompany accounts and transactions have been eliminated.

 

Revenue Recognition

 

We recognize revenue upon shipment of manufactured products to customers, when title has passed, all contractual obligations have been satisfied and collection of the resulting receivable is reasonably assured. We also provide engineering services separate from the manufacture of a product. Revenue for engineering services is recognized upon completion of the engineering process, providing standalone fair value to our customers. Our engineering services are short-term in nature. In addition, we have another separate source of revenue that comes from short-term repair services, which are recognized upon completion of the repairs and shipment of product back to the customer.

 

Shipping and handling costs charged to our customers are included in net sales, while the corresponding shipping expenses are included in cost of goods sold.

 

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Stock Options

 

Following is the status of all stock options as of September 30, 2011, including changes during the nine-month period then ended:

 

		Shares		Weighted- Average Exercise Price Per Share			Weighted- Average Remaining Contractual Term (in years)		Aggregate Intrinsic Value
Outstanding - January 1, 2011		663,150		$	7.32
Forfeited		(39,550	)	$	7.28
Outstanding - September 30, 2011		623,600		$	7.33		4.77		$	91
Exercisable - September 30, 2011		292,000		$	7.28		3.57		$	—

 

There were no options exercised during the three and nine months ended September 30, 2011.  The total intrinsic value of options exercised during the three and nine months ended September 30, 2010 was $0 and $20, respectively.  Cash received from option exercises during the three and nine months ended September 30, 2010 was $0 and $12,500, respectively.

 

Total compensation expense related to stock options with time-based vesting for the three months ended September 30, 2011 and 2010 was $7,930 and $7,932, respectively.  Total compensation expense related to stock options with time-based vesting for the nine months ended September 30, 2011 and 2010 was $23,792 and $23,796, respectively.  As of September 30, 2011, there was approximately $3,000 of unrecognized compensation expense related to unvested option awards that we expect to recognize by November 30, 2011.

 

Equity Appreciation Rights Plan

 

In November 2010, the Board of Directors approved the adoption of the Nortech Systems Incorporated Equity Appreciation Rights Plan (the “2010 Plan”).  The total number of Equity Appreciation Right Units (Units) the Plan can issue shall not exceed an aggregate of 750,000 Units, of which 100,000 Units were granted during the year ended December 31, 2010.  There were no additional Units granted during the three and nine months ended September 30, 2011.

 

The 2010 Plan provides that Units granted shall fully vest three years from the grant date unless terminated earlier.  Units give the holder a right to receive a cash payment equal to the appreciation in book value per share of common stock from the base date, as defined, to the redemption date.  Unit redemption payments under this plan shall be paid in cash within 90 days after we determine the book value of the Units as of the calendar year immediately preceding the redemption date.  The Units granted during the year ended December 31, 2010 have a book value per Unit of $6.84 and have a weighted average life remaining of 1.25 years at September 30, 2011.  Total compensation expense related to these Units based on the estimated appreciation over their remaining term was $10,193 and $42,655 for the three and nine months ended

 

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September 30, 2011, respectively.  No compensation expense related to these Units was recognized in the three and nine months ended September 30, 2010.

 

Earnings per Common Share

 

For the three and nine months ended September 30, 2011 and 2010, the effect of all outstanding stock options was antidilutive.  Therefore, no outstanding options were included in the computation of per-share amounts.

 

Segment Reporting Information

 

For the three and nine months ended September 30, 2011 and 2010 all of our operations fall under the Contract Manufacturing segment within the Electronic Manufacturing Services industry.  We strategically direct production between our various manufacturing facilities based on a number of considerations to best meet our customers’ requirements.  We share resources for sales, marketing, cash and risk management, banking, credit and collections, human resources, payroll, internal control, audit, taxes, SEC reporting and corporate accounting.  Consolidated financial information is available that is evaluated regularly by the chief operating decision maker in assessing performance and allocating resources.

 

Inventories

 

Inventories are stated at the lower of cost (first-in, first-out method) or market (based on the lower of replacement cost or net realizable value).  Costs include material, labor, and overhead required in the warehousing and production of our products.  Inventory reserves are maintained for the estimated value of the inventories that may have a lower value than stated or quantities in excess of future production needs.

 

Inventories are as follows:

 

		September 30			December 31
		2011			2010
Raw Materials		$	14,643,580		$	11,277,741
Work in Process		4,268,633			3,477,236
Finish Goods		3,501,299			2,395,843
Reserve		(1,017,054		)	(1,042,047		)
Total		$	21,396,458		$	16,108,773

 

Finite Life Intangible Assets

 

Finite life intangible assets at September 30, 2011 and December 31, 2010 are as follows:

 

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		September 30, 2011
		Remaining		Gross
		Lives		Carrying			Accumulated			Net Book
		(Years)		Amount			Amortization			Value
Bond Issue Costs		10		$	79,373		$	27,782		$	51,591
Customer Base		1		676,557			631,450			45,107
Totals				$	755,930		$	659,232		$	96,698

 

		December 31, 2010
		Remaining		Gross
		Lives		Carrying			Accumulated			Net Book
		(Years)		Amount			Amortization			Value
Bond Issue Costs		11		$	79,373		$	23,814		$	55,559
Customer Base		2		676,557			529,966			146,591
Totals				$	755,930		$	553,780		$	202,150

 

Amortization expense for the three months ended September 30, 2011 and 2010 was $35,150 and $35,151, respectively.  Amortization expense for the nine months ended September 30, 2011 and 2010 was $105,452 and $106,248, respectively.  Estimated future amortization expense related to these assets is as follows:

 

Remainder of 2011		$	35,000
2012		17,000
2013		5,000
2014		5,000
2015		5,000
Thereafter		30,000
Total		$	97,000

 

NOTE 2. CONCENTRATION OF CREDIT RISK AND MAJOR CUSTOMERS

 

Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash and accounts receivable.  With regard to cash, we maintain our excess cash balances in checking accounts at one high-credit quality financial institution.  These accounts may at times exceed federally insured limits.  We grant credit to customers in the normal course of business and do not require collateral on our accounts receivable.

 

One customer accounted for 10% or more of our net sales for the three and nine months ended September 30, 2011 and 2010.  G.E.’s Medical Division accounted for 18% and 16% of net sales for the three and nine months ended September 30, 2011, respectively.  G.E.’s Medical Division accounted for 17% and 18% of net sales for the three and nine months ended September 30,

 

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2010.  GE’s Transportation Division accounted for 9% and 8% of net sales for the three and nine months ended September 30, 2011, respectively.  GE’s Transportation Division accounted for 6% and 8% of net sales for the three and nine months ended September 30, 2010, respectively.  GE’s Medical and Transportation Divisions combined accounted for 28% and 24% of net sales for the three and nine month periods ended September 30, 2011, respectively.  GE’s Medical and Transportation Divisions combined accounted for 23% and 27% of net sales for the three and nine month periods ended September 30, 2010.  Accounts receivable from G.E.’s Medical and Transportation Divisions represented 18% and 14% of total accounts receivable at September 30, 2011 and December 31, 2010, respectively.

 

Export sales represented 6% of consolidated net sales for the three and nine months ended September 30, 2011.  Export sales represented 6% and 5% of consolidated net sales for the three and nine months ended September 30, 2010, respectively.

 

NOTE 3. FINANCING ARRANGEMENTS

 

Our credit agreement with Wells Fargo Bank (WFB) provides for a line of credit arrangement of $13.5 million, which expires on May 31, 2013, if not renewed.  The credit arrangement also has a real estate term note with a maturity date of May 31, 2012, a new $475,000 equipment term loan tied to equipment purchased in the Mankato acquisition (Note 6), and a new term loan of up to $1.0 million for capital expenditures to be made in 2011.

 

Both the line of credit and real estate term note are subject to variations in LIBOR rates.  The weighted-average interest rate on our line of credit was 3.6% and 3.8% for the three and nine months ended September 30, 2011, respectively, while the weighted-average rate on our real estate term loan was 3.6% and 4.4% for the same periods, respectively.  The line of credit, real estate term note, and equipment term 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.  On September 30, 2011, we had an outstanding balance of $9.3 million under the line of credit, with unused availability of $4.0 million supported by our borrowing base and we were in compliance with all covenants.  As of September 30, 2011 the entire $1.0 million for capital expenditure is available.

 

NOTE 4.  DERIVATIVE INSTRUMENTS AND HEDGING STRATEGIES

 

We are exposed to interest rate risk associated with fluctuations in the interest rates on our variable interest rate debt.  In order to manage some of the risk, we entered into an interest rate swap agreement with a notional amount of $1.4 million to effectively convert our industrial revenue bond debt from a variable rate to a fixed rate of 4.07% for five years.  This swap agreement matured on June 28, 2011 and we did not renew.  We did not use this interest rate swap for speculative purposes.  At December 31, 2010, the fair value of the swap of approximately $18,000 was recorded in other long-term liabilities.  The change in fair value of $18,000 and $20,000 for the nine month periods ended September 30, 2011 and 2010, respectively, was recorded as a component of interest expense.

 

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NOTE 5.  INCOME TAXES

 

On a quarterly basis, we estimate what our effective tax rate will be for the full fiscal year and record a quarterly income tax provision based on the anticipated rate.  As the year progresses, we refine our estimate based on the facts and circumstances by each tax jurisdiction.  Our effective tax rate for the three and nine months ended September 30, 2011 was 35% and 31%, respectively, compared with 42% and 52% for the three and nine months ended September 30, 2010, respectively.

 

The differences between federal income taxes computed at the federal statutory rate and reported income taxes for the three and nine months ended September 30, 2011 are as follows:

 

		Three Months Ended						Nine Months Ended
		September 30						September 30
		2011			2010			2011			2010
Statutory federal tax provision		$	96,000		$	71,000		$	473,000		$	261,000
State income taxes		8,000			8,000			41,000			24,000
Income tax credits		(20,000		)	(2,000		)	(52,000		)	(6,000		)
NOL carryback true up		—			—			—			111,000
Tax authority closing agreement		—			—			(96,000		)	—
Reserve for uncertain tax positions		5,000			—			95,000			—
Other		9,000			16,000			(26,000		)	8,000
Income tax expense		$	98,000		$	93,000		$	435,000		$	398,000

 

At September 30, 2011 we had $113,000 of net uncertain tax benefit positions recorded in other long-term liabilities that would reduce our effective income tax rate if recognized.  The $1,000 decrease from December 31, 2010 was related to the release of reserves for uncertain tax positions of $96,000 recorded for the years ended December 31, 2004 through 2009, offset in part by an increase in uncertain tax positions of $95,000 related to R&E credits.

 

NOTE 6. ACQUISITIONS

 

On May 4, 2010, we acquired all of the intellectual property and assets, excluding cash and receivables, of Trivirix Corporation, Milaca, MN from Silicon Valley Bank for cash of $403,000.  The fair value of assets acquired included $303,000 in inventory and $100,000 in property and equipment.  This operation specializes in design, manufacturing and post-production services of complex electronic and electromechanical medical devices for diagnostic, analytical and other life-science applications.  This acquisition expanded our capabilities and expertise serving medical electronics manufacturers.  The acquisition was accounted for as a business combination and results of operations for Milaca since the date of acquisition are included in the consolidated financial statements.

 

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On January 1, 2011, we completed the purchase of Winland Electronics, Inc. assets and certain liabilities relating to their EMS operations located in Mankato, MN.  Winland is a designer and manufacturer of custom electronic control products and systems.  This purchase provided needed manufacturing capacity, particularly for supporting medical and industrial customers with printed circuit board assemblies and higher-level builds.  The acquisition was accounted for as a business combination and results of operations since the date of acquisition are included in the consolidated financial statements.

 

We paid $1,042,389 in cash at closing, $212,233 on July 1, 2011 and $250,000 on October 1, 2011.  As provided for in the purchase agreement, our July 1, 2011 required payment of $250,000 was reduced by $37,767 for acquired accounts receivable which were deemed uncollectible in the second quarter and assigned back to Winland.  As part of the acquisition we also agreed to purchase from Winland a minimum of $2,200,000 of inventory to be consumed over a period of 24 months.  We have exceeded this minimum requirement as of September 30, 2011.

 

We also agreed to manufacture certain products for Winland’s remaining proprietary monitoring devices business unit.  For the nine months ended September 30, 2011, sales to Winland were approximately $2,100,000.  We also signed a six year agreement to lease office and manufacturing space at 1950 Excel Drive, Mankato, Minnesota, 56001, and sublease 1,924 square feet back to Winland for one year.  Net rent expense under this operating lease for the three and nine months ended September 30, 2011 was approximately $65,000 and $196,000, respectively, and is included in cost of good sold.

 

The following table presents the allocation of the acquisition cost to the assets acquired and liabilities assumed, based on their estimated fair values at the time of the acquisition:

 

Accounts receivable		$	1,914,723
Property, plant and equipment		2,451,000
Accounts payable assumed		(1,772,334		)
Lease payoff		(259,385		)
Net assets acquired		$	2,334,004
Cash Paid at Closing		1,042,389
Due to Winland		500,000
Purchase price		1,542,389
Bargain purchase gain		791,615
Net assets acquired		$	2,334,004

 

We recognized a $791,615 bargain purchase gain related to the excess fair value over the purchase price for the assets acquired in the first quarter.

 

The table below reflects our unaudited pro forma combined results of operations as if the acquisition had taken place as of January 1, 2010:

 

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		Pro Forma			Pro Forma
		Three Months Ended			Nine Months Ended
		September 30, 2010			September 30, 2010
		(unaudited)			(unaudited)
Net Sales		$	29,497,000		$	83,996,000
Income from Continuing Operations		$	50,000		$	221,000
Net Income		$	22,000		$	31,000
Basic Income per Common Share		$	0.01		$	0.01

 

Combined results for the two companies for the three and nine months ended September 30, 2010 were adjusted for the following in order to create the unaudited proforma results in the table above:

 

·                  Additional rent expense of approximately $65,000 per quarter for the lease of the facility from Winland, offset by building depreciation of $21,000 per quarter,

·                  Additional depreciation expense of approximately $40,000 per quarter resulting from the adjustment of property and equipment to their fair values,

·                  Tax benefit of approximately $65,000 and $208,000 using an effective tax rate of 38% for the three and nine months ended September 30, 2010.

·                  The impact of these adjustments on outstanding shares of 2,742,992 was to decrease proforma income per share by $0.04 and $0.12 for the three and nine months ended September 30, 2010.

 

The pro forma unaudited results do not purport to be indicative of the results which would have been obtained had the acquisition been completed as of the beginning of the earliest period presented.  In addition they do not include any benefits that may result from the acquisition due to synergies that may be derived from the elimination of any duplicative costs.

 

ITEM 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

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 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.

 

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Summary of Results:

 

In the third quarter we continued to see growth in revenue from our recent acquisitions offset in party by some shortfalls in sales and orders from our existing industrial customers.  We attribute this to continued uncertainty in the overall economy and buyers being more cautious about placing orders and carrying excess inventory.  For the quarter ended September 30, 2011, we reported net sales of $28.3 million compared to $26.0 million reported in the same quarter of 2010, a 9% improvement.  For the nine months ended September 30, 2011, we reported net sales of $85.1 million compared to $72.4 million reported for the first nine months of 2010, an increase of 18%.  Our 90-day backlog decreased 4% from the start of the quarter to $21.9 million as of September 30, 2011.  This compares to $23.5 million for the same period last year.

 

Gross profit improved in the third quarter as a result of favorable product and service mix, along with cost and efficiency initiatives at our newly acquired operations.  Our gross profit in the third quarter of 2011 was 11.6% compared to 11.1% in the third quarter of 2010.  Gross profit in the first nine months of 2011 was 11.4% compared to 11.9% in the first nine months of 2010.

 

Income from operations totaled $0.4 million and $0.2 million for the three months ended September 30, 2011 and 2010, respectively.  Income from operations totaled $1.0 million for the each of the nine months ended September 30, 2011 and 2010.

 

Net income for the third quarter of 2011 totaled $0.2 million or $0.07 per diluted common share.  Net income for the nine months ended September 30, 2011 totaled $1.0 million or $0.35 per diluted common share; $0.4 million or $0.15 per diluted common share excluding the bargain purchase gain of $0.5 million, net of tax.  Net income totaled $0.1 million and $0.4 million for the three and nine months ended September 30, 2010.

 

Our cash position improved in the third quarter as we extended terms with key suppliers.  Cash provided from operating activities was $2.5 million in the third quarter of 2011.  Cash used in operating activities for the nine months ended September 30, 2011 was $2.2 million compared to cash provided by operating activities of $1.6 million for the same nine month period in 2010.

 

(1.)         Results of Operations:

 

The following table presents statements of income data as percentages of total net sales for the periods indicated:

 

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		Three Months Ended				Nine Months Ended
		September 30				September 30
		2011		2010		2011		2010
Net Sales		100.0	%	100.0	%	100.0	%	100.0	%
Cost of Goods Sold		88.4		88.9		88.6		88.1
Gross Profit		11.6		11.1		11.4		11.9
Selling Expenses		3.2		3.0		3.2		3.2
General and Administrative Expenses		6.9		7.5		7.0		7.4
Income from Operations		1.5		0.6		1.2		1.3
Bargain Purchase Gain		0.0		0.0		0.9		0.0
Other Income (Expense), Net		(0.5	)	0.2		(0.5	)	(0.3	)
Income Before Income Taxes		1.0		0.8		1.6		1.0
Income Tax Expense		0.3		0.3		0.5		0.5
Net Income		0.7	%	0.5	%	1.1	%	0.5	%

 

Net Sales:

 

We reported net sales of $28.3 million and $26.0 million for the three months ended September 30, 2011 and 2010, respectively, a 9% increase.  Net sales for the nine months ended September 30, 2011 and 2010 were $85.1 million and $72.4 million, respectively, an 18% increase.  The 2011 net sales were impacted by our two recent acquisitions which added $5.2 million and $15.9 million of net sales for the three and nine months ended September 30, 2011, respectively.

 

Net sales by industry markets for the three and nine month periods ended September 30, 2011 and 2010 are as follows:

 

		Three Months Ended						Nine Months Ended
		September 30						September 30
		2011		2010		%		2011		2010		%
(in thousands)		$		$		Change		$		$		Change
Aerospace and Defense		3,774		3,930		(4	)	10,949		12,003		(9	)
Medical		8,503		7,004		21		24,293		18,965		28
Industrial		16,055		15,023		7		49,871		41,425		20
Total Sales		28,332		25,957		9		85,113		72,393		18

 

Net sales to our Aerospace and Defense customers for the three months ended September 30, 2011 were slightly lower than last year due to production delays.  The decrease for the nine months ended September 30, 2011 was related to late approval of the Federal Government’s funding of 2011 defense programs.  The increase in net sales to our Medical customers of $1.5 million for the three months ended September 30, 2011 was primarily due to growth in our existing customer base of $0.8 million and the Mankato acquisition which generated an additional $0.7 million in additional net sales.  The increase in net sales to our Medical customers of $5.3 million for the nine months ended September 30, 2011 is primarily due to the

 

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Mankato and Milaca acquisitions, which added $2.4 million and $2.6 million, respectively.  The Mankato acquisition also positively impacted net sales to Industrial customers by $4.6 million and $11.4 million for the three and nine months ending September 30, 2011, respectively, offset by shortfalls to our existing Industrial customers being impacted by an overall uncertain economy.

 

Backlog:

 

Our 90-day order backlog as of September 30, 2011 was approximately $21.9 million, compared to approximately $22.8 million at the beginning of the quarter and $23.5 million at September 30, 2010.  Backlog by industry market is shown below.

 

		Backlog as of the Quarter Ended
		September 30			June 30			%
(in thousands)		2011			2011			Change
Aerospace and Defense		$	5,384		$	4,025		34
Medical		6,077			6,314			(4	)
Industrial		10,438			12,445			(16	)
Total Backlog		$	21,899		$	22,784		(4	)

 

The overall 90 day backlog is down from the start of the quarter due to continued uncertainty in the economy, especially as it relates to our Medical and Industrial customers. Our Aerospace and Defense backlog has increased in the second half of the year as funding is now available to complete the 2011 defense projects.

 

Gross Profit:

 

Gross profit percentage for the three months ended September 30, 2011 and 2010 was 11.6% and 11.1% of net sales, respectively.  Gross profit percentage for the nine months ended September 30, 2011 and 2010 was 11.4% and 11.9%, respectively.  In the third quarter we started to see margin improvements due to favorable product mix, price adjustments and cost reduction initiatives which resulted in gross profit improvement over the first six months of 2011.

 

General and Administrative Expense:

 

Our general and administrative expenses were $2.0 million or 6.9% of net sales and $1.9 million or 7.5% of net sales for the three months ended September 30, 2011 and 2010, respectively.  General and administrative expenses were $6.0 million or 7.0% of net sales and $5.4 million or 7.4% of net sales for the nine months ended September 30, 2011 and 2010, respectively.  The increase in general and administrative dollars spent in 2011 is primarily attributed to additional personnel and related costs incurred as a result of our recent acquisitions.  The decrease in general and administrative expense as a percent of net sales is due to the leveraging effect on the increased revenue.

 

Other Income (Expense):

 

Other expense for the three months ended September 30, 2011 was $0.1 million compared to other income of $0.1 million for the three months ended September 30, 2010.  The increase in

 

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other expense relates primarily to higher interest expense and less miscellaneous income.  Other income for the nine months ended September 30, 2011 was $0.3 million, while other expense for the nine months ended September 30, 2010 was $0.2 million.  The other income for the first nine months of 2011 is primarily due to recognizing a bargain purchase gain of $0.8 million from the Mankato acquisition in the first quarter of 2011, offset in part by higher interest expense.

 

Income Taxes:

 

Our effective tax rate for the three and nine months ended September 30, 2011 was 35% and 31%, respectively, compared with 42% and 52% for the three and nine months ended September 30, 2010, respectively.  The differences between federal income taxes computed at the federal statutory rate and reported income taxes for the three and nine months ended September 30, 2011 and 2010 are as follows:

 

		Three Months Ended						Nine Months Ended
		September 30						September 30
		2011			2010			2011			2010
Statutory federal tax provision		$	96,000		$	71,000		$	473,000		$	261,000
State income taxes		8,000			8,000			41,000			24,000
Income tax credits		(20,000		)	(2,000		)	(52,000		)	(6,000		)
NOL carryback true up		—			—						111,000
Tax authority closing agreement		—			—			(96,000		)	—
Reserve for uncertain tax positions		5,000			—			95,000			—
Other		9,000			16,000			(26,000		)	8,000
Income tax expense		$	98,000		$	93,000		$	435,000		$	398,000

 

Liquidity and Capital Resources:

 

We have satisfied our liquidity needs over the past several years through revenue 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 note are subject to fluctuations in the LIBOR rates.  The line of credit, real estate term note, 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 September 30, 2011, we had an outstanding balance of $9.3 million under the line of credit and unused availability of $4.0 million supported by our borrowing base.  We also have $1.0 million available under a 2011 capital expenditure term loan agreement.  We believe our financing arrangements and cash flows provided by operations will be sufficient to satisfy our future working capital needs.

 

Our working capital of $11.8 million as of September 30, 2011 decreased from $13.1 million at December 31, 2010 mainly due to increased usage of our line of credit and current maturities of long term debt of $4.9 million and increased accounts payable and accruals of $3.4 million, partially offset by increased inventories of $5.3 million and increased accounts receivable of $2.1

 

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million.  $4.0 million of the inventory increase and all of the accounts receivable is attributable to operations at our new Mankato facility.

 

Net cash used in operating activities for the nine months ended September 30, 2011 was $2.2 million.  The cash flow used in operations for the nine months ended September 30, 2011 is primarily the result of working capital requirements needed to support the Mankato operations, which included the purchase of approximately $4.0 million of inventory.  Beginning in the third quarter of 2011, we are back to generating cash from operating activities.  The cash provided from operating activities for the three months ended September 30, 2011 was $2.5 million, mainly attributed to an increase in accounts payable of $2.2 million resulting from extending terms with our large suppliers.

 

Net cash used in investing activities of $1.6 million for the nine months ended September 30, 2011 is comprised of $0.6 million in property and equipment purchases to support the business and $1.0 million for the Mankato operation acquisition (see Note 6).

 

Net cash provided by financing activities for the nine months ended September 30, 2011 was $3.6 million, mainly due to the increase in borrowing on the line of credit and notes payable of $5.0 million, in the aggregate, required to fund the Mankato acquisition and growth, partially offset by debt payments of $1.4 million.

 

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, 2010.  There have been no significant changes in these critical accounting policies since December 31, 2010.  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.

 

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:

 

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·                  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;

·                  Successful integration of recent acquisitions

 

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 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, 2010.

 

ITEM 4.   CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls and Procedures:

 

In accordance with Rule 13a-15(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), as of the end of the period covered by this Quarterly Report on Form 10-Q, our management evaluated, with the participation of our Chief Executive Officer and Executive Vice President and Chief Financial Officer, the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) under the Exchange Act).  Based upon their evaluation of these disclosure controls and procedures, the Chief Executive Officer and Chief Financial Officer have concluded that the disclosure controls and procedures were effective as of the date of such evaluation in ensuring that information required to be disclosed in our Exchange Act reports is (1) recorded, processed, summarized and reported in a timely manner, and (2) accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

 

Changes in Internal Control Over Financial Reporting:

 

There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II

 

ITEM 1.    LEGAL PROCEEDINGS

 

We are subject to various legal proceedings and claims that arise in the ordinary course of business.

 

ITEM 6. EXHIBITS

 

Exhibits

 

31.1		Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.
31.2		Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.
32		Certification of the Chief Executive Officer and Chief Financial Officer, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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