Nortech Systems (NSYS) 10-Q2023 Q2 Quarterly report

TABLE OF CONTENTS

PART

ITEM 1. FINANCIAL STATEMENTS

See Accompanying Condensed Notes to Condensed Consolidated Financial Statements

See Accompanying Condensed Notes to Condensed Consolidated Financial Statements

⁽¹⁾ The balance sheet at December 31, 2022 has been derived from the audited financial statements at that date

See Accompanying Condensed Notes to Condensed Consolidated Financial Statements

See Accompanying Condensed Notes to Condensed Consolidated Financial Statements

CONDENSED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(UNAUDITED)

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying unaudited condensed 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 condensed consolidated financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2022. 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 condensed consolidated financial statements, we have made our best estimates and judgments of certain amounts included in the condensed 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 condensed consolidated financial statements include the accounts of Nortech Systems Incorporated and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

Revenue Recognition

Our revenue is comprised of product, engineering services and repair services. All revenue is recognized when the Company satisfies its performance obligation(s) under the contract by transferring the promised product or service to our customer either when (or as) our customer obtains control of the product or service, with the majority of our revenue being recognized over time including goods produced under contract manufacturing agreements and services revenue. A performance obligation is a promise in a contract to transfer a distinct product or service to a customer. A contract’s transaction price is allocated to each distinct performance obligation. The majority of our contracts have a single performance obligation. Revenue is recorded net of returns, allowances and customer discounts. Our net sales for services were less than 10% of our total sales for all periods presented, and accordingly, are included in net sales in the Condensed Consolidated Statements of Operations and Comprehensive Income. Sales, value add, and other taxes collected from customers and remitted to governmental authorities are accounted for on a net (excluded from revenues) basis. 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.

Stock-Based Awards

Stock Options

In May 2017, the shareholders approved the 2017 Stock Incentive Plan which authorized the issuance of 350,000 shares. Subsequent to this approval, an additional 325,000 shares have been authorized by the shareholders.

We granted 29,000 service-based stock options during the three and six months ended June 30, 2023. The weighted-average grant-date fair value of options granted during the six months ended June 30, 2023 was $5.66. There were no market-based stock options granted during the three and six months ended June 30, 2023.

We granted 0 and 21,000 market-based stock options during the three and six months ended June 30, 2022, respectively. The market condition options vest if certain stock prices are exceeded between February 27, 2024 and February 27, 2028. We granted 13,000 and 66,000 service-based options during the three and six months ended June 30, 2022, respectively. Total option grants for the three and six months ended June 30, 2022 were 13,000 and 108,000, respectively.

Total compensation expense related to stock options was $55 and $123 for the three and six months ended June 30, 2023, respectively. Total compensation expense related to stock options was $64 and $106 for the three and six months ended June 30, 2022, respectively. As of June 30, 2023, there was $632 of unrecognized compensation which will vest over a weighted average period of 3.7 years.

Following is the status of all stock options as of June 30, 2023:

Restricted Stock Units

During the three months and six months ended June 30, 2023, we granted 18,000 restricted stock units (“RSUs”) under our 2017 Stock Incentive Plan to non-employee directors which vest over two years. The RSUs granted in the three and six months ended June 30, 2023 had an average grant price of $9.37 per share. Total compensation expense related to the RSUs was $38 and $69 for the three and six months ended June 30, 2023, respectively. Total unrecognized compensation expense related to the RSUs was $195, which will vest over a weighted average period of 1.4 years.

During the three months and six months ended June 30, 2022, we granted 3,000 and 18,000 restricted stock units, respectively to non-employee directors which vest over two years. Total compensation expense related to the RSUs was $29 and $35 for the three and six months ended June 30, 2022, respectively.

Following is a status of all RSUs as of June 30, 2023:

Net Income per Common Share

Basic net income per common share is computed by dividing net income by the weighted-average number of common shares outstanding. Dilutive net income per common share assumes the exercise and issuance of all potential common stock equivalents in computing the weighted-average number of common shares outstanding, unless their effect is antidilutive. All stock options and restricted stock units, while outstanding, are considered common stock equivalents.

For the three and six months ended June 30, 2023, stock options of 152,782 and 182,192, respectively were included in the computation of diluted net income per common share as their impact were dilutive. For the three and six months ended June 30, 2022, stock options of 203,625 and 197,285, respectively were included in the computation of diluted net income per share as their impact were dilutive.

We had outstanding stock options totaling 40,550 and RSUs totaling 20,178 that are not included in the computation of diluted net income per share as their effect would have been anti-dilutive for the three months ended June 30, 2023. We had average outstanding stock options totaling 33,034 and RSUs totaling 14,148 that are not considered in the computation of diluted net income per share as their effect would have been anti-dilutive for the six months ended June 30, 2023. We had outstanding stock options totaling 45,878 and RSUs totaling 19,114 that are not considered in the computation of diluted net income per share as their effect would have been anti-dilutive for the three months ended June 30, 2022. We had average outstanding stock options totaling 48,895 and RSUs totaling 20,057 that are not considered in the computation of diluted net income per share as their effect would have been anti-dilutive for the six months ended June 30, 2022.

Restricted Cash

Cash and cash equivalents classified as restricted cash on our consolidated balance sheets are restricted as to withdrawal or use under the terms of certain contractual agreements. As of June 30, 2023, we had outstanding letters of credit for $300. Restricted cash as of June 30, 2023 was $1,134. The June 30, 2023 and December 31, 2022 restricted cash balance included lockbox deposits that are temporarily restricted due to timing at the period end. The lockbox deposits are applied against our line of credit the next business day.

Accounts Receivable

Credit is extended based upon an evaluation of the customer’s financial condition and, while collateral is not required, the Company periodically receives surety bonds that guarantee payment. Credit terms are consistent with industry standards and practices.

Allowance for Credit Losses

When we record customer receivables and contract assets arising from revenue transactions, we record an allowance for credit losses for the current expected credit losses (CECL) inherent in the asset over its expected life. The allowance for credit losses is a valuation account deducted from the cost basis of the assets to present their net carrying value at the amount expected to be collected. Each period, the allowance for credit losses is adjusted through earnings to reflect expected credit losses over the remaining lives of the assets.

We estimate expected credit losses based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. When measuring expected credit losses, we pool assets with similar country risk and credit risk characteristics. Changes in the relevant information may significantly affect the estimates of expected credit losses.

Assets are written off when we determine them to be uncollectible. Write-offs are recognized as a deduction from the allowance for credit losses.

Inventories

Inventories are stated at the lower of average cost (which approximates first-in, first out) 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:

Other Intangible Assets

Other intangible assets at June 30, 2023 and December 31, 2022 are as follows:

Intangible assets are amortized on a straight-line basis over their estimated useful lives. The weighted-average remaining amortization period of our intangible assets is 1.4 years. Of the patents value at June 30, 2023, $88 are being amortized and $110 are in process and a patent has not yet been received.

Amortization expense of finite life intangible assets for the three and six months ended June 30, 2023 was $40 and $80, respectively. Amortization expense of finite life intangible assets for the three and six months ended June 30, 2022 was $35 and $71, respectively.

Estimated future annual amortization expense (not including patents in process of $110) related to these assets is approximately as follows:

Adoption of New Accounting Standards

In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326). The ASU introduces a new credit loss methodology, Current Expected Credit Losses (CECL), which requires earlier recognition of credit losses, while also providing additional transparency about credit risk.

The CECL methodology utilizes a lifetime “expected credit loss” measurement objective for the recognition of credit losses for loans, held-to-maturity securities and other receivables at the time the financial asses is originated or acquired. The expected credit losses are adjusted each period for changes in expected lifetime credit losses. The methodology replaces the multiple existing impairment methods in current GAAP, which generally require that a loss be incurred before it is recognized.

On January 1, 2023, we adopted the guidance prospectively with a cumulative adjustment to retained earnings. We have not restated comparative information for 2022 and, therefore, the comparative information for 2022 is reported under the old model and is not comparable to the information presented for 2023.

At adoption, we recognized an allowance for credit losses related to accounts receivable and contract assets of $30, net of tax, and a decrease in retained earnings of $30 associated with the increased estimated credit losses.

Revision and Immaterial Correction of an Error in Previously Issued Financial Statements

The Company identified an error related to the classification of the activity on our line of credit facility with Bank of America at December 31, 2022 as reported on Form 10-K. In our June 30, 2022 condensed consolidated financial statements, we incorrectly classified borrowings and payments on our line of credit facility on a net basis within the financing section of the condensed consolidated cash flow statement; this activity should be shown on a gross basis. This change in presentation to the condensed consolidated cash flow statement does not impact total operating, investing, or financing cash flows. There was no change to the condensed consolidated statement of income or condensed consolidated balance sheet. In accordance with ASC 250, Accounting Changes and Error Corrections, we evaluated the materiality of the errors from quantitative and qualitative perspectives and concluded that the errors were immaterial to the Company’s 2022 audited financial statements. Since these revisions were not material to any prior period financial statements, no amendments to previously filed financial statements are required. Consequently, the Company has corrected these immaterial errors by revising the June 30, 2022 consolidated financial statements presented herein.

The tables below present the effect of the financial statement adjustments related to the revision discussed above of the Company’s previously reported financial statements as of and for the period ended June 30, 2022:

NOTE 2. CONCENTRATION OF CREDIT RISK AND MAJOR CUSTOMERS

Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash, accounts receivable, and contract assets. With regard to cash, we maintain our excess cash balances in checking accounts at primarily two financial institutions, one in the United States and one in China. The account in the United States may at times exceed federally insured limits. Of the $1,915 in cash and restricted cash at June 30, 2023, approximately $749 and $15 was held at banks located in China and Mexico, respectively. We grant credit to customers in the normal course of business and do not require collateral on our accounts receivable.

We have certain customers whose revenue individually represented 10% or more of net sales, or whose accounts receivable balances individually represented 10% or more of gross accounts receivable. Two customers accounted for 39% of net sales for both the three and six months ended June 30, 2023. One customer accounted for 28% and 26% of net sales for the three and six months ended June 30, 2022, respectively.

At June 30, 2023, two customers represented approximately 38% of our gross accounts receivable. At December 31, 2022, one customer represented approximately 21% of our gross accounts receivable.

Contract assets for one customer accounted for 18% and 22% of gross contract assets at June 30, 2023 and December 31, 2022, respectively.

Export sales represented approximately 3% for both the three and six months ended June 30, 2023. Export sales represented approximately 4% of net sales for both the three and six months ended June 30, 2022.

NOTE 3. REVENUE

Revenue recognition

Our revenue is comprised of product, engineering services and repair services. All revenue is recognized when the Company satisfies its performance obligation(s) under the contract by transferring the promised product or service to our customer either when (or as) our customer obtains control of the product or service, with the majority of our revenue being recognized over time including goods produced under contract manufacturing agreements and services revenue. A performance obligation is a promise in a contract to transfer a distinct product or service to a customer. A contract’s transaction price is allocated to each distinct performance obligation. The majority of our contracts have a single performance obligation, as the promise to transfer products or services is not separately identifiable from other promises in the contract and, therefore, not distinct.

Revenue is measured as the amount of consideration we expect to receive in exchange for transferring products or providing services. As such, revenue is recorded net of returns, allowances and customer discounts. Sales, value add, and other taxes collected from customers and remitted to governmental authorities are accounted for on a net (excluded from revenues) basis. Shipping and handling costs are included in cost of goods sold.

The majority of our revenue is derived from the transfer of goods produced under contract manufacturing agreements which have no alternative use and we have an enforceable right to payment for our performance completed to date. Our performance obligations within our contract manufacturing agreements are generally satisfied over time as the goods are produced based on customer specifications and we have an enforceable right to payment for the goods produced. Revenues under these agreements are generally recognized over time using an input measure based upon the proportion of actual costs incurred. If these requirements are not met, the revenue is recognized at a point in time, generally upon shipment. Revenue under contract manufacturing agreements that was recognized over time accounted for approximately 73% and 74% of net sales for the three and six months ended June 30, 2023, respectively and 74% of net sales for both the three and six months ended June 30, 2022.

Accounting for contract manufacturing agreements involves the use of various techniques to estimate total revenue and costs. We estimate profit on these agreements as the difference between total estimated revenue and expected costs to complete the performance obligation within the terms of the agreement and recognize the respective profit as the goods are produced. The estimates to determine the profit earned on the performance obligation are based on anticipated selling prices and historical cost of goods sold and represent our best judgement at the time. Changes in judgements on these above estimates could impact the timing and amount of revenue recognized with a resulting impact on the timing and amount of associated profit.

On occasion our customers provide materials to be used in the manufacturing process and the fair value of the materials is included in revenue as noncash consideration at the point in time when the manufacturing process commences along with the same corresponding amount recorded as cost of goods sold. The inclusion of noncash consideration has no impact on overall profitability.

Contract Assets

Contract assets, recorded as such in the Consolidated Balance Sheet, consist of unbilled amounts related to revenue recognized over time. Significant changes in the contract assets balance during the six months ended June 30, 2023 was as follows (in thousands):

We expect substantially all of the remaining performance obligations for the contract assets recorded as of June 30, 2023, to be transferred to receivables within 90 days, with any remaining amounts to be transferred within 180 days. We bill our customers upon shipment with payment terms of up to 120 days.

The following tables summarize our net sales by market for the three months ended June 30, 2023 and 2022, respectively:

The following tables summarize our net sales by market for the six months ended June 30, 2023 and 2022, respectively:

NOTE 4. FINANCING ARRANGEMENTS

We have a credit agreement with Bank of America, which was entered into on June 15, 2017 and provides for a line of credit arrangement of $16,000 that expires on June 15, 2026.

Under the amended Bank of America credit agreement signed December 31, 2021, the line of credit is subject to variations in the Bloomberg Short-Term Bank Yield (BSBY) index rate. Our line of credit bears interest at a weighted-average interest rate of 7.9% and 5.2% as of June 30, 2023 and December 31, 2022, respectively. We had borrowings on our line of credit of $7,056 and $6,897 outstanding as of June 30, 2023 and December 31, 2022, respectively. There are no subjective acceleration clauses under the credit agreement that would accelerate the maturity of our outstanding borrowings. In addition, the credit agreement does not expire within one year, the Company is not in violation of the covenants and the Company expects Bank of America to be capable of honoring the financing arrangement. The line of credit is shown net of debt issuance costs of $37 and $44 on the condensed consolidated balance sheet for the periods ended June 30, 2023 and December 31, 2022, respectively.

The line of credit with Bank of America contains 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 Bank of America Credit Agreement provides for, among other things, a Fixed Charge Coverage Ratio of not less than 1.0 to 1.0, for the twelve months ending December 31, 2020 and each Fiscal Quarter end thereafter subject only during a trigger period commencing when our availability under our line is less than $2,000 until availability is above that amount for 30 days. The Company met the covenants for the period ended June 30, 2023.

At June 30, 2023, we had unused availability under our line of credit of $5,292 supported by our borrowing base. The line is secured by substantially all of our assets.

NOTE 5. LEASES

We have operating leases for certain manufacturing sites, office space, and equipment. Most leases include the option to renew, with renewal terms that can extend the lease term from one to five years or more. Right-of-use lease assets and lease liabilities are recognized at the commencement date based on the present value of the remaining lease payments over the lease term which includes renewal periods we are reasonably certain to exercise. Our leases do not contain any material residual value guarantees or material restrictive covenants. At June 30, 2023, we do not have material lease commitments that have not commenced.

The components of lease expense were as follows:

Supplemental balance sheet information related to leases was as follows:

Supplemental cash flow information related to leases was as follows:

Maturities of lease liabilities were as follows:

The lease term and discount rate at June 30, 2023 were as follows:

NOTE 6. 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, including discrete events, by each tax jurisdiction.

Our effective tax rate for the three and six months ended June 30, 2023 was 35% and 31%, respectively. Our effective tax rate for the three and six months ended June 30, 2022 was 21% and 12%, respectively. The primary drivers of the change in the effective tax rate relate to an increase in projected pre-tax book income as well as an increase in the valuation allowance due to Section 174.

NOTE 7. EMPLOYEE RETENTION CREDIT

On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) was signed into law providing numerous tax provisions and other stimulus measures, including an employee retention credit (“ERC”), which is a refundable tax credit against certain employment taxes. The Taxpayer Certainty and Disaster Tax Relief Act of 2020 and the American Rescue Plan Act of 2021 extended and expanded the availability of the ERC.

All ERC payments have been received as of June 30, 2023. At December 31, 2022, the Company had ERC benefits of $2,650 within Employee Retention Credits Receivable on the condensed consolidated balance sheet.

NOTE 8. RELATED PARTY TRANSACTIONS

David Kunin, our Chairman, is a minority owner of Abilitech Medical, Inc. Mr. Kunin also was a consultant to Abilitech through March 1, 2021. In the three and six months ended June 30, 2022, Abilitech paid the Company $163 and $217, respectively, for the delivery of medical products. No payments were received for the three and six months ended June 30, 2023. We have assets recorded related to Abilitech including $226 of accounts receivable and inventory. We do not believe that Abilitech will pay the Company for outstanding accounts receivable or for inventory and we have recorded a full reserve against the gross amounts. The Company believes that transactions with Abilitech are on terms comparable to those that the Company could reasonably expect in an arm's length transaction with an unrelated third party.

David Kunin, our Chairman, is a minority owner (less than 10%) of Marpe Technologies, LTD an early-stage medical device company dedicated to the early detection of skin cancer through full body scanners. Mr. Kunin is also a member of the Board of Directors of Marpe Technologies. The Company worked with Marpe Technologies to apply for a grant from the Israel-United States Binational Industrial Research and Development Foundation, a legal entity created by Agreement between the Government of the State of Israel and the Government of the United States of America (“BIRD Foundation”). The parties were successful in receiving approval for a $1,000 conditional grant. The Company and Marpe Technologies will each receive $500 from the BIRD Foundation and, among other obligations under the grant, each is required to contribute $500 to match grant funds from the BIRD Foundation. The Company will meet its obligation by providing certain services at cost or with respect to administrative services at no cost to Marpe Technologies. The total value of the Company’s contribution will not exceed $500. Marpe is engaged in raising funds for its operations, which funds are necessary to pay for the Company’s services beyond its contribution. The Company will receive a 10-year exclusive right to manufacture the products of Marpe Technologies. There can be no assurances that Marpe Technologies’ medical device operations will be commercially successful, that Marpe Technologies will be successful in raising additional funds to finance its operations or, if commercially successful, the Company will recover the value of services provided to Marpe if not paid when the services are provided. The transactions between the Company and Marpe Technologies have been approved by the Audit Committee pursuant to the Company Related-Party Transactions Policy. During the six months ended June 30, 2023 and 2022, we recognized revenue to Marpe Technologies of $163 and $113, respectively. The Company believes that transactions with Marpe are on terms comparable to those that the Company could reasonably expect in an arm’s length transaction with an unrelated third party.

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

Overview

We are a Minnesota, United States based full-service global EMS contract manufacturer in the Medical, Aerospace & Defense and Industrial markets offering a full range of value-added engineering, technical and manufacturing services and support including project management, design, testing, prototyping, manufacturing, supply chain management and post-market services. Our products are complex electromedical and electromechanical products including medical devices, wire and cable assemblies, printed circuit board assemblies, higher-level assemblies, and other box builds for a wide range of industries. We serve three major markets within the EMS industry: Aerospace and Defense, Medical, and the Industrial market, which includes industrial capital equipment, transportation, vision, agriculture, oil and gas. We maintain facilities in Bemidji, Blue Earth, Mankato, and Milaca, Minnesota; Monterrey, Mexico; and Suzhou, China. All of our facilities are certified to one or more of the ISO/AS standards, including 9001, AS9100 and 13485, with most having additional certifications based on the needs of the customers they serve.

Results of Operations

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

Net Sales

Net sales for the three months ended June 30, 2023 and 2022 were $35.0 million and $32.5 million, respectively, an increase of $2.5 million or 8%. Net sales for the six months ended June 30, 2023 and 2022 were $69.9 million and $63.2 million, respectively, an increase of $6.7 million or 11%. The three and six month increase in net sales was driven primarily by higher production volume as well as price increases to counteract higher material and labor cost.

Net sales by our major industry markets for the three months ended June 30, 2023 and 2022 were as follows (in millions):

Net sales by timing of transfer of goods and services for the three and six months ended June 30, 2023 is as follows (in millions):

Net sales by timing of transfer of goods and services for the three and six months ended June 30, 2022 is as follows (in millions):

Backlog

Our 90-day shipment backlog as of June 30, 2023 was $34.3 million, a 1% increase from the beginning of the quarter and a 4% decrease from June 30, 2022. Our backlog consists of firm purchase orders we expect to ship in the next 90 days, with any remaining amounts to be shipped within 180 days.

Our 90-day order backlog by market has remained relatively constant when compared to the prior quarter and the same period of the prior year. 90-day backlog varies due to order size, manufacturing delays, contract terms and conditions and timing from customer delivery schedules and releases. These variables cause inconsistencies in comparing the backlog from one period to the next.

90-day shipment backlog by our major industry markets are as follows (in millions):

Our total order backlog as of June 30, 2023 was $101.0 million, a 2% increase from $98.8 million the beginning of the quarter and a 5% decrease from June 30, 2022. Our total backlog remains strong, however our medical customers are returning to their pre-pandemic ordering practices as the global supply chain improves.

Total order backlog by our major industry markets are as follows (in millions):

The 90-day and total backlog at June 30, 2023 contain the contract asset value of $11.6 million which has been recognized as revenue.

Gross Profit

Gross profit as a percent of net sales was 15.6% and 15.7% for the three and six months ended June 30, 2022, respectively. Gross profit as a percent of net sales was 15.4% and 14.3% for the three and six months ended June 30, 2022, respectively. The gross profit improvement was primarily driven by price increases in response to material and labor cost inflation as well as higher production volume which increased plant utilization.

Selling Expense

Selling expenses for the three and six months ended June 30, 2023 were $1.0 million or 2.7% of sales and $1.8 million or 2.6% of sales, respectively. Selling expenses for the three and six months ended June 30, 2022 were $1.0 million or 2.9% of sales and $1.8 million or 2.8% of sales, respectively.

General and Administrative Expense

General and administrative expenses for the three and six months ended June 30, 2023 were $3.1 million or 8.9% of sales and $6.4 million or 9.1% of sales, respectively. General and administrative expenses for the three and six months ended June 30, 2022 were $2.7 million or 8.2% of net sales and $5.4 million or 8.5% of net sales, respectively. The increase in general and administrative expense was mainly due to higher professional fees and higher cost of labor.

Research and Development Expense

Research and development expenses for the three and six months ended June 30, 2023 were $0.3 or 0.9% of net sales and $0.6 million or 0.8% of net sales, respectively. Research and development expenses for the three and six months ended June 30, 2022 were $0.4 or 1.1% of net sales and $0.7 million or 1.1% of net sales, respectively.

Income From Operations

Income from operations was $1.1 million and $2.2 million for the three and six months ended June 30, 2023, respectively. Income from operations was $1.0 million and $1.2 million for the three and six months ended June 30, 2022. The increase in income from operations was driven by the increase in sales and gross margin as a percent of sales, primarily due to price increases in response to material and labor cost inflation as well as higher plant utilization.

Interest Expense

Interest expense was $0.1 million for both the three months ended June 30, 2023 and 2022, respectively. Interest expense was $0.2 million for both the six months ended June 30, 2023 and 2022, respectively.

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, including discrete events, by each tax jurisdiction.

Our effective tax rate for the three and six months ended June 30, 2023 was 35% and 31%, respectively. Our effective tax rate for the three and six months ended June 30, 2022 was 21% and 12%, respectively The primary drivers of the change in the effective tax rate relate to an increase in projected pre-tax book income as well as an increase in the valuation allowance due to Section 174.

Net Income

Net income for the three months ended June 30, 2023 was $0.6 million or $0.23 per basic common share and $0.22 per diluted common share. Net income for the three months ended June 30, 2022 was $0.7 million or $0.27 per basic common share and $0.25 per diluted common share. Net income for the six months ended June 30, 2023 was $1.3 million or $0.49 per basic and $0.46 per diluted common share. Net income for the six months ended June 30, 2022 was $0.9 million or $0.32 per basic common share and $0.30 per diluted common share. The increase in net income was driven by the increase in sales and gross margin as a percent of sales, primarily due to price increases in response to material and labor cost inflation as well as higher plant utilization.

Liquidity and Capital Resources

We believe that our existing financing arrangements, anticipated cash flows from operations, funds expected to be received for the ERC and cash on hand will be sufficient to satisfy our working capital needs for the next twelve months, capital expenditures and debt repayments.

Credit Facility

We have a credit agreement with Bank of America, which was entered into on June 15, 2017 and provides for a line of credit arrangement of $16,000 that expires on June 15, 2026.

Under the amended Bank of America credit agreement signed December 31, 2021, the line of credit is subject to variations in the Bloomberg Short-Term Bank Yield (BSBY) index rate. Our line of credit bears interest at a weighted-average interest rate of 7.9% and 5.2% as of June 30, 2023 and December 31, 2022, respectively. We had borrowings on our line of credit of $7.0 million and $6.9 million outstanding as of June 30, 2023 and December 31, 2022, respectively. There are no subjective acceleration clauses under the credit agreement that would accelerate the maturity of our outstanding borrowings. The line of credit is shown net of debt issuance costs of $38 thousand and $44 thousand on the consolidated balance sheet for the periods ended June 30, 2023 and December 31, 2022, respectively.

The line of credit with Bank of America contains 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 Bank of America Credit Agreement provides for, among other things, a Fixed Charge Coverage Ratio of not less than 1.0 to 1.0, for the twelve months ending December 31, 2020 and each Fiscal Quarter end thereafter subject only during a trigger period commencing when our availability under our line is less than $2.0 million until availability is above that amount for 30 days days. The Company met the covenants for the period ended June 30, 2023.

At June 30, 2023, we had unused availability under our line of credit of $5.3 million supported by our borrowing base. The line is secured by substantially all of our assets.

Off-Balance Sheet Arrangements

We have not engaged in any off-balance sheet activities as defined in Item 303(a)(4) of Regulation S-K.

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, 2022. 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.

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. Discussion of these factors is also incorporated in Part I, Item 1A, “Risk Factors,” and should be considered an integral part of Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” 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-K 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 Annual Report on Form 10-K for the fiscal year ended December 31, 2022.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable.

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 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). These controls and procedures are designed to ensure that information required to be disclosed in the Company’s Exchange Act reports is (1) recorded, processed, summarized and reported in a timely manner, and (2) accumulated and communicated to management, including the Company’s Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Based upon their evaluation of these disclosure controls and procedures as of the date of the evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures were effective.

Changes in Internal Control Over Financial Reporting

There was no change in our internal control over financial reporting during our most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II

ITEM 1. LEGAL PROCEEDINGS

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

ITEM 1A. RISK FACTORS

We are affected by the risks specific to us as well as factors that affect all businesses operating in a global market. The significant factors known to us that could materially adversely affect our business, financial condition or operating results or could cause our actual results to differ materially from our expectations are described in our annual report on Form 10-K for the fiscal year ended under the heading “Part I – Item 1A.Risk Factors.” There have been no material changes in the risk factors from those disclosed in the Annual Report on Form 10-K for the year ended December 31, 2022.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Our share repurchase program has expired, and no additional amounts are available for repurchase.

ITEM 3. DEFAULTS ON SENIOR SECURITIES

None.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

Exhibits

*Filed herewith

Signatures

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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Nortech Systems Incorporated and Subsidiaries

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