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Nortech Systems: Profitable Net-Net with Thin Margins

December 17, 2012 | About:
Mark Lin

Mark Lin

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Nortech Systems Inc. (NSYS) is a full-service electronics manufacturing services provider of wire and cable assemblies, printed circuit board assemblies and higher-level complete box build assemblies for a wide range of industries. Markets served include industrial equipment, aerospace/defense and medical. NSYS has manufacturing capabilities and operating partners in the U.S., Asia and Latin America.

Valuation

NSYS is a net-net trading at a P/NCAV of 0.75 and P/NTA of 0.41. Its current P/B valuation represents a 28% discount to its five-year average P/B of 0.57. In terms of earnings-based valuations, it is valued at a trailing 12 months P/E of 14.49 and a trailing 12 months EV/EBITDA of 5.94. NSYS achieved a 2.9% ROE for the past 12 months and a five-year average ROE of 1.2%.

The GuruFocus chart below shows a negative value for NCAV, as GuruFocus calculates NCAV using the traditional Graham Net Current Asset Value definition of 100% of cash, 75% of receivables and 50% of inventories, while I simply deduct total liabilities from total current assets. In NSYS' case, receivables and inventories each account for about half of current assets, while the remaining current assets comprises prepaid expenses and deferred income taxes.

Also, NSYS has grown its book value per share by a modest 5-year CAGR of 1.8% and a 10-year CAGR of 5.3% respectively.

NSYS NAV, NTA, NCAV Comparison

NSYS has been profitable in 9 of the last 10 years, except for 2009. Except for 2011, NSYS' free cash flow has exceeded net income since 2005, which is a positive sign. Profit margins in recent years have not recovered to the pre-Global Financial Crisis levels.

NSYS Earnings-Cash Flow Comparison

NSYS Profit Margins Analysis

Financial and Business Risks

NSYS is moderately geared with a gross debt-to-equity ratio of 53% and a long term debt-to-equity ratio of 13%. This is not helped by a low interest coverage ratio of 4.2.

The chart below shows that NSYS does not have a business model that generates a lot of free cash flow, most, if not all of the cash flow is typically reinvested in the business.

NSYS Cash-Debt-Market Capitalization Comparison

While NSYS is diversified across end-markets, it does have some customer concentration risk with G.E.'s medical division and transportation division accounting for 16% and 7% of its 2011 sales, respectively.

The in-house operations of OEMs and low-cost foreign manufacturers are NSYS's biggest competitive threats. In addition, the willingness of foreign manufacturers to "stock" finished product at warehouse locations in the United States is another of their competitive advantages, in addition to their lower cost structure and lower labour costs.

Business Quality and Capital Allocation

NSYS' diverse customer base, with a wide range of original equipment manufacturers in the Aerospace & Defense, Medical and Industrial markets, has helped it avoid the effects of fluctuations in any one industry. For example, NSYS has indicated that its customers in the medical device markets are gaining momentum, while those in the industrial markets are either making inventory adjustments or delaying orders.

NSYS operates in a niche segment of the market by playing to its strengths of operational flexibility and close customer relationships to manage low volume, high mix customer demand. It claims that it does not compete directly with small closely held contract manufacturing companies and large global full-service contract manufacturers. Small closely held contract manufacturing companies typically do not have the complete manufacturing and engineering services or capabilities required by NSYS' target customers; while the large global full-service contract manufacturers are more focused on higher volume customer engagements. OEM companies that are or are considering outsourcing to contract manufacturers, represent the largest growth opportunities for NSYS. To successfully compete with foreign low cost manufacturers for this outsourcing business, NSYS operates manufacturing operations in Mexico.

NSYS does not pay a dividend.

Conclusion

NSYS has not been free cash flow generative with most of the cash going back into the business. That also explains the lack of dividends, despite a good profitability track record. In that case, investors have to look at asset growth as a proxy for the valuation upside. A five year book value per share CAGR of 1.8% is unacceptable; the ten year book value per share CAGR of 5.3% is decent. Margins are showing signs of weakness from excess manufacturing capacity and price pressure. A return to pre-global financial crisis profit margins will be a reason to have a second look at the stock.

Disclosure

The author does not have a position in any of the stocks mentioned.

About the author:

Mark Lin
Working hard to be a better investor

Rating: 2.3/5 (3 votes)

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