NORTECH SYSTEMS INC - Annual Report: 2005 (Form 10-K)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-K
(Mark One)
x	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2005
	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) 345-2277

Securities registered pursuant to Section 12(b) of the Act:       None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, Par Value $.01 Per Share

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes o No x

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

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

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

The aggregate market value of voting stock held by non-affiliates of the registrant, based on the closing price of $6.31 per share, was $7,611,210 on June 30, 2005.

Shares of common stock outstanding at March 6, 2006: 2,618,197.

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DOCUMENTS INCORPORATED BY REFERENCE

The following documents are incorporated by reference to the parts indicated of the Annual Report on Form 10-K:

 

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NORTECH SYSTEMS INCORPORATED
ANNUAL REPORT ON FORM 10K
TABLE OF CONTENTS

 

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NORTECH SYSTEMS INCORPORATED
FORM 10-K
For the Year Ended December 31, 2005
PART   I

ITEM 1.   BUSINESS

DESCRIPTION OF BUSINESS

We are a Minnesota corporation organized in December 1990, filing annual reports, quarterly reports, proxy statements, and other documents with the Securities Exchange Act of 1934 (Exchange Act). Prior to December 1990, we operated as DSC Nortech, Inc., who filed a petition for reorganization under Chapter 11 of the United States Bankruptcy Code during 1990. The business and assets of DSC Nortech, Inc. were transferred to us during 1990.

The public may read and copy any materials that we file with the SEC at the SEC’s Public Reference Room at 340 Fifth Street N.W., Washington, D.C. 20549. Also, the SEC maintains an Internet website that contains reports, proxy and information statements, and other information regarding issuers, including us, who file electronically with the SEC. The public can obtain any documents that we file with the SEC at http://www.sec.gov.

We make available free of charge through our Internet website (http://www.nortechsys.com) our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Press Releases, and Current Reports on Form 8-K.

GENERAL

We are an EMS (Electronic Manufacturing Service) contract manufacturing company with our headquarters in Wayzata, Minnesota, a suburb of Minneapolis, Minnesota. We maintain manufacturing facilities in Minnesota including Bemidji, Fairmont, Blue Earth, Baxter, and Merrifield as well as Augusta, Wisconsin, and Monterrey, Mexico. We manufacture wire harness and cable assemblies, electronic sub-assemblies, and printed circuit board assemblies. We provide value added services and technical support including design, testing, prototyping and supply chain management. The majority of our revenue is derived from products built to the customer’s design specifications.

We provide a high degree of manufacturing expertise using statistical process controls to ensure product quality, total supply chain solution techniques and the systems necessary to effectively manage the business. This level of sophistication enables us to attract major original equipment manufacturers (OEMs) and to expand and diversify our customer base.  Our strategy is to develop a customer base across several markets to avoid the effects of fluctuations within a given industry. The major markets we serve are Industrial Equipment, Medical, Military/Defense and Transportation and to a lesser extent the food, communications, consumer and computers industries.

We believe the current growth and expansion trends for contract manufacturing and the EMS (Electronic Manufacturing Services) industry will continue both in the United States and overseas. OEM outsourcing will continue to escalate as more companies focus their investments on Marketing and Development of their products and rely more on EMS providers for their production and supply chain requirements.

ACQUISITIONS

On June 23, 2004, we acquired all of the business assets of Zachariah and Lundbergh, Inc. (Z&L). This acquisition of assets allows for further expansion of our InterconOne brand of specialty cable and power supplies for use in industrial and medical grade video cameras and ancillary equipment. (See Note 4 for further information)

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BUSINESS SEGMENTS

All of our operations fall under the Contract Manufacturing segment within the Electronic Manufacturing Services industry.

BUSINESS STRATEGY

The Electronic Manufacturing Services industry continues to evolve from a small job shop oriented business into a dynamic, higher tech global electronics contract services industry. We continue to expand our capabilities to better meet these changing market requirements. Along with adding technical expertise in our quality processes, design, applications and testing, we are also increasing our focus on supplier-managed inventory services and the cost drivers throughout the supply chain. We continue to expand our international operations and partnerships to take advantage of lower-cost alternatives for our customers and to remain competitive in the marketplace when required.

Our quality systems and processes are based on ISO standards with all our domestic and Monterrey, Mexico facilities certified to the latest version of the ISO 9001 standards. We believe these certifications benefit our customer base and increase our chances on attracting new business opportunities.

We are committed to quality, cost effectiveness and responsiveness to customer requirements. To achieve these objectives we have invested in ROHS (lead free) processing, equipment, additional plant capacity, people, systems and we have adopted lean manufacturing and supply chain management techniques at our facilities. We are committed to continuous improvement in order to provide competitive and complete manufacturing service solutions to our customers. We will continue to maintain a diversified customer base, and expand into other capabilities and services when they fit our core competencies and strategic vision.

MARKETING

We concentrate our marketing efforts in the industrial equipment, medical, military/defense and transportation industries. Our marketing strategy emphasizes the breadth of our manufacturing, supply chain and engineering services and reflects the one-stop solution for meeting our customers’ current and future requirements.

The emphasis continues to be on mature companies, which require a contract manufacturer with a high degree of manufacturing and quality sophistication, including statistical process control (SPC), statistical quality control (SQC), International Standards Organization (ISO), Military (Mill Spec) Specifications and Aerospace Systems 9100 (AS). We have initiated efforts to penetrate our existing customer base and expand new market opportunities in Mexico, Asia and Europe, as well as increased participation in industry publications and selected trade shows. We target customers who value proven manufacturing performance, design and application engineering expertise and who value the flexibility to manage the supply chain of a high mix of product and service. We market our products and services through our in-house sales force and independent manufacturers’ representatives.

SOURCES AND AVAILABILITY OF MATERIALS

We are not dependent on any one supplier for materials for products sold to customers. Components utilized in the assembly of wire harnesses, cable assemblies and printed circuit assemblies are purchased directly from the component manufacturers or from their distributors. On occasion some components may be placed on a stringent allocation basis; however, due to the excess manufacturing capacity currently available at most component manufacturers, we do not anticipate any major material purchasing or availability problems occurring in the foreseeable future.

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PATENTS AND LICENSES

We are not presently dependent on a proprietary product requiring licensing, patent, copyright or trademark protection. There are no revenues derived from a service-related business for which patents, licenses, copyrights and trademark protection are necessary for successful operations.

COMPETITION

The contract manufacturing EMS industry competitive makeup includes small closely held contract manufacturing companies, large full-service contract manufacturers, company-owned manufacturing facilities and foreign contract manufacturers. We do not believe that the small closely held operations pose a significant competitive threat in the markets and customers we serve, as they generally do not have the complete manufacturing services or capabilities required by our target customers. We believe the larger domestic full service and foreign manufacturers do provide a substantial competitive environment while the company-owned operations create an increasing opportunity as the trend of more outsourcing continues. Technical support from foreign competition has improved greatly along with their ability to be more responsive to engineering and schedule changes. The willingness of foreign manufacturers to “stock” finished product at warehouse locations in the United States is another of their competitive advantages, however, their inability to react to engineering, product or schedule changes is a disadvantage and plays into our strength. To mitigate foreign competition, we maintain a contractual agreement allowing us to provide a China manufacturing solution and we operate a manufacturing operation in Mexico to support our customers with a “Low Cost” supply chain solution.

We continue to pursue acquisitions, mergers, and/or joint ventures of companies in the EMS industries to both remain competitive and grow our customer and revenue base. Our strategic objectives and our history have been based on both organic and acquired growth.

BACKLOG

Historically, our backlog has been running 60 to 90 days. However, because of the increased emphasis on just-in-time manufacturing (JIT), reduced lead times and repetitive scheduling, our historical backlog levels may not be indicative of future results. As of December 31, 2005 our 90-day order backlog was approximately $24.9 million compared to approximately $14.5 million on December 31, 2004. We expect a major portion of the backlog will be realized as revenue during first quarter 2006.

MAJOR CUSTOMERS

Two divisions of G.E. combined account for 10% or more of our net sales during 2005. G.E.’s Medical and Transportation Divisions together accounted for 17%, 15% and 23% of sales for the years ended December 31, 2005, 2004 and 2003, respectively. Additionally, Northrop Grumman accounted for 10% of net sales in 2005. Historically, we have not experienced significant losses on customer receivable collections in any particular industry or geographic area.

RESEARCH AND DEVELOPMENT

We perform research and development for customers on an as requested and program basis for development of conceptual engineering and design activities prior to manufacturing the products. We did not expend significant dollars in 2005, 2004 or 2003 on company-sponsored product research and development.

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ENVIRONMENTAL LAW COMPLIANCE

We believe that our manufacturing facilities are currently operating under compliance with local, state, and federal environmental laws. We have incurred and plan to continue incurring, the necessary expenditures for compliance with applicable laws. Any environmental-oriented equipment is capitalized and depreciated over a seven-year period. The annualized depreciation expense for this type of environmental equipment is insignificant.

EMPLOYEES

We have 785 full-time, 70 part-time and 161 temporary employees as of December 31, 2005. Manufacturing personnel, including direct, indirect support and sales functions, comprise 980 employees, while general administrative employees total 36.

FOREIGN OPERATIONS AND EXPORT SALES

We have a leased manufacturing facility in Monterrey, Mexico with approximately $886,000 in long-term assets. Export sales represent 5%, 5% and 2% of consolidated sales for the years ended December 31, 2005, 2004 and 2003, respectively.

ITEM 1A.   RISK FACTORS

The following are risk factors known to us that could affect our business, financial condition and/or operating results.

We purchase raw materials, commodities and components for use in our production. Increased costs of these materials could have an adverse affect on our production costs if we are unable to pass along price increases or reduce the other cost of goods produced through cost improvement initiatives. Fuel and energy cost increases could also adversely affect our freight and operating costs.

We do face through the normal course of business excess and obsolete inventory losses as a result of customer order changes, cancellations, product changes and contract termination. We estimate and reserve for any known or potential impact from these possibilities.

The manufacture and sale of our products carries potential risk for product liability claims. We represent and warrant the goods and services we deliver are free from defects in material and workmanship for one year (1) from ship date. Unless otherwise agreed to, workmanship shall be in accordance with IPC and ANSI/J- Standards such as IPC-A-610, class 2, IPC—A-620, class 2, ANSI/J-STD001, class 2, C-20. We make no other guarantees or warranties, expressed or implied, of any nature whatsoever as to the goods including without limitation, warranties to merchantability, fit for a particular purpose or non-infringement of patent or the like unless agreed upon in writing. If a product liability claim results in us being liable and the amount is in excess of our insurance coverage or there is no insurance coverage for the claim then it could have a negative impact on our business and financial position.

Our strategy is to grow our business organically and through acquisitions, alliances and joint venture arrangements. In June 2002, we acquired Manufacturing Assembly Solutions of Monterrey, Inc. (MAS), a Mexican corporation, located in Monterrey, Mexico. The benefits of this acquisition has taken more time then expected to integrate into our marketing strategies.

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ITEM 1B.   UNRESOLVED STAFF COMMENTS

Not Applicable

ITEM 2.   PROPERTIES

ADMINISTRATION

Our Corporate Headquarters consist of approximately 3,648 square feet located in Wayzata, Minnesota, a western suburb of Minneapolis, Minnesota. The Corporate Headquarters has a lease with a five-year term that expires on July 31, 2010. A portion of the Bemidji facility is used for corporate financial and information shared services.

MANUFACTURING FACILITIES

We own our Bemidji, Minnesota facility consisting of eight acres of land and a building of approximately 69,300 square feet where 55,800 square feet is designated for manufacturing space of which 90% is utilized and the remaining space is used for offices. We also lease a 6,000 square foot warehouse in Bemidji, Minnesota. We believe the productive capacity is sufficient, and the buildings are both suitable and adequate to handle our foreseeable manufacturing needs.

We own our Augusta, Wisconsin facility consisting of five acres of land and a building of approximately 20,000 square feet where 15,000 square feet is designated for manufacturing space of which 80% is utilized and the remaining space is used for offices. We believe the productive capacity is sufficient, and the building is both suitable and adequate to handle our foreseeable manufacturing needs.

We own three buildings in Fairmont, Minnesota, which together contain approximately 51,000 square feet where 38,000 square feet is designated for manufacturing space of which 95% is utilized, and the remaining space is used for offices. As foreseeable productions needs for this facility have increased, we entered into an agreement in November 2005 to lease 20,000 square feet of a building located in Blue Earth, Minnesota, to be used for manufacturing space effective December 1, 2005. Presently, all 20,000 square feet of leased space is designated for manufacturing space, of which 60% is being utilized. The lease, which has a 90-day option to renew, expires as of March 31, 2006. At the end of December 2005, we signed an agreement to purchase the entire 140,000 square foot Blue Earth, Minnesota building, the closing is scheduled for June 2006, with the seller having the option to lease back from us 50,000 square feet through the first quarter of 2007. We believe the productive capacity is sufficient, and the buildings are all suitable and adequate to handle our foreseeable manufacturing needs.

We own a building in Merrifield, Minnesota, consisting of approximately 45,800 square feet where 33,800 square feet is designated for manufacturing of which 50% is being utilized and the remaining space is used for offices and warehouse. We believe the productive capacity is sufficient, and the building is both suitable and adequate to handle our foreseeable manufacturing needs.

We lease two buildings in Baxter, Minnesota where we lease 8,700 square feet in one building and 8,300 square feet in the other building for electronic board repair for medical equipment of which 75% of total leased space is being utilized.  The leases, which have a 5-year renewal option, are scheduled to expire on June 30, 2006 and January 31, 2007. We believe the productive capacity is sufficient, and the building is both suitable and adequate to handle our foreseeable manufacturing needs.

We lease a 15,000 square foot building in our Monterrey, Mexico where 13,500 square feet is designated for manufacturing space of which 60% is being utilized and the remaining space is used for offices. We believe the productive capacity is sufficient, and the building is both suitable and adequate to handle our foreseeable manufacturing needs. The lease expires in June 2007, and we plan on exercising the additional three-year option at that time.

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ITEM 3.   LEGAL PROCEEDINGS

From time to time, we are involved in ordinary, routine or regulatory legal proceedings incidental to the business. When a loss is deemed probable and reasonably estimable an amount is recorded in our financial statements. We currently are not a party to any material legal proceeding.

ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

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PART II

ITEM 5.                MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

As of March 6, 2006, there were 846 shareholders of record. Our stock is listed on the National Association of Securities Dealers Automated Quotation System (“NASDAQ”) Small Cap Market under the symbol “NSYS”. We intend to invest our profits into the growth of our operations and, therefore, do not plan to pay out dividends to shareholders in the foreseeable future. Stock price comparisons follow.

Stock price comparisons (NASDAQ):

 

EQUITY COMPENSATION PLAN INFORMATION

Certain information with respect to our equity compensation plans are contained in Part III, Item 12 of this Annual Report on Form 10-K.

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ITEM 6.                SELECTED FINANCIAL DATA

The following selected historical financial data have been derived from, and are qualified by reference to the audited Consolidated Financial Statements of Nortech Systems Incorporated and Subsidiary as of December 31, 2005 and 2004 and for each of the years ended December 31, 2005, 2004 and 2003. The audited consolidated financial statements of Nortech Systems Incorporated and Subsidiary referred to above are included elsewhere herein. The selected historical financial data set forth below as of December 31, 2003, 2002 and 2001 and for each of the years ended December 31, 2002 and 2001 have been derived from the audited consolidated financial statements of Nortech Systems Incorporated and Subsidiary not included herein. The selected financial data set forth below should be read in conjunction with, and are qualified by reference to, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and accompanying notes thereto of Nortech Systems Incorporated and Subsidiary included elsewhere herein.

*                    In 2004, the revolving line of credit, with outstanding borrowings of $7,523,058, was classified in current liabilities. In the previous years these amounts had been reflected as long-term. As of December 31, 2005, the revolving line of credit had outstanding borrowings of $4,228,234 and is also classified as a current liability. For additional financial data (2005 and 2004 by quarter information), see Note 12 of the Consolidated Financial Statements.

ITEM 7.                MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K contains forward-looking statements within the meaning 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:

·       Volatility in the marketplace which may affect market supply and demand of our products;

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·       Increased competition;

·       Changes in the reliability and efficiency of our 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.

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-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.

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. Markets served include industrial equipment, transportation, medical, military/defense, computer, recreation and food. In Minnesota, we have facilities in Baxter, Bemidji, Blue Earth, Fairmont and Merrifield. We also have facilities in Augusta, Wisconsin, and Monterrey, Mexico.

The vast majority of our revenue is derived from products that are built to the customer’s design specifications. We provide a high degree of manufacturing sophistication. During 2005, we continued our supply chain initiatives designed to reduce costs, improve asset utilization and increase responsiveness to customers. Our strategy has been to expand and diversify our customer base, and we are focusing our sales and marketing approach to target greater value-added service opportunities. Our market strength is low-volume, high-mix production, particularly with complex products. Our investment in the Mexico operation in 2002 allows for expansion into medium volume, medium mix and lower cost production and our contractual arrangements with Chinese manufacturers allow us to meet high-volume, low mix and lower cost customer requirements.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our significant accounting policies and estimates are summarized in the footnotes to our annual consolidated financial statements. Some of the 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 historical experience, known trends in the industry, terms of existing contracts and other information from outside sources, as appropriate. Actual results may differ from these estimates under different assumptions and conditions. Certain of the most critical policies that require significant judgment are as follows:

Revenue Recognition:

We recognize revenue upon shipment of products to customers, when title has passed, all contractual obligations have been satisfied and collection of the resulting receivable is reasonably assured. In the normal course of business we enter into a number of contracts with customers under which we provide

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engineering services on a per project basis. Revenue for these services is recognized upon completion of the engineering process, usually upon initial shipment of the product. Revenues from repair services are recognized upon shipment of related equipment to customers.

Allowance for Uncollectible Accounts:

We analyze accounts receivable, historical write-offs of bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in customer payment terms when evaluating the adequacy of the allowance for uncollectible accounts. We maintain an allowance for doubtful accounts at an amount estimated to be sufficient to provide adequate protection against losses resulting from collecting less than full payment on receivables. A considerable amount of judgment is required when assessing the realizability of receivables, including assessing the probability of collection and the current credit-worthiness of each customer. If the financial condition of our customers was to deteriorate, resulting in an impairment of their ability to make payments, an additional provision for uncollectible accounts may be required. We have not experienced significant bad debts expense and the reserve for uncollectible accounts of $297,000 is considered adequate for any exposure to loss in the December 31, 2005 accounts receivable.

Inventory Reserves:

Inventory reserves are maintained for the estimated value of the inventory that may have a lower value than stated or quantities in excess of future production needs. We have an evaluation process that is used to assess the value of the inventory that is slow moving, excess or obsolete on a quarterly basis. We believe the total reserve of $1.2 million at December 31, 2005 is adequate.

Long-Lived and Intangible Asset Impairment:

We evaluate long-lived assets and intangible assets with finite lives for impairment, as well as the related amortization periods, to determine whether adjustments to these amounts or useful lives are required based on current events and circumstances. The evaluation is based on our projection of the undiscounted future operating cash flows of the underlying assets. To the extent such projections indicate that future undiscounted cash flows are not sufficient to recover the carrying amounts of related assets, a charge is recorded to reduce the carrying amount to equal estimated fair value.

The test for impairment requires us to make several estimates about fair value, most of which are based on projected future cash flows. The estimates associated with the asset impairment tests are considered critical due to the judgments required in determining fair value amounts, including projected future cash flows. Changes in these estimates may result in the recognition of an impairment loss.

Income taxes:

Our estimate of the tax rates utilized in the calculation of the deferred tax balances is based on historical taxable income and expected future taxable income and corresponding rates. Further, our consideration of a valuation allowance for deferred tax assets is based upon estimates of taxable income in future periods and future realizability of these assets.

Self-Insured Health Claim Accruals:

We estimate our reserve for employee health claims based on health claims incurred, historical lag times and an analysis of claims activity during the period, while taking into consideration insurance limits and coverage. We believe the total accrual of $271,000 at December 31, 2005 is adequate.

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Based on a critical assessment of our accounting policies and the underlying judgments and uncertainties affecting the application of those policies, we believe that our consolidated financial statements provide a meaningful and fair perspective of our financial position. This is not to suggest that other general risk factors, such as changes in worldwide economic conditions, fluctuations in foreign currency exchange rates, changes in materials costs, performance of acquired businesses and others, could not adversely impact our consolidated financial position, results of operations and cash flows in future periods.

No matters have come to our attention since December 31, 2005 that would cause the estimates included in the consolidated financial statements to change materially.

OPERATING RESULTS

The following table presents statement of operations data as percentages of total revenues for the indicated year:

 

Revenues:

For the years ended December 31, 2005 and 2004, we had sales of $84.2 million and $72.7 million, respectively, an increase of $11.5 million or 15.9%. The Aerospace Systems division led the strong revenue growth in 2005 and accounts for 60% of the overall increase, followed by increased revenue in Electronic Circuit Board Assembly division accounting for 43% of the overall growth and a decrease of 3% for all other Cable & Wire divisions combined.

For the year ended December 31, 2003 sales were $58.0 million. In 2004 we saw our sales grow over 2003 by $14.7 million or 25.4%. The Aerospace Systems division accounted for 37% of the overall increase, the Electronic Circuit Board assembly division for 27% of the growth and our startup Mexico Cable & Wire assemble division accounted for 22% of the overall growth over 2003 levels.

We continue to foresee growth rates stronger than the EMS industry average, which analysts project at 11.4 percent through 2009. Our emphasis and focus will remain on mature OEM companies seeking total solution contract manufacturers such as us.

Gross Profit:

For the years ended December 31, 2005, 2004 and 2003, we had gross profit of $10.0 million, $8.5 million and $6.5 million, respectively. Gross profits as a percentage of gross sales were 11.9%, 11.8% and 11.2% for the years ended December 31, 2005, 2004 and 2003, respectively. The 2005 gross profit dollar increase was favorably impacted by volume and helped offset energy (Oil & Gas) and commodity (Copper) cost pressures throughout all of 2005.

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Selling:

Selling expenses were $3.2 million or 3.8% of net sales for the year ended December 31, 2005, $3.2 million or 4.3% of net sales for the year ended December 31, 2004, and $2.4 million or 4.1% of net sales for the years ended December 31, 2003. The decrease in selling expenses in 2005 from 2004 as a percentage of sales was a result of lower commission rates and lower commissionable sales and an 8.4% reduction in spending in marketing and sales related expenses.

General and Administrative:

For the years ended December 31, 2005, 2004 and 2003, general and administrative expenses were $4.7 million, $4.1 million and $3.3 million, respectively. The increase in general and administrative expenses of $0.6 million from 2004 is attributable to the increased investment in infrastructure and employee related expenses, comprised primarily of $0.4 million to support the growth and consolidation of corporate shared services (i.e. accounting, information services, and human resources). In addition, overall outside service costs increased $0.2 million and were related to increased compliance requirements and process improvements

The increased general and administrative expenses of $0.8 million from 2003 to 2004 related to investments made in infrastructure of $0.4 million, incentive compensation of $0.5 million and a reduction of other expenses of $0.1 million.

Other Income (Expense):

Interest income for the years ended December 31, 2005, 2004 and 2003 was approximately $2,500, $2,000, and $25,000, respectively. Miscellaneous income (loss) was ($70,000), $16,000 and $86,000 for the years ended December 31, 2005, 2004 and 2003, respectively. In 2005, the majority of the miscellaneous loss is related to foreign currency transaction losses.

Interest expense was approximately $646,000, $490,000, and $386,000 for the years ended December 31, 2005, 2004 and 2003, respectively. In 2005, a steady increase in interest rates throughout the year accounted for the majority of the increased interest expense. 2003 and 2004 saw favorable interest rates throughout the year and lower working capital requirements that kept interest expenses low.

Income Taxes:

Income tax expense (benefit) amounted to $465,000, $268,000, and ($123,000) for the years ended December 31, 2005, 2004 and 2003, respectively. In 2005, the income tax rate was 33% and was impacted favorably by R & D tax credits of $81,000 and Section 199 Deduction for Income Attributable to Domestic Production Activities of $60,000. In 2004 the income tax rate was 31% and was impacted favorably by R & D tax credits of $129,000. During 2003, we recorded $246,000 of net benefit for a refund claim relating to federal and state research and development tax credits for tax years 1999, 2000 and 2001. A reconciliation of income tax expense (benefit) for the years ending December 31, 2005, 2004 and 2003 is included in Note 6 to the consolidated financial statements.

Net Income:

Our net income in 2005 was $928,781 or $0.36 per diluted common share compared to $587,329 or $0.23 per diluted common share in 2004. Our 2003 net income was $633,448, or $0.25 per diluted common share. The changes in net income are the result of the aforementioned factors.

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RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In March 2005, the FASB issued Interpretation No.47, or “FIN 47,” which clarifies terminology in FASB Statement No. 143, Accounting for Asset Retirement Obligations. FIN 47 clarifies when an entity has sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effective for us in fiscal 2006. We do not expect adoption of FIN 47 to have a material impact on our consolidated financial statements.

In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment. This statement revises SFAS No. 123, Accounting for Stock-Based Compensation, and requires companies to expense the value of employee stock options and similar awards using the fair value method. The effective date of this standard is interim and annual periods beginning after June 15, 2005. FAS 123(R) allows two methods for determining the effects of the transition: the modified prospective transition method and the modified retrospective method of transition. Although we have not fully analyzed the effect this new statement will have on the consolidated financial statements in the future, the pro forma net income effects of using a fair value method for the past three fiscal years are presented in Note 1 to the consolidated financial statements.

In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4. The amendments made by the SFAS No. 151 require that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) be recognized as current-period charges. This Statement requires the allocation of fixed production overhead to inventory based on the normal capacity of production facilities. SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We do not believe the adoption of SFAS No. 151 will have a material effect on our financial position or results of operations.

FINANCIAL CONDITION AND LIQUIDITY

The following are unaudited ratios:

 

Cash Flow:

 

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On March 4, 2005 we entered into an agreement with Wells Fargo Bank for a renewal and extension of our revolving line of credit. In addition to the extension of the maturity date, the financial covenants were modified and include minimum working capital, tangible net worth and net income requirements, along with certain other ratios. The availability under the line is subject to borrowing base requirements, and advances are at the discretion of the lender. The line is secured by substantially all of our assets. This commitment is summarized as described below:

 

As of December 31, 2005, our cash and cash equivalent balances totaled $840,123.

On December 31, 2005, we had working capital of approximately $12.2 million as compared to $11.7 million at the end of 2004. During 2005, we generated approximately $5.1 million of cash flow from operating activities. The cash flow from operations is the result of net income of $0.9 million adjusted for noncash depreciation, amortization, foreign currency transaction loss, and the change in deferred taxes, which totaled $1.4 million in net positive adjustments, and the net increase in operating assets and liabilities of $2.8 million. The net increase in cash from changes in operating assets and liabilities was primarily attributable to the increases in accounts receivable of $1.1 million and inventory of $1.6 million, which were offset by an increase in accounts payable of $4.3 million due to the volume growth and extended terms and conditions with some of our key suppliers.

Our net cash flow from investing activities was comprised of $1.4 million spent on capital asset purchases. The 2005 major investments are related to tooling and operating equipment of $0.8 million to support our growth and software tools of $0.3 million for our corporate shared services areas, which enables us to meet additional compliance requirements.

Net cash used in financing activities of $3.3 million consisted primarily of paying down our line of credit by $3.3 million along with a net decrease in long-term debt of $0.5 million, which was offset by the increase in our checks in excess of our bank balance of $0.3 million and issuance of shares of common stock of $0.2 million. Our liquidity and capital resources are strong, and we believe that our future financial requirements can be met with funds generated from the operating activities and our operating line of credit.

Set forth below is information about our long-term contractual obligations outstanding as of December 31, 2005. It brings together data for easy reference from the consolidated balance sheet and from individual notes to the consolidated financial statements. This information is important in understanding our financial position.

 

For above Real Property Purchase Commitment for $1,350,000, we intend to issue an Variable Rate Demand Industrial Development Revenue Bond through the City of Blue Earth, MN, secured by an Irrevocable Letter of Credit to be issued by Wells Fargo Bank, National Association.

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From time to time, we enter into purchase commitments with our suppliers under customary purchase order terms. Any significant losses implicit in those contracts will be recognized in accordance with generally accepted accounting principles. At December 31, 2005, no such losses existed.

ITEM 7a.   QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK

Market risk is the potential change in an instrument’s value caused, for example, by fluctuations in interest and currency exchange rates. Our primary market risk exposures are interest rate and unfavorable movements in exchange rates between the U.S. dollar and the Mexican peso. Monitoring and managing these risks is a continual process carried out by senior management. Market risk is managed based on an ongoing assessment of trends in interest rates, foreign exchange rates, and economic developments, giving consideration to possible effects on both total return and reported earnings. Our financial advisors, both internal and external, provide ongoing advice regarding trends that affect management’s assessment.

Exchange Rate Sensitivity:

We conduct operations in Mexico. Accordingly, exposure exists to potentially adverse movements in foreign currency rates. We do not use foreign exchange forward contracts to hedge the risk of change in foreign currency exchange rates. Our consolidated financial statements are denominated in U.S. dollars and accordingly, changes in the exchange rates between the Mexico subsidiary’s local currency and the U.S. dollar will affect the translation of the subsidiary’s financial results into U.S. dollars for the purposes of reporting the consolidated financial results. We do not hedge these matters because cash flows from international operations are generally re-invested locally. It is estimated that a 10% change in foreign exchange rates would not have a material impact on earnings.

Interest Rate Sensitivity:

The effective interest rate on our credit facilities are influenced by the actions of the Federal Reserve in establishing from time to time the Federal Funds Interest Rate which is the rate banks borrow from the Federal Reserve Bank. During 2003 and 2002, the Federal Reserve implemented a number of reductions in the Federal Funds Interest Rate in an effort to stimulate the U.S. economy. As a result the effective interest rate that we paid on our borrowings under the facilities declined, leading to a corresponding reduction in interest expense. However, in the latter half of 2004 and throughout 2005, the Federal Reserve increased the Federal Funds Interest Rate, causing the effective interest rate on our facilities to increase. Based on the balance outstanding under our interest-bearing facilities at year-end, a percentage point change in the effective interest rate would change interest expense by less than $100,000 annually.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

TABLE OF CONTENTS

DECEMBER 31, 2005, 2004, AND 2003

ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA

	PAGE
Reports of Independent Registered Public Accounting Firms		20-21
Consolidated Financial Statements:
Consolidated Balance Sheets as of December 31, 2005 and 2004		22
Consolidated Statements of Income for the years ended December 31, 2005, 2004 and 2003		23
Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2005, 2004 and 2003		24
Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004 and 2003		25
Notes to Consolidated Financial Statements		26-41
Reports of Independent Registered Public Accounting Firms on Supplementary Information		42-43
Schedule II Valuation and Qualifying Accounts		44
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Report of Independent Registered Public Accounting Firm

To the Board of Directors
Nortech Systems Incorporated and Subsidiary
Wayzata, Minnesota

We have audited the consolidated balance sheet of Nortech Systems Incorporated and Subsidiary as of December 31, 2005 and 2004, and the related consolidated statements of income, shareholders’ equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Nortech Systems Incorporated and Subsidiary as of December 31, 2005 and 2004, and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.

/s/  MCGLADREY & PULLEN, LLP

Minneapolis, Minnesota
February 24, 2006

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Report of Independent Registered Public Accounting Firm

Board of Directors and Shareholders
Nortech Systems Incorporated:

We have audited the accompanying consolidated statements of income, shareholders’ equity and cash flows of Nortech Systems Incorporated and Subsidiary (the Company) for the year ended December 31, 2003. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of Nortech Systems Incorporated and Subsidiary operations and their cash flows for the year ended December 31, 2003, in conformity with U.S. generally accepted accounting principles.

/s/ KPMG LLP

Minneapolis, Minnesota
February 13, 2004, except as to note 4 to the 2003 financial statements

which is as of March 9, 2004

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2005 AND 2004

 

See accompanying Notes to Consolidated Financial Statements.

22

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 2005, 2004, AND 2003

 

See accompanying Notes to Consolidated Financial Statements.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF SHAREHOLDER’S EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2005, 2004, AND 2003

 

See accompanying Notes to Consolidated Financial Statements.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2005, 2004, AND 2003

 

See accompanying Notes to Consolidated Financial Statements.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2005, 2004, AND 2003

NOTE 1   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Business

We manufacture wire harnesses, cables and electromechanical assemblies, printed circuit boards and higher-level assemblies for a wide range of commercial and defense industries. We provide a full “turn-key” contract manufacturing service to our customers. All products are built to the customer’s design specifications. Products are sold to customers both domestically and internationally. We also provide repair service on circuit boards used in machines in the medical industry.

Our manufacturing facilities are located in Bemidji, Fairmont, Blue Earth, Merrifield and Baxter, Minnesota as well as Augusta, Wisconsin, and Monterrey, Mexico.

A summary of our significant accounting policies follows:

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Estimates also affect the reported amounts of revenue and expense during the reporting period. Significant items subject to estimates and assumptions include the valuation allowance for inventories and estimated future cash flows used in the impairment test of intangible assets. Actual results could differ from those estimates.

Principles of Consolidation

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

Cash and Cash Equivalents

For purposes of reporting cash flows, we consider cash equivalents to be short-term, highly liquid interest-bearing accounts readily convertible to cash. The carrying amount approximates fair value.

Accounts Receivable and Allowance for Doubtful Accounts

We grant credit to customers in the normal course of business. Accounts receivable are unsecured and are presented net of an allowance for uncollectible accounts. The allowance for uncollectible accounts was $297,000 and $280,000 at December 31, 2005 and 2004, respectively. We determine our allowance by considering a number of factors, including the length of time trade accounts receivable are past due, our previous loss history, the customer’s current ability to pay its obligation to us, and the condition of the general economy and the industry as a whole. We write-off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for uncollectible accounts. We do not accrue interest on past due accounts receivable.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2005, 2004, AND 2003

NOTE 1   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

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 inventory that may have a lower value than stated or quantities in excess of future production needs. Inventory is shown net of reserve for excess and obsolete inventory as follows:

 

Property, Equipment and Depreciation

Property and equipment are stated at cost less accumulated depreciation. Additions, improvements and major renewals are capitalized, while maintenance, repairs and minor renewals are expensed as incurred. When assets are retired or disposed of, the assets and related accumulated depreciation are removed from the accounts and the resulting gain or loss is reflected in operations. Leasehold improvements are depreciated over the shorter of the estimated use life or the remaining lease term. All other property and equipment are depreciated by the straight-line method of depreciation over their estimated useful lives.

 

Depreciation expense was $1,185,599, $1,112,210 and $1,259,175, for the years ended December 31, 2005, 2004 and 2003, respectively.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2005, 2004, AND 2003

NOTE 1   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Goodwill and Finite Life Intangible Assets

We account for goodwill and other intangible assets in accordance with Statement of Financial Accounting Standards Board No. (“SFAS”) 142, “Goodwill and Other Intangible Assets,” which requires that goodwill and certain indefinite-lived assets not be amortized but evaluated annually for impairment. Finite life intangible assets are amortized on a straight-line basis over their estimated useful lives, which range from three to four years. Finite life intangible assets at December 31, 2005 and 2004 are as follows:

 

 

Amortization expense related to these assets is as follows:

 

Estimated amortization expense related to these assets is as follows:

 

Impairment Analysis

We evaluate property and equipment and intangible assets with finite lives for impairment, as well as the related amortization periods, to determine whether adjustments to these amounts or useful lives are required based on current events and circumstances. The evaluation is based on our projection of the undiscounted future operating cash flows of the underlying assets. To the extent such projections indicate that future undiscounted cash flows are not sufficient to recover the carrying amounts of related assets, a charge is recorded to reduce the carrying amount to the asset’s estimated fair value.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2005, 2004, AND 2003

NOTE 1   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Preferred Stock

Preferred stock issued is non-cumulative and nonconvertible. The holders of the preferred stock are entitled to a non-cumulative dividend of 12% when and as declared. In liquidation, holders of preferred stock have preference to the extent of $1.00 per share plus dividends accrued but unpaid. No preferred stock dividends were declared or paid during the years ended December 31, 2005, 2004, and 2003.

Revenue Recognition

We recognize revenue upon shipment of products to customers, when title has passed, all contractual obligations have been satisfied and collection of the resulting receivable is reasonably assured. In the normal course of business we enter into a number of contracts with customers under which we provide engineering services on a per project basis. Revenue for these services is recognized upon completion of the engineering process, usually upon initial shipment of the product. Revenues from repair services are recognized upon shipment of related equipment to customers. Our 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.

Estimated Warranty Claims

The sales of our products include warranties that provide for repairs or replacement of defective products. The warranty periods range from one to two years, depending on the product, following the sale. We estimate a warranty reserve based on actual historical warranty claims coupled with an analysis of unfulfilled claims at the balance sheet date.  Warranty claims have been minimal in the past and are anticipated to remain low. Estimated warranty liabilities of approximately $3,000 are included in Other Accrued Liabilities at December 31, 2005 and 2004.

Advertising

Advertising costs are charged to operations as incurred. Total amount charged to expense was $173,464, $197,914 and $106,873, for the years ended December 31, 2005, 2004 and 2003, respectively.

Income Taxes

We account for income taxes under the asset and liability method. Deferred income tax assets and liabilities are recognized annually for differences between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.

Fair Value of Financial Instruments

The carrying amounts for all financial instruments approximate fair values. The carrying amounts for cash, receivables, payables, accrued liabilities and the line of credit approximate fair value because of the

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
DECEMBER 31, 2005, 2004, AND 2003

NOTE 1   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

short maturity of these instruments. Based on the borrowing rates currently available to us for bank loans with similar terms and average maturities, the carrying value of long-term debt and the line of credit materially approximates fair value.

Stock Based Compensation

As of December 31, 2005, we account for stock-based compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Under APB No. 25, compensation cost is determined based on the difference, if any, on the grant date between the fair value of our stock and the amount an employee must pay to acquire the stock. Compensation expense is recognized over the vesting period.

For the years ended December 31, 2005, 2004, and 2003, we have adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation.”  Accordingly, no compensation costs were charged to operations for the years ended December 31, 2005, 2004, and 2003.

Had compensation cost for the our stock option plan been determined pursuant to SFAS No. 123, net earnings and earnings per common share would have been as follows:

 

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