UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

 

FORM 10-Q

 

(Mark One)
ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 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

 

 

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 of file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of regulation S-K 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. ý

 

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

 

Number of shares of $.01 par value common stock outstanding at July 22, 2005 - 2,582,265

 

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

 

 

TABLE OF CONTENTS

 

PART I  - FINANCIAL INFORMATION
	Item 1	-	Financial Statements
			Consolidated Balance Sheets
			Consolidated Statements of Income
			Consolidated Statements of Cash Flows
			Condensed Notes to Consolidated Financial Statements
	Item 2	-	Management’s Discussion and Analysis of Financial Condition And Results of Operations
	Item 3	-	Quantitative and Qualitative Disclosures About Market Risk
	Item 4	-	Controls and Procedures
PART II - OTHER INFORMATION
	Item 1	-	Legal Proceedings
	Item 4	-	Submission of Matters to a Vote of Security Holders
	Item 6	-	Exhibits
SIGNATURES
	Exhibit 31.1
	Exhibit 31.2
	Exhibit 32.1

 

2

 

PART 1

 

ITEM 1.  FINANCIAL STATEMENTS

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

JUNE 30, 2005 AND DECEMBER 31, 2004

 

		JUNE 30 2005			DECEMBER 31 2004
		(Unaudited)
ASSETS
Current Assets
Cash and Cash Equivalents		$	548,248		$	555,783
Accounts Receivable, Less Allowance for Uncollectible Accounts of $353,000 and $280,000, respectively		14,368,286			13,355,730
Inventories:
Raw Materials		11,209,454			10,662,571
Work In Process		2,909,189			2,418,850
Finished Goods		2,463,724			2,373,495
Reserves		(1,372,364		)	(1,219,200		)
Total Inventories		15,210,003			14,235,716
Prepaid Expenses		294,110			399,210
Income Taxes Receivable		26,116			351,369
Deferred Tax Assets		979,000			818,000
Total Current Assets		31,425,763			29,715,808
Property and Equipment
Land		151,800			151,800
Building and Leasehold Improvements		4,734,913			4,720,518
Manufacturing Equipment		7,399,091			7,222,437
Office and Other Equipment		3,317,363			3,010,793
Total Property and Equipment		15,603,167			15,105,548
Accumulated Depreciation		(9,267,297		)	(8,681,033		)
Net Property and Equipment		6,335,870			6,424,515
Other Assets
Deposits		11,012			11,012
Non-Compete, Net of Accumulated Amortization		406,287			603,267
Goodwill		75,006			75,006
Deferred Tax Assets		94,000			52,000
Total Other Assets		586,305			741,285
Total Assets		$	38,347,938		$	36,881,608

 

See Accompanying Condensed Notes to Consolidated Financial Statements

 

3

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

JUNE 30, 2005 AND DECEMBER 31, 2004

 

		JUNE 30 2005			DECEMBER 31 2004
		(Unaudited)
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities
Bank Note Payable		$	6,927,235		$	7,523,058
Current Maturities of Notes Payable		1,050,827			997,815
Checks Written in Excess of Bank Balance		1,014,000			950,000
Accounts Payable		7,493,017			5,602,913
Accrued Payroll and Commissions		2,361,420			2,375,939
Accrued Health and Dental Claims		370,956			250,330
Other Accrued Liabilities		518,926			265,762
Total Current Liabilities		19,736,381			17,965,817
Long-Term Liabilities
Notes Payable (Net of Current Maturities)		2,836,779			3,399,210
Total Liabilities		22,573,160			21,365,027
Shareholders’ Equity
Preferred Stock, $1 par value; 1,000,000 Shares Authorized; 250,000 Shares Issued and Outstanding		250,000			250,000
Common Stock - $0.01 par value; 9,000,000 Shares Authorized: 2,582,265 Shares Issued and Outstanding at June 30, 2005; 2,582,147 Shares Issued and Outstanding at December 31, 2004		25,823			25,821
Additional Paid-In Capital		14,119,262			14,118,658
Accumulated Other Comprehensive Loss		(20,991		)	(40,729		)
Retained Earnings		1,400,684			1,162,831
Total Shareholders’ Equity		15,774,778			15,516,581
Total Liabilities and Shareholders’ Equity		$	38,347,938		$	36,881,608

 

See Accompanying Condensed Notes to Consolidated Financial Statements

 

4

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

FOR THE THREE MONTHS ENDED

JUNE 30, 2005 AND 2004

(UNAUDITED)

 

		JUNE 30 2005			JUNE 30 2004
Net Sales		$	20,562,916		$	18,028,197
Cost of Goods Sold		17,974,470			16,014,274
Gross Profit		2,588,446			2,013,923
Operating Expenses:
Selling Expenses		936,709			892,747
General and Administrative Expenses		1,275,942			942,431
Total Operating Expenses		2,212,651			1,835,178
Income From Operations		375,795			178,745
Other Income (Expense)
Interest Income		415			25,387
Miscellaneous Expense, net		(8,849		)	54,920
Interest Expense		(161,400		)	(89,068		)
Total Other Expense		(169,834		)	(8,761		)
Income Before Income Taxes		205,961			169,984
Income Tax Expense		67,000			65,000
Net Income		$	138,961		$	104,984
Earnings Per Common Share:
Basic		$	0.05		$	0.04
Weighted Average Number of Common Shares Outstanding Used for Basic Earnings Per Common Share		2,582,222			2,550,391
Diluted		$	0.05		$	0.04
Weighted Average Number of Common Shares Outstanding Plus Dilutive Common Stock Options		2,610,040			2,600,086

 

See Accompanying Condensed Notes to Consolidated Financial Statements

 

5

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

FOR THE SIX MONTHS ENDED

JUNE 30, 2005 AND 2004

(UNAUDITED)

 

		JUNE 30 2005			JUNE 30 2004
Net Sales		$	39,630,418		$	33,074,282
Cost of Goods Sold		34,677,439			29,460,088
Gross Profit		4,952,979			3,614,194
Operating Expenses:
Selling Expenses		1,801,937			1,482,170
General and Administrative Expenses		2,459,914			1,738,105
Total Operating Expenses		4,261,851			3,220,275
Income From Operations		691,128			393,919
Other Income (Expense)
Interest Income		779			26,682
Miscellaneous Expense, net		(14,522		)	41,003
Interest Expense		(302,532		)	(222,571		)
Total Other Expense		(316,275		)	(154,886		)
Income Before Income Taxes		374,853			239,033
Income Tax Expense		137,000			91,000
Net Income		$	237,853		$	148,033
Earnings Per Common Share:
Basic		$	0.09		$	0.06
Weighted Average Number of Common Shares Outstanding Used for Basic Earnings Per Common Share		2,582,185			2,545,028
Diluted		$	0.09		$	0.06
Weighted Average Number of Common Shares Outstanding Plus Dilutive Common Stock Options		2,609,879			2,599,782

 

See Accompanying Condensed Notes to Consolidated Financial Statement

 

6

 

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE SIX MONTHS ENDED

JUNE 30, 2005 AND 2004

(Unaudited)

 

		JUNE 30 2005			JUNE 30 2004
Cash Flows From Operating Activities
Net Income		$	237,853		$	148,033
Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:
Depreciation and Amortization		783,244			504,299
Deferred Taxes		(203,000		)	(67,000		)
Foreign Currency Transaction Loss		14,254			14,441
Changes in Current Operating Items:
Accounts Receivable		(1,012,556		)	(351,307		)
Inventories		(974,287		)	(2,953,793		)
Income Taxes Receivable		325,253			137,822
Prepaid Expenses and Other Assets		105,100			92,813
Accounts Payable		1,890,104			2,449,893
Accrued Payroll and Commissions		106,107			238,934
Other Accrued Liabilities		253,164			79,415
Net Cash Provided by Operating Activities		1,525,236			293,550
Cash Flows from Investing Activities:
Acquisition of Equipment		(482,778		)	(525,691		)
Cash Flows from Financing Activities:
Net Change in Line of Credit		(595,823		)	1,060,445
Payments on Notes and Capital Lease Payable		(509,419		)	(129,183		)
Issuance of Stock		606			21,750
Checks in Excess of Bank Balance		64,000			—
Net Cash Provided by (Used in) Financing Activities		(1,040,636		)	953,012
Effect of Exchange Rate Changes on Cash		(9,357		)	(3,683		)
Net Increase (Decrease) in Cash and Cash Equivalents		(7,535		)	717,188
Cash and Cash Equivalents - Beginning		555,783			101,179
Cash and Cash Equivalents - Ending		$	548,248		$	818,367
Supplemental disclosure of cash flow information:
Cash paid during the period for interest		$	161,533		$	222,375
Cash paid (received) during the period for income taxes		—			186

 

See Accompanying Condensed Notes to Consolidated Financial Statements

 

7

 

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

NOTE 1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation

The accompanying unaudited consolidated financial statements for the interim periods have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and in accordance with 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.  However, as disclosed herein, there have been no material changes in the information disclosed in the notes to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2004.  In our opinion, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included.

 

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

 

The operating results of the interim periods presented are not necessarily indicative of the results expected for the full year or for any other interim period.  The accompanying condensed notes to consolidated financial statements should be read in conjunction with the audited financial statements and notes thereto for the year ended December 31, 2004 included in our Annual Report Form 10-K for the year ended December 31, 2004 as filed with the Securities and Exchange Commission.

 

Reclassification

Certain expenses on the consolidated statements of income for the three and six-month periods ended June 30, 2004 have been reclassified, with no effect on net income or earnings per common share amounts, to be consistent with the classifications adopted for the three and six-month periods ended June 30, 2005 (see December 31, 2004 consolidated financial statements for further discussion).

 

Stock Based Compensation

As allowed by Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” and by SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure,” we elected to continue to apply the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.”  Accordingly, no compensation cost is recognized in our statement of income for options granted with exercise prices that are equal to the market values of the underlying common stock on the dates of grant.  Had compensation cost for the stock options been based on the estimated fair values at grant dates, our pro forma net income and net income per common share would have been as follows:

 

8

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2005			2004			2005			2004
Net income, as reported		$	138,961		$	104,984		$	237,853		$	148,033
Deduct: Total stock-based compensation expense, determined under fair value- based method for all awards, net of related tax effects		(34,843		)	(25,935		)	(65,613		)	(51,869		)
Pro forma net income		$	104,118		$	79,049		$	172,240		$	96,164
Earnings per share:
Basic – as reported		$	0.05		$	0.04		$	0.09		$	0.06
Basic – pro forma		$	0.04		$	0.03		$	0.07		$	0.04
Diluted – as reported		$	0.05		$	0.04		$	0.09		$	0.06
Diluted – pro forma		$	0.04		$	0.03		$	0.07		$	0.04

 

For the three-month and six-month periods ended June 30, 2005, we granted 20,000 stock options. The Company will be required to apply SFAS 123R as of the beginning of fiscal year 2006 (see Note 10).

 

Segment Reporting Information

Our results of operations for the three months and six months ending June 30, 2005 and 2004 represent a single segment referred to as Contract Manufacturing.  Export sales represent 4% of consolidated net sales for the three-month and six-month periods ending June 30, 2005 and 2004.

 

Long-lived assets by country are as follows:

 

		United States			Mexico			Total
June 30, 2005
Net Property and Equipment		$	5,636,343		$	699,527		$	6,335,870
Other Assets		192,709			393,596			586,305
December 31, 2004
Net Property and Equipment		$	5,755,401		$	669,114		$	6,424,515
Other Assets		156,889			584,396			741,285

 

NOTE 2.  PRINCIPLES OF CONSOLIDATION

 

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

 

9

 

NOTE 3.  ACCOUNTING PRINCIPLES

 

In preparing the consolidated financial statements in conformity with accounting principles generally accepted in the United States, we must make decisions, which impact the reported amounts and related disclosures. Such decisions include the selection of the appropriate principles to be applied and the assumptions on which to base accounting estimates. In reaching such decisions, we apply judgment based on our understanding and analysis of the relevant circumstances.

 

The accounting principles followed in the preparation of the financial information contained on Form 10-Q are the same as those described in our Annual Report on Form 10-K for the year ended December 31, 2004. Refer to our Annual Report on Form 10-K for detailed information on accounting policies.

 

NOTE 4. MAJOR CUSTOMERS AND CONCENTRATION OF CREDIT RISK

 

Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash and trade accounts receivable.  With regard to cash, we maintain our excess cash balances in checking accounts at three high-credit quality financial institutions.  We do not require collateral on our receivables.  Historically, we have not suffered significant losses with respect to trade accounts receivable.

 

On May 13, 2005, we negotiated new terms for a customer account, which is supported by a promissory note.  The balance on this account as of June 30, 2005 was $309,627 with full payment required by year-end.

 

Two customers accounted for more than 10% of net sales for the six-month period ended June 30, 2005, and one customer accounted for more than 10% of net sales for the same period in 2004.  For the six-month periods ended June 30, 2005 and 2004, G.E. Medical and Transportation Divisions accounted for 13% and 15% of net sales, respectively.  For the six-month period ended June 30, 2005, Northrop Grumman Corp. accounted for 10% of net sales.

 

NOTE 5. LONG TERM DEBT

 

We currently have an $8 million line of credit arrangement with a maturity date of January 31, 2007 at Wells Fargo Bank, N.A. (WFB). The line of credit and other installment debt with WFB contain certain covenants, which, among other things, require us to adhere to regular reporting requirements, abide by annual shareholder dividend limitations, maintain certain financial ratios, and limit the amount of annual capital expenditures.  On June 30, 2005, we had an outstanding balance of $6.9 million under the line of credit and unused availability of $1.1 million.

 

10

 

NOTE 6. NET INCOME PER COMMON SHARE

 

The following is a reconciliation of the numerators and the denominators of the basic and diluted per common share computations.

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2005			2004			2005			2004
Basic Earnings Per Common Share
Net income, as reported		$	138,961		$	104,984		$	237,853		$	148,033
Weighted average common shares outstanding		2,582,222			2,550,391			2,582,185			2,545,028
Basis earnings per common share		$	0.05		$	0.04		$	0.09		$	0.06
Diluted Earnings Per Common Share
Net income, as reported		$	138,961		$	104,984		$	237,853		$	148,033
Weighted average common shares outstanding		2,582,222			2,550,391			2,582,185			2,545,028
Effect of Stock options		27,818			49,695			27,694			54,754
Weighted average common shares for diluted earnings per common share		2,610,040			2,600,086			2,609,879			2,599,782
Diluted earnings per common share		$	0.05		$	0.04		$	0.09		$	0.06

 

For the three-month and six-month periods ended June 30, 2005, 50,263 shares and 98,240 shares, respectively, were excluded from the computation of diluted earnings per share as these shares were antidilutive.  For the three-month and six-month periods ended June 30, 2004, 7,427 and 8,523 shares, respectively, were excluded from the computation of diluted earnings per share as these shares were antidilutive.

 

NOTE 7. FOREIGN CURRENCY TRANSLATION

 

Local currency is considered the functional currency for operations outside the United States.  Assets and liabilities are translated at period-end exchange rates.  Income and expense items are translated at average rates of exchange prevailing during the period.  Translation adjustments are recorded as a component of accumulated other comprehensive loss in stockholders’ equity.  Foreign currency exchange transaction gains and losses attributable to exchange rate movements on intercompany receivables and payables not deemed to be of a long-term investment nature are recorded in Miscellaneous Income (Expense).  For the six-month period ended June 30, 2005 and 2004, we experienced foreign currency transaction losses of $14,254 and $14,441, respectively.  The Mexican peso is the only foreign currency being translated.

 

11

 

NOTE 8. COMPREHENSIVE INCOME

 

Comprehensive income is comprised of net income and other comprehensive income (loss).  Other comprehensive income (loss) includes gains and losses resulting from foreign currency translations.  The details of comprehensive income are as follows:

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2005			2004			2005			2004
Net Income, as reported		$	138,961		$	104,984		$	237,853		$	148,033
Other Comprehensive Income (Loss):
Currency Translation Adjustment		19,738			(7,119		)	19,738			(7,119		)
Comprehensive Income		$	158,699		$	97,865		$	257,591		$	140,914

 

NOTE 9. CONTINGENCIES

 

We are subject to various legal proceedings and claims that arise in the ordinary course of business. There are no known legal proceedings or claims at this time.

 

NOTE 10.  RECENTLY ISSUED ACCOUNTING STANDARDS

 

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 the first interim period of fiscal year 2006.  Although we have not fully analyzed the effect this new statement will have on our consolidated financial statements in the future, the pro forma net income effect of using the fair value method for the past three fiscal years is presented in Note 1 to our consolidated financial statements on Form 10-K.

 

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs”, an amendment to ARB No. 43, Chapter 4.  The amendments made by 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.

 

In May 2005, the FASB issued FASB Statement No. 154, Accounting Changes and Error Corrections.  This new standard replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements.  Among other changes, Statement 154 requires retrospective application of a voluntary change in accounting principle with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so.  Statement 154 also requires accounting for a change in method of depreciating or amortizing a long-lived nonfinancial asset as a change in estimate (prospectively) effected by a change in accounting principle.  Further, the Statement requires that correction of errors in previously issued

 

12

 

financial statements be termed a “restatement.”  The new standard is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005.  Early adoption of this standard is permitted for accounting changes and correction of errors made in fiscal years beginning after June 1, 2005.  We do not believe the adoption of FASB Statement 154 will have a material effect on our financial position or results of operations.

 

In March 2005, the FASB issued FASB 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.

 

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

 

Overview:

 

We are a full-service Electronic Manufacturing service (EMS) provider of wire and cable assemblies, printed circuit board assemblies, higher-level assemblies and box builds for a wide range of industries, based in Wayzata, Minnesota. Markets we serve include medical, automotive, defense, computer, peripheral, commercial, telecom, government, and consumer.  In Minnesota, we have facilities in Baxter, Bemidji, Fairmont and Merrifield. We also have facilities in Augusta, Wisconsin, and Monterrey, Mexico.

 

Summary:

 

For the second quarter ended June 30, 2005, we reported net sales of $20.6 million, up 14 percent over the $18.0 million we reported in the second quarter of 2004.  The second quarter gross profit percentage for 2005 was 13% compared to 11% for the second quarter of 2004.  Income from operations for the second quarter of 2005 totaled $375,795, an increase of 110% above the $178,745 reported in the second quarter of 2004.  Net income for the second quarter of 2005 totaled $138,961, or $0.05 per diluted common share and was above the $104,984, or $0.04 per diluted common share, reported in the second quarter of 2004.  The increased volume in the second quarter of 2005, coupled with a favorable product and customer mix positively impacted our gross profit.  This improvement in gross profit along with relatively constant operating expenses resulted in improved operating income and net income.

 

For the six-month period ended June 30, 2005, we had net sales of $39.6 million, up 20 percent over the $33.1 million we reported for the six months ended June 30, 2004. The gross profit for the six-month period ended June 30, 2005 of $5.0 million or 12% of net sales showed an increase of $1.3 million or a 2% improvement over the six-month period ended June 30, 2004, as a result of our product and customer mix and increased volume absorption.  Income from operations of $691,128 for the six-months of 2005 increased 75% from the $393,919, reported in the first six months of 2004.  Net income for the six-month period ended June 30, 2005, totaled $237,853, or $0.09 per diluted common share and was above the $148,033, or $0.06 per diluted common share, reported in the six-month period ended June 30, 2004.  Again, the improvement in profitability from 2004 was attributable to improved gross margins as well as the maintenance of operating expenses at constant levels.

 

13

 

(1.)        Results of Operations:

 

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

 

		Three Months Ended June 30,				Six Months Ended June 30,
		2005		2004		2005		2004
Net Sales		100	%	100	%	100	%	100	%
Cost of Good Sold		87	%	89	%	88	%	90	%
Gross Profit		13	%	11	%	12	%	10	%
Selling Expenses		5	%	5	%	4	%	4	%
General and Administrative Expenses		6	%	5	%	6	%	5	%
Income from Operations		2	%	1	%	2	%	1	%
Other Expenses, Net		1	%	0	%	1	%	0	%
Income Tax Expense		0	%	0	%	0	%	0	%
Net Income		1	%	1	%	1	%	1	%

 

Net Sales:

We reported net sales of $20.6 million and $18.0 million for the second quarter of June 30, 2005 and 2004, respectively, a 14% increase year over year. For the six months ended June 30, 2005 and 2004, we reported net sales of $39.6 million and $33.1 million for an increase of 20%.  The increase in net sales of $2.6 million and $6.5 million for both the current quarter and year-to-date, is primarily due to increased sales volume in our Aerospace Systems Division of $1.9 million and $5.5 million, respectively, Industrial Electronic Printed Circuit Board Assemblies Division of $0.5 million and $1.5 million, respectively and an increase in sales of Commercial Wire and Cable Division of $0.2 million for the current quarter.  For the six-month period ended June 30, 2005, we saw a decrease in Commercial Wire and Cable sales of $0.5 million compared to the same period in 2005.  Our Commercial Wire and Cable Division’s sales continue to be negatively impacted by competitive pricing pressures from overseas competition, and domestic excess capacity levels.  Our 90-day order backlog was approximately $17.6 million as of June 30, 2005, compared to approximately $14.6 million at the beginning of the quarter.  Based on current trends we expect the third quarter to have similar sales levels as the second quarter.

 

Gross Profit:

Our gross profit for the second quarter of 2005 was $2.6 million or 13% of net sales compared to gross profit of $2.0 million or 11% of net sales for the second quarter of 2004.  For the six months ended June 30, 2005, we had gross profit of $5.0 million or 12% of net sales compared to gross profit of $3.6 million or 10% of net sales for the same period in 2004.  The gross profit, for both the current quarter and year-to-date, was impacted by a favorable product and customer mix, as well as increased volume absorption.

 

Selling Expense:

We had selling expenses of $936,709 or 5% of net sales for the second quarter of 2005 compared to $892,747 or 5% of net sales for the second quarter of 2004.  For the six months ended June 30, 2005, we had selling expenses of $1.8 million or 4% of net sales compared to $1.5 million or 4% of net sales for the same period in 2004.  Comparing the second quarter of 2005 to the second quarter of 2004, the increase in selling expenses of $43,962 resulted from an increase in commissions of $94,151, which

 

14

 

was offset by a reduction in other selling expenses of $50,189.  Comparing the first six months of 2005 to the first six months of 2004, the increase in selling expenses of $319,767 resulted from an increase in commissions of $266,037 and an increase in other selling expenses of $53,730. We continue to invest in our sales force and brand in order to maintain a high level of customer service and continue the revenue growth.

 

General and Administrative Expense:

Our general and administrative expenses were $1,275,942 or 6% of net sales for the second quarter of 2005 and $942,431 or 5% of net sales for the second quarter of June 30, 2004.  The increase in general and administrative expenses is attributable in part to the increased investment in infrastructure, primarily additional personnel, of $240,000 to support the current growth trends and corporate shared services (i.e. accounting, information services, and human resources) of $32,000.  In addition, outside service costs increased $61,000 and related to process improvements and increased compliance requirements including Sarbanes-Oxley requirements.  For the six months ended June 30, 2005, we had general and administrative expenses of $2.5 million or 6% of net sales compared to $1.7 million or 5% of net sales for the same period in 2004.  As previously described above, the increase in general and administrative expenses resulted from the investment in infrastructure of $0.4 million, corporate shared services of $0.1 million and outside service costs related to process improvements and increased compliance requirements of $0.3 million.

 

Other Expense:

Other expenses, net were $169,834 for the quarter ended June 30, 2005 compared to $8,761 for the second quarter of 2004.  For the six months ended June 30, 2005, other expenses, net were $316,275 compared to $154,886 for the same period in 2004.  The increase in other expenses is due, in part, to an increase in interest expense of $72,332 and $79,961 for the three months and six months ended June 30, 2005, respectively.  Interest expense increased as a result of higher interest rates.  Interest income from the previous year’s income tax refund has decreased by $24,972 and $25,903 for the three months and six months ended June 30, 2005, respectively.  The remaining other income decreased as a result of the modification of the commission agreement with our overseas partner.

 

Income Tax:

Income tax expense for the three months ended June 30, 2005 is $67,000 compared to an income tax expense of $65,000 for the three months ended June 30, 2004.  For the six months ended June 30, 2005, income tax expenses were $137,000 compared to $91,000 for the same period in 2004.  The effective tax rate for 2005 is expected to approximate 36.5%, comprised of an effective rate of 33% for domestic federal and state taxes and 3.5% for foreign taxes.  The effective tax rate for 2004 was 31%, comprised of an effective rate of 28.5% for domestic federal and state taxes and 2.5% for foreign taxes.  While additional Research & Development Tax Credits are anticipated in 2005, we continue to see an overall decrease in the benefit derived from these credits, resulting in a higher effective domestic tax rate. In addition, the effective rate for foreign taxes decreased from 7% in the first quarter of 2005 due to a federal decree in Mexico, which reduced the revenue of the Mexico subsidiary that is subject to Mexico taxes.

 

(2.) Liquidity and Capital Resources:

We have financed our liquidity needs over the past several years through revenue generated from operations and an operating line of credit through Wells Fargo Bank, N.A. (WFB).  We currently have an $8 million line of credit arrangement with a maturity date of January 31, 2007. The line of credit and other installment debt with WFB contain certain covenants, which, among other things, require us to adhere to regular reporting requirements, abide by annual shareholder dividend limitations, maintain certain financial ratios, and limit the amount of annual capital expenditures.  On June 30, 2005, we had an outstanding balance of $6.9 million under the line of credit and unused availability of $1.1 million.

 

15

 

The following unaudited ratios are not required under the SEC guidelines or accounting principles generally accepted in the United States of America, however, we believe they are meaningful measures and are useful to readers of our financial statements.

 

Our line of credit is classified as a current liability as of June 30, 2005 and December 31, 2004.  At December 31, 2003 and 2002, the line of credit was classified as a long-term liability.  Therefore, in order to present the following ratios as comparable to the prior periods, the line of credit at December 31, 2003 and 2002 has been included in the current liabilities to compute the ratios below to make the comparisons below more meaningful.

 

		June 30, 2005			December 31, 2004			December 31, 2003*			December 31, 2002*
Current Ratio		1.59			1.65			1.80			1.80
(Current Assets / Current Liabilities)
Working Capital		$	11,689,382		$	11,749,991		$	10,816,072		$	9,843,203
(Current Assets – Current Liabilities)
Quick Ratio		0.76			0.77			0.81			0.65
(Cash + Accounts Receivable / Current Liabilities)
Accounts Receivable to Working Capital		1.19			1.03			0.85			0.85
(Average Accounts Receivable/ Working Capital)
Inventory to Working Capital		1.26			1.10			1.11			1.26
(Average Inventory/ Working Capital)

 

* Line of credit debt reclassified to current liabilities as noted in above comments.

 

Our working capital remained consistent at approximately $11.7 million at December 31, 2004 and June 30, 2005. The revenue growth has caused a build up in inventory and accounts receivable, impacting the ratios.  We are taking action and implementing initiatives to improve our working capital position by lowering inventory levels and continued efforts to collect the accounts receivable in terms.

 

Net cash provided by operating activities for the six months ended June 30, 2005 was $1.5 million; an improvement over the net cash used in operating activities of $0.3 million for the six months ended June 30, 2004.  The cash flow from operations for the six months ended June 30, 2005 is the result of net income of $0.2 million adjusted for noncash depreciation, amortization, foreign currency transaction loss, and the change in deferred taxes, which totaled $0.5 million in positive adjustments, plus a net change in operating assets and liabilities of $0.6 million.  Sales growth has increased our balances in accounts receivable, inventory and accounts payable.

 

Net cash used in investing activities of $482,778 for the first six months of 2005 is down from $525,691 spent on capital equipment purchases in the first six months of 2004.  The 2005 investments related to software for corporate shared services, which enables us to meet additional compliance requirements, and equipment to support our growth activities.

 

16

 

Net cash used in financing for the six months ended June 30, 2005 was $1,040,636, consisting primarily of paying down the line of credit by $595,823 and principal on notes payable of $509,419, which was offset by an increase in checks in excess of cash.

 

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 June 30, 2005. Refer to the Annual Report on Form 10-K for detailed information on our long-term contractual obligations.

 

		Payments Due by Period
		Remainder of 2005			2 - 3 Yrs			4 - 5 Yrs
Notes Payable		$	501,029		$	3,362,737		$	23,840
Operating Leases		120,901			311,651			60,708
Total Contractual Obligations		$	621,930		$	3,674,388		$	84,548

 

(3.) Critical Accounting Policies:

Our significant accounting policies and estimates are summarized in the footnotes to the annual consolidated financial statements.  Some of the most critical accounting policies and estimates that require us to exercise significant judgment are listed below.

 

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.

 

Allowance for Uncollectible Accounts:

We evaluate our allowance for uncollectible accounts on a quarterly basis and review any significant customers with delinquent balances to determine future collectibility.  We base our determinations on legal issues (such as bankruptcy status), past history, current financial and credit agency reports, and experience.  We reserve accounts deemed to be uncollectible in the quarter in which we make the determination.  We maintain additional reserves based on our historical bad debt experience. We believe these estimates may differ from actual results. We believe that, based on past history and credit policies, the net accounts receivable are of good quality.

 

Inventory Valuation and Reserves:

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 in excess of production needs.  These estimates may differ from actual results.  We have an evaluation process that is used to assess the value of the inventory by part and customer that is slow moving, excess or obsolete.  This process is reviewed and evaluated quarterly.

 

17

 

Deferred Income Tax Valuation:

At June 30, 2005 and December 31, 2004, we have recorded U.S. deferred tax assets pertaining to the recognition of future deductible temporary differences.  We have not provided any valuation allowance with respect to these assets, as we believe their realization is “more likely than not.”  This determination is primarily based upon our expectation that future U.S. operations will be sufficiently profitable, as well as various tax, business and other planning strategies available to us.  We cannot assure you that we will be able to realize this asset or that future valuation allowances will not be required.  The failure to utilize this asset would adversely affect our results of operations and financial position.

 

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 its 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.

 

Based on a critical assessment of its 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 as of June 30, 2005.  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.

 

(4.) Forward-Looking Statements:

Those statements in the foregoing report that are not historical facts are forward-looking statements made pursuant to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995.  Such statements generally will be accompanied by words such as “anticipate,” “believe,” “estimate,” “expect,” “forecast,” “intend,” “possible,” “potential,” “predict,” “project,” or other similar words that convey the uncertainty of future events or outcomes.  Although we believe these forward-looking statements are reasonable, they are based upon a number of assumptions concerning future conditions, any or all of which may ultimately prove to be inaccurate.  Forward-looking statements involve a number of risks and uncertainties.  Important factors that could cause actual results to differ materially from the forward-looking statements include, without limitation:

 

•                  Volatility in the marketplace which may affect market supply and demand for our products;

•                  Increased competition;

•                  Changes in the reliability and efficiency of operating facilities or those of third parties;

•                  Risks related to availability of labor;

•                  Increase in certain raw material costs such as copper;

•                  Commodity and energy cost instability;

•                  General economic, financial and business conditions that could affect our financial condition and results of operations.

 

18

 

The factors identified above are believed to be important factors (but not necessarily all of the important factors) that could cause actual results to differ materially from those expressed in any forward-looking statement made by us.  Unpredictable or unknown factors not discussed herein could also have material adverse effects on forward-looking statements.  All forward-looking statements included in this Form 10-Q are expressly qualified in their entirety by the forgoing cautionary statements.  We undertake no obligations to update publicly any forward-looking statement (or its associated cautionary language) whether as a result of new information or future events.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

There have been no material changes in market risk from what was reported on Form 10-K for the year ended December 31, 2004.

 

ITEM 4. CONTROLS AND PROCEDURES

 

We evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of June 30, 2005. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and regulations and are operating in an effective manner.

 

No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act) occurred during the fiscal quarter ended March 31, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.  We believe the deficiency, regarding our ability to forecast financial results accurately enough to determine expected compliance with debt covenants at future quarter ends, has been remedied by improving and expanding our monthly forecasting process put into place in the first week of June 2004.  At the August 13, 2004 discussion with the Chairman of the audit committee, KPMG stated that this deficiency did not in its view constitute a “material weakness” within the meaning of the standards established by the American Institute of Certified Public Accountants.

 

19

 

PART II

ITEM 1.     LEGAL PROCEEDINGS:

 

NONE

 

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

 

NONE

 

ITEM 6. EXHIBITS

 

(a)           Exhibits

 

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

 

20

 

Signatures

 

 

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 Subsidiary
Date: August 4, 2005	by	/s/ Michael J. Degen
	Michael J. Degen
	President and Chief Executive Officer
Date: August 4, 2005	by	/s/ Richard G. Wasielewski
	Richard G. Wasielewski
	Chief Financial Officer

 

21