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NORTECH SYSTEMS INC - Quarter Report: 2006 September (Form 10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2006

OR

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

For the transition period from                 to

NORTECH SYSTEMS INCORPORATED

Commission file number 0-13257

State of Incorporation: Minnesota

IRS Employer Identification No. 41-1681094

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

Telephone number: (952) 345-2244

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

Large Accelerated Filer o

Accelerated Filer o

Non-accelerated Filer 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

Number of shares of $.01 par value common stock outstanding at October 31, 2006 - 2,674,729

 




TABLE OF CONTENTS

PAGE

 

 

PART I - FINANCIAL INFORMATION

 

 

 

Item 1

-

Condensed Financial Statements

 

 

 

 

 

 

 

Consolidated Balance Sheets

3 - 4

 

 

 

 

 

 

Consolidated Statements of Income

5 - 6

 

 

 

 

 

 

Consolidated Statements of Cash Flows

7

 

 

 

 

 

 

Notes to Condensed Consolidated Financial Statements

8 - 15

 

 

 

 

Item 2

-

Management’s Discussion and Analysis of Financial Condition And Results of Operations

16 - 22

 

 

 

 

Item 3

-

Quantitative and Qualitative Disclosures About Market Risk

22

 

 

 

 

Item 4

-

Controls and Procedures

22 - 23

 

 

 

 

PART II - OTHER INFORMATION

 

 

 

Item 1

-

Legal Proceedings

24

 

 

 

 

Item 1A

-

Risk Factors

24

 

 

 

 

Item 6

-

Exhibits

24

 

 

 

 

SIGNATURES

 

 

25

 

 

 

 

Exhibit 31.1

 

 

 

Exhibit 31.2

 

 

 

Exhibit 32.1

 

 

2




PART 1

ITEM 1.  FINANCIAL STATEMENTS

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

SEPTEMBER 30, 2006 AND DECEMBER 31, 2005

 

 

SEPTEMBER 30

 

DECEMBER 31

 

 

 

2006

 

2005

 

 

 

(Unaudited)

 

 

 

ASSETS

 

 

 

 

 

 

 

 

 

 

 

Current Assets

 

 

 

 

 

Cash and Cash Equivalents

 

$

204,769

 

$

840,123

 

Accounts Receivable, Less Allowance for Uncollectible

 

 

 

 

 

Accounts of $434,000 and $297,000, respectively

 

16,107,389

 

14,447,612

 

Inventories:

 

 

 

 

 

Raw Materials

 

12,355,544

 

10,616,894

 

Work In Process

 

3,999,660

 

4,423,892

 

Finished Goods

 

2,694,040

 

2,027,118

 

Reserves

 

(1,426,169

)

(1,218,434

)

 

 

 

 

 

 

Total Inventories

 

17,623,075

 

15,849,470

 

 

 

 

 

 

 

Prepaid Expenses

 

650,155

 

466,083

 

Income Taxes Receivable

 

193,614

 

 

Deferred Income Tax Assets

 

939,000

 

912,000

 

 

 

 

 

 

 

Total Current Assets

 

35,718,002

 

32,515,288

 

 

 

 

 

 

 

Property and Equipment

 

 

 

 

 

Land

 

300,000

 

151,800

 

Building and Leasehold Improvements

 

5,892,416

 

4,819,919

 

Manufacturing Equipment

 

9,059,923

 

7,662,699

 

Office and Other Equipment

 

3,486,518

 

3,413,968

 

Construction in Progress

 

204,577

 

502,374

 

 

 

 

 

 

 

Total Property and Equipment

 

18,943,434

 

16,550,760

 

 

 

 

 

 

 

Accumulated Depreciation

 

(10,480,909

)

(9,868,536

)

 

 

 

 

 

 

Net Property and Equipment

 

8,462,525

 

6,682,224

 

 

 

 

 

 

 

Other Assets

 

 

 

 

 

Finite Life Intangibles

 

87,303

 

209,307

 

Goodwill

 

75,006

 

75,006

 

Deferred Income Tax Assets

 

269,000

 

179,000

 

Restricted Cash

 

427,500

 

 

Deposits

 

7,726

 

7,726

 

 

 

 

 

 

 

Total Other Assets

 

866,535

 

471,039

 

 

 

 

 

 

 

Total Assets

 

$

45,047,062

 

$

39,668,551

 

 

See Accompanying Notes to Condensed Consolidated Financial Statements

3




 

 

 

SEPTEMBER 30

 

DECEMBER 31

 

 

 

2006

 

2005

 

 

 

(Unaudited)

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

 

 

Current Liabilities

 

 

 

 

 

Bank Note Payable

 

$

7,176,430

 

$

4,228,234

 

Current Maturities of Notes Payable

 

1,572,814

 

1,207,305

 

Current Maturities of Bonds Payable

 

130,000

 

 

Checks Written in Excess of Bank Balance

 

 

1,200,000

 

Accounts Payable

 

11,160,780

 

9,902,998

 

Accrued Payroll and Commissions

 

2,890,836

 

2,849,472

 

Accrued Health and Dental Claims

 

400,000

 

271,104

 

Income Taxes Payable

 

 

317,487

 

Other Accrued Liabilities

 

212,620

 

324,360

 

Total Current Liabilities

 

23,543,480

 

20,300,960

 

 

 

 

 

 

 

Long-Term Liabilities

 

 

 

 

 

Notes Payable (Net of Current Maturities)

 

2,388,187

 

2,714,227

 

Bonds Payable (Net of Current Maturities)

 

1,310,000

 

 

Other Long-Term Liabilities

 

27,295

 

 

Total Long-Term Liabilities

 

3,725,482

 

2,714,227

 

 

 

 

 

 

 

Total Liabilities

 

27,268,962

 

23,015,187

 

 

 

 

 

 

 

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:

 

 

 

 

 

2,674,729 and 2,618,197 Shares Issued and Outstanding at September 30, 2006 and December 31, 2005, respectively

 

26,747

 

26,182

 

Additional Paid-In Capital

 

14,553,573

 

14,306,602

 

Accumulated Other Comprehensive Loss

 

(21,032

)

(21,032

)

Retained Earnings

 

2,968,812

 

2,091,612

 

 

 

 

 

 

 

Total Shareholders’ Equity

 

17,778,100

 

16,653,364

 

 

 

 

 

 

 

Total Liabilities and Shareholders’ Equity

 

$

45,047,062

 

$

39,668,551

 

 

See Accompanying Notes to Condensed Consolidated Financial Statements

4




NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)

 

 

THREE MONTHS ENDED

 

 

 

SEPTEMBER 30

 

 

 

2006

 

2005

 

 

 

 

 

 

 

Net Sales

 

$

25,288,095

 

$

20,919,151

 

 

 

 

 

 

 

Cost of Goods Sold

 

22,330,692

 

18,364,908

 

 

 

 

 

 

 

Gross Profit

 

2,957,403

 

2,554,243

 

 

 

 

 

 

 

Operating Expenses:

 

 

 

 

 

Selling Expenses

 

1,199,752

 

794,094

 

General and Administrative Expenses

 

1,103,465

 

1,169,536

 

Total Operating Expenses

 

2,303,217

 

1,963,630

 

 

 

 

 

 

 

Income From Operations

 

654,186

 

590,613

 

 

 

 

 

 

 

Other Income (Expense)

 

 

 

 

 

Interest Income

 

4,886

 

676

 

Miscellaneous Income (Expense), net

 

61,707

 

(29,229

)

Interest Expense

 

(251,192

)

(148,703

)

Total Other Expense

 

(184,599

)

(177,256

)

 

 

 

 

 

 

Income Before Income Taxes

 

469,587

 

413,357

 

 

 

 

 

 

 

Income Tax Expense

 

165,000

 

153,000

 

 

 

 

 

 

 

Net Income

 

$

304,587

 

$

260,357

 

 

 

 

 

 

 

Earnings Per Common Share:

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.12

 

$

0.10

 

Weighted Average Number of Common Shares Outstanding Used for Basic Earnings Per Common Share

 

2,630,403

 

2,582,292

 

 

 

 

 

 

 

Diluted

 

$

0.12

 

$

0.10

 

Weighted Average Number of Common Shares Outstanding Plus Dilutive Common Stock Options

 

2,672,091

 

2,622,108

 

 

See Accompanying Notes to Condensed Consolidated Financial Statements

5




 

 

 

NINE MONTHS ENDED

 

 

 

SEPTEMBER 30

 

 

 

2006

 

2005

 

 

 

 

 

 

 

Net Sales

 

$

77,479,273

 

$

60,549,569

 

 

 

 

 

 

 

Cost of Goods Sold

 

67,949,479

 

53,042,347

 

 

 

 

 

 

 

Gross Profit

 

9,529,794

 

7,507,222

 

 

 

 

 

 

 

Operating Expenses:

 

 

 

 

 

Selling Expenses

 

3,447,928

 

2,596,031

 

General and Administrative Expenses

 

4,199,211

 

3,629,450

 

Total Operating Expenses

 

7,647,139

 

6,225,481

 

 

 

 

 

 

 

Income From Operations

 

1,882,655

 

1,281,741

 

 

 

 

 

 

 

Other Income (Expense)

 

 

 

 

 

Interest Income

 

5,888

 

1,455

 

Miscellaneous Income (Expense), net

 

76,053

 

(43,751

)

Interest Expense

 

(617,396

)

(451,235

)

Total Other Expense

 

(535,455

)

(493,531

)

 

 

 

 

 

 

Income Before Income Taxes

 

1,347,200

 

788,210

 

 

 

 

 

 

 

Income Tax Expense

 

470,000

 

290,000

 

 

 

 

 

 

 

Net Income

 

$

877,200

 

$

498,210

 

 

 

 

 

 

 

Earnings Per Common Share:

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.33

 

$

0.19

 

Weighted Average Number of Common Shares Outstanding Used for Basic Earnings Per Common Share

 

2,622,672

 

2,582,221

 

 

 

 

 

 

 

Diluted

 

$

0.33

 

$

0.19

 

Weighted Average Number of Common Shares Outstanding Plus Dilutive Common Stock Options

 

2,679,797

 

2,613,956

 

 

See Accompanying Notes to Condensed Consolidated Financial Statements

6




NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

 

 

NINE MONTHS ENDED

 

 

 

SEPTEMBER 30

 

 

 

2006

 

2005

 

Cash Flows From Operating Activities

 

 

 

 

 

Net Income

 

$

877,200

 

$

498,210

 

Adjustments to Reconcile Net Income to Net Cash

 

 

 

 

 

Provided by (Used in) Operating Activities:

 

 

 

 

 

Depreciation

 

1,032,251

 

885,278

 

Amortization

 

201,377

 

295,470

 

Compensation on Restricted Stock and Stock Option Grants

 

120,558

 

 

Other

 

27,295

 

 

Deferred Taxes

 

(117,000

)

(171,000

)

(Gain) Loss on Disposal of Assets

 

867

 

 

Foreign Currency Transaction Loss

 

 

45,650

 

Changes in Current Operating Items:

 

 

 

 

 

Accounts Receivable

 

(1,659,777

)

(643,873

)

Inventories

 

(1,773,605

)

(297,343

)

Prepaid Expenses and Other Assets

 

(184,071

)

96,174

 

Income Taxes Payable

 

(511,101

)

446,151

 

Accounts Payable

 

1,257,782

 

74,920

 

Accrued Payroll and Commissions

 

41,364

 

(11,354

)

Accrued Health and Dental Claims

 

128,896

 

67,923

 

Other Accrued Liabilities

 

(111,740

)

34,417

 

Net Cash Provided by (Used in) Operating Activities

 

(669,704

)

1,320,623

 

 

 

 

 

 

 

Cash Flows from Investing Activities:

 

 

 

 

 

Proceeds from Sale of Assets

 

275

 

 

Restricted Cash

 

(427,500

)

 

Purchase of Property and Equipment

 

(2,813,695

)

(706,039

)

Net Cash Used in Investing Activities

 

(3,240,920

)

(706,039

)

 

 

 

 

 

 

Cash Flows from Financing Activities:

 

 

 

 

 

Net Change in Line of Credit

 

2,948,196

 

(378,662

)

Proceeds from Notes Payable

 

1,100,926

 

636,502

 

Proceeds from Bonds Payable

 

1,440,000

 

 

Payments on Notes Payable

 

(1,061,457

)

(787,765

)

Payments of Bond Issue Costs

 

(79,373

)

 

 

Issuance of Stock Upon Exercise of Options

 

126,978

 

907

 

Checks in Excess of Bank Balance

 

(1,200,000

)

15,000

 

Net Cash Provided by (Used in) Financing Activities

 

3,275,270

 

(514,018

)

 

 

 

 

 

 

Effect of Exchange Rate Changes on Cash

 

 

(43,556

)

Net Increase (Decrease) in Cash and Cash Equivalents

 

(635,354

)

57,010

 

Cash and Cash Equivalents - Beginning

 

840,123

 

555,783

 

Cash and Cash Equivalents - Ending

 

$

204,769

 

$

612,793

 

 

 

 

 

 

 

Supplemental disclosure of cash flow information:

 

 

 

 

 

Cash paid during the period for interest

 

$

588,300

 

$

451,175

 

Cash paid during the period for income taxes

 

1,090,540

 

 

 

 

 

 

 

 

Supplemental schedule of noncash financing activity:

 

 

 

 

 

Issuance of Common Stock on a restricted basis

 

$

212,040

 

$

 

 

See Accompanying Notes to Condensed Consolidated Financial Statements

7




NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

NOTE 1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying condensed 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, although we believe the disclosures are adequate to make the information presented not misleading.  These statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2005.  The operating results for the interim periods presented are not necessarily indicative of the results expected for the full year or for any other interim period.  In our opinion, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included.

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

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.

Restricted Cash

As of September 30, 2006, restricted cash of $427,500 is to be used for the purchase of equipment and facility upgrades at the Blue Earth, Minnesota facility as required by the Industrial Revenue Bond agreement into which we entered on June 28, 2006 to purchase the Blue Earth, Minnesota facility, see Note 5.

Stock Based Compensation

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement No. 123R (SFAS 123R), “Share-Based Payment: An Amendment of FASB Statement No. 123,” which requires companies to recognize in the income statement the grant-date fair value of stock options and other equity-based compensation issued to employees. In adopting SFAS 123R, as of January 1, 2006, we used the modified prospective transition method.

Under the modified prospective transition method, awards that are granted, modified or settled after the date of adoption will be measured and accounted for in accordance with SFAS 123R. Compensation cost for awards granted prior to, but not vested, as of the date SFAS 123R was adopted are based on the grant date attributes originally used to value those awards for pro forma purposes under SFAS 123.  Our condensed consolidated financial statements as of and for the nine months ended September 30, 2006 reflect the impact of SFAS 123R.  In accordance with the modified prospective transition method, the consolidated financial statements for prior periods have not been

8




restated to reflect, and do not include, the impact of SFAS 123R.  Share-based compensation expense before income taxes recognized under SFAS 123R for the three months and nine months ended September 30, 2006 was $54,351 and $120,558, respectively.

Prior to January 1, 2006, we applied Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for options and the disclosure-only provisions of Statement of Financial Accounting Standards No. 123 (SFAS 123), “Accounting for Stock-Based Compensation.”  Accordingly, no stock-based compensation expense for stock options was recognized in our consolidated statements of income prior to 2006, as the option exercise price was equal to the market price of our stock on the date of grant.

On November 15, 2005, our Board of Directors accelerated the vesting of the then outstanding and unvested stock options. Had these vesting periods not been accelerated, under SFAS 123R we would have recognized approximately $370,000 in cumulative expense spread over five years beginning in fiscal 2006.

Had compensation cost for the our stock option plan been determined pursuant to SFAS 123 in 2005, net income and earnings per common share on a proforma basis would have been as follows:

 

For the Three
Months Ended

 

For the Nine
Months Ended

 

 

 

September 30, 2005

 

September 30, 2005

 

 

 

 

 

 

 

Net income, as reported

 

$

260,357

 

$

498,210

 

Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects

 

(32,807

)

(98,420

)

Pro forma net income

 

$

227,550

 

$

399,790

 

Earnings per common share:

 

 

 

 

 

Basic—as reported

 

$

0.10

 

$

0.19

 

Basic—pro forma

 

$

0.09

 

$

0.15

 

Diluted—as reported

 

$

0.10

 

$

0.19

 

Diluted—pro forma

 

$

0.09

 

$

0.15

 

 

SFAS 123R requires companies to estimate the fair value of share-based awards on the date of grant using an option-pricing model.  The value of the portion of the award that is ultimately expected to vest is recognized as expense in the condensed consolidated statement of operations over the requisite service periods.  Share-based compensation expense for share-based awards granted prior to, but not yet vested as of December 31, 2005, is based on the grant date fair value estimated in accordance with the provisions of SFAS 123.  For options granted subsequent to December 31, 2005, compensation expense is based on the grant date fair value estimated in accordance with SFAS 123R.  Because share-based compensation expense is based on awards that are ultimately expected to vest, share-based compensation expense will be reduced to account for estimated forfeitures.  SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.  In the pro forma information required under SFAS 123 for periods prior to fiscal 2006, we accounted for forfeitures as they occurred.

9




We have two types of stock-based compensation awards consisting of restricted stock and stock options.  Following is a summary of the key terms and methods of valuation for our stock-based compensation awards.

Restricted Stock

On March 7, 2006, 28,500 shares of restricted common stock were granted to our management and directors.  This benefit was valued at the market price of the stock on the date of grant.  These awards vest over a three-year term and are expensed ratably over the same period.  The arrangements do contain an acceleration condition whereby if we attain certain financial measurements, the awards would vest in their entirety on December 31, 2006.  Total compensation expense related to restricted stock included in the statements of income for the three months and nine months ended September 30, 2006 was $22,073 and $47,827, respectively.  The following is the status of our restricted shares as of September 30, 2006, including changes during the nine-month period ended September 30, 2006:

 

Restricted
Shares

 

Weighted-
Average
Grant Date
Fair Value

 

 

 

 

 

 

 

Outstanding - January 1, 2006

 

 

$

 

Granted - March 7, 2006

 

28,500

 

7.44

 

 

 

 

 

 

 

Outstanding - September 30, 2006

 

28,500

 

$

7.44

 

 

 

 

 

 

 

Exercisable on September 30, 2006

 

 

 

 

 

As of September 30, 2006, there was approximately $164,000 of unrecognized compensation expense related to unvested restricted stock awards, which we expect to recognize over a weighted average period of 2.25 years.

Stock Options

On March 7, 2006, 73,500 options were granted to our management and directors with the exercise price equaling the closing price of the common shares on that date.  To calculate the option-based compensation under SFAS 123R, we used the Black-Scholes option-pricing model, which we had previously used for the valuation of option-based awards for our pro forma information required under SFAS 123 for periods prior to fiscal 2006.  Our determination of fair value of option-based awards on the date of grant using the Black-Scholes model is affected by our stock price as well as assumptions regarding a number of subjective variables.  These variables include, but are not limited to, our expected stock price volatility over the term of the awards, risk-free interest rate, and the expected life of the options.  The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected life of our stock options.  The expected volatility, holding period, and forfeitures of options are based on our historical experience.

Total compensation expense related to stock options included in our statements of income for the three months and nine months ended September 30, 2006 was $32,278 and $72,731, respectively.  For all grants, the amount of compensation expense to be recognized is adjusted for an estimated forfeiture rate, which is based on historical data.

10




Following is the status of our stock option plan as of September 30, 2006, including changes during the nine-month period ended September 30, 2006:

 

Options

 

Weighted-
Average
Exercise
Price Per
Share

 

Weighted-
Average
Remaining
Contractual
Term
(in years)

 

Aggregate
Intrinsic
Value

 

Outstanding – January 1, 2006

 

287,000

 

$

6.27

 

 

 

 

 

Granted

 

73,500

 

$

7.44

 

 

 

 

 

Exercised

 

(28,000

)

$

4.53

 

 

 

 

 

Forfeited

 

(8,000

)

$

8.00

 

 

 

 

 

Outstanding – September 30, 2006

 

324,500

 

$

6.65

 

6.55

 

$

264,066

 

Exercisable on September 30, 2006

 

251,000

 

$

6.41

 

5.71

 

$

264,066

 

 

As of September 30, 2006, there was approximately $242,000 of unrecognized compensation expense related to unvested option awards that we expect to recognize over a weighted average period of 2.25 years.  SFAS 123R also requires that the tax benefit from the exercise of options be reflected in the statement of cash flows as a cash inflow from financing activities.  Prior to the adoption of SFAS 123R, these tax benefits have been reflected as a cash inflow from operations.

 Segment Reporting Information

Our results of operations for the three months and nine months ended September 30, 2006 and 2005 represent a single segment referred to as Contract Manufacturing.  Export sales represented 4% and 5% of consolidated net sales for the three-month and nine-month periods ended September 30, 2006, respectively.  Export sales represented 6% and 5% of consolidated net sales for the three-month and nine-month periods ended September 30, 2005, respectively.

Long-lived assets by country are as follows:

 

United States

 

Mexico

 

Total

 

September 30, 2006

 

 

 

 

 

 

 

Net Property and Equipment

 

$

7,878,020

 

$

584,505

 

$

8,462,525

 

Other Assets

 

857,809

 

8,726

 

866,535

 

 

 

 

 

 

 

 

 

December 31, 2005

 

 

 

 

 

 

 

Net Property and Equipment

 

$

5,995,465

 

$

686,759

 

$

6,682,224

 

Other Assets

 

271,529

 

199,510

 

471,039

 

 

11




Finite Life Intangible Assets

Finite life intangible assets at September 30, 2006 and December 31, 2005 are as follows:

 

September 30, 2006

 

 

 

Estimated

 

Gross

 

 

 

 

 

 

 

Lives

 

Carrying

 

Accumulated

 

Net Book

 

 

 

(Years)

 

Amount

 

Amortization

 

Value

 

Deferred Bond Issue Costs

 

15

 

$

79,373

 

$

1,323

 

$

78,050

 

Non-Compete

 

4

 

1,526,384

 

1,526,384

 

 

Other Intangibles

 

3

 

37,059

 

27,806

 

9,253

 

Totals

 

 

 

$

1,642,816

 

$

1,555,513

 

$

87,303

 

 

 

December 31, 2005

 

 

 

Estimated

 

Gross

 

 

 

 

 

 

 

Lives

 

Carrying

 

Accumulated

 

Net Book

 

 

 

(Years)

 

Amount

 

Amortization

 

Value

 

Non-Compete

 

4

 

$

1,526,384

 

$

1,335,600

 

$

190,784

 

Other Intangibles

 

3

 

37,059

 

18,536

 

18,523

 

Totals

 

 

 

$

1,563,443

 

$

1,354,136

 

$

209,307

 

 

Amortization expense related to these assets is as follows:

Quarter ended September 30, 2006

 

$

4,413

 

Quarter ended September 30, 2005

 

98,490

 

Nine months ended September 30, 2006

 

201,377

 

Nine months ended September 30, 2005

 

295,470

 

 

Estimated future amortization expense related to these assets is as follows:

Remainder of 2006

 

$

4,000

 

2007

 

11,000

 

2008

 

5,000

 

2009

 

5,000

 

2010

 

5,000

 

Thereafter

 

57,000

 

 

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.

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

12




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 condensed consolidated 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, 2005, except as previously noted herein. 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 financial institutions.  We do not require collateral on our receivables.  Historically, we have not suffered significant losses with respect to trade accounts receivable.

Two customers accounted for 10% or more of our net sales for the three-month and nine-month periods ended September 30, 2006 and 2005.  For the three-month periods ended September 30, 2006 and 2005, G.E. Medical and Transportation Divisions accounted for 16% and 21% of net sales, respectively.  For the nine-month periods ended September 30, 2006 and 2005, G.E. Medical and Transportation Divisions accounted for 15% and 16% of net sales, respectively.  Accounts receivable from G.E. Medical and Transportation Divisions at September 30, 2006 and 2005, represented 16% and 21% of total accounts receivable, respectively.  For the three-month periods ended September 30, 2006 and 2005, Northrop Grumman Corp. accounted for 8% and 10% of net sales, respectively.  For both the nine-month periods ended September 30, 2006 and 2005, Northrop Grumman Corp. accounted for 11% and 10% of net sales, respectively.  Accounts receivable from Northrop Grumman Corp. at September 30, 2006 and 2005, represented 12% and 9% of total accounts receivable, respectively.

NOTE 5.  LONG TERM DEBT

On June 28, 2006, we received $1.4 million in exchange for an industrial revenue bond with Wells Fargo Bank, N.A. (WFB), where the City of Blue Earth, Minnesota is issuer of the bond.  The bond, which matures on June 1, 2021, bears a variable interest rate, which we have exchanged with WFB for a 5-year fixed rate of 4.07%, converting back to a variable rate in 2012.  The bond is payable in annual installments per the agreement with WFB.  Our first bond principal payment on June 1, 2007 will be $130,000.  The proceeds of the bond were used to purchase the facility in Blue Earth, Minnesota as well as facility upgrades and equipment to support the Blue Earth operations.

On April 28, 2006, we entered into a 6th amendment to our credit agreement with WFB, increasing our line of credit arrangement from $8 million to $10 million and extending the maturity dates of the line of credit to April 30, 2008 and our real estate term note to July 30, 2011.  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 September 30, 2006, we had an outstanding balance of $7.2 million under the line of credit and unused availability of $2.8 million supported by the borrowing base level.

On April 5, 2006, we secured a $1.1 million promissory note, payable to WFB bearing an interest rate of 7.3%, payable over 36 monthly installments to March 15, 2009, with collateral comprised of equipment purchases.

13




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

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Basic Earnings Per Common Share

 

 

 

 

 

 

 

 

 

Net income, as reported

 

$

304,587

 

$

260,357

 

$

877,200

 

$

498,210

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

2,630,403

 

2,582,292

 

2,622,672

 

2,582,221

 

 

 

 

 

 

 

 

 

 

 

Basis earnings per common share

 

$

0.12

 

$

0.10

 

$

0.33

 

$

0.19

 

 

 

 

 

 

 

 

 

 

 

Diluted Earnings Per Common Share

 

 

 

 

 

 

 

 

 

Net income, as reported

 

$

304,587

 

$

260,357

 

$

877,200

 

$

498,210

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

2,630,403

 

2,582,222

 

2,622,672

 

2,582,221

 

Effect of Stock options

 

36,423

 

39,816

 

46,984

 

31,735

 

Effect of Restricted stock

 

5,265

 

 

10,142

 

 

Weighted average common shares for diluted earnings per common share

 

2,672,091

 

2,622,108

 

2,679,797

 

2,613,956

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per common share

 

$

0.12

 

$

0.10

 

$

0.33

 

$

0.19

 

 

For the three-month and nine-month periods ended September 30, 2006, 10,012 shares and 36,171 shares, respectively, were excluded from the computation of diluted earnings per common share as these shares were antidilutive.  For the three-month and nine-month periods ended September 30, 2005, 33,556 and 131,796 shares, respectively, were excluded from the computation of diluted earnings per common 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 shareholders’ 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).  The Mexican peso is the only foreign currency being translated.

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:

14




 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Net Income, as reported

 

$

304,587

 

$

260,357

 

$

877,200

 

$

498,210

 

 

 

 

 

 

 

 

 

 

 

Other Comprehensive Income (Loss):

 

 

 

 

 

 

 

 

 

Currency Translation Adjustment

 

20,001

 

(10,626

)

 

9,112

 

 

 

 

 

 

 

 

 

 

 

Comprehensive Income

 

$

324,588

 

$

249,731

 

$

877,200

 

$

507,322

 

 

NOTE 9.  RECENTLY ISSUED ACCOUNTING STANDARDS

In September 2006, the Securities & Exchange Commission issued Staff Accounting Bulletin 108 (SAB 108) “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements”.  SAB 108 requires that public companies utilize a “dual-approach” to assessing the quantitative effects of financial misstatements.  This dual approach includes both an income statement focused assessment and a balance sheet focused assessment.  The guidance in SAB 108 must be applied to annual financial statements for fiscal years ending after November 15, 2006.  We are currently assessing the impact of adopting SAB 108, but we do not expect that it will have a material effect on our consolidated financial position or results of operations.

In September 2006, the FASB issued SFAS No. 157 (SFAS 157), “Fair Value Measurements”.  SFAS 157 establishes a common definition for fair value to be applied to U.S. GAAP guidance requiring use of fair value, establishes a framework for measuring fair value, and expands disclosure about such fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. We are currently assessing the impact of SFAS 157 on its consolidated financial position and results of operations.

In July 2006, the FASB issued Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement 109”, which clarifies the accounting for uncertainty in tax positions. FIN 48 provides that the tax effects from an uncertain tax position can be recognized in our consolidated financial statements, only if the position is more likely than not to be sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective as of the beginning of fiscal 2007, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. We are currently evaluating the impact of adopting FIN 48 on our consolidated financial statements.

In March 2005, the FASB issued Interpretation No. 47 (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 became effective for us in the first quarter of fiscal 2006.  The adoption of FIN 47 did not have a material impact on our consolidated financial statements.

In November 2004, the FASB issued Statement No. 151 (SFAS 151), “Inventory Costs – an amendment of ARB No. 43, Chapter 4”.  The amendments made by SFAS 151 require that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) be recognized as current-period charges.  In addition, SFAS requires the allocation of fixed production overhead to inventory based on the normal capacity of production facilities.  We adopted SFAS 151 on January 1, 2006 with no material impact to the consolidated financial statements.

15




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

Overview:

We are a Wayzata, Minnesota based full-service Electronics Manufacturing Services (EMS) contract manufacturer of wire and cable assemblies, printed circuit board assemblies, higher-level assemblies and box builds for a wide range of industriesMarkets served include industrial equipment, transportation, medical, military/defense, computer, recreation and food. In Minnesota, we have operating facilities in Baxter, Bemidji, Blue Earth, Fairmont and Merrifield.  We also have operating facilities in Augusta, Wisconsin, and Monterrey, Mexico.

Summary:

For the quarter ended September 30, 2006, we reported net sales of $25.3 million, up 21% over the $20.9 million we reported in the same quarter of 2005.  For the nine months ended September 30, 2006, we reported net sales of $77.5 million, up 28% over the $60.6 million we reported for the nine months ended September 30, 2005.  The gross profit percentage for the third quarter and nine months ended for September 30, 2006 and 2005 was 12%.  Income from operations for the third quarter of 2006 totaled $654,185, an increase of 11% above the $590,613 reported in the third quarter of 2005.  For the nine months ended September 30, 2006 and 2005, income from operations totaled $1,882,655 and $1,281,741, respectively, a 47% increase from 2005.  Net income for the third quarter of 2006 totaled $304,587, or $0.12 per diluted common share compared to $260,357, or $0.10 per diluted common share, reported in the third quarter of 2005.  Net income for the first nine months of 2006 totaled $877,200, or $0.33 per diluted common share compared to $498,210, or $0.19 per diluted common share, reported for the nine months ended September 30, 2005. The increased profit for the three months and nine months ending September 30, 2006 comes from revenue growth.

(1.)         Results of Operations:

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

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

 

 

 

 

 

 

Net Sales

 

100

%

100

%

100

%

100

%

Cost of Good Sold

 

88

%

88

%

88

%

88

%

Gross Profit

 

12

%

12

%

12

%

12

%

 

 

 

 

 

 

 

 

 

 

Selling Expenses

 

5

%

4

%

5

%

4

%

General and Administrative Expenses

 

4

%

5

%

5

%

6

%

Income from Operations

 

3

%

3

%

2

%

2

%

 

 

 

 

 

 

 

 

 

 

Other Expenses, Net

 

1

%

1

%

1

%

1

%

Income Tax Expense

 

1

%

1

%

0

%

0

%

Net Income

 

1

%

1

%

1

%

1

%

 

16




Net Sales:

We reported net sales of $25.3 million and $20.9 million for the third quarter ended September 30, 2006 and 2005, respectively, a 21% increase year over year.  The increase in net sales of $4.4 million for the third quarter is due to increased sales in our Aerospace Systems Division of $3.1 million, our Industrial Electronic Printed Circuit Board Assemblies Division of $0.1 million and our Commercial Wire and Cable Divisions of $1.2 million.  We reported net sales of $77.5 million and $60.6 million for the nine months ended September 30, 2006 and 2005, respectively, a 28% increase year over year.  The increase in net sales of $16.9 million for the nine-month period is due to increased sales in our Aerospace Systems Division of $8.9 million, our Industrial Electronic Printed Circuit Board Assemblies Division of $4.2 million and our Commercial Wire and Cable Divisions of $3.8 million.  Our 90-day order backlog as of September 30, 2006 was approximately $19.1 million, compared to approximately $17.1 million at the beginning of the quarter.  We expect, based on the current backlog position and the normal strong year-end trend, the fourth quarter of 2006 to have higher sales levels as compared to the third quarter of 2006.

Gross Profit:

Our gross profit for the third quarter of 2006 and 2005 was $3.0 and $2.6 million, respectively or 12% of net sales.  Our gross profit for the nine months ended September 30, of 2006 and 2005 was $9.5 or $7.5 million, respectfully or 12% of net sales.  The gross profit improvement in dollars for both the third quarter and nine months was positively impacted by the increased sales and associated leveraging of our fixed operating costs which helped offset higher costs for copper and oil-based commodities, higher energy costs and underutilized plant capacity during these periods. The sales growth has allowed us to maintain our Gross Margin at 12% of net sales.

Selling Expense:

We had selling expenses of $1.2 million or 5% of net sales for the third quarter of 2006 and $0.8 million or 4% of net sales for the third quarter of 2005.  For the nine months ended September 30, 2006 and 2005, we had selling expenses of $3.4 million and $2.6 million, respectively, representing 5% and 4% of net sales, respectively.  The increase in selling expenses for the quarter of $0.4 million resulted from the increased sales volume and related commissions of $0.2 million and $0.2 million of expenses associated with our continued investment in sales and marketing infrastructure and their associated expenses.  The nine month $0.8 million spending increase in selling expense is the result of $0.5 million of volume-related commission expense and $0.3 million in other sales and marketing expenses.  We continue to expand our sales and marketing initiatives in order to maintain a high level of customer service, support the revenue growth and communicate our brand and services.

General and Administrative Expense:

Our general and administrative expenses were $1.1 million or 4% of net sales for the third quarter of 2006 and $1.2 million or 5% of net sales reported for the third of 2005. The decrease in expense for the quarter was related to the $0.1 million decrease in amortization expense as shown in Note 1.  For the nine months ended September 30, 2006 expenses were $4.2 million or 5% of net sales and $3.6 million or 6% of net sales for the nine months ended September 30, 2005.  The nine-months percent of sales improvement resulted from the decrease of amortization expense of $0.1 million and the increase in personnel-related costs of $0.7 million represented an 18% increase while sales grew 28% from the nine-month period of 2005.

Other Expense:

Other expenses, net were $184,599 for the quarter ended September 30, 2006 compared to $177,256 for the third quarter of 2005.  Other expenses, net were $535,455 for the nine months ended September 30, 2006 compared to $493,531 for the nine months ended September 30, 2005.  The increase in interest expense for the quarter and nine-month period of $102,489 and $166,161, respectively, is

17




attributable to higher interest rates, which on average were 1% higher than prior year and increased funded debt levels.  Miscellaneous income during the three-month and nine-month periods ended September 30, 2006 has been positively impacted by $17,000 per month from leasing 45,000 square feet of space in our Blue Earth facility that started at the end of the second quarter, offsetting the increase in interest expense.  The remaining miscellaneous income increase from 2005 resulted from experiencing more favorable currency exchange rates.

Income Tax:

Income tax expense for the three months ended September 30, 2006 was $165,000 compared to an income tax expense of $153,000 for the three months ended September 30, 2005.  Income tax expense for the nine months ended September 30, 2006 was $470,000 compared to an income tax expense of $290,000 for the nine months ended September 30, 2005.  The effective tax rate for 2006 is expected to approximate 35%, comprised of an effective rate of 33.5% for domestic federal and state taxes and 1.5% for foreign taxes.  The effective tax rate for 2005 was 33%, comprised of an effective rate of 31.2% for domestic federal and state taxes and 1.8% for foreign taxes.

(2.) Liquidity and Capital Resources:

We have satisfied our liquidity needs over the past several years through revenue generated from operations and an operating line of credit through Wells Fargo Bank, N.A. (WFB).  Due to our continued growth and increased working capital requirements in the past several quarters our line of credit arrangement with Wells Fargo Bank was increased from $8.0 million to $10.0 million on April 28, 2006 with a maturity date of April 30, 2008. 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 September 30, 2006, we had an outstanding balance of $7.2 million under the line of credit and unused availability of $2.8 million supported by our borrowing base level.

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.

 

September 30,
2006

 

December 31,
2005

 

December 31,
2004

 

 

 

 

 

 

 

 

 

Current Ratio

 

 

 

 

 

 

 

(Current Assets / Current Liabilities)

 

1.52

 

1.60

 

1.65

 

Working Capital

 

 

 

 

 

 

 

(Current Assets - Current Liabilities)

 

$

12,174,522

 

$

12,214,328

 

$

11,749,991

 

Quick Ratio

 

 

 

 

 

 

 

(Cash + Accounts Receivable / Current Liabilities)

 

0.69

 

0.75

 

0.77

 

Accounts Receivable to Working Capital

 

 

 

 

 

 

 

(Average Accounts Receivable/ Working Capital)

 

1.25

 

1.14

 

1.03

 

Inventory to Working Capital

 

 

 

 

 

 

 

(Average Inventory/ Working Capital)

 

1.37

 

1.23

 

1.10

 

 

Our working capital of $12.2 million as of September 30, 2006 was relatively unchanged from the $12.2 million at December 31, 2005.  Working capital changes were increases in inventory of $1.8

18




million, in Accounts Receivable of $1.7 million, in Accounts Payable of $1.3 million, and the remaining major changes were in current financing activities.  We continue to take the necessary actions needed and implement initiatives to improve our working capital position during our current growth trends by focusing on lowering inventory levels and collecting accounts receivable within terms.

Net cash used in operating activities for the nine months ended September 30, 2006 was $0.7 million, which is down from the $1.3 million of net cash provided by operating activities for the nine months ended September 30, 2005.  The cash flow from operations for the nine months ended September 30, 2006 is provided by the result of net income of $0.9 million, adjusted for noncash depreciation, amortization, loss on the disposal of assets, stock-based compensation expense, foreign currency transaction loss, and the change in deferred taxes of $1.2 million in net positive adjustments, totaling $2.1 million less cash used in operating activities from the net change in operating assets and liabilities of $2.8 million.  Increases in Accounts Receivable of $1.7 million, Inventories of $1.8 million and Accounts Payable of $1.3 million, account for the majority of net use of working capital cash in the nine months and is associated with the 2006 nine months year-to-date revenue increase of 28%.

Net cash used in investing activities of $3.2 million comprised of $2.8 million in Property and Equipment and $0.4 million in Restrictive Cash for the nine months ended September 30, 2006 is up from $0.7 million spent on property and equipment purchases for the nine months ended September 30, 2005.  The 2006 major investments are related to the June 28, 2006 purchase of the facility in Blue Earth, Minnesota for $1.4 million and other property and equipment purchases of $1.4 million to support existing operations.

Net cash provided by financing activities for the nine months ended September 30, 2006 was $3.3 million, consisting primarily of drawing on the line of credit by $2.9 million, proceeds from the $1.1 million equipment note, $1.4 million from the industrial revenue bond for the Blue Earth facility purchase, and net cash used in financing activities were principal payments on notes payable of $1.1 million and reduced checks in excess of bank balance of $1.2 million.

We believe that our future financing requirements can be met with funds generated from our operating activities and our operating line of credit.  Set forth below is information about our long-term contractual obligations outstanding as of September 30, 2006.  Refer to the Annual Report on Form 10-K for detailed information on our long-term contractual obligations and commitments.

 

Payments Due by Period

 

 

 

 

 

Remainder

 

 

 

 

 

 

 

 

 

of 2006

 

2 - 3 Yrs

 

4 - 5 Yrs

 

Thereafter

 

Bank Note Payable

 

$

7,176,430

 

$

 

$

 

$

 

Notes and Bonds Payable

 

367,595

 

2,357,450

 

723,178

 

1,952,778

 

Operating Leases

 

73,001

 

361,759

 

163,856

 

 

Equipment Purchase Commitments

 

85,000

 

427,500

 

 

 

Total Contractual Obligations and Commitments

 

$

7,702,026

 

$

3,146,709

 

$

887,034

 

$

1,952,778

 

 

As result of the purchase of the Blue Earth facility on June 28, 2006, we are leasing 45,000 square feet of the building to the previous owner until March 2007 for approximately $17,000 per month.  Included in the equipment purchase commitments is $427,500 that will be used for the purchase of equipment for the Blue Earth facility as specified in the Industrial Revenue Bond Agreement.

19




From time to time we enter into purchase commitments with our suppliers under customer purchase order forms.  Any significant losses implicit in these contracts would be recognized in accordance with generally accepted accounting principles.  At September 30, 2006, no such losses existed.

(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 receivables are 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.

Deferred Income Tax Valuation:

At September 30, 2006 and December 31, 2005, 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

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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.

Stock-Based Compensation:

We adopted the provisions of SFAS 123R, “Share-Based Payment” on January 1, 2006.  SFAS 123R requires us to measure and recognize in our consolidated statements of operations the expense associated with all share-based payment awards made to employees and directors based on estimated fair values. We have two types of stock-based compensation awards consisting of restricted stock and stock options.

Restricted stock is valued at the market price of the stock on the date of grant.  These awards vest over a three-year term and are expensed ratably over the same period.  The arrangements contain an acceleration condition whereby, if we attain certain financial measurements, the awards vest in their entirety on December 31, 2006.

We utilize the Black-Scholes option valuation model to measure the amount of compensation expense to be recognized for each stock option award. There are several assumptions that must be made when using the Black-Scholes model such as the expected term of each option, the expected volatility of the stock price during the expected term of the option, the expected dividends to be paid and the risk free interest rate expected during the option term. We have reviewed each of these assumptions carefully and we determined our best estimate for these variables. Of these assumptions, the expected term of the option and expected volatility of our common stock are the most difficult to estimate since they are based on the exercise behavior of employees and the expected performance of our stock. An increase in the volatility of our stock will increase the amount of compensation expense on new awards. An increase in the holding period of options will also cause an increase in compensation expense. Dividend yields and risk-free interest rates are less difficult to estimate, but an increase in the dividend yield will cause a decrease in expense and an increase in the risk-free interest rate will increase compensation expense.

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 as of September 30, 2006.  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

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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.

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

We are exposed to changes in interest rates primarily as a result of our borrowing activities used to maintain liquidity.  Our earnings have been affected by recent changes in interest rates on our floating interest rate debt because interest rates have risen over the past year while our utilization on our line of credit has remained stable.  Based on our current borrowings, an increase of 100 basis points in prevailing interest rates would increase our annual interest expense by less than $100,000,which may be offset in part by the interest rate swap agreement entered into in connection with the issuance of bonds at the end of the second quarter.

We are exposed to currency exchange fluctuations related to our Mexico subsidiary; however, the Mexican peso continues to remain fairly stable.

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 September 30, 2006. 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.

We are currently in the process of reviewing and formalizing our internal controls and procedures for financial reporting in accordance with the Securities and Exchange Commission’s rules implementing the internal control reporting requirements included in Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”).  Changes have been and will be made to our internal controls over financial reporting as a result of these efforts.  We are dedicating significant resources, including senior management time

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and effort, and incurring substantial costs in connection with its ongoing Section 404 assessment.  We are currently documenting and testing internal controls and considering whether any improvements are necessary for maintaining an effective control environment.  The evaluation of internal controls is being conducted under the direction of senior management in consultation with an independent third party consulting firm.  In addition, senior management is regularly discussing proposed improvements to the control environment with the Audit Committee.  We expect to assess controls and procedures on a regular basis and will continue to work to improve controls and procedures and educate and train employees on the existing controls and procedures in connection with the efforts to maintain an effective controls infrastructure.

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PART II

ITEM 1.    LEGAL PROCEEDINGS

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

ITEM 1A.  RISK FACTORS

We are affected by risks specific to us as well as factors that affect all businesses operating in a global market.  The significant factors known to us that could materially adversely affect our business, financial condition, or operating results are described in our most recently filed Annual Report on Form 10-K (Item 1A).  There has been no material change in those risk factors.

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.

 

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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: November 1, 2006

by

/s/ Michael J. Degen

 

 

 

 

Michael J. Degen

 

President and Chief

 

Executive Officer

 

 

 

 

Date: November 1, 2006

by

/s/ Richard G. Wasielewski

 

 

 

 

Richard G. Wasielewski

 

Chief Financial Officer

 

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