NORTECH SYSTEMS INC - Annual Report: 2010 (Form 10-K)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549

FORM 10-K

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

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

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

         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 ý

         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 ý

         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. ý

         Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o    No o

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

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

         Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o    No ý

         The aggregate market value of voting stock held by non-affiliates of the registrant, based on the closing price of $3.75 per share, was $4,571,370 on June 30, 2010.

         Shares of common stock outstanding at March 9, 2011: 2,742,992.

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DOCUMENTS INCORPORATED BY REFERENCE

        Portions of the registrant's Proxy Statement for the 2010 Annual Shareholders' Meeting have been incorporated by reference into Part III of this Form 10-K. The Proxy Statement is expected to be filed with the Securities and Exchange Commission within 120 days after December 31, 2010, the end of our fiscal year.

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NORTECH SYSTEMS INCORPORATED

ANNUAL REPORT ON FORM 10K

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NORTECH SYSTEMS INCORPORATED
FORM 10-K
For the Year Ended December 31, 2010

PART I

ITEM 1.        BUSINESS

DESCRIPTION OF BUSINESS

        We are a Minnesota corporation organized in December 1990, filing annual reports, quarterly reports, proxy statements, and other documents with the Securities Exchange Act of 1934 (Exchange Act). The public may read and copy any materials that we file with the SEC at the SEC's Public Reference Room at 340 Fifth Street N.W., Washington, D.C. 20549. Also, the SEC maintains an Internet website that contains reports, proxy and information statements, and other information regarding issuers, including us, who file electronically with the SEC. The public can obtain any documents that we file with the SEC at http://www.sec.gov.

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

GENERAL

        We are an Electronic Manufacturing Service (EMS) contract manufacturing company with our headquarters in Wayzata, Minnesota, a suburb of Minneapolis, Minnesota. We maintain manufacturing facilities in Minnesota including Bemidji, Blue Earth, Milaca, Baxter, and Merrifield as well as Augusta, Wisconsin; Monterrey, Mexico; and as of January 1, 2011, Mankato, Minnesota. We manufacture wire harness cable and printed circuit board assemblies, electronic sub-assemblies, higher level assemblies and complete devices. We provide value added services and technical support including design, testing, prototyping and supply chain management. The vast majority of our revenue is derived from products built to the customer's design specifications.

        We provide a high degree of manufacturing expertise using statistical process controls to ensure product quality, total supply chain solution management, lean manufacturing practices, and the systems necessary to effectively manage the business. This level of sophistication enables us to attract major original equipment manufacturers (OEMs) and to expand and diversify our customer base across several markets to avoid the effects of fluctuations within a given industry. Our primary focus is in three major markets: Aerospace and Defense, Medical and Industrial Equipment.

        We believe the EMS industry will provide growth for contract manufacturing as the macro economy improves along with further industry consolidations. Outsourcing remains a strong option for OEMs as they prefer to invest and focus on marketing and product development, and rely on EMS providers for their production and supply chain requirements.

ACQUISITIONS

        On May 4, 2010, we acquired all of the intellectual property and assets, excluding cash and receivables, of Trivirix Corporation, Milaca, MN for $403,000 which consisted of $303,000 in inventory and $100,000 in property and equipment. This operation specializes in design, manufacturing and post-production services of complex electronic and electromechanical medical devices for diagnostic, analytical and other life-science applications. This acquisition expands our capabilities and expertise serving medical electronics manufacturers. The acquisition has been accounted for as a business combination and results of operations for Milaca since the date of acquisition are included in the consolidated financial statements.

        On January 1, 2011, we completed the acquisition of the EMS business unit of Winland Electronics, Inc., (Winland) a Minnesota corporation. We paid $1,042,389 in cash at closing and will make deferred payments of $250,000 each on July 1, 2011 and October 1, 2011 for substantially all of the assets and assumed certain liabilities of their EMS operations. We have also agreed to a six year agreement with Winland to lease office and manufacturing space in Mankato, Minnesota and sublease a portion of it back to them through December 31, 2011.

        In connection with the acquisition, we agreed to purchase a minimum of $2,200,000 of inventory as consumed over the next 24 months. We also entered into an agreement to manufacture certain products related to the production of Winland's proprietary monitoring devices business unit. See note 13 to the consolidated financial statements for further information on this acquisition.

        We continue to investigate potential acquisition opportunities as a normal course of business and a strategy for growth.

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BUSINESS SEGMENT

        All of our operations fall under the Contract Manufacturing segment within the Electronic Manufacturing Services (EMS) industry. We strategically direct production between our various manufacturing facilities based on a number of considerations to best meet our customers' requirements. We share resources for sales, marketing, information services, cash and risk management, banking, credit and collections, human resources, payroll, internal control, audit, taxes, SEC reporting and corporate accounting. Our financial information is consolidated and evaluated regularly by the chief decision maker in assessing performance and allocating resources.

BUSINESS STRATEGY

        The EMS industry has evolved into a dynamic, high tech global electronics contract services industry. We continue to expand our capabilities to better meet these changing market requirements. Along with offering technical expertise in our quality processes, design applications and testing, we are also increasing our focus on supplier-managed inventory services and the cost drivers throughout the supply chain. Our international operation and international partnerships allow us to take advantage of lower-cost alternatives for our customers and remain competitive in the marketplace.

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

        Our quality systems and processes are based on ISO standards with all facilities certified to the latest version of the ISO 9001 and/or AS 9100 Aerospace standards. We also have ISO 13485 certification which recognizes our quality management systems applicable to contract design, manufacture and repair of assemblies for the medical industry. Our Milaca operation is an FDA registered facility. We believe these certifications and registrations benefit our customer base and increase our chances of attracting new business opportunities.

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

MARKETING

        We concentrate our marketing efforts in the Aerospace and Defense, Medical and Industrial Equipment markets. Our marketing strategy emphasizes the breadth of our manufacturing, supply chain and engineering services and reflects the complete turnkey solution for meeting our customers' current and future requirements.

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

SOURCES AND AVAILABILITY OF MATERIALS

        We currently purchase the majority of our electronic components directly from electronic component manufacturers and large electronic distributors. On occasion some of our components may be placed on a stringent allocation basis; however, we are not experiencing any major material purchasing or availability problems.

PATENTS AND LICENSES

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

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copyrights and trademark protection are necessary for successful operations.

COMPETITION

        The contract manufacturing EMS industry's competitive makeup includes small closely held contract manufacturing companies, large global full-service contract manufacturers, company-owned in-house manufacturing facilities and foreign contract manufacturers. We do not believe that the small closely held operations pose a significant competitive threat in the markets and customers we serve, as they generally do not have the complete manufacturing services or capabilities required by our target customers. We do believe the larger global full service and foreign manufacturers do provide a substantial competitive environment as their technical support has improved greatly along with their ability to be more responsive to engineering and schedule changes. We continue to see opportunities with OEM companies that have their own in-house electronic manufacturing capabilities as they evaluate their internal costs and investments against outsourcing to contract manufacturers. The willingness of foreign manufacturers to "stock" finished product at warehouse locations in the United States is another of their competitive advantages, however, their inability to react to engineering, product or schedule changes is a disadvantage and plays into our strength. To mitigate foreign competition, we operate a manufacturing operation in Mexico and have other sourcing solutions to support our customers with a "Low Cost" supply chain solution.

MAJOR CUSTOMERS

        Two divisions of General Electric, Co. (G.E.) accounted for 10% or more of our net sales during the past two years. G.E.'s Medical Division accounted for 19% and 13% of net sales for the years ended December 31, 2010 and 2009, respectively. G.E.'s Transportation Division accounted for 8% and 12% of net sales for the years ended December 31, 2010 and 2009, respectively. Together, G.E.'s Medical and Transportation Divisions accounted for 27% and 25% of net sales for the years ended December 31, 2010 and 2009, respectively. Accounts receivable from G.E.'s Medical and Transportation Divisions at December 31, 2010 and 2009 represented 14% and 16% of total accounts receivable, respectively.

RESEARCH AND DEVELOPMENT

        We perform research and development for customers on an as requested and program basis for development of conceptual engineering and design activities prior to manufacturing the products. We did not expend significant dollars in 2010 or 2009 on company-sponsored product research and development.

ENVIRONMENTAL LAW COMPLIANCE

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

EMPLOYEES

        We have 667 full-time and 42 part-time/temporary employees as of December 31, 2010. Manufacturing personnel, including direct, indirect support and sales functions, comprise 681 employees, while general administrative employees total 28. At December 31, 2009 we had 515 full-time and 23 part-time/temporary employees.

FOREIGN OPERATIONS AND EXPORT SALES

        We have a leased manufacturing facility in Monterrey, Mexico with approximately $192,000 in long-term assets at December 31, 2010. Export sales represent 6% and 4% of net sales for the years ended December 31, 2010 and 2009, respectively.

FORWARD-LOOKING STATEMENTS

        This Annual Report on Form 10-K, including "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. We may also make forward-looking statements in other reports filed with the SEC, in materials delivered to stockholders and in press releases. 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

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reasonable, they are based upon a number of assumptions concerning future conditions, any or all of which may ultimately prove to be inaccurate. Forward-looking statements involve a number of risks and uncertainties. Important factors that could cause actual results to differ materially from the forward-looking statements include, without limitation:

•

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



•

Increased competition;



•

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



•

Risks related to availability of labor;



•

Increase in certain raw material costs such as copper and oil;



•

Commodity and Energy cost instability;



•

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



•

Successful integration of recent acquisitions

        The factors identified above are believed to be important factors (but not necessarily all of the important factors) that could cause actual results to differ materially from those expressed in any forward-looking statement made by us. Discussion of these factors is also incorporated in Part I, Item 1A, "Risk Factors", and should be considered an integral part of Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations". Unpredictable or unknown factors not discussed herein could also have material adverse effects on forward-looking statements. All forward-looking statements included in this Form 10-K are expressly qualified in their entirety by the forgoing cautionary statements. We undertake no obligations to update publicly any forward-looking statement (or its associated cautionary language) whether as a result of new information or future events.

ITEM 1A.        RISK FACTORS

        In evaluating us as a company, careful consideration should be given to the following risk factors, in addition to the other information included in this Annual Report on Form 10-K. Each of these risk factors could adversely affect our business, operating results and/or financial condition, as well as adversely affect the value of an investment in our common stock. In addition to the following disclosures, please refer to the other information contained in this report, including our consolidated financial statements and the related notes.

The economic conditions in the United States and around the world could adversely affect our financial results.

        Demand for our products and services depends upon worldwide economic conditions, including but not limited to overall economic growth rates, construction, consumer spending, financing availability, employment rates, interest rates, inflation, consumer confidence, defense spending levels, and the profits, capital spending, and liquidity of industrial companies.

We operate in the highly competitive EMS industry.

        We compete against many EMS companies. The larger global competitors have more resources and greater economies of scale. We also compete with OEM in-house operations that are continually evaluating manufacturing products internally against the advantages of outsourcing. We may also be at a competitive disadvantage with respect to price when compared to manufacturers with excess capacity, lower cost structures and availability of lower cost labor.

        The availability of excess manufacturing capacity of our competitors also creates competitive pressure on price and winning new business. We must continue to provide a quality product, be responsive and flexible to customers' requirements, and deliver to customers' expectations. Our lack of execution could have an adverse effect on our operations.

A large percentage of our sales have been made to a small number of customers, and the loss of a major customer, if not replaced, would adversely affect us.

        G.E.'s Medical and Transportation Divisions accounted for 27% and 25% of net sales for the years ended December 31, 2010 and 2009, respectively.

We are dependent on suppliers for electronic components and may experience shortages, extended lead times, cost premiums and shipment delays that would adversely affect our customers and us.

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

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cost increases could also adversely affect our freight and operating costs. Due to customer specifications and requirements, we are dependent on suppliers to provide critical electronic components and materials for our operations that could result in shortages of some of the electronic components needed for their production. Component shortages may result in expedited freight, overtime premiums and increased component costs. In addition to the financial impact on operations from lost revenue and increased cost, there could potentially be harm to our customer relationships.

Our customers cancel orders, change order quantity, timing and specifications that if not managed would have an adverse affect on inventory carrying costs.

        We do face, through the normal course of business, customer cancellations and rescheduled orders and are not always successful in recovering the costs of such cancellations or rescheduling. In addition, excess and obsolete inventory losses as a result of customer order changes, cancellations, product changes and contract termination could have an adverse effect on our operations. We estimate and reserve for any known or potential impact from these possibilities.

The manufacture and sale of our products carries potential risk for product liability claims.

        We represent and warrant the goods and services we deliver are free from defects in material and workmanship for one year from ship date. We make no other guarantees or warranties, expressed or implied, of any nature whatsoever as to the goods including without limitation, warranties to merchantability, fit for a particular purpose, non-infringement of patent or the like unless agreed upon in writing. If a product liability claim results in our being liable and the amount is in excess of our insurance coverage or there is no insurance coverage for the claim then it could have an adverse effect on our business and financial position.

We depend heavily on our people and may from time to time have difficulty attracting and retaining skilled employees.

        Our operations depend upon the continued contributions of our key management, marketing, technical, financial, accounting, product development engineers, sales people and operational personnel. We also believe that our continued success will depend upon our ability to attract, retain and develop highly skilled managerial and technical resources within the highly competitive EMS industry. Not being able to attract or retain these employees could have a material adverse effect on revenues and earnings.

Operating in foreign countries exposes our operations to risks that could adversely affect our operating results.

        We've operated a manufacturing facility in Mexico since 2002. Our operation there is subject to risks that could adversely impact our financial results, such as economic or political volatility, crime, severe weather, employee turnover, staffing, managing personnel in diverse culture, labor instability, transportation delays, and foreign currency fluctuations.

Non-compliance with environmental laws may result in restrictions and could adversely affect operations.

        Our operations are regulated under a number of federal, state, and foreign environmental and safety laws and regulations that govern the discharge of hazardous materials into the air and water, as well as the handling, storage, and disposal of such materials. These laws and regulations include the Clean Air Act; the Clean Water Act; the Resource Conservation and Recovery Act; and the Comprehensive Environmental Response, Compensation, and Liability Act; as well as analogous state and foreign laws. Compliance with these environmental laws is a major consideration for us due to our manufacturing processes and materials. It is possible we may be subject to potential financial liability for costs associated with the investigation and remediation at our sites; this may have an adverse effect on operations. We have not incurred significant costs related to compliance with environmental laws and regulations and we believe that our operations comply with all applicable environmental laws.

        Environmental laws could also become more stringent over time, imposing greater compliance costs and increasing risks and penalties associated with violation. We operate in environmentally sensitive locations and are subject to potentially conflicting and changing regulatory agendas of political, business, and environmental groups. Changes or restrictions on discharge limits; emissions levels; or material storage, handling, or disposal might require a high level of unplanned capital investment or relocation. It is possible that environmental compliance costs and penalties from new or existing regulations may harm our business, financial condition, and results of operations.

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We may be subject to risks associated with our acquisitions, and the risks could adversely affect our operating results.

        Our strategy is to grow our business organically and through acquisitions, alliances and joint venture arrangements. We will continue to pursue and acquire additional businesses in the EMS industry that fit our long-term objectives for growth and profitability. The success of our acquisitions will depend on our ability to integrate the new operations with the existing operations.

If we fail to comply with the covenants contained in our revolving credit facility we may be unable to secure additional financing and repayment obligations on our outstanding indebtedness may be accelerated.

        Our revolving credit facility and debt agreements contain financial and operating covenants with which we must comply. As of December 31, 2010, we were in compliance with these covenants. However, our continued compliance with these covenants is dependent on our financial results, which are subject to fluctuation as described elsewhere in these risk factors. If we fail to comply with the covenants in the future or if our lender does not agree to waive any future non-compliance, we may be unable to borrow funds and any outstanding indebtedness could become immediately due and payable, which could materially harm our business.

We are dependent on our management information systems for order, inventory and production management, financial reporting, communications and other functions. If our information systems fail or experience major interruptions, our business and our financial results could be adversely affected.

        We rely on our management information systems to effectively manage our operational and financial functions. Our computer systems, Internet web sites, telecommunications, and data networks are also vulnerable to damage or interruption from power loss, natural disasters and attacks from viruses or hackers. These types of system failures or interruption could adversely affect our business and operating results.

Our business may be impacted by natural disasters.

        Tornadoes, blizzards and other natural disasters could negatively impact our business and supply chain. In countries that we rely on for operations and materials, such as Mexico, China and Thailand, potential natural disasters could disrupt our manufacturing operations, reduce demand for our customers' products and increase supply chain costs.

ITEM 2.        PROPERTIES

ADMINISTRATION

        Our Corporate Headquarters consists of approximately 5,000 square feet located in Wayzata, Minnesota, a western suburb of Minneapolis, Minnesota. The Corporate Headquarters has a lease with a five-year term that expires on July 31, 2015. A portion of the Bemidji facility is used for corporate financial and information systems shared services.

MANUFACTURING FACILITIES

        Our manufacturing facilities as described below are in good operating condition and are suitable for our needs. We believe our overall productive capacity is sufficient to handle our foreseeable manufacturing needs and customer requirements.

        We own our Bemidji, Minnesota facility consisting of eight acres of land and a building of approximately 69,000 square feet consisting of 56,000 square feet designated for manufacturing space, and the remaining space is used for offices.

        In November 2009, we sold a 14,000 square foot building in Fairmont, Minnesota. We still own two buildings in Fairmont which together contain approximately 37,000 square feet. Both buildings are held for sale.

        We own a building in Blue Earth, Minnesota, of approximately 140,000 square feet consisting of 92,000 square feet designated for manufacturing space. The remaining space is being used for offices and warehouse.

        We own a building in Merrifield, Minnesota, of approximately 46,000 square feet consisting of 34,000 square feet designated for manufacturing; the remaining space is used for offices and warehouse.

        In Baxter, Minnesota we lease 9,000 square feet in one building and 8,000 square feet in another building. Together the buildings contain 13,000 square feet designated for electronic board repair of medical equipment with the remaining space being used for offices and warehouse. We are leasing these buildings on a month-to-month basis.

        We own our Augusta, Wisconsin facility consisting of five acres of land and a building of approximately 20,000 square feet. 15,000 square feet are designated for manufacturing space, and the remaining space is used for offices.

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        We lease a 30,000 square foot building in Monterrey, Mexico consisting of 29,000 square feet designated for manufacturing space with the remaining space being used for offices. The lease expires on June 30, 2011 at which point we expect to renew.

        In Garner, Iowa we lease a 38,000 square foot building. The lease expires on June 30, 2011. In connection with the restructuring activities during 2009, this facility was sub-leased on August 26, 2009 through the remaining term of the lease.

        We lease a 20,000 square foot building in Milaca, Minnesota consisting of 15,000 square feet designated for manufacturing space with the remaining space being used for offices. The lease expires on July 31, 2011 at which point we intend to renew.

        As part of the acquisition of the EMS business unit of Winland in January 2011, we agreed to lease a 58,000 square foot building consisting of 43,000 square feet designated for manufacturing and the remaining space used for offices. The lease expires on January 1, 2017 at which point we have the right of first refusal and an option to purchase the building. A portion of this facility will be subleased back to Winland through December 31, 2011.

ITEM 3.        LEGAL PROCEEDINGS

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

PART II

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

        As of March 3, 2011, there were 752 shareholders of record. Our stock is listed on the National Association of Securities Dealers Automated Quotation System ("NASDAQ") Small Cap Market under the symbol "NSYS". We intend to invest our profits into the growth of our operations and, therefore, do not plan to pay out dividends to shareholders in the foreseeable future. We did not declare or pay a cash dividend in 2010 or 2009. Future dividend policy and payments, if any, will depend upon earnings and our financial condition, our need for funds, any limitations on payments of dividends present in our current or future debt agreements, and other factors.

        Stock price comparisons (NASDAQ):

        Sales of Unregistered Securities:

        We did not have any unregistered sales of equity securities in 2010.

        Purchases of Equity Securities by the Issuer and Affiliated Purchasers:

        We did not make any purchases of our equity securities in 2010.

EQUITY COMPENSATION PLAN INFORMATION

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

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

OVERVIEW

        We are a Wayzata, Minnesota based full-service EMS contract manufacturer of wire and cable assemblies, printed circuit board assemblies, higher-level assemblies and box builds for a wide range of industries. We serve three major markets within the EMS industry: Aerospace and Defense, Medical, and the Industrial market which includes industrial equipment, transportation, vision, agriculture, oil and gas. In Minnesota, we have facilities in Baxter, Bemidji, Blue Earth, Fairmont, Merrifield, Milaca and Wayzata. We also have facilities in Augusta, Wisconsin; Monterrey, Mexico; and as of January 1, 2011, Mankato, Minnesota.

        The vast majority of our revenue is derived from products that are built to the customer's design specifications and consist of a wide range of simple to highly complex manufacturing processes. During 2010, we continued our supply chain and lean manufacturing initiatives designed to reduce costs, improve asset utilization and increase responsiveness to customers. Our initiatives focused on improving our ability to promise based on our capabilities and scheduling as well as improving our manufacturing processes and yields by doing it right the first time. Our goal is to expand and diversify our customer base by focusing on sales and marketing efforts that fit our value-added service strategy. Our Mexico operation allows for medium volume and mix with lower cost production alternatives when the opportunities are presented. We also benefit from our relationships with Asian manufacturers and suppliers that allow us to meet higher volume, lower mix and lower cost customer requirements when lead times and product stability are not as critical.

        In the first half of 2010 we saw our revenues stabilize and customer confidence improve. Our 90 day backlog increased steadily leading to a double digit revenue growth for the year.

        Our net sales for the year ended December 31, 2010 were $99.8 million, an increase of 25% compared to 2009. Gross profit as a percentage of net sales was 11.5% and 7.2% for the years ended December 31, 2010 and 2009, respectively. The cost reduction and capacity consolidation efforts which were completed in third quarter 2009, account for the significant improvements in gross profit performance in 2010. Our net income in 2010 was $506,766 or $0.18 per diluted common share compared to net loss of $3,835,041 or $1.40 per diluted common share in 2009.

        We continued to focus on cash management and cash conservation throughout 2010. Cash from Operating Activities was $2,890,000 for the year. On January 6, 2011 we entered into the first amendment to the third amended and restated credit and security agreement with Wells Fargo Bank (WFB) which provides a $13.5 million line of credit through May 31, 2013. We believe our financing arrangements and cash flows provided by operations will be sufficient to satisfy our working capital needs through the foreseeable future.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

        Our significant accounting policies and estimates are summarized in the footnotes to our annual consolidated financial statements. Some of the accounting policies require us to exercise significant judgment in selecting the appropriate assumptions for calculating financial estimates. Such judgments are subject to an inherent degree of uncertainty. These judgments are based on historical experience, known trends in the industry, terms of existing contracts and other information from outside sources, as appropriate. Actual results may differ from these estimates under different assumptions and conditions. Certain of the most critical estimates that require significant judgment are as follows:

Revenue Recognition:

        We recognize revenue upon shipment of manufactured products to customers, when title has passed, all contractual obligations have been satisfied and collection of the resulting receivable is reasonably assured. We also provide engineering services separate from the manufacture of a product. Revenue for engineering services is recognized upon completion of the engineering process, providing standalone fair value to our customers. Our engineering services are short-term in nature. In addition, we have another separate source of revenue that comes from short-term repair services, which are recognized upon completion of the repairs, and the repaired products are shipped back to the customer. Shipping and handling costs charged to our customers are included in net sales, while the corresponding shipping expenses are included in cost of goods sold.

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Allowance for Uncollectible Accounts:

        When evaluating the adequacy of the allowance for doubtful accounts, we analyze accounts receivable, historical write-offs of bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in customer payment terms. We maintain an allowance for doubtful accounts at an amount estimated to be sufficient to provide adequate protection against losses resulting from collecting less than full payment on outstanding accounts receivable. A considerable amount of judgment is required when assessing the realizability of accounts receivable, including assessing the probability of collection and the current credit-worthiness of each customer. If the financial condition of our customers was to deteriorate, resulting in an impairment of their ability to make payments, an additional provision for uncollectible accounts may be required. We have historically not experienced significant bad debts expense and believe the reserve is adequate for any exposure to loss in the December 31, 2010 accounts receivable.

Inventory Reserves:

        Inventory reserves are maintained for the estimated value of the inventory that may have a lower value than stated or quantities in excess of future production needs. We have an evaluation process that is used to assess the value of the inventory that is slow moving, excess or obsolete on a quarterly basis. We evaluate our inventory based on current usage and the latest forecasts of product demand and production requirements from our customers. We believe the total reserve at December 31, 2010 is adequate.

Long-Lived and Intangible Asset Impairment:

        We evaluate long-lived assets and intangible assets with finite lives for impairment, as well as the related amortization periods, to determine whether adjustments to these amounts or useful lives are required based on current events and circumstances. The evaluation is based on our projection of the undiscounted future operating cash flows of the underlying assets. To the extent such projections indicate that future undiscounted cash flows are not sufficient to recover the carrying amounts of related assets, a charge might be required to reduce the carrying amount to equal estimated fair value. In 2010, we recorded an impairment charge of $56,000 on a building held for sale. In connection with the closing of two facilities in 2009, we recorded an impairment charge of approximately $502,000 on certain property and equipment that were no longer being used in operations.

Valuation Allowance:

        We record valuation allowances against our deferred tax assets when necessary. Realization of deferred tax assets (such as net operating loss carry forwards) is dependent on future taxable earnings and therefore uncertain. At least quarterly, we assess the likelihood that our deferred tax assets will be recovered from future taxable income. To the extent we believe that recovery is not likely, we establish a valuation allowance against these assets, thereby increasing income tax expense or decreasing the income tax benefit in the period the determination is made. As of December 31, 2010 we expect to recover our deferred tax assets in their entirety, and thus no valuation allowance was deemed necessary.

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

        No matters have come to our attention since December 31, 2010 that would cause the estimates included in the consolidated financial statements to change materially.

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OPERATING RESULTS

        The following table presents statement of operations data as percentages of net sales for the indicated year:

Net sales:

        For the years ended December 31, 2010 and 2009, we had net sales of $99.8 million and $79.9 million, respectively, an increase of 25%. The Milaca medical device operation acquired in May 2010 accounted for $3.6 million of net sales for the year ended December 31, 2010. Net sales by our major EMS industry markets for the year ended December 31, 2010 and 2009 are as follows:

        We saw sales to our Aerospace and Defense customers decline 39% due to the end of major contracts and the timing of new replacement business. Sales to our Medical and Industrial customers increased 68% and 51%, respectively as the overall economy stabilized and we began to see more new business opportunities and improved buying confidence from our existing customer base.

Backlog:

        Our 90 day backlog as of December 31, 2010 was approximately $18.5 million compared to approximately $17.7 million on December 31, 2009. Our backlog consists of firm purchase orders and we expect a major portion of the current 90 day backlog to be realized as revenue during the following quarter.

Gross Profit:

        For the years ended December 31, 2010 and 2009, we had gross profit of $11.4 million and $5.8 million, respectively. Gross profit as a percentage of net sales was 11.5% and 7.2% for the years ended December 31, 2010 and 2009, respectively. The year over year increase in gross profit as a percentage of net sales was a direct result of the increase in sales volume in 2010 and the restructuring which occurred in the third quarter of 2009 resulting in better utilization of our fixed cost structure.

Selling:

        Selling expenses were $3.1 million or 3.1% of net sales for the year ended December 31, 2010 and $4.4 million or 5.6% of net sales for the year ended December 31, 2009. The majority of the $1.3 million decrease was due to approximately $0.7 million less commissions and $0.6 million in cost reductions.

General and Administrative:

        General and administrative expenses were $7.0 million or 7.0% of net sales for the year ended December 31, 2010 and $5.9 million or 7.3% of net sales for the year ended December 31, 2009. The 2010 increase of $1.1 million is mainly attributed to the reversal of wage decreases and the re-instatement of merit increases, 401K matching and incentive programs on July 1, 2010.

Restructuring and Impairment Charges:

        We recognized $0.1 million and $1.0 million of restructuring and impairment charges in Income (Loss) from Operations during the years ended December 31, 2010 and 2009, respectively. The 2010 costs relate to the impairment of a Fairmont building that is held for

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sale. The 2009 restructuring and impairment costs included $0.5 million in non-cash impairment charges for property and equipment that are no longer being used in operations and $0.5 million related to employee benefits, contract termination costs, and other expenses incurred to relocate production. The 2009 restructuring and impairment charges were the result of the facility closings and consolidation efforts taken throughout the year to better align our capacity to current customer demand levels.

Other Income (Expense):

        Other expense for the years ended December 31, 2010 and 2009 was approximately $0.3 million and $0.7 million, respectively. Interest expense and foreign exchange transaction losses make up the majority of the other expense in 2010.

Income Taxes:

        Income tax expense for the year ended December 31, 2010 was $375,000. Due to the loss incurred in 2009, we recorded an income tax benefit of $2.4 million for the year ended December 31, 2009. The effective tax rate for fiscal 2010 was 42.5% compared to 38.4% in fiscal 2009. The increase in effective tax rate from 2009 to 2010 relates primarily to the true-up of our net operating loss (NOL) carryback which resulted in additional tax expense of approximately $103,000 partially offset by state and federal research credits.

Net Income (Loss):

        Our net income in 2010 was $506,766 or $0.18 per diluted common share compared to net loss of $3,835,041 or $1.40 per diluted common share in 2009. We returned to profitability in 2010 primarily due to increased sales and the cost reductions experienced from the prior year restructuring activities.

FINANCIAL CONDITION AND LIQUIDITY

        We believe that our existing financing arrangements and anticipated cash flows from operations will be sufficient to satisfy our working capital needs, capital expenditures, investments, and debt repayments for the foreseeable future.

Credit Facility:

        On May 27, 2010 we entered into a third amended and restated credit and security agreement with Wells Fargo Bank which provides a $12 million line of credit through May 31, 2013 and a real estate note maturing on May 31, 2012. On January 6, 2011, we entered into the first amendment to this agreement which provides a $13.5 million line of credit through May 31, 2013, a new $475,000 equipment term loan tied to equipment purchased in the recent acquisition announced January 3, 2011 and a new term loan of up to $1.0 million for capital expenditures to be made in 2011. Under the new agreement, both the line of credit and real estate term note are subject to variations in the LIBOR rate. Advances on our line of credit will bear interest at three-month LIBOR + 4.00% (4.30% at December 31, 2010). The weighted-average interest rate on our line of credit and other long-term debt was 4.63% and 5.04%, respectively for the year ended December 31, 2010.

        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 performance, and limit the amount of annual capital expenditures. The availability under the line is subject to borrowing base requirements, and advances are at the discretion of the lender. The line is secured by substantially all of our assets. This commitment is summarized as described below:

        As of December 31, 2010 we have net unused availability under our line of credit agreement of approximately $5.2 million as supported by our borrowing base. Under the terms of our new agreement, our unused availability increased to $6.5 million on January 6, 2011.

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Cash Flow:

        On December 31, 2010, we had working capital of approximately $13.1 million as compared to $13.2 million at the end of 2009. During 2010, we generated approximately $2.9 million of cash flow from operating activities. The cash flow from operations is primarily due to net income of $0.5 million plus $2.1 million of noncash charges, including depreciation, amortization, property and equipment impairment charges, restructuring charges, the change in deferred taxes and other miscellaneous noncash expenses. The cash flow from operating assets and liabilities was $0.3 million. This was driven by a decrease in income taxes receivable of $2.1 million and an increase in accounts payable and accruals of $1.8 million offset in part by a $3.5 million increase in accounts receivable.

        Our net cash used in investing activities of $1.0 million is due to $0.6 million of capital equipment purchases and $0.4 million for the acquisition in May 2010. Net cash used in financing activities of $1.9 million consisted of $2.0 million reduction of long-term debt offset by $0.1 million line of credit increase.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

TABLE OF CONTENTS

DECEMBER 31, 2010 AND 2009

ITEM 8.        FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

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Report of Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders
Nortech Systems Incorporated and Subsidiary

        We have audited the accompanying consolidated balance sheets of Nortech Systems Incorporated and Subsidiary as of December 31, 2010 and 2009, and the related consolidated statements of operations, shareholders' equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

        We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

        In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Nortech Systems Incorporated and Subsidiary as of December 31, 2010 and 2009, and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.

/s/ McGladrey & Pullen, LLP

Minneapolis, Minnesota
March 11, 2011

See accompanying Notes to Consolidated Financial Statements.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

DECEMBER 31, 2010 AND 2009

See accompanying Notes to Consolidated Financial Statements.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS (Continued)

DECEMBER 31, 2010 AND 2009

See accompanying Notes to Consolidated Financial Statements.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009

See accompanying Notes to Consolidated Financial Statements.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009

See accompanying Notes to Consolidated Financial Statements.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

DECEMBER 31, 2010 AND 2009

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2010 AND 2009

NOTE 1 NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Business

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

        Our manufacturing facilities are located in Bemidji, Blue Earth, Merrifield, Milaca and Baxter, Minnesota as well as Augusta, Wisconsin; Monterrey, Mexico; and as of January 1, 2011, Mankato, Minnesota.

        A summary of our significant accounting policies follows:

Principles of Consolidation

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

Use of Estimates

        The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of our consolidated financial statements. Estimates also affect the reported amounts of revenue and expense during the reporting period. Significant items subject to estimates and assumptions include the valuation allowance for inventories, allowance for doubtful accounts and realizability of deferred tax assets. 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 and whose original maturity is three months or less.

Accounts Receivable and Allowance for Doubtful Accounts

        We grant credit to customers in the normal course of business. Accounts receivable are unsecured and are presented net of an allowance for uncollectible accounts. The allowance for uncollectible accounts was $86,000 and $138,000 at December 31, 2010 and 2009, respectively. We determine our allowance by considering a number of factors, including the length of time accounts receivable are past due, our previous loss history, the customers' current ability to pay their obligations to us, and the condition of the general economy and the industry as a whole. We write-off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for uncollectible accounts.

Inventories

        Inventories are stated at the lower of cost (first-in, first-out method) or market (based on the lower of replacement cost or net realizable value). Costs include material, labor, and overhead required in the warehousing and production of our products. Inventory reserves are maintained for the estimated value of the inventory that may have a lower value than stated or quantities in excess of future production needs.

        Inventories are as follows:

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

DECEMBER 31, 2010 AND 2009

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