UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-K

(Mark One)

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

For the fiscal year ended December 31, 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

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

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

Common Stock, Par Value $.01 Per Share

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

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x    No  o

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

Indicate by check mark whether the registrant is 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.

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

The aggregate market value of voting stock held by non-affiliates of the registrant, based on the closing price of $7.20 per share, was $8,591,522 on June 30, 2006.

Shares of common stock outstanding at March 6, 2007: 2,714,729.

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DOCUMENTS INCORPORATED BY REFERENCE

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

Parts of Annual Report on Form 10-K					Documents Incorporated by Reference
Part III
Item	10					Reference is made to the Registrant’s proxy statements to be used in connection with the 2006 Annual Shareholders’ Meeting and filed with the Securities and Exchange Commissionno later than April 30, 2007
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NORTECH SYSTEMS INCORPORATED

ANNUAL REPORT ON FORM 10K

TABLE OF CONTENTS

PART I
Item 1.	Business
Item 1A.	Risk Factors
Item 1B.	Unresolved Staff Comments
Item 2.	Properties
Item 3.	Legal Proceedings
Item 4.	Submission of Matters to a Vote of Security Holders
PART II
Item 5.	Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Item 6.	Selected Financial Data
Item 7.	Management’s Discussion and Analysis
Item 7a	Quantitative and Qualitative Disclosure about Market Risk
Item 8.	Consolidated Financial Statements and Supplemental Data
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Item 9A.	Controls and Procedures
Item 9B.	Other Information
PART III
Item 10.	Directors and Executive Officers of the Registrant
Item 11.	Executive Compensation
Item 12.	Security Ownership of Certain Beneficial Owners and Management
Item 13.	Certain Relationships and Related Transactions
Item 14.	Principal Accountant Fees and Services

 

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PART IV
Item 15.	Exhibits, Consolidated Financial Statement Schedules
	Signatures
	Index to Exhibits

 

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NORTECH SYSTEMS INCORPORATED

FORM 10-K

For the Year Ended December 31, 2006

PART   I

ITEM 1.   BUSINESS

DESCRIPTION OF BUSINESS

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

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

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

GENERAL

We are an EMS (Electronic Manufacturing Service) contract manufacturing company with our headquarters in Wayzata, Minnesota, a suburb of Minneapolis, Minnesota.  We maintain manufacturing facilities in Minnesota including Bemidji, Fairmont, Blue Earth, Baxter, and Merrifield as well as Augusta, Wisconsin, and Monterrey, Mexico.  On February 4, 2007, we acquired a manufacturing operation in Garner, Iowa.  We manufacture wire harness and cable assemblies, electronic sub-assemblies, and printed circuit board assemblies.  We provide value added services and technical support including design, testing, prototyping and supply chain management. The 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 techniques and the systems necessary to effectively manage the business.  This level of sophistication enables us to attract major original equipment manufacturers (OEMs) and to expand and diversify our customer base.   Our strategy is to develop a customer base across several markets to avoid the effects of fluctuations within a given industry. The markets we serve are Industrial Equipment, Medical, Military/Defense and Transportation.

We believe the current growth and expansion trends for contract manufacturing and the EMS (Electronic Manufacturing Services) industry will continue both in the United States and overseas. OEM outsourcing will continue to escalate as more companies focus their investments

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on marketing and development of their products and rely more on EMS providers for their production and supply chain requirements.

ACQUISITIONS

On February 4, 2007, we acquired the business assets of Suntron Corporation’s Mid-West Operation located in Garner, Iowa.  This acquisition will strengthen our capabilities in printed circuit board assemblies and high level complete box build assemblies while opening new market segments in the agriculture and oil and gas industries

On June 28, 2006, we acquired a 140,000 square foot building in Blue Earth, Minnesota from Telex Communications, Inc.  This acquisition expanded our capacity allowing us to better meet the needs of the growing Military/Defense market.

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

See Notes 4 and 13 to the consolidated financial statements for further information on these acquisitions.

BUSINESS SEGMENT

All of our operations fall under the Contract Manufacturing segment within the Electronic Manufacturing Services industry.  We strategically direct production amongst our various manufacturing facilities based on a number of considerations to best meet our customers’ requirements.

BUSINESS STRATEGY

The Electronic Manufacturing Services industry continues to evolve into a dynamic, higher tech global electronics contract services industry.  We continue to expand our capabilities to better meet these changing market requirements. Along with 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.  We continue to expand our international operations and partnerships to take advantage of lower-cost alternatives for our customers and to remain competitive in the marketplace when required.

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

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

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

MARKETING

We concentrate our marketing efforts in the industrial equipment, medical, military/defense and transportation industries and with the recent acquisition of our Iowa circuit board operation, we enter into the agriculture and oil and gas 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 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) and Aerospace Systems 9100 (AS).  We continue efforts to penetrate our existing customer base and expand new market opportunities in Mexico, Asia and Europe, in addition to participation in industry publications and selected trade shows.  We target customers who value proven manufacturing performance, design and application engineering expertise and who value the flexibility to manage the supply chain of a high mix of product and service. We market our products and services through our in-house sales force and independent manufacturers’ representatives.

SOURCES AND AVAILABILITY OF MATERIALS

On occasion some of our components may be placed on a stringent allocation basis; however, due to the excess manufacturing capacity currently available at most component manufacturers, we do not anticipate any major material purchasing or availability problems occurring in the foreseeable future.

PATENTS AND LICENSES

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

COMPETITION

The contract manufacturing EMS industry competitive makeup includes small closely held contract manufacturing companies, large 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 believe the larger global full service and foreign manufacturers do provide a substantial competitive environment while the company-owned operations create an increasing opportunity as the trend of more outsourcing continues.

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Technical support from foreign competition has improved greatly along with their ability to be more responsive to engineering and schedule changes.  The willingness of foreign manufacturers to “stock” finished product at warehouse locations in the United States is another of their competitive advantages, however, their inability to react to engineering, product or schedule changes is a disadvantage and plays into our strength.  To mitigate foreign competition, we maintain a contractual agreement allowing us to provide a China manufacturing solution and we operate a manufacturing operation in Mexico to support our customers with a “Low Cost” supply chain solution.

BACKLOG

Historically, our backlog has been running 60 to 90 days.  However, because of the increased emphasis on just-in-time manufacturing (JIT), reduced lead times and repetitive scheduling, our historical backlog levels may not be indicative of future results due to customers rescheduling and canceling of orders.  As of December 31, 2006 our 90 day backlog was approximately $19.5 million compared to approximately $24.9 million on December 31, 2005.  We expect a major portion of the backlog will be realized as revenue during first quarter 2007.

MAJOR CUSTOMERS

Two divisions of General Electric, Co. (G.E.) combined account for 10% or more of our net sales during the past three years.  G.E.’s Medical and Transportation Divisions together accounted for 17%, 17% and 15% of net sales for the years ended December 31, 2006, 2005 and 2004, respectively.  Accounts receivable from G.E.’s Medical and Transportation Divisions at December 31, 2006 and 2005 represented 14% and 12% of total accounts receivable, respectively.  Additionally, Northrop Grumman Corp. accounted for 10% of net sales for the years ended December 31, 2006 and 2005.  Accounts receivable from Northrop Grumman at December 31, 2006 and 2005 represented 15% and 9% of total accounts receivable, respectively.  Historically, we have not experienced significant losses on customer receivable collections in any particular industry or geographic area.

RESEARCH AND DEVELOPMENT

We perform research and development for customers on an as requested and program basis for development of conceptual engineering and design activities prior to manufacturing the products.  We did not expend significant dollars in 2006, 2005 or 2004 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 911 full-time, 80 part-time and 17 temporary employees as of December 31, 2006.  Manufacturing personnel, including direct, indirect support and sales functions, comprise 967 employees, while general administrative employees total 41.

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FOREIGN OPERATIONS AND EXPORT SALES

We have a leased manufacturing facility in Monterrey, Mexico with approximately $562,000 in long-term assets at December 31, 2006.  Export sales represent 5% of consolidated sales for the years ended December 31, 2006, 2005 and 2004.

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 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

·                  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.  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

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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 the consolidated financial statements and the related notes.

We operate in a in the highly competitive EMS (Electronic Manufacturing Services) industry.

We compete against many EMS companies. The larger global competitors have more resources and greater economics 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 services, a quality product, be responsive and flexible to customers’ requirements for design and technical support schedule changes and deliver. 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.

We have several customers that are responsible for a significant portion of our net sales.  General Electric Co.’s (G.E.) Medical and Transportation Divisions together accounted for 17%, 17% and 15% of net sales for the years ended December 31, 2006, 2005 and 2004, respectively. Additionally, Northrop Grumman Corp. accounted for 10% of net sales for the years ended December 31, 2006 and 2005. If there is a loss of one or more major customers or a significant decline in sales to our major customers it could have an adverse effect on our results from operations. We will continue to expand our customer base through our in-house sales efforts and target our acquisitions to reduce the dependence.

We are dependent on suppliers for electronic components and may experience shortages, 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 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 need for their production. Component shortages may result in expedited freight, overtime premium 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 and if not managed would have an adverse affect on inventory carrying costs.

We do face through the normal course of business excess and obsolete inventory losses as a result of customer order changes, cancellations, product changes and contract termination that

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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 (1) from ship date. Unless otherwise agreed to, workmanship shall be in accordance with IPC and ANSI/J- Standards such as IPC-A-610, class 2, IPC—A-620, class 2, ANSI/J-STD001, class 2, C-20.  We make no other guarantees or warranties, expressed or implied, of any nature whatsoever as to the goods including without limitation, warranties to merchantability, fit for a particular purpose or non-infringement of patent or the like unless agreed upon in writing.  If a product liability claim results in 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 competition 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 expose our operations to risks that could adversely affect our operating results.

We’ve operated a manufacturing facility in Mexico since 2002 and we may in the future expand into other foreign countries. The benefits projected for our Mexico operation have taken more time then expected to integrate into our marketing strategies and our operation there is subject to risks, which could adversely impact our financial results such as economic or political volatility, employee turnover, staffing, managing personnel in diverse culture, labor instability, transportation delays, and foreign currency flux.

Non-compliance with environmental laws may result in restrictions and adverse effects on 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 and compliance with these environmental laws is a major consideration for us because of 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 and 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.

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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.

We may be subject to risks associated with our acquisitions, and the risks could have an adverse effect on 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.

In June 2002, we acquired Manufacturing Assembly Solutions of Monterrey, Inc. (MAS), a Mexican corporation, located in Monterrey, Mexico.  The benefits of this acquisition has taken more time then expected to integrate into our marketing strategies. In February 2007, we purchased a printed circuit board operation in Garner, Iowa with the expectation that the results will be accretive to the overall business.

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, 2006, we were in compliance with each of these covenants.  However, among other factors, 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.

Our business may be impacted by natural disasters.

Tornadoes, blizzards and other natural disasters could negatively impact our business and supply chain. In countries, which 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.

 

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ITEM 1B. UNRESOLVED STAFF COMMENTS

Not Applicable

ITEM 2.   PROPERTIES

ADMINISTRATION

Our Corporate Headquarters consists of approximately 3,600 square feet located in Wayzata, Minnesota, a western suburb of Minneapolis, Minnesota.  The Corporate Headquarters has a lease with a five-year term that expires on July 31, 2010.  A portion of the Bemidji facility is used for corporate financial and information shared services.

MANUFACTURING FACILITIES

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

We own our Bemidji, Minnesota facility consisting of eight acres of land and a building of approximately 69,300 square feet consisting of 55,800 square feet designated for manufacturing space, and the remaining space is used for offices.  We also lease a 6,000 square foot warehouse in Bemidji, Minnesota.

We own three buildings in Fairmont, Minnesota, which together contain approximately 51,000 square feet consisting of 38,000 square feet designated for manufacturing space, and the remaining space is used for offices.

On June 28, 2006, we purchased a building in Blue Earth, Minnesota, of approximately 140,000 square feet consisting of 92,000 square feet designated for manufacturing with 46,000 square feet of the 92,000 manufacturing square footage being leased back to the seller through June 30, 2007, per the lease agreement, and the remaining space is being used for offices and warehouse.

We own a building in Merrifield, Minnesota, consisting of approximately 45,800 square feet consisting of 33,800 square feet designated for manufacturing, and the remaining space is used for offices and warehouse.

We lease two buildings in Baxter, Minnesota where we lease 8,700 square feet in one building and 8,300 square feet in the other building, which together 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 which consist of 15,000 square feet designated for manufacturing space with the remaining manufacturing space being used as warehouse, and the remaining 5,000 square feet is used for offices.

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We lease a 15,000 square foot building in our Monterrey, Mexico consisting of 13,500 square feet designated for manufacturing space with the remaining space being used for offices.    The lease expires in June 2007, and we plan on exercising the additional three-year option at that time.

As part of the acquisition of the Garner, Iowa operations on February 4, 2007, we assumed the existing building lease, which expires in June 2008.  The leased building consists of 38,000 square feet with designated manufacturing space of 30,000 square feet with the remaining space being used for offices.

ITEM 3.    LEGAL PROCEEDINGS

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

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

None.

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PART II

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

As of March 6, 2007, there were 846 shareholders of record. Our stock is listed on the National Association of Securities Dealers Automated Quotation System (“NASDAQ”) Small Cap Market under the symbol “NSYS”.  We intend to invest our profits into the growth of our operations and, therefore, do not plan to pay out dividends to shareholders in the foreseeable future. We did not declare or pay a cash dividend in 2006 or 2005. 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 follow.

Stock price comparisons (NASDAQ):

During the Three Months Ended		Low			High
March 31, 2006		$	6.16		$	8.16
June 30, 2006		$	6.52		$	9.08
September 30, 2006		$	6.59		$	7.90
December 31, 2006		$	7.05		$	7.94
March 31, 2005		$	5.52		$	6.92
June 30, 2005		$	5.00		$	7.00
September 30, 2005		$	5.62		$	6.60
December 31, 2005		$	5.30		$	6.25

 

Sales of Unregistered Securities:

We did not have any unregistered sales of equity securities in 2006.

Purchases of Equity Securities by the Issuer and Affiliated Purchasers:

We did not make any purchases of our equity securities in 2006.

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.

ITEM 6. SELECTED FINANCIAL DATA

The following selected historical financial data have been derived from, and are qualified by reference to the audited Consolidated Financial Statements of Nortech Systems Incorporated and Subsidiary as of December 31, 2006 and 2005 and for each of the years in the three year period ended December 31, 2006.  The audited consolidated financial statements of Nortech Systems Incorporated and Subsidiary referred to above are included elsewhere herein.  The selected historical financial data set forth below as of December 31, 2004, 2003 and 2002 and for each of

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

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Year ended December 31:		2006			2005			2004			2003			2002
Net Sales		$	105,147,228		$	84,215,663		$	72,674,159		$	57,958,698		$	60,655,579
Gross Profit		12,779,720			10,032,228			8,538,973			6,494,976			10,519,536
Net Income		1,311,778			928,781			587,329			633,448			2,403,112
Basic Income Per Common Share		.50			.36			.23			.26			1.00
Diluted Income Per Common Share		.49			.36			.23			.25			.95
At December 31:
Total Assets		41,877,944			39,668,551			36,881,608			31,580,790			29,602,400
Working Capital		*12,711,278			*12,214,328			*11,749,991			16,723,263			14,266,058
Total Long-Term Debt		*3,534,709			*2,714,227			*3,399,210			9,643,336			8,580,944
Shareholders’ Equity		18,301,859			16,653,364			15,516,581			14,321,280			13,090,130

No dividends were declared or paid in any year from 2002 to 2006.

*  In 2006, 2005 and 2004, the revolving line of credit was classified in current liabilities.  In the previous years these amounts had been reflected as long-term.  As of December 31, 2006, 2005 and 2004, the revolving line of credit, classified as a current liability, had outstanding borrowings of $4,694,027, $4,228,234 and $7,523,058, respectively.  For additional financial data (2006 and 2005 by quarter information), see Note 12 to the Consolidated Financial Statements.

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

The vast majority of our revenue is derived from products that are built to the customer’s design specifications.  We provide a high degree of manufacturing sophistication.  During 2006, we continued our supply chain initiatives designed to reduce costs, improve asset utilization and increase responsiveness to customers.  Our strategy has been to expand and diversify our customer base, and we are focusing our sales and marketing approach to target greater value-added service opportunities.  Our market strength is low-volume, high-mix production, particularly with complex products.  Our investment in the Mexico operation in 2002 allows for expansion into medium volume, medium mix and lower cost production and our contractual arrangements with Chinese manufacturers allow us to meet high-volume, low mix and lower cost customer requirements.

During 2006, we experienced growth in our Sales, Gross Profit, and Net Income.   For the years ended December 31, 2006 we had sales of $105.1 million, compared to $84.2 million for 2005 and $72.7 million for 2004. The increase for 2006 of $20.9 million was a 24.9% improvement over 2005.  For the years ended December 31, 2006, 2005 and 2004, we had gross profit of $12.8 million, $10.0 million and $8.5 million, respectively.  Gross profits as a percentage of gross sales were 12.2%, 11.9% and 11.8% for the years ended December 31, 2006, 2005 and 2004, respectively. The modest gross profit increase in 2006 was attributed to volume leveraging in our operations and a favorable mix of products helping offset material and energy cost increases.   Our net income in 2006 was $1,311,778 or $0.49 per diluted common share compared to $928,781 or $0.36 per diluted common share in 2005.  Our 2004 net income was $587,329, or $0.23 per diluted common share.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

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

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Revenue Recognition:

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

Allowance for Uncollectible Accounts:

We analyze accounts receivable, historical write-offs of bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in customer payment terms when evaluating the adequacy of the allowance for uncollectible accounts.  We maintain an allowance for doubtful accounts at an amount estimated to be sufficient to provide adequate protection against losses resulting from collecting less than full payment on receivables.  A considerable amount of judgment is required when assessing the realizability of receivables, including assessing the probability of collection and the current credit-worthiness of each customer.  If the financial condition of our customers was to deteriorate, resulting in an impairment of their ability to make payments, an additional provision for uncollectible accounts may be required.  We have not experienced significant bad debts expense and the reserve for uncollectible accounts of $220,000 is considered adequate for any exposure to loss in the December 31, 2006 accounts receivable.

Inventory Reserves:

Inventory reserves are maintained for the estimated value of the inventory that may have a lower value than stated or quantities in excess of future production needs.  We have an evaluation process that is used to assess the value of the inventory that is slow moving, excess or obsolete on a quarterly basis. We believe the total reserve of $1.3 million at December 31, 2006 is adequate.

Long-Lived and Intangible Asset Impairment:

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

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

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Income taxes:

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

Self-Insured Health Claim Accruals:

We estimate our reserve for employee health claims based on health claims incurred, historical lag times and an analysis of claims activity during the period, while taking into consideration insurance limits and coverage.  We believe the total accrual of $325,000 at December 31, 2006 is adequate.

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 utilize the Black-Scholes option valuation model to measure the amount of compensation expense to be recognized for each 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. 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 future performance of our stock. An increase in the volatility of our stock price or an increase in the average period before exercise will increase the amount of compensation expense related to awards granted after December 31, 2006.

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 presentation of our financial position.  This is not to suggest that other general risk factors, such as changes in worldwide economic conditions, fluctuations in foreign currency exchange rates, changes in materials costs, performance of acquired businesses and others, could not adversely impact our consolidated financial position, results of operations and cash flows in future periods.

No matters have come to our attention since December 31, 2006 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 total revenues for the indicated year:

		2006		2005		2004
Net Sales		100	%	100	%	100	%
Cost of Goods Sold		88	%	88	%	88	%
Gross Profit		12	%	12	%	12	%
Selling Expenses		4	%	4	%	4	%
General and Administrative Expenses		5	%	5	%	6	%
Income from Operations		3	%	3	%	2	%
Other Expenses, Net		1	%	1	%	1	%
Income Tax Expense		1	%	1	%	0	%
Net Income		1	%	1	%	1	%

 

Revenues:

For the years ended December 31, 2006 and 2005, we had sales of $105.1 million and $84.2 million, respectively, an increase of $20.9 million or 24.9%. Our Aerospace Systems sales led the strong revenue growth in 2006 and accounted for 51% of the overall increase, followed by increased sales of Electronic Circuit Board Assemblies accounting for 27% of the overall growth and an increase of 22% for all other Cable & Wire sales combined.  Our 2006 sales increase was mainly driven by increased demand, minimal price increases to offset commodity and energy costs and favorable Aerospace Systems product mix.

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

Gross Profit:

For the years ended December 31, 2006, 2005 and 2004, we had gross profit of $12.8 million, $10.0 million and $8.5 million, respectively.  Gross profits as a percentage of gross sales were 12.2%, 11.9% and 11.8% for the years ended December 31, 2006, 2005 and 2004, respectively.  The 2006 gross profit improvement in both dollar and percentage was mainly due to the favorable impact of volume and leveraging on our operations which more than offset energy and commodity (copper and petroleum based products) cost pressures throughout all of 2006.

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Selling:

Selling expenses were $4.7 million or 4.4% of net sales for the year ended December 31, 2006, $3.2 million or 3.8% of net sales for the year ended December 31, 2005, and $3.2 million or 4.3% of net sales for the years ended December 31, 2004.  The increase in selling expense in 2006 from 2005 as a percentage of sales was a result of increased commissions of $0.5 million as a result of increased commissionable sales accounting for 31% of the increase and an overall increase of $1.0 million or 69% of the increase in marketing and sales related spending, consisting mostly of personnel, travel and expense to support the sales growth.  The decrease in selling expenses in 2005 from 2004 as a percentage of sales was a result of lower commission rates and lower commissionable sales and an 8.4% reduction in spending in marketing and sales related expenses.

General and Administrative:

For the years ended December 31, 2006, 2005 and 2004, general and administrative expenses were $5.4 million, $4.7 million and $4.1 million, respectively.  The increase in general and administrative expenses of $0.7 million in 2006 from 2005 is mainly attributed to the increased employee related expenses of approximately $0.5 million to support the growth and services, and the recognition of approximately $0.2 million of stock-based compensation expense.  The increase in general and administrative expenses of $0.6 million in 2005 from 2004 is attributable to the increased investment in infrastructure and employee related expenses, comprised primarily of $0.4 million to support the growth and consolidation of corporate shared services.  In addition, overall outside service costs increased $0.2 million and were related to increased compliance requirements and process improvements.

Other Income (Expense):

Interest income for the years ended December 31, 2006, 2005 and 2004 was approximately $9,100, $2,600, and $2,100, respectively.  Miscellaneous income (loss) was $45,000, ($70,000) and $16,000 for the years ended December 31, 2006, 2005 and 2004, respectively.  The increase in miscellaneous income experienced in 2006 over 2005 is attributable to fairly stable exchange rates experienced in 2006.

Interest expense was approximately $821,000, $652,000, and $490,000 for the years ended December 31, 2006, 2005 and 2004, respectively.  In 2006 and 2005, a steady increase in interest rates of approximately 1% throughout the year and higher average carrying debt levels accounted for the majority of the increased interest expense.  2004 saw favorable interest rates throughout the year and lower working capital requirements that kept interest expenses low.

Income Taxes:

Income tax expense amounted to $570,000, $465,000, and $268,000 for the years ended December 31, 2006, 2005 and 2004, respectively.  In 2006, the effective income tax rate was 30% and was impacted favorably by R & D tax credits of $140,000 and Section 199 Deduction for Income Attributable to Domestic Production Activities. In 2005, the effective income tax rate was 30% and was impacted favorably by R & D tax credits of $127,000 and Section 199 Deduction for Income Attributable to Domestic Production Activities.  In 2004 the effective income tax rate was 31% and was impacted favorably by R & D tax credits of

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$129,000. A reconciliation of income tax expense for the years ending December 31, 2006, 2005 and 2004 is included in Note 6 to the consolidated financial statements.

Net Income:

Our net income in 2006 was $1,311,778 or $0.49 per diluted common share compared to $928,781 or $0.36 per diluted common share in 2005.  Our 2004 net income was $587,329, or $0.23 per diluted common share.  The changes in net income are the result of the aforementioned factors.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

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.  The adoption of SAB 108 did not have a material impact on our financial statements.

In September 2006, the Financial Accounting Standards Board (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 may have on our 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 for our fiscal 2007 year end, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings.  We have evaluated the impact of adopting FIN 48 on January 1, 2007 and found that we presently do not anticipate any impact 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.  We adopted FIN 47 on January 1, 2006 with no material impact to the consolidated financial statements.

In December 2004, the FASB issued SFAS 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

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to employees.  In adopting SFAS 123R, as of January 1, 2006, we used the modified prospective transition method.  A further discussion of the effects of SFAS 123R can be found in Note 9.

In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4. The amendments made by the SFAS No. 151 require that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) be recognized as current-period charges.  This Statement requires the allocation of fixed production overhead to inventory based on the normal capacity of production facilities.  SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We adopted SFAS 151 on January 1, 2006 with no material impact to our consolidated financial statements.

FINANCIAL CONDITION AND LIQUIDITY

The following are unaudited ratios:

		December 31, 2006			December 31, 2005			December 31, 2004
Current Ratio		1.63			1.60			1.65
(Current Assets / Current Liabilities)
Working Capital		$	12,711,278		$	12,214,328		$	11,749,991
(Current Assets — Current Liabilities)
Quick Ratio		.76			.75			.77
(Cash + Accounts Receivable / Current Liabilities)
Accounts Receivable to Working Capital		1.14			1.14			1.03
(Average Accounts Receivable/ Working Capital)
Inventory to Working Capital		1.25			1.23			1.10
(Average Inventory/ Working Capital)

 

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Cash Flow:

		December 31, 2006			December 31, 2005			December 31, 2004
Cash flows provided by (used in):
Operating Activities		$	2,842,531		$	5,120,151		$	(324,130	)
Investing Activities		(3,405,914		)	(1,427,059		)	(1,420,126		)
Financing Activities		449,275			(3,332,012		)	2,204,451
Effect of exchange rate changes on cash		(124		)	(76,740		)	(5,591		)
Net increase (decrease) in cash and cash equivalents		$	(114,232	)	$	284,340		$	454,604

 

On April 28, 2006 we entered into a 6th amendment to our credit agreement with Wells Fargo Bank, N.A. (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.  On February 2, 2007, we entered into a 7th amendment to our credit agreement with WFB increasing our line of credit arrangement from $10 million to $15 million and extending the maturity date of the line of credit to April 30, 2009.  Additionally, the 7th amendment increased our real estate term note balance of $1,680,555 at February 2, 2007 to $3,348,750 and extended the maturity date to May 31, 2012.  Per the 7th amendment, both the line of credit and real estate term note are subject to variations in the LIBOR rates. The 7th amendment funded the Iowa acquisition on February 4, 2007.

The line of credit and other installment debt with WFB contain certain covenants, which, among other things, require us to adhere to regular reporting requirements, abide by annual shareholder dividend limitations, maintain certain financial ratios, and limit the amount of annual capital expenditures.  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:

Other Commercial Commitment		Total Amount Committed			Outstanding at December 31, 2006			Date of Expiration
Line of credit		$	15,000,000		$	4,694,027		April 30, 2009

 

As of December 31, 2006 and prior to the 7th Amendment, we have net unused availability under our line of credit agreement of approximately $5.3 million.

On December 31, 2006, we had working capital of approximately $12.7 million as compared to $12.2 million at the end of 2005.  During 2006, we generated approximately $2.8 million of cash flow from operating activities.  The cash flow from operations is due primarily to net income of

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$1.3 million and noncash depreciation, amortization, foreign currency transaction loss, and the change in deferred taxes, which totaled $1.8 million in net positive adjustments.  The most significant impact on cash due to changes in operating assets and liabilities was the use of cash to pay income taxes, which was offset, in part, by increases in accrued payroll and commissions.

Our net cash used in investing activities of $3.4 million primarily consisted of $1.4 million spent on a building we purchased on June 28, 2006, in Blue Earth, Minnesota, $1.5 million on equipment purchases, $0.1 million on building additions and improvements $0.4 million of cash restricted for the future purchase of fixed assets at our new Blue Earth facility.

Net cash provided by financing activities of $0.4 million consisted primarily of drawing $0.5 million on our line of credit along with increases in long-term debt of $1.1 million from the equipment note and $1.4 million from the industrial revenue bond for the Blue Earth, MN facility purchase, and issuance of shares of common stock of $0.1 million, which was offset by the decrease in our checks in excess of our bank balance of $1.2 million, payments of long-term debt of $1.4 million and payments of bond issue costs $0.1 million.

Set forth below is information about our long-term contractual obligations outstanding as of December 31, 2006 as adjusted for the long-term liabilities assumed in connection with the acquisition of the Garner, Iowa operation on February 4, 2007.  It brings together data for easy reference from the consolidated balance sheet and from individual notes to the consolidated financial statements.  This information is important in understanding our financial position.

		Payments Due by Period
		Less than 1 Yr			2 - 3 Yrs			4 - 5 Yrs			Future
Bank Note Payable		$	4,694,027		$	—		$	—		$	—
Long-Term Debt		1,576,612			1,377,761			696,500			3,037,215
Operating Leases		391,509			378,251			60,368			—
Equipment Purchase Commitments		532,000			—			—			—
Total Contractual Obligations		$	7,194,148		$	1,756,012		$	756,868		$	3,037,215

 

From time to time, we enter into purchase commitments with our suppliers under customary purchase order terms.  Any significant losses implicit in those contracts will be recognized in accordance with generally accepted accounting principles.  At December 31, 2006, no such losses existed.

We believe that our existing resources and anticipated cash flows from operations will be sufficient to satisfy our working capital needs for the foreseeable future.

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ITEM 7a.        QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK

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

Exchange Rate Sensitivity:

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

Interest Rate Sensitivity:

The effective interest rate on our credit facilities are influenced by the actions of the Federal Reserve in establishing from time to time the Federal Funds Interest Rate which is the rate banks borrow from the Federal Reserve Bank.  During the latter half of 2004 and throughout 2005 and 2006, the Federal Reserve has been increasing the Federal Funds Interest Rate, causing the effective interest rate on our facilities to increase.  Based on the balance outstanding under our interest-bearing facilities at year-end, a percentage point change in the effective interest rate would change interest expense by less than $100,000 annually.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

TABLE OF CONTENTS

DECEMBER 31, 2005, 2004, AND 2003

ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA

Reports of Independent Registered Public Accounting Firm
Consolidated Financial Statements:
Consolidated Balance Sheets as of December 31, 2006 and 2005
Consolidated Statements of Income for the years ended December 31, 2006, 2005 and 2004
Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2006, 2005 and 2004
Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005 and 2004
Notes to Consolidated Financial Statements
Reports of Independent Registered Public Accounting Firm on Supplementary Data
Schedule II Valuation and Qualifying Accounts

 

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Report of Independent Registered Public Accounting Firm

To the Board of Directors

Nortech Systems Incorporated and Subsidiary

Wayzata, Minnesota

We have audited the consolidated balance sheet of Nortech Systems Incorporated and Subsidiary as of December 31, 2006 and 2005, and the related consolidated statements of income, shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2006.  These consolidated financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Nortech Systems Incorporated and Subsidiary as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.

As discussed in Note 9 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment” in 2006.

/s/  McGladrey & Pullen, LLP

Minneapolis, Minnesota

March 7, 2007

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

DECEMBER 31, 2006 AND 2005

ASSETS		2006			2005
CURRENT ASSETS
Cash and Cash Equivalents		$	725,891		$	840,123
Accounts Receivable, Less Allowance for Uncollectible Accounts		14,493,339			14,447,612
Inventories		15,976,222			15,849,470
Prepaid Expenses		492,177			466,083
Income Taxes Receivable		209,025			—
Deferred Tax Assets		856,000			912,000
Total Current Assets		32,752,654			32,515,288
PROPERTY AND EQUIPMENT
Land		300,000			151,800
Building and Leasehold Improvements		6,063,385			4,819,919
Manufacturing Equipment		9,092,455			7,662,699
Office and Other Equipment		3,532,038			3,413,968
Construction in Progress		90,945			502,374
Total Property and Equipment		19,078,823			16,550,760
Accumulated Depreciation		(10,823,655		)	(9,868,536		)
Net Property and Equipment		8,255,168			6,682,224
OTHER ASSETS
Restricted Cash		427,500			—
Finite-Lived Intangible Assets, Net of Accumulated Amortization		82,890			209,307
Goodwill		75,006			75,006
Deferred Tax Assets		277,000			179,000
Other Assets		7,726			7,726
Total Other Assets		870,122			471,039
Total Assets		$	41,877,944		$	39,668,551

 

See accompanying Notes to Consolidated Financial Statements.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

DECEMBER 31, 2006 AND 2005

LIABILITIES AND SHAREHOLDERS’ EQUITY		2006			2005
CURRENT LIABILITIES
Bank Note Payable		$	4,694,027		$	4,228,234
Current Maturities of Long-Term Debt		1,524,743			1,207,305
Checks Written in Excess of Bank Balance		—			1,200,000
Accounts Payable		10,018,263			9,902,998
Accrued Payroll and Commissions		3,094,092			2,849,472
Accrued Health and Dental Claims		325,000			271,104
Other Accrued Liabilities		385,251			324,360
Income Taxes Payable		—			317,487
Total Current Liabilities		20,041,376			20,300,960
LONG-TERM LIABILITIES
Long-Term Debt (Net of Current Maturities)		3,509,039			2,714,227
Other Long-Term Liabilities		25,670			—
Total Long-Term Liabilities		3,534,709			2,714,227
Total Liabilities		23,576,085			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 Shares Issued and Outstanding at December 31, 2006; 2,618,197 Shares Issued and Outstanding at December 31, 2005		26,747			26,182
Additional Paid-In Capital		14,644,901			14,306,602
Accumulated Other Comprehensive Loss		(23,179		)	(21,032		)
Retained Earnings		3,403,390			2,091,612
Total Shareholders’ Equity		18,301,859			16,653,364
Total Liabilities and Shareholders’ Equity		$	41,877,944		$	39,668,551

 

See accompanying Notes to Consolidated Financial Statements.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005, AND 2004

		2006			2005			2004
Net sales		$	105,147,228		$	84,215,663		$	72,674,159
Cost of goods sold		92,367,508			74,183,435			64,135,186
Gross profit		12,779,720			10,032,228			8,538,973
Operating expenses:
Selling expenses		4,674,826			3,198,654			3,157,212
General and administrative expenses		5,456,077			4,720,860			4,054,326
Total operating expenses		10,130,903			7,919,514			7,211,538
Income from operations		2,648,817			2,112,714			1,327,435
Other income (expense)
Interest income		9,061			2,635			2,120
Miscellaneous income (expense)		44,631			(70,059		)	15,839
Interest expense		(820,731		)	(651,509		)	(490,065		)
Total other expense		(767,039		)	(718,933		)	(472,106		)
Income before income taxes		1,881,778			1,393,781			855,329
Income tax expense		570,000			465,000			268,000
Net income		$	1,311,778		$	928,781		$	587,329
Net income per common share:
Basic		$	0.50		$	0.36		$	0.23
Weighted average number of common shares outstanding used for basic earnings per common share		2,628,635			2,583,309			2,561,419
Diluted		$	0.49		$	0.36		$	0.23
Weighted average number of common share outstanding plus dilutive common stock options		2,682,454			2,613,942			2,604,411

 

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, 2006, 2005, AND 2004

											Accumulated			Retained
								Additional			Other			Earnings			Total
		Preferred			Common			Paid-In			Comprehensive			(Accumulated			Shareholders’
		Stock			Stock			Capital			Income (Loss)			Deficit)			Equity
BALANCE DECEMBER 31, 2003		$	250,000		$	25,127		$	13,497,339		$	(26,688	)	$	575,502		$	14,321,280
2004 net income		—			—			—			—			587,329			587,329
Issuance of stock		—			694			621,319			—			—			622,013
Translation loss		—			—			—			(14,041		)	—			(14,041		)
BALANCE DECEMBER 31, 2004		250,000			25,821			14,118,658			(40,729		)	1,162,831			15,516,581
2005 net income		—			—			—			—			928,781			928,781
Issuance of stock upon exercise of stock options		—			361			187,944			—			—			188,305
Translation gain		—			—			—			19,697			—			19,697
BALANCE DECEMBER 31, 2005		250,000			26,182			14,306,602			(21,032		)	2,091,612			16,653,364
2006 net income		—			—			—			—			1,311,778			1,311,778
Issuance of stock upon exercise of stock options		—			280			126,698			—			—			126,978
Issuance of restricted stock		—			285			187,974			—			—			188,259
Excess tax benefits from stock-based awards		—			—			23,627			—			—			23,627
Translation loss		—			—			—			(2,147		)	—			(2,147		)
BALANCE DECEMBER 31, 2006		$	250,000		$	26,747		$	14,644,901		$	(23,179	)	$	3,403,390		$	18,301,859

 

See accompanying Notes to Consolidated Financial Statements.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE YEARS ENDED DECEMBER 31, 2006, 2005, AND 2004

		2006			2005			2004
CASH FLOWS FROM OPERATING ACTIVITIES
Net income		$	1,311,778		$	928,781		$	587,329
Adjustments to reconcile net income to net Cash provided by (used in) operating activities:
Depreciation		1,393,360			1,185,599			1,112,210
Amortization		205,790			397,246			387,776
Compensation on stock-based awards		188,259			—			—
Interest on swap valuation		25,670			—			—
Deferred taxes		(42,000		)	(221,000		)	166,000
(Gain) Loss on disposal of assets		10,632			—			(17,169		)
Other		(1,355		)	80,187			18,786
Changes in current operating items:
Accounts receivable		(46,228		)	(1,091,882		)	(2,520,034		)
Inventories		(126,752		)	(1,613,754		)	(2,641,159		)
Prepaid expenses and other assets		(26,132		)	(66,872		)	24,161
Income taxes receivable/payable		(526,461		)	668,856			68,265
Accounts payable		115,629			4,300,085			1,534,765
Accrued payroll and commissions		245,554			473,533			1,094,620
Accrued health and dental claims		53,896			20,774			32,816
Other accrued liabilities		60,891			58,598			(172,496		)
Net cash provided by (used in) operating activities		2,842,531			5,120,151			(324,130		)
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sale of assets		2,379			—			31,802
Restricted Cash		(427,500		)	—			—
Purchase of property and equipment		(2,980,793		)	(1,427,059		)	(1,451,928		)
Net cash used by investing activities		(3,405,914		)	(1,427,059		)	(1,420,126		)
CASH FLOWS FROM FINANCING ACTIVITIES
Net change in checks written in excess of bank balance		(1,200,000		)	250,000			700,000
Net change in line of credit		465,793			(3,294,824		)	1,615,867
Proceeds from long-term debt		2,540,926			636,502			788,944
Payments on long-term debt		(1,428,676		)	(1,111,995		)	(922,373		)
Payments of bond issue costs		(79,373		)	—			—
Issuance of stock		126,978			188,305			22,013
Excess tax benefits from stock-based awards		23,627			—			—
Net cash provided by (used in) financing activities		449,275			(3,332,012		)	2,204,451
Effect of exchange rate changes on cash		(124		)	(76,740		)	(5,591		)
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		(114,232		)	284,340			454,604
Cash and cash equivalents - beginning of year		840,123			555,783			101,179
CASH AND CASH EQUIVALENTS - END OF YEAR		$	725,891		$	840,123		$	555,783

 

See accompanying Notes to Consolidated Financial Statements.

34