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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2009

OR

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

For the transition period from                  to                

NORTECH SYSTEMS INCORPORATED

Commission file number 0-13257

State of Incorporation: Minnesota

IRS Employer Identification No. 41-1681094

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

Telephone number: (952) 345-2244

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

Indicate by check mark whether the registrant 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 Regulations 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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions 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 x

Number of shares of $.01 par value common stock outstanding at October 29, 2009 - 2,738,991

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

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PART 1

ITEM 1.  FINANCIAL STATEMENTS

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

See Accompanying Condensed Notes to Consolidated Financial Statements

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

See Accompanying Condensed Notes to Consolidated Financial Statements

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)

See Accompanying Condensed Notes to Consolidated Financial Statements

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)

See Accompanying Condensed Notes to Consolidated Financial Statements

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

See Accompanying Condensed Notes to Consolidated Financial Statements

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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

NOTE 1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

In June 2009, the Financial Accounting Standards Board (FASB) issued FASB Accounting Standards Codification (ASC) 105, Generally Accepted Accounting Principles, which establishes the FASB ASC as the sole source of authoritative generally accepted accounting principles.  Pursuant to the provisions of FASB ASC 105, we have updated references to generally accepted accounting principles (GAAP) in our consolidated financial statements issued for the period ended September 30, 2009.  The adoption of FASB ASC 105 did not impact our financial position or results of operation.

The accompanying unaudited consolidated financial statements for the interim periods have been prepared in accordance with GAAP for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission.  Accordingly, they do not include all of the financial information and footnotes required by GAAP for complete financial statements, although we believe the disclosures are adequate to make the information presented not misleading.  It is suggested that these consolidated financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in our latest shareholders’ annual report on Form 10-K.  The operating results for the interim periods presented are not necessarily indicative of the results expected for the full year or for any other interim period.  In our opinion, all adjustments (consisting of normal recurring and one-time adjustments) considered necessary for a fair presentation have been included.

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

We have evaluated the period after the balance sheet date up through November 4, 2009, which is the date that the consolidated financial statements were issued, and determined that there were no subsequent events or transactions that required recognition or disclosure in the consolidated financial statements.

Summary of Significant Accounting Policies

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

The accounting principles followed in the preparation of the consolidated financial information contained on Form 10-Q are the same as those described in our Annual Report on Form 10-K for the year ended December 31, 2008, some of which have been included herein.

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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 shipment of product 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.

Stock-Based Compensation

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

Restricted Stock

On March 7, 2006, 28,500 shares of restricted common stock were granted to our management and directors.  This benefit was valued at the market price of the stock on the date of grant.  These awards vested over a three-year term and were expensed ratably over the same period.  We recorded compensation expense of $17,475 and $52,425 for the three and nine months ended September 30, 2008.  All restricted shares were fully vested as of December 31, 2008, and as a result there was no compensation expense recorded for the three and nine months ended September 30, 2009.

Stock Options

Following is the status of all stock options as of September 30, 2009, including changes during the nine-month period then ended:

To calculate the fair value of option-based awards we used the Black-Scholes option-pricing model.  Our determination of fair value of option-based awards on the date of grant using the Black-Scholes model is affected by our stock price as well as assumptions regarding a number of subjective variables.  These variables include, but are not limited to the risk-free interest rate and our expected stock price volatility over the expected life of the options.  The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected life of our stock options.  The expected volatility and holding period of options are based on our historical experience.  For all grants, the amount of compensation expense to be recognized is adjusted for an estimated forfeiture rate, which is

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also based on historical data.  The variables used for the grants for the three and nine months ended September 30, 2009 and 2008 are below.  There were no grants issued during the three months ended September 30, 2009.

Stock Options with Time-Based Vesting

Total compensation expense related to stock options with time-based vesting for the three months ended September 30, 2009 and 2008 was $31,295 and $49,615, respectively.  Total compensation expense related to stock options with time-based vesting for the nine months ended September 30, 2009 and 2008 was $93,885 and $148,845, respectively.  At September 30, 2009 we have 360,750 time-based options outstanding.

As of September 30, 2009 there was approximately $90,000 of unrecognized compensation expense related to unvested option awards that we expect to recognize over a weighted-average period of 0.90 years.

Stock Options with Performance-Based Vesting

The vesting of certain options granted is conditional upon our achievement of established performance measurements. At September 30, 2009, management has estimated the probability of achieving any of the performance goals is less than 50% and therefore, no compensation expense has been recorded for the three and nine months ended September 30, 2009 and 2008.

As of September 30, 2009 we have 388,400 performance-based options outstanding.  At September 30, 2009 there was approximately $1,330,000 of unrecognized compensation expense available to be earned and expensed in future periods up through December 2009 on performance-based stock options.

Segment Reporting Information

For the three and nine months ended September 30, 2009 and 2008 all of our operations fall under the Contract Manufacturing segment within the Electronic Manufacturing Services 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, cash and risk management, banking, credit and collections, human resources, payroll, internal control, audit, taxes, SEC reporting and corporate accounting.  Export sales represented 4% of consolidated net sales for the three-month and nine-month periods ended September 30, 2009.  Export sales represented 5% and 4% of consolidated net sales for the three-month and nine-month periods ended September 30, 2008, respectively.

Long-lived assets by country are as follows:

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Finite Life Intangible Assets

Finite life intangible assets at September 30, 2009 and December 31, 2008 are as follows:

Amortization expense related to these assets is as follows:

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

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Fair Value of Financial Instruments

The carrying amounts of all financial instruments approximate their fair values.  The carrying amounts for cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities and the line of credit approximate fair value because of the short maturity of these instruments.  Based on the borrowing rates currently available to us for bank loans with similar terms and average maturities, the carrying value of our long-term debt approximates its fair value.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  Valuation techniques used to measure fair value maximize the use of observable inputs and minimize the use of unobservable inputs.

The fair value framework requires the categorization of assets and liabilities into one of three levels based on the assumptions (inputs) used in valuing the asset or liability.  Level 1 provides the most reliable measure of fair value, while Level 3 generally requires significant management judgment.  The three levels are defined as follows:

Our assessment of the significance of a particular input to the fair value measurements requires judgment, and may affect the valuation of the assets and liabilities being measured and their placement within the fair value hierarchy.  We endeavor to use the best available information in measuring fair value.  Assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.  As of September 30, 2009, our only asset or liability accounted for at fair value is our interest rate swap included in other long-term liabilities.  We have determined that the fair value of the swap, based on LIBOR and swap rates, falls within Level 2 in the fair value hierarchy.

NOTE 2.  PRINCIPLES OF CONSOLIDATION

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

NOTE 3. CONCENTRATION OF CREDIT RISK AND MAJOR CUSTOMERS

Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash and cash equivalents and accounts receivable.  With regard to cash and cash equivalents, we maintain our excess cash balances in checking accounts at two high-credit quality financial institutions.  These accounts may at times exceed federally insured limits.  We do not require collateral on our accounts receivable.  Historically, we have not suffered significant losses with respect to accounts receivable.

Two customers accounted for 10% or more of our net sales for the three-month and nine-month periods ended September 30, 2009 and 2008.  G.E.’s Medical Divisions accounted for 19% of net

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sales while GE’s Transportation Divisions accounted for 18% of net sales for the three months ended September 30, 2009.  GE’s Medical and Transportation Divisions combined accounted for 37% and 19% of net sales for the three-month periods ended September 30, 2009 and 2008, respectively.  For the nine-month periods ended September 30, 2009 and 2008, G.E.’s Medical and Transportation Divisions together accounted for 28% and 18% of net sales, respectively.  Accounts receivable from G.E.’s Medical and Transportation Divisions represented 21% of total accounts receivable at September 30, 2009.  Additionally, Northrop Grumman Corp. accounted for 9% and 15% of net sales for the three-month periods ended September 30, 2009 and 2008, respectively.  For the nine-month periods ended September 30, 2009 and 2008, Northrop Grumman Corp. accounted for 12% and 20% of net sales, respectively.  Accounts receivable from Northrop Grumman Corp. at September 30, 2009 represented 15% of total accounts receivable.

NOTE 4. FINANCING ARRANGEMENTS

On August 6, 2009 we entered into a second amended and restated credit agreement with Wells Fargo Bank (WFB), which provides for a line of credit arrangement of $12 million, which expires if not renewed, on June 30, 2010.  The credit arrangement also has a real estate term note with a maturity date of May 31, 2012.  The line of credit and real estate term note 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.  Both the line of credit and real estate term note are subject to variations in LIBOR rates.  We believe our financing arrangements and anticipated cash flows from operations will be sufficient to satisfy our working capital needs.

NOTE 5.  DERIVATIVE INSTRUMENTS AND HEDGING STRATEGIES

We are exposed to interest rate risk associated with fluctuations in the interest rates on our variable interest rate debt.  In order to manage some of the risk, we have entered into an interest rate swap agreement with a notional amount of $1.4 million with a goal to effectively convert our industrial revenue bond debt from a variable rate to a fixed rate of 4.07% for five years, maturing on June 28, 2011.  We do not use this interest rate swap for speculative purposes.  The fair value of the swap of approximately $52,000 and $65,000 was recorded in other long-term liabilities at September 30, 2009 and December 31, 2008 respectively.  The change in fair value of $5,000 and $13,000 for the three and nine-month periods ended September 30, 2009, respectively, was recorded as a component of interest expense.  The change in fair value for the three and nine-months ended September 30, 2008 were $6,000 and $10,000, respectively.

NOTE 6. NET INCOME (LOSS) PER COMMON SHARE

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

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For the nine-month period ended September 30, 2009, the effect of all stock options is antidilutive due to the net loss incurred and, therefore, they were not included in the computation of per-share amounts.  For the nine-month period ended September 30, 2008, 15,744 shares were excluded from the computation of diluted earnings per share because to include them would be antidilutive.

NOTE 7.  INCOME TAXES

On a quarterly basis, we estimate what our effective tax rate will be for the full fiscal year and record a quarterly income tax provision based on the anticipated rate.  As the year progresses, we refine our estimate based on the facts and circumstances by each tax jurisdiction.  The effective tax rates for the quarters ended September 30, 2009 and 2008 were 38% and 40%, respectively.  The year to date effective tax rates for the nine months ended September 30, 2009 and 2008 were 38% and 39%, respectively.  The decrease in the third quarter effective tax rate from 2008 to 2009 relates primarily to the additional credits taken upon the finalization of our 2008 research and experimentation (R&E) study and tax return.

At September 30, 2009 we had $109,000 of net uncertain tax benefit positions recorded in other long-term liabilities that would reduce our effective income tax rate if recognized.  The $20,000 increase from December 31, 2008 was the result of increases of $47,000 related to restricted stock deductions and $15,000 related to R&E credits, offset by $42,000 in 2005 R&E and Section 199 deductions whose statute of limitations expired.

NOTE 8. COMPREHENSIVE INCOME (LOSS)

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

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NOTE 9. RESTRUCTURING AND IMPAIRMENT CHARGES

To better align our cost structure with recent changes in customer demand, our Board of Directors approved a restructuring plan in the second quarter of fiscal year 2009.  This restructuring resulted in the closing of our Garner, Iowa facility at the end of August 2009 with production moving to Merrifield, Minnesota and closing our Fairmont Aerospace assembly production facility and moving these activities to Blue Earth, Minnesota.  As a result of these moves, we recognized approximately $0.4 million and $1.0 million of restructuring and impairment charges during the three months and nine months ended September 30, 2009, respectively, in Income (Loss) from Operations.

The restructuring and impairment costs included $0.5 million of non-cash property and equipment charges and $0.5 million in cash charges related to employee benefits, contract termination costs, and other expenses incurred to relocate production.  The property and equipment impairment charges are for certain assets identified that will no longer be used in our operations as a result of the restructuring. The table below sets forth the significant components and activity in the restructuring during the three months and nine months ended September 30, 2009:

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At September 30, 2009, accrued liabilities of approximately $87,000 related to the restructuring remain and are expected to be paid over the next nine months.

All restructuring activities were completed in the third quarter.  At this time, we do not foresee any additional restructuring activities.

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

Overview:

We are a Wayzata, Minnesota based full-service Electronics Manufacturing Services (EMS) contract manufacturer of wire and cable assemblies, printed circuit board assemblies, higher-level assemblies and box builds for a wide range of industries.  We provide value added services and technical support including design, testing, prototyping and supply chain management to customers mainly in the industrial equipment and transportation, vision, medical and military/defense industries. We maintain manufacturing facilities in Baxter, Bemidji, Blue Earth, Fairmont, and Merrifield, Minnesota, Augusta, Wisconsin, and Monterrey, Mexico.

During the nine months of 2009, we experienced a period of declining growth from the overall poor global economy that resulted in a negative impact on our financial performance.  The reduction in revenue led us to implement a restructuring of our operations to match resources with current demand levels as discussed in Note 9.  At this time we do not foresee any additional restructuring activities, we will continue to assess market conditions and evaluate the need for any additional actions but it appears that our level of business has stabilized.

Our third quarter revenue was down only 6% compared to second quarter levels, as we continue to see some stabilization with our customer demand.  We have also begun to see improvements in our Loss

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from Operations, before restructuring charges due to the cost reduction and capacity adjustment initiatives, improving our gross margin by three percentage points over the second quarter.

Summary of Results:

For the quarter ended September 30, 2009, we reported net sales of $18.7 million compared to $31.7 million reported in the same quarter of 2008, a 41% decline year over year.  We continue to see stabilization in our top line as third quarter sales were down only slightly compared to second quarter sales.  The gross profit percentage was 8.7% and 13.6% for the third quarter of 2009 and 2008, respectively.  Our gross profits were heavily impacted by lower production volume, resulting in the under utilization of our manufacturing facilities.  The cost reductions and capacity restructuring initiative are beginning to take hold as we saw continued improvement in the gross margin percentage over second quarter.  The full impact of the cost savings from these events will not be realized until the fourth quarter.

Loss from operations for the third quarter of 2009 totaled $1.1 million, including one-time restructuring and impairment charges, or $0.8 million excluding one-time restructuring and impairment charges compared to income from operations of $0.9 million reported in the third quarter of 2008.  The 2009 third quarter loss, before restructuring costs, improved 48%, on lower revenue, when compared to the second quarter.  Loss from operations for the first nine months of 2009 totaled $5.5 million compared to income from operations of $3.3 million reported in the first nine months of 2008.

Net loss for the third quarter of 2009 totaled $0.9 million or $(0.31) per diluted common share, or $(0.23) excluding one-time restructuring and impairment charges, compared to net income of $0.5 million, or $0.18 per diluted common share, reported in the third quarter of 2008.  Net loss for the nine months ended September 30, 2009 totaled $3.7 million, or $(1.35) per diluted common share, or $(1.13) excluding one-time restructuring and impairment charges, compared to net income of $1.7 million, or $0.61 per diluted common share for the nine months ended September 30, 2008.  The impact of the one-time restructuring charges per diluted common share was $(0.08) and $(0.22) for the three and nine months ended September 30, 2009.

Net cash used in operating activities for the first nine months of 2009 was $2.6 million but the net cash provided over the past six months has been positive $0.5 million as we focused on improving operating profit, working capital and operating cash flows.

(1.) Results of Operations:

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

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Net Sales:

We reported net sales of $18.7 million and $31.7 million for the quarters ended September 30, 2009 and 2008, respectively.  Net sales for the nine months ended September 30, 2009 and 2008 were $60.1 million and $94.9 million respectively.  Aerospace and Defense sales for the three-months ended September 30, 2009 were down 63%, Medical sales were down 11%, and Industrial sales were down 30% compared to the three-months ended September 30, 2008.  For the nine-months ended September 30, 2009, Aerospace and Defense sales were down 41%, Medical sales down 11% and Industrial sales were down 40% compared to the same period in 2008.  Aerospace and Defense sales were down due to the end of major contracts and the timing of other new replacement business.  The slow economy has caused lower Medical and Industrial sales, with a larger impact on Industrial sales.  Net sales by industry markets for the three and nine month periods ended September 30, 2009 and 2008 are as follows: