| **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, 2005** |
|                                                 | **OR** |
| **o**                                                | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE** |
| **SECURITIES EXCHANGE ACT OF 1934**                  |

**For the transition period from                                   to                                **

**NORTECH SYSTEMS INCORPORATED**

**Commission file number 0-13257**

State of Incorporation: **Minnesota**

IRS Employer Identification No.**41-1681094**

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

Telephone number: **(952) 345-2277**

Securities registeredpursuant to Section 12(b) of the Act:       **None**

Securitiesregistered pursuant to Section 12(g) of the Act:

**CommonStock, Par Value $.01 Per Share**

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes oNo x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or15(d) of the Act. Yes oNo x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes xNo o

Indicate by check mark ifdisclosure 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 informationstatements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. x

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act). Yes oNo x

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes oNo x

The aggregate market valueof voting stock held by non-affiliates of the registrant, based on the closingprice of $6.31 per share, was $7,611,210 on June 30, 2005.

Shares of common stockoutstanding at March 6, 2006: 2,618,197.

(Theremainder of this page was intentionally left blank.)

 

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**DOCUMENTS INCORPORATED BY REFERENCE**

The following documents are incorporated by referenceto 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 |   |
|                                                          | 11            |                                                   |       | with the 2005 Annual Shareholders’ Meeting and filed with the  Securities and |   |
|                                                          | 12            |                                                   |       | Exchange Commission no later than April 30, 2006 |   |
|                                                          | 13            |                                                   |       |   |   |

 

(The remainder ofthis page was intentionally left blank)

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**NORTECHSYSTEMS INCORPORATEDANNUAL REPORT ON FORM 10K**TABLE OF CONTENTS

|                 | ** ** | ** **                                                                                                         | ** ** | **PAGE** | ** ** |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| *PART I*   |       |                                                                                                               |       |     |       |
| Item  1.        |       | Business                                                                                                           |       | 4-7      |       |
| Item  1A.       |       | Risk Factors                                                                                                       |       | 7        |       |
| Item 1B.        |       | Unresolved Staff Comments                                                                                          |       | 8        |       |
| Item  2.        |       | Properties                                                                                                         |       | 8        |       |
| Item  3.        |       | Legal Proceedings                                                                                                  |       | 9        |       |
| Item 4.         |       | Submission of Matters to a Vote of Security Holders                                                                |       | 9        |       |
| *PART II*  |       |                                                                                                               |       |     |       |
| Item 5.         |       | Market For Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       | 10       |       |
| Item 6.         |       | Selected  Financial Data                                                                                           |       | 11       |       |
| Item 7.         |       | Management’s Discussion and Analysis                                                                          |       | 11-17    |       |
| Item 7a         |       | Quantitative and Qualitative Disclosure about Market  Risk                                                         |       | 18       |       |
| Item 8.         |       | Consolidated Financial Statements and Supplemental  Data                                                           |       | 19-44    |       |
| Item 9.    |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                              |       | 44-45    |       |
| Item 9A.        |       | Controls and Procedures                                                                                            |       | 45       |       |
| Item 9B.        |       | Other  Information                                                                                                 |       | 45       |       |
| *PART III* |       |                                                                                                               |       |     |       |
| Item 10.        |       | Directors and Executive Officers of the Registrant                                                                 |       | 45       |       |
| Item 11.        |       | Executive Compensation                                                                                             |       | 45       |       |
| Item 12.        |       | Security Ownership of Certain Beneficial Owners and  Management                                                    |       | 45-46    |       |
| Item 13.        |       | Certain Relationships and Related Transactions                                                                     |       | 46       |       |
| Item 14.        |       | Principal Accountant Fees and Services                                                                             |       | 46       |       |
| *PART IV*  |       |                                                                                                               |       |     |       |
| Item 15.        |       | Exhibits, Consolidated Financial Statement Schedules                                                               |       | 46-47    |       |
|            |       | Signatures                                                                                                         |       | 48       |       |
|            |       | Index to  Exhibits                                                                                                 |       | 49       |       |

 

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**NORTECH SYSTEMS INCORPORATEDFORM 10-KFor the Year Ended December 31, 2005PART   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 documentswith the Securities Exchange Act of 1934 (Exchange Act). Prior to December 1990,we operated as DSC Nortech, Inc., who filed a petition for reorganizationunder Chapter 11 of the United States Bankruptcy Code during 1990. The businessand assets of DSC Nortech, Inc. were transferred to us during 1990.

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

We make available free ofcharge through our Internet website (http://www.nortechsys.com) our AnnualReport 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, asuburb of Minneapolis, Minnesota. We maintain manufacturing facilities inMinnesota including Bemidji, Fairmont, Blue Earth, Baxter, and Merrifield aswell as Augusta, Wisconsin, and Monterrey, Mexico. We manufacture wire harnessand cable assemblies, electronic sub-assemblies, and printed circuit boardassemblies. We provide value added services and technical support includingdesign, testing, prototyping and supply chain management. The majority of ourrevenue is derived from products built to the customer’s design specifications.

We provide a high degree of manufacturing expertiseusing statistical process controls to ensure product quality, total supplychain solution techniques and the systems necessary to effectively manage thebusiness. This level of sophistication enables us to attract major originalequipment manufacturers (OEMs) and to expand and diversify our customer base.  Our strategy is to develop a customer baseacross several markets to avoid the effects of fluctuations within a givenindustry. The major markets we serve are Industrial Equipment, Medical,Military/Defense and Transportation and to a lesser extent the food,communications, consumer and computers industries.

We believe the currentgrowth and expansion trends for contract manufacturing and the EMS (ElectronicManufacturing Services) industry will continue both in the United States andoverseas. OEM outsourcing will continue to escalate as more companies focustheir investments on Marketing and Development of their products and rely moreon EMS providers for their production and supply chain requirements.

**ACQUISITIONS**

On June 23, 2004, weacquired all of the business assets of Zachariah and Lundbergh, Inc.(Z&L). This acquisition of assets allows for further expansion of ourInterconOne brand of specialty cable and power supplies for use in industrialand medical grade video cameras and ancillary equipment. (See Note 4 forfurther information)

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**BUSINESS SEGMENTS**

All of our operations fallunder the Contract Manufacturing segment within the Electronic ManufacturingServices industry.

**BUSINESS STRATEGY**

The Electronic Manufacturing Services industrycontinues to evolve from a small job shop oriented business into a dynamic,higher tech global electronics contract services industry. We continue toexpand our capabilities to better meet these changing market requirements.Along with adding technical expertise in our quality processes, design,applications and testing, we are also increasing our focus on supplier-managedinventory services and the cost drivers throughout the supply chain. Wecontinue to expand our international operations and partnerships to takeadvantage of lower-cost alternatives for our customers and to remain competitivein the marketplace when required.

Our quality systems and processes are based on ISOstandards with all our domestic and Monterrey, Mexico facilities certified tothe latest version of the ISO 9001 standards. We believe these certificationsbenefit our customer base and increase our chances on attracting new businessopportunities.

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

**MARKETING**

We concentrate our marketing efforts in the industrialequipment, medical, military/defense and transportation industries. Ourmarketing strategy emphasizes the breadth of our manufacturing, supply chainand engineering services and reflects the one-stop solution for meeting ourcustomers’ current and future requirements.

The emphasis continues tobe on mature companies, which require a contract manufacturer with a highdegree of manufacturing and quality sophistication, including statisticalprocess control (SPC), statistical quality control (SQC), InternationalStandards Organization (ISO), Military (Mill Spec) Specifications and AerospaceSystems 9100 (AS). We have initiated efforts to penetrate our existing customerbase and expand new market opportunities in Mexico, Asia and Europe, as well asincreased participation in industry publications and selected trade shows. Wetarget customers who value proven manufacturing performance, design andapplication engineering expertise and who value the flexibility to manage thesupply chain of a high mix of product and service. We market our products andservices through our in-house sales force and independent manufacturers’representatives.

**SOURCESAND AVAILABILITY OF MATERIALS**

We are not dependent onany one supplier for materials for products sold to customers. Componentsutilized in the assembly of wire harnesses, cable assemblies and printedcircuit assemblies are purchased directly from the component manufacturers orfrom their distributors. On occasion some components may be placed on astringent allocation basis; however, due to the excess manufacturing capacitycurrently available at most component manufacturers, we do not anticipate anymajor material purchasing or availability problems occurring in the foreseeablefuture.

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**PATENTS AND LICENSES**

We are not presentlydependent on a proprietary product requiring licensing, patent, copyright ortrademark protection. There are no revenues derived from a service-relatedbusiness for which patents, licenses, copyrights and trademark protection arenecessary for successful operations.

**COMPETITION**

The contract manufacturing EMS industry competitivemakeup includes small closely held contract manufacturing companies, largefull-service contract manufacturers, company-owned manufacturing facilities andforeign contract manufacturers. We do not believe that the small closely heldoperations pose a significant competitive threat in the markets and customerswe serve, as they generally do not have the complete manufacturing services orcapabilities required by our target customers. We believe the larger domesticfull service and foreign manufacturers do provide a substantial competitiveenvironment while the company-owned operations create an increasing opportunityas the trend of more outsourcing continues. Technical support from foreigncompetition has improved greatly along with their ability to be more responsiveto engineering and schedule changes. The willingness of foreign manufacturersto “stock” finished product at warehouse locations in the United States isanother of their competitive advantages, however, their inability to react toengineering, product or schedule changes is a disadvantage and plays into ourstrength. To mitigate foreign competition, we maintain a contractual agreementallowing us to provide a China manufacturing solution and we operate amanufacturing operation in Mexico to support our customers with a “Low Cost”supply chain solution.

We continue to pursueacquisitions, mergers, and/or joint ventures of companies in the EMS industriesto both remain competitive and grow our customer and revenue base. Ourstrategic objectives and our history have been based on both organic andacquired growth.

**BACKLOG**

Historically, our backloghas been running 60 to 90 days. However, because of the increased emphasis onjust-in-time manufacturing (JIT), reduced lead times and repetitive scheduling,our historical backlog levels may not be indicative of future results. As of December 31,2005 our 90-day order backlog was approximately $24.9 million compared toapproximately $14.5 million on December 31, 2004. We expect a majorportion of the backlog will be realized as revenue during first quarter 2006.

**MAJOR CUSTOMERS**

Two divisions of G.E.combined account for 10% or more of our net sales during 2005. G.E.’s Medical andTransportation Divisions together accounted for 17%, 15% and 23% of sales forthe years ended December 31, 2005, 2004 and 2003, respectively. Additionally,Northrop Grumman accounted for 10% of net sales in 2005. Historically, we havenot experienced significant losses on customer receivable collections in anyparticular industry or geographic area.

**RESEARCH AND DEVELOPMENT**

We perform research anddevelopment for customers on an as requested and program basis for developmentof conceptual engineering and design activities prior to manufacturing theproducts. We did not expend significant dollars in 2005, 2004 or 2003 oncompany-sponsored product research and development.

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**ENVIRONMENTAL LAW COMPLIANCE**

We believe that ourmanufacturing facilities are currently operating under compliance with local,state, and federal environmental laws. We have incurred and plan to continueincurring, the necessary expenditures for compliance with applicable laws. Anyenvironmental-oriented equipment is capitalized and depreciated over aseven-year period. The annualized depreciation expense for this type ofenvironmental equipment is insignificant.

**EMPLOYEES**

We have 785 full-time, 70part-time and 161 temporary employees as of December 31, 2005. Manufacturingpersonnel, including direct, indirect support and sales functions, comprise 980employees, while general administrative employees total 36.

**FOREIGN OPERATIONS AND EXPORT SALES**

Wehave a leased manufacturing facility in Monterrey, Mexico with approximately$886,000 in long-term assets. Export sales represent 5%, 5% and 2% ofconsolidated sales for the years ended December 31, 2005, 2004 and 2003,respectively.

**ITEM 1A.   RISK FACTORS**

The following are risk factors known to us that couldaffect our business, financial condition and/or operating results.

We purchase raw materials, commodities and componentsfor use in our production. Increased costs of these materials could have anadverse affect on our production costs if we are unable to pass along priceincreases or reduce the other cost of goods produced through cost improvementinitiatives. Fuel and energy cost increases could also adversely affect ourfreight and operating costs.

We do face through the normal course of businessexcess and obsolete inventory losses as a result of customer order changes,cancellations, product changes and contract termination. We estimate andreserve for any known or potential impact from these possibilities.

The manufacture and sale of our products carriespotential risk for product liability claims. We represent and warrant the goodsand services we deliver are free from defects in material and workmanship forone year (1) from ship date. Unless otherwise agreed to, workmanship shallbe in accordance with IPC and ANSI/J- Standards such as IPC-A-610, class2, IPC—A-620, class 2, ANSI/J-STD001, class 2, C-20. We make noother guarantees or warranties, expressed or implied, of any nature whatsoeveras to the goods including without limitation, warranties to merchantability,fit for a particular purpose or non-infringement of patent or the like unlessagreed upon in writing. If a product liability claim results in us being liableand the amount is in excess of our insurance coverage or there is no insurancecoverage for the claim then it could have a negative impact on our business andfinancial position.

Our strategy is to growour business organically and through acquisitions, alliances and joint venturearrangements. In June 2002, we acquired Manufacturing Assembly Solutionsof Monterrey, Inc. (MAS), a Mexican corporation, located in Monterrey,Mexico. The benefits of this acquisition has taken more time then expected tointegrate into our marketing strategies.

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**ITEM 1B.   UNRESOLVED STAFF COMMENTS**

**Not Applicable**

**ITEM 2.   PROPERTIES**

**ADMINISTRATION**

Our Corporate Headquartersconsist of approximately 3,648 square feet located in Wayzata, Minnesota, awestern suburb of Minneapolis, Minnesota. The Corporate Headquarters has a leasewith a five-year term that expires on July 31, 2010. A portion of theBemidji facility is used for corporate financial and information sharedservices.

**MANUFACTURING FACILITIES**

We own our Bemidji, Minnesota facility consisting ofeight acres of land and a building of approximately 69,300 square feet where55,800 square feet is designated for manufacturing space of which 90% isutilized and the remaining space is used for offices. We also lease a 6,000square foot warehouse in Bemidji, Minnesota. We believe the productive capacityis sufficient, and the buildings are both suitable and adequate to handle ourforeseeable manufacturing needs.

We own our Augusta, Wisconsin facility consisting offive acres of land and a building of approximately 20,000 square feet where15,000 square feet is designated for manufacturing space of which 80% isutilized and the remaining space is used for offices. We believe the productivecapacity is sufficient, and the building is both suitable and adequate tohandle our foreseeable manufacturing needs.

We own three buildings in Fairmont, Minnesota, whichtogether contain approximately 51,000 square feet where 38,000 square feet isdesignated for manufacturing space of which 95% is utilized, and the remainingspace is used for offices. As foreseeable productions needs for this facilityhave increased, we entered into an agreement in November 2005 to lease20,000 square feet of a building located in Blue Earth, Minnesota, to be usedfor manufacturing space effective December 1, 2005. Presently, all 20,000square feet of leased space is designated for manufacturing space, of which 60%is being utilized. The lease, which has a 90-day option to renew, expiresas of March 31, 2006. At the end of December 2005, we signed anagreement to purchase the entire 140,000 square foot Blue Earth, Minnesotabuilding, the closing is scheduled for June 2006, with the seller havingthe option to lease back from us 50,000 square feet through the first quarterof 2007. We believe the productive capacity is sufficient, and the buildingsare all suitable and adequate to handle our foreseeable manufacturing needs.

We own a building in Merrifield, Minnesota, consistingof approximately 45,800 square feet where 33,800 square feet is designated formanufacturing of which 50% is being utilized and the remaining space is usedfor offices and warehouse. We believe the productive capacity is sufficient,and the building is both suitable and adequate to handle our foreseeablemanufacturing needs.

We lease two buildings in Baxter, Minnesota where welease 8,700 square feet in one building and 8,300 square feet in the otherbuilding for electronic board repair for medical equipment of which 75% oftotal leased space is being utilized.  The leases, which have a 5-year renewaloption, are scheduled to expire on June 30, 2006 and January 31, 2007.We believe the productive capacity is sufficient, and the building is bothsuitable and adequate to handle our foreseeable manufacturing needs.

We lease a 15,000 squarefoot building in our Monterrey, Mexico where 13,500 square feet is designatedfor manufacturing space of which 60% is being utilized and the remaining spaceis used for offices. We believe the productive capacity is sufficient, and thebuilding is both suitable and adequate to handle our foreseeable manufacturingneeds. The lease expires in June 2007, and we plan on exercising theadditional three-year option at that time.

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**ITEM 3.   LEGAL PROCEEDINGS**

From time to time, we areinvolved in ordinary, routine or regulatory legal proceedings incidental to thebusiness. When a loss is deemed probable and reasonably estimable an amount isrecorded in our financial statements. We currently are not a party to anymaterial legal proceeding.

**ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

None.

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**PART II**

**ITEM 5.**                MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

As of March 6, 2006, there were 846 shareholdersof record. Our stock is listed on the National Association of SecuritiesDealers 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 foreseeablefuture. Stock price comparisons follow.

Stockprice comparisons (NASDAQ):

| ** **                     | ** ** | **Low** | ** ** | **High** | ** ** |
|--------------------------------|------------|---------|------------|----------|------------|
| During the Three Months  Ended |       |    |       |     |       |
| 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 |   |
| March 31, 2004            |       | $       | 6.33       |     | $          | 9.13 |   |
| June 30, 2004             |       | $       | 6.55       |     | $          | 8.21 |   |
| September 30, 2004        |       | $       | 4.83       |     | $          | 7.93 |   |
| December 31,  2004        |       | $       | 5.00       |     | $          | 6.53 |   |

 

**EQUITYCOMPENSATION PLAN INFORMATION**

Certain information withrespect to our equity compensation plans are contained in Part III, Item12 of this Annual Report on Form 10-K.

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**ITEM 6.**                SELECTEDFINANCIAL DATA

Thefollowing selected historical financial data have been derived from, and arequalified by reference to the audited Consolidated Financial Statements ofNortech Systems Incorporated and Subsidiary as of December 31, 2005 and2004 and for each of the years ended December 31, 2005, 2004 and 2003. Theaudited consolidated financial statements of Nortech Systems Incorporated andSubsidiary referred to above are included elsewhere herein. The selectedhistorical financial data set forth below as of December 31, 2003, 2002and 2001 and for each of the years ended December 31, 2002 and 2001 havebeen derived from the audited consolidated financial statements of NortechSystems Incorporated and Subsidiary not included herein. The selected financialdata set forth below should be read in conjunction with, and are qualified byreference to, “Management’s Discussion and Analysis of Financial Condition andResults of Operations” and the Consolidated Financial Statements andaccompanying notes thereto of Nortech Systems Incorporated and Subsidiaryincluded elsewhere herein.

| ** **                                                             | ** ** | **2005**    | ** ** | **2004**    | ** ** | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** |
|------------------------------------------------------------------------|------------|-------------|------------|-------------|------------|------------|------------|------------|------------|------------|------------|
| **Year ended December 31:**                                       |       |        |       |        |       |       |       |       |       |       |       |
| Net Sales                                                              |       | $           | 84,215,663 |        | $          | 72,674,159 |       | 57,958,698 |       | $          | 60,655,579 |   | $ | 58,460,589 |   |
| Gross Profit                                                           |       | 10,032,228  |       | 8,538,973   |       | 6,494,976  |       | 10,519,536 |       | 10,446,345 |       |
| Net Income                                                             |       | 928,781     |       | 587,329     |       | 633,448    |       | 2,403,112  |       | 2,102,863  |       |
| Basic Earnings From Continuing Operations Per Share  of Common Stock   |       | .36         |       | .23         |       | .26        |       | 1.00       |       | .89        |       |
| Diluted Earnings From Continuing Operations Per  Share of Common Stock |       | .36         |       | .23         |       | .25        |       | .95        |       | .86        |       |
| **At December 31:**                                               |       |        |       |        |       |       |       |       |       |       |       |
| Total Assets                                                           |       | 39,668,551  |       | 36,881,608  |       | 31,580,790 |       | 29,602,400 |       | 29,507,538 |       |
| Working Capital                                                        |       | *12,214,328 |       | *11,749,991 |       | 16,723,263 |       | 14,266,058 |       | 14,459,344 |       |
| Total Long-Term Debt                                                   |       | *2,714,227  |       | *3,399,210  |       | 9,643,336  |       | 8,580,944  |       | 9,791,722  |       |
| Shareholders’  Equity                                             |       | 16,653,364  |       | 15,516,581  |       | 14,321,280 |       | 13,090,130 |       | 10,571,793 |       |
|                                                                        |            |             |            |             |            |            |            |            |            |            |            |  |  |  |  |

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*                    In2004, the revolving line of credit, with outstanding borrowings of $7,523,058,was classified in current liabilities. In the previous years these amounts hadbeen reflected as long-term. As of December 31, 2005, the revolving lineof credit had outstanding borrowings of $4,228,234 and is also classified as acurrent liability. For additional financial data (2005 and 2004 by quarterinformation), see Note 12 of the Consolidated Financial Statements.

**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

**FORWARD-LOOKING STATEMENTS**

This Annual Reporton Form 10-K contains forward-looking statements within the meaningof the Private Securities Litigation Reform Act of 1995. Such statementsgenerally 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 arebased upon a number of assumptions concerning future conditions, any or all ofwhich may ultimately prove to be inaccurate. Forward-looking statements involvea number of risks and uncertainties. Important factors that could cause actualresults to differ materially from the forward-looking statements include,without limitation:

·       Volatilityin the marketplace which may affect market supply and demand of our products;

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·       Increasedcompetition;

·       Changesin the reliability and efficiency of our operating facilities or those of thirdparties;

·       Risksrelated to availability of labor;

·       Increasein certain raw material costs such as copper

·       Commodityand Energy cost instability

·       Generaleconomic, financial and business conditions that could affect our financialcondition and results of operations.

The factors identifiedabove are believed to be important factors (but not necessarily all of theimportant factors) that could cause actual results to differ materially fromthose expressed in any forward-looking statement made by us. Unpredictable orunknown factors not discussed herein could also have material adverse effectson forward-looking statements. All forward-looking statements included in this Form 10-Kare 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 informationor future events.

**OVERVIEW**

We are a Wayzata, Minnesota based full-serviceElectronics Manufacturing Services (EMS) contract manufacturer of wire andcable assemblies, printed circuit board assemblies, higher-level assemblies andbox builds for a wide range of industries. Markets served include industrial equipment, transportation, medical,military/defense, computer, recreation and food. In Minnesota, we havefacilities in Baxter, Bemidji, Blue Earth, Fairmont and Merrifield. We alsohave facilities in Augusta, Wisconsin, and Monterrey, Mexico.

The vast majority of ourrevenue is derived from products that are built to the customer’s designspecifications. We provide a high degree of manufacturing sophistication. During2005, we continued our supply chain initiatives designed to reduce costs,improve asset utilization and increase responsiveness to customers. Ourstrategy has been to expand and diversify our customer base, and we arefocusing our sales and marketing approach to target greater value-added serviceopportunities. Our market strength is low-volume, high-mix production,particularly with complex products. Our investment in the Mexico operation in2002 allows for expansion into medium volume, medium mix and lower costproduction and our contractual arrangements with Chinese manufacturers allow usto meet high-volume, low mix and lower cost customer requirements.

**CRITICALACCOUNTING POLICIES AND ESTIMATES**

Our significant accountingpolicies and estimates are summarized in the footnotes to our annualconsolidated financial statements. Some of the accounting policies require usto exercise significant judgment in selecting the appropriate assumptions forcalculating financial estimates. Such judgments are subject to an inherentdegree of uncertainty. These judgments are based on historical experience,known trends in the industry, terms of existing contracts and other informationfrom outside sources, as appropriate. Actual results may differ from theseestimates under different assumptions and conditions. Certain of the mostcritical policies that require significant judgment are as follows:

*RevenueRecognition:*

Werecognize revenue upon shipment of products to customers, when title haspassed, all contractual obligations have been satisfied and collection of theresulting receivable is reasonably assured. In the normal course of business weenter into a number of contracts with customers under which we provide 

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engineering services on a per project basis. Revenue forthese services is recognized upon completion of the engineering process,usually upon initial shipment of the product. Revenues from repair services arerecognized upon shipment of related equipment to customers.

*Allowance for UncollectibleAccounts:*

We analyze accountsreceivable, historical write-offs of bad debts, customer concentrations,customer credit-worthiness, current economic trends and changes in customerpayment terms when evaluating the adequacy of the allowance for uncollectibleaccounts. We maintain an allowance for doubtful accounts at an amount estimatedto be sufficient to provide adequate protection against losses resulting fromcollecting less than full payment on receivables. A considerable amount ofjudgment is required when assessing the realizability of receivables, includingassessing the probability of collection and the current credit-worthiness ofeach customer. If the financial condition of our customers was to deteriorate,resulting in an impairment of their ability to make payments, an additionalprovision for uncollectible accounts may be required. We have not experiencedsignificant bad debts expense and the reserve for uncollectible accounts of$297,000 is considered adequate for any exposure to loss in the December 31,2005 accounts receivable.

*InventoryReserves:*

Inventoryreserves are maintained for the estimated value of the inventory that may havea lower value than stated or quantities in excess of future production needs. Wehave an evaluation process that is used to assess the value of the inventorythat is slow moving, excess or obsolete on a quarterly basis. We believe thetotal reserve of $1.2 million at December 31, 2005 is adequate.

*Long-Lived and Intangible AssetImpairment:*

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

The test for impairmentrequires us to make several estimates about fair value, most of which are basedon projected future cash flows. The estimates associated with the assetimpairment tests are considered critical due to the judgments required indetermining fair value amounts, including projected future cash flows. Changesin these estimates may result in the recognition of an impairment loss.

*Income taxes:*

Our estimate of the taxrates utilized in the calculation of the deferred tax balances is based onhistorical taxable income and expected future taxable income and correspondingrates. Further, our consideration of a valuation allowance for deferred taxassets is based upon estimates of taxable income in future periods and futurerealizability of these assets.

*Self-Insured Health Claim Accruals:*

We estimate our reserve for employee health claimsbased on health claims incurred, historical lag times and an analysis of claimsactivity during the period, while taking into consideration insurance limitsand coverage. We believe the total accrual of $271,000 at December 31,2005 is adequate.

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Based on a critical assessment of our accountingpolicies and the underlying judgments and uncertainties affecting theapplication of those policies, we believe that our consolidated financialstatements provide a meaningful and fair perspective of our financial position.This is not to suggest that other general risk factors, such as changes inworldwide 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 ofoperations and cash flows in future periods.

No matters have come toour attention since December 31, 2005 that would cause the estimatesincluded in the consolidated financial statements to change materially.

**OPERATING RESULTS**

The following table presents statement of operationsdata as percentages of total revenues for the indicated year:

| ** **                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net Sales                            |       |     | 100        | %        |       |     | 100        | % |   |   | 100 | % |   |
| Cost of Goods  Sold                  |       |     | 88         | %        |       |     | 88         | % |   |   | 89 | % |   |
| Gross Profit                         |       |     | 12         | %        |       |     | 12         | % |   |   | 11 | % |   |
| Selling Expenses                     |       |     | 4          | %        |       |     | 4          | % |   |   | 4 | % |   |
| General and  Administrative Expenses |       |     | 5          | %        |       |     | 6          | % |   |   | 6 | % |   |
| Income from Operations               |       |     | 3          | %        |       |     | 2          | % |   |   | 1 | % |   |
| Other Expenses,  Net                 |       |     | 1          | %        |       |     | 1          | % |   |   | 0 | % |   |
| Income Tax  Expense                  |       |     | 1          | %        |       |     | 0          | % |   |   | 0 | % |   |
| Net Income                           |       |     | 1          | %        |       |     | 1          | % |   |   | 1 | % |   |

 

*Revenues:*

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%. The Aerospace Systems division led the strong revenuegrowth in 2005 and accounts for 60% of the overall increase, followed byincreased revenue in Electronic Circuit Board Assembly division accounting for43% of the overall growth and a decrease of 3% for all other Cable &Wire divisions combined.

For the year ended December 31, 2003 sales were$58.0 million. In 2004 we saw our sales grow over 2003 by $14.7 million or25.4%. The Aerospace Systems division accounted for 37% of the overallincrease, the Electronic Circuit Board assembly division for 27% of the growthand our startup Mexico Cable & Wire assemble division accounted for22% of the overall growth over 2003 levels.

We continue to foreseegrowth rates stronger than the EMS industry average, which analysts project at11.4 percent through 2009. Our emphasis and focus will remain on mature OEMcompanies seeking total solution contract manufacturers such as us.

*Gross Profit:*

For the years ended December 31, 2005, 2004 and2003, we had gross profit of $10.0 million, $8.5 million and $6.5 million,respectively. Gross profits as a percentage of gross sales were 11.9%, 11.8%and 11.2% for the years ended December 31, 2005, 2004 and 2003,respectively. The 2005 gross profit dollar increase was favorably impacted byvolume and helped offset energy (Oil & Gas) and commodity (Copper)cost pressures throughout all of 2005.

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*Selling:*

Selling expenses were $3.2million or 3.8% of net sales for the year ended December 31, 2005, $3.2million or 4.3% of net sales for the year ended December 31, 2004, and$2.4 million or 4.1% of net sales for the years ended December 31, 2003. Thedecrease in selling expenses in 2005 from 2004 as a percentage of sales was aresult 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, 2005, 2004 and2003, general and administrative expenses were $4.7 million, $4.1 million and$3.3 million, respectively. The increase in general and administrative expensesof $0.6 million from 2004 is attributable to the increased investment ininfrastructure and employee related expenses, comprised primarily of $0.4million to support the growth and consolidation of corporate shared services(i.e. accounting, information services, and human resources). In addition,overall outside service costs increased $0.2 million and were related toincreased compliance requirements and process improvements

The increased general andadministrative expenses of $0.8 million from 2003 to 2004 related toinvestments made in infrastructure of $0.4 million, incentive compensation of$0.5 million and a reduction of other expenses of $0.1 million.

*Other Income (Expense)*:

Interest income for the years ended December 31,2005, 2004 and 2003 was approximately $2,500, $2,000, and $25,000, respectively.Miscellaneous income (loss) was ($70,000), $16,000 and $86,000 for the yearsended December 31, 2005, 2004 and 2003, respectively. In 2005, themajority of the miscellaneous loss is related to foreign currency transactionlosses.

Interest expense wasapproximately $646,000, $490,000, and $386,000 for the years ended December 31,2005, 2004 and 2003, respectively. In 2005, a steady increase in interest ratesthroughout the year accounted for the majority of the increased interestexpense. 2003 and 2004 saw favorable interest rates throughout the year andlower working capital requirements that kept interest expenses low.

*Income Taxes:*

Income tax expense(benefit) amounted to $465,000, $268,000, and ($123,000) for the years ended December 31,2005, 2004 and 2003, respectively. In 2005, the income tax rate was 33% and wasimpacted favorably by R & D tax credits of $81,000 and Section 199Deduction for Income Attributable to Domestic Production Activities of $60,000.In 2004 the income tax rate was 31% and was impacted favorably by R &D tax credits of $129,000. During 2003, we recorded $246,000 of net benefit fora refund claim relating to federal and state research and development taxcredits for tax years 1999, 2000 and 2001. A reconciliation of income taxexpense (benefit) for the years ending December 31, 2005, 2004 and 2003 isincluded in Note 6 to the consolidated financial statements.

*Net Income*:

Our net income in 2005 was$928,781 or $0.36 per diluted common share compared to $587,329 or $0.23 perdiluted common share in 2004. Our 2003 net income was $633,448, or $0.25 perdiluted common share. The changes in net income are the result of theaforementioned factors.

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**RECENTLYISSUED ACCOUNTING PRONOUNCEMENTS**

In March 2005, the FASBissued Interpretation No.47, or “FIN 47,” which clarifies terminology in FASBStatement No. 143, *Accounting for AssetRetirement Obligations*. FIN 47 clarifies when an entity hassufficient information to reasonably estimate the fair value of an assetretirement obligation. FIN 47 is effective for us in fiscal 2006. We do notexpect adoption of FIN 47 to have a material impact on our consolidatedfinancial statements.

In December 2004, the FASB issued SFAS No. 123R,Share-Based Payment. This statement revises SFAS No. 123, Accounting for Stock-BasedCompensation, and requires companies to expense the value of employee stockoptions and similar awards using the fair value method. The effective date ofthis standard is interim and annual periods beginning after June 15, 2005.FAS 123(R) allows two methods for determining the effects of thetransition: the modified prospective transition method and the modifiedretrospective method of transition. Although we have not fully analyzed theeffect this new statement will have on the consolidated financial statements inthe future, the pro forma net income effects of using a fair value method forthe past three fiscal years are presented in Note 1 to the consolidatedfinancial statements.

In November 2004, theFASB issued SFAS No. 151, Inventory Costs*,*an amendment of ARB No. 43, Chapter 4. The amendments made by the SFAS No. 151require that abnormal amounts of idle facility expense, freight, handling costsand wasted materials (spoilage) be recognized as current-period charges. ThisStatement requires the allocation of fixed production overhead to inventorybased on the normal capacity of production facilities. SFAS No. 151 iseffective for inventory costs incurred during fiscal years beginning after June 15,2005. We do not believe the adoption of SFAS No. 151 will have a materialeffect on our financial position or results of operations.

**FINANCIAL CONDITION AND LIQUIDITY**

Thefollowing are unaudited ratios:

| ** **                                                                             | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Current Ratio (Current Assets / Current Liabilities)                                   |       | 1.60                        |       | 1.65                        |       | 3.20                        |       |
| Working Capital (Current Assets - Current  Liabilities)                                |       | $                           | 12,214,328 |                        | $          | 11,749,991                  |       | $ | 16,723,263 |   |
| Quick Ratio (Cash + Accounts Receivable / Current Liabilities)                         |       | .75                         |       | .77                         |       | 1.44                        |       |
| Accounts Receivable to Working Capital (Average Accounts  Receivable/ Working Capital) |       | 1.14                        |       | 1.03                        |       | 0.55                        |       |
| Inventory  to Working Capital (Average Inventory/ Working Capital)                     |       | 1.23                        |       | 1.10                        |       | 0.72                        |       |
|                                                                                        |            |                             |            |                             |            |                             |            |  |  |  |

 

CashFlow:

| ** **                                            | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Cash flows provided by  (used in):                    |       |                        |       |                        |       |                        |       |
| Operating  Activities                                 |       | $                           | 5,120,151  |                        | $          | (324,130                    | )          | $ | (288,460 | ) |
| Investing  Activities                                 |       | (1,427,059                  | )          | (1,420,126                  | )          | (1,412,069                  | )          |
| Financing  Activities                                 |       | (3,332,012                  | )          | 2,204,451                   |       | 1,355,538                   |       |
| Effect of  exchange rate changes on cash              |       | (76,740                     | )          | (5,591                      | )          | (2,581                      | )          |
| Net increase (decrease)  in cash and cash equivalents |       | $                           | 284,340    |                        | $          | 454,604                     |       | $ | (347,572 | ) |

 

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On March 4,2005 we entered into an agreement with Wells Fargo Bank for a renewal andextension of our revolving line of credit. In addition to the extension of thematurity date, the financial covenants were modified and include minimumworking capital, tangible net worth and net income requirements, along withcertain other ratios. The availability under the line is subject to borrowingbase requirements, and advances are at the discretion of the lender. The lineis secured by substantially all of our assets. This commitment is summarized asdescribed below:

| **Other Commercial Commitment** | ** ** | ** ** | ** ** | **Total Amount  Committed** | ** ** | **Outstanding at  December 31, 2005** | ** ** | **Date of Expiration** | ** ** |
|-------------------------------------------|------------|------------|------------|----------------------------------|------------|------------------------------------------------------|------------|----------------------------------|------------|
| Line of credit                            |       |       | $          | 8,000,000                        |       |                                                 |       | $                                | 4,228,234  |   |   | January 31, 2007 |   |
|                                           |            |            |            |                                  |            |                                                      |            |                                  |            |  |  |  |  |  |  |

 

As of December 31, 2005, our cash and cashequivalent balances totaled $840,123.

On December 31, 2005, we had working capital ofapproximately $12.2 million as compared to $11.7 million at the end of 2004. During2005, we generated approximately $5.1 million of cash flow from operatingactivities. The cash flow from operations is the result of net income of $0.9million adjusted for noncash depreciation, amortization, foreign currencytransaction loss, and the change in deferred taxes, which totaled $1.4 millionin net positive adjustments, and the net increase in operating assets andliabilities of $2.8 million. The net increase in cash from changes in operatingassets and liabilities was primarily attributable to the increases in accountsreceivable of $1.1 million and inventory of $1.6 million, which were offset byan increase in accounts payable of $4.3 million due to the volume growth andextended terms and conditions with some of our key suppliers.

Our net cash flow from investing activities wascomprised of $1.4 million spent on capital asset purchases. The 2005 majorinvestments are related to tooling and operating equipment of $0.8 million tosupport our growth and software tools of $0.3 million for our corporate sharedservices areas, which enables us to meet additional compliance requirements.

Net cash used in financing activities of $3.3 millionconsisted primarily of paying down our line of credit by $3.3 million alongwith a net decrease in long-term debt of $0.5 million, which was offset by theincrease in our checks in excess of our bank balance of $0.3 million andissuance of shares of common stock of $0.2 million. Our liquidity and capitalresources are strong, and we believe that our future financial requirements canbe met with funds generated from the operating activities and our operatingline of credit.

Setforth below is information about our long-term contractual obligationsoutstanding as of December 31, 2005. It brings together data for easyreference from the consolidated balance sheet and from individual notes to theconsolidated financial statements. This information is important inunderstanding our financial position.

| ** **                         | ** ** | **Payments Due by Period** | ** ** |
|------------------------------------|------------|-------------------------------------------|------------|
| ** **                         | ** ** | **Less than 1 Yr**         | ** ** | **2 - 3 Yrs** | ** ** | **4 - 5 Yrs** | ** ** |
| Notes Payable                      |       |                                      | $          | 4,228,234 |   |   | $ | — |   | $ | — |   |
| Long-term Debt                     |       |                                      | 1,207,305  |   |   | 2,714,227 |   | — |   |
| Operating Leases                   |       |                                      | 322,614    |   |   | 353,382 |   | 183,759 |   |
| Real Property  Purchase Commitment |       |                                      | 1,350,000  |   |   | — |   | — |   |
| Equipment  Purchase Commitments    |       |                                      | 352,626    |   |   | — |   | — |   |
| Total Contractual  Obligations     |       |                                      | $          | 7,460,779 |   |   | $ | 3,067,609 |   | $ | 183,759 |   |

 

For above Real PropertyPurchase Commitment for $1,350,000, we intend to issue an Variable Rate DemandIndustrial Development Revenue Bond through the City of Blue Earth, MN, securedby an Irrevocable Letter of Credit to be issued by Wells Fargo Bank, NationalAssociation.

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From time to time, weenter into purchase commitments with our suppliers under customary purchaseorder terms. Any significant losses implicit in those contracts will berecognized in accordance with generally accepted accounting principles. At December 31,2005, no such losses existed.

**ITEM 7a.   QUALITATIVE AND QUANTITATIVE DISCLOSUREABOUT MARKET RISK**

Market risk is thepotential change in an instrument’s value caused, for example, by fluctuationsin interest and currency exchange rates. Our primary market risk exposures areinterest rate and unfavorable movements in exchange rates between the U.S.dollar and the Mexican peso. Monitoring and managing these risks is a continualprocess carried out by senior management. Market risk is managed based on anongoing assessment of trends in interest rates, foreign exchange rates, andeconomic developments, giving consideration to possible effects on both totalreturn and reported earnings. Our financial advisors, both internal andexternal, provide ongoing advice regarding trends that affect management’sassessment.

*Exchange Rate Sensitivity:*

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

*Interest Rate Sensitivity*:

The effective interest rate on our credit facilitiesare influenced by the actions of the Federal Reserve in establishing from timeto time the Federal Funds Interest Rate which is the rate banks borrow from theFederal Reserve Bank. During 2003 and 2002, the Federal Reserve implemented anumber of reductions in the Federal Funds Interest Rate in an effort tostimulate the U.S. economy. As a result the effective interest rate that wepaid on our borrowings under the facilities declined, leading to acorresponding reduction in interest expense. However, in the latter half of2004 and throughout 2005, the Federal Reserve increased the Federal FundsInterest Rate, causing the effective interest rate on our facilities toincrease. Based on the balance outstanding under our interest-bearingfacilities at year-end, a percentage point change in the effective interestrate would change interest expense by less than $100,000 annually.

(The remainder of this page was intentionallyleft blank)

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**NORTECH SYSTEMSINCORPORATED AND SUBSIDIARY**

**TABLE OF CONTENTS**

**DECEMBER 31, 2005,2004, AND 2003**

**ITEM8.   FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA**
|                                                                                                                                               | **PAGE** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|----------|
| Reports of Independent Registered Public Accounting  Firms                                                                                    |     | 20-21 |   |
| Consolidated  Financial Statements:                                                                                                           |     |   |   |
| Consolidated Balance Sheets as of December 31,  2005 and 2004                                                                            |     | 22 |   |
| Consolidated Statements of Income for the years ended  December 31, 2005, 2004 and 2003                                                  |     | 23 |   |
| Consolidated Statements of Shareholders’ Equity for  the years ended December 31, 2005, 2004 and 2003      |     | 24 |   |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2005, 2004 and 2003                                              |     | 25 |   |
| Notes to Consolidated Financial Statements                                                                                                    |     | 26-41 |   |
| Reports of Independent Registered Public Accounting  Firms on Supplementary Information                                                       |     | 42-43 |   |
| Schedule II Valuation and Qualifying Accounts                                                                                                 |     | 44 |   |
| (The remainder of this  page was intentionally left blank.)                                                                              |     |   |   |

 

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**Report of Independent Registered Public AccountingFirm**

To the Board of DirectorsNortech Systems Incorporated and SubsidiaryWayzata, Minnesota

We have audited the consolidated balance sheet ofNortech Systems Incorporated and Subsidiary as of December 31, 2005 and2004, and the related consolidated statements of income, shareholders’ equityand cash flows for the years then ended. These consolidated financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Nortech Systems Incorporated andSubsidiary as of December 31, 2005 and 2004, and the results of theiroperations and their cash flows for the years then ended, in conformity withU.S. generally accepted accounting principles.

/s/  MCGLADREY & PULLEN, LLP

Minneapolis, MinnesotaFebruary 24, 2006

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**Report of Independent Registered Public AccountingFirm**

Board of Directors and ShareholdersNortech Systems Incorporated:

We have audited the accompanying consolidatedstatements of income, shareholders’ equity and cash flows of Nortech SystemsIncorporated and Subsidiary (the Company) for the year ended December 31,2003. These consolidated financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the consolidated financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the consolidated financial statements.An audit also includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall consolidatedfinancial statement presentation. We believe that our audit provides areasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the results ofNortech Systems Incorporated and Subsidiary operations and their cash flows forthe year ended December 31, 2003, in conformity with U.S. generallyaccepted accounting principles.

/s/ KPMG LLP

Minneapolis,MinnesotaFebruary 13, 2004, except as to note 4 to the 2003 financial statements

which is as of March 9, 2004

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARYCONSOLIDATED BALANCE SHEETSDECEMBER 31, 2005 AND 2004**

| ** **                                                                                                                                                                                             | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **ASSETS**                                                                                                                                                                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| CURRENT ASSETS                                                                                                                                                                                         |       |       |       |       |       |
| Cash and Cash Equivalents                                                                                                                                                                              |       | $          | 840,123    |       | $          | 555,783 |   |
| Accounts Receivable, Less Allowance for Uncollectible  Accounts                                                                                                                                        |       | 14,447,612 |       | 13,355,730 |       |
| Inventories                                                                                                                                                                                            |       | 15,849,470 |       | 14,235,716 |       |
| Prepaid Expenses                                                                                                                                                                                       |       | 466,083    |       | 399,210    |       |
| Income Taxes Receivable                                                                                                                                                                                |       | —     |       | 351,369    |       |
| Deferred Tax Assets                                                                                                                                                                                    |       | 912,000    |       | 818,000    |       |
| Total Current Assets                                                                                                                                                                                   |       | 32,515,288 |       | 29,715,808 |       |
| PROPERTY AND EQUIPMENT                                                                                                                                                                                 |       |       |       |       |       |
| Land                                                                                                                                                                                                   |       | 151,800    |       | 151,800    |       |
| Building and Leasehold Improvements                                                                                                                                                                    |       | 4,819,919  |       | 4,720,518  |       |
| Manufacturing Equipment                                                                                                                                                                                |       | 7,662,699  |       | 7,222,437  |       |
| Office and Other Equipment                                                                                                                                                                             |       | 3,413,968  |       | 3,010,793  |       |
| Construction in Progress                                                                                                                                                                               |       | 502,374    |       | —     |       |
| Total Property and Equipment                                                                                                                                                                           |       | 16,550,760 |       | 15,105,548 |       |
| Accumulated Depreciation                                                                                                                                                                               |       | (9,868,536 | )          | (8,681,033 | )          |
| Net Property and Equipment                                                                                                                                                                             |       | 6,682,224  |       | 6,424,515  |       |
| OTHER ASSETS                                                                                                                                                                                           |       |       |       |       |       |
| Finite-Lived Intangible Assets, Net of Accumulated  Amortization                                                                                                                                       |       | 209,307    |       | 603,267    |       |
| Goodwill                                                                                                                                                                                               |       | 75,006     |       | 75,006     |       |
| Deferred Tax Assets                                                                                                                                                                                    |       | 179,000    |       | 52,000     |       |
| Other Assets                                                                                                                                                                                           |       | 7,726      |       | 11,012     |       |
| Total Other Assets                                                                                                                                                                                     |       | 471,039    |       | 741,285    |       |
| Total Assets                                                                                                                                                                                           |       | $          | 39,668,551 |       | $          | 36,881,608 |   |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| CURRENT LIABILITIES                                                                                                                                                                                    |       |       |       |       |       |
| Bank Note Payable                                                                                                                                                                                      |       | $          | 4,228,234  |       | $          | 7,523,058 |   |
| Current Maturities of Notes Payable                                                                                                                                                                    |       | 1,207,305  |       | 997,815    |       |
| Checks Written in Excess of Bank Balance                                                                                                                                                               |       | 1,200,000  |       | 950,000    |       |
| Accounts Payable                                                                                                                                                                                       |       | 9,902,998  |       | 5,602,913  |       |
| Accrued Payroll and Commissions                                                                                                                                                                        |       | 2,849,472  |       | 2,375,939  |       |
| Accrued Health and Dental Claims                                                                                                                                                                       |       | 271,104    |       | 250,330    |       |
| Income Taxes Payable                                                                                                                                                                                   |       | 317,487    |       | —     |       |
| Other Accrued Liabilities                                                                                                                                                                              |       | 324,360    |       | 265,762    |       |
| Total Current Liabilities                                                                                                                                                                              |       | 20,300,960 |       | 17,965,817 |       |
| LONG-TERM  LIABILITIES                                                                                                                                                                                 |       |       |       |       |       |
| Notes Payable (Net of Current Maturities)                                                                                                                                                              |       | 2,714,227  |       | 3,399,210  |       |
| Total Liabilities                                                                                                                                                                                      |       | 23,015,187 |       | 21,365,027 |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                                                         |       |       |       |       |       |
| 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: 2,618,197 Shares Issued and Outstanding at December 31,  2005; 2,582,147 Shares Issued and Outstanding at December 31, 2004 |       | 26,182     |       | 25,821     |       |
| Additional Paid-In Capital                                                                                                                                                                             |       | 14,306,602 |       | 14,118,658 |       |
| Accumulated Other Comprehensive Loss                                                                                                                                                                   |       | (21,032    | )          | (40,729    | )          |
| Retained Earnings                                                                                                                                                                                      |       | 2,091,612  |       | 1,162,831  |       |
| Total Shareholders’ Equity                                                                                                                                                                        |       | 16,653,364 |       | 15,516,581 |       |
| Total Liabilities  and Shareholders’ Equity                                                                                                                                                       |       | $          | 39,668,551 |       | $          | 36,881,608 |   |

 

See accompanying Notes to Consolidated Financial Statements.

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARYCONSOLIDATED STATEMENTS OF INCOMEFOR THE YEARS ENDED DECEMBER 31, 2005, 2004, AND 2003**

| ** **                                                                                     | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Net sales                                                                                      |       | $          | 84,215,663 |       | $          | 72,674,159 |       | $ | 57,958,698 |   |
| Cost of goods sold                                                                             |       | 74,183,435 |       | 64,135,186 |       | 51,463,722 |       |
| Gross profit                                                                                   |       | 10,032,228 |       | 8,538,973  |       | 6,494,976  |       |
| Operating  expenses:                                                                           |       |       |       |       |       |       |       |
| Selling expenses                                                                               |       | 3,198,654  |       | 3,157,212  |       | 2,377,311  |       |
| General and administrative expenses                                                            |       | 4,720,860  |       | 4,054,326  |       | 3,332,474  |       |
| Total operating expenses                                                                       |       | 7,919,514  |       | 7,211,538  |       | 5,709,785  |       |
| Income from operations                                                                         |       | 2,112,714  |       | 1,327,435  |       | 785,191    |       |
| Other income  (expense)                                                                        |       |       |       |       |       |       |       |
| Interest income                                                                                |       | 2,635      |       | 2,120      |       | 24,624     |       |
| Miscellaneous income (expense)                                                                 |       | (70,059    | )          | 15,839     |       | 86,386     |       |
| Interest expense                                                                               |       | (651,509   | )          | (490,065   | )          | (385,753   | )          |
| Total other expense                                                                            |       | (718,933   | )          | (472,106   | )          | (274,743   | )          |
| Income before income taxes                                                                     |       | 1,393,781  |       | 855,329    |       | 510,448    |       |
| Income tax expense (benefit)                                                                   |       | 465,000    |       | 268,000    |       | (123,000   | )          |
| Net income                                                                                     |       | $          | 928,781    |       | $          | 587,329    |       | $ | 633,448 |   |
| Net income per  common share:                                                                  |       |       |       |       |       |       |       |
| Basic                                                                                          |       | $          | 0.36       |       | $          | 0.23       |       | $ | 0.26 |   |
| Weighted average  number of common shares outstanding used for basic earnings per common share |       | 2,583,309  |       | 2,561,419  |       | 2,478,921  |       |
| Diluted                                                                                        |       | $          | 0.36       |       | $          | 0.23       |       | $ | 0.25 |   |
| Weighted average number  of common share outstanding plus dilutive common stock options        |       | 2,613,942  |       | 2,604,411  |       | 2,528,810  |       |

 

See accompanying Notes to Consolidated Financial Statements.

23

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARYCONSOLIDATED STATEMENTS OF SHAREHOLDER’S EQUITYFOR THE YEARS ENDED DECEMBER 31, 2005, 2004, AND 2003**

| ** **                                       | ** ** | ** **    | ** ** | ** ** | ** ** | ** **     | ** ** | **Accumulated**        | ** ** | **Retained**     | ** ** | ** **             | ** ** |
|--------------------------------------------------|------------|---------------|------------|------------|------------|----------------|------------|------------------------|------------|------------------|------------|------------------------|------------|
| ** **                                       | ** ** | ** **    | ** ** | ** ** | ** ** | **Additional** | ** ** | **Other**              | ** ** | **Earnings**     | ** ** | **Total**              | ** ** |
| ** **                                       | ** ** | **Preferred** | ** ** | **Common** | ** ** | **Paid-In**    | ** ** | **Comprehensive**      | ** ** | **(Accumulated** | ** ** | **Shareholders’** | ** ** |
| ** **                                       | ** ** | **Stock**     | ** ** | **Stock**  | ** ** | **Capital**    | ** ** | **Income (Loss)** | ** ** | **Deficit)**     | ** ** | **Equity**             | ** ** |
| **BALANCE**                                      |       |          |       |       |       |           |       |                   |       |             |       |                   |       |   |   |   |   |   |   |   |   |
| **DECEMBER 31, 2002**                            |       | $             | 250,000    |       |       | $              | 24,419     |                   |       | $                | 12,873,657 |                   |       | $ | — |   |   |   | $ | (57,946 | ) |   |   | $ | 13,090,130 |   |   |
| 2003 net income                                  |       | —        |       |       | —     |           |       | —                 |       |             | —     |                   |       |   | 633,448 |   |   |   | 633,448 |   |   |
| Issuance of stock                                |       | —        |       |       | 708        |           |       | 623,682                |       |             | —     |                   |       |   | — |   |   |   | 624,390 |   |   |
| Translation loss                                 |       | —        |       |       | —     |           |       | —                 |       |             | (26,688    | )                      |       |   | — |   |   |   | (26,688 | ) |   |
| **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 |   |   |

 

See accompanying Notes to Consolidated Financial Statements.

24

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARYCONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE YEARS ENDED DECEMBER 31, 2005, 2004, AND 2003**

| ** **                                             | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|--------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **CASH FLOWS FROM OPERATING  ACTIVITIES**              |       |       |       |       |       |       |       |
| Net income                                             |       | $          | 928,781    |       | $          | 587,329    |       | $ | 633,448 |   |
| Adjustments to  reconcile net income to net            |       |       |       |       |       |       |       |
| Cash provided by  (used in) operating activities:      |       |       |       |       |       |       |       |
| Depreciation                                           |       | 1,185,599  |       | 1,112,210  |       | 1,259,175  |       |
| Amortization                                           |       | 397,246    |       | 387,776    |       | 381,600    |       |
| Deferred Taxes                                         |       | (221,000   | )          | 166,000    |       | (44,000    | )          |
| Gain on disposal of assets                             |       | —     |       | (17,169    | )          | (1,491     | )          |
| Other                                                  |       | 80,187     |       | 18,786     |       | (12,237    | )          |
| Changes in  current operating items:                   |       |       |       |       |       |       |       |
| Accounts receivable                                    |       | (1,091,882 | )          | (2,520,034 | )          | (3,221,380 | )          |
| Inventories                                            |       | (1,613,754 | )          | (2,641,159 | )          | 725,760    |       |
| Prepaid expenses and other assets                      |       | (66,872    | )          | 24,161     |       | (93,642    | )          |
| Income taxes receivable/payable                        |       | 668,856    |       | 68,265     |       | 64,337     |       |
| Accounts payable                                       |       | 4,300,085  |       | 1,534,765  |       | 770,370    |       |
| Accrued payroll and commissions                        |       | 473,533    |       | 1,094,620  |       | (837,966   | )          |
| Accrued health and dental claims                       |       | 20,774     |       | 32,816     |       | (60,350    | )          |
| Other accrued liabilities                              |       | 58,598     |       | (172,496   | )          | 147,916    |       |
| Net cash provided by (used in) operating activities    |       | 5,120,151  |       | (324,130   | )          | (288,460   | )          |
| **CASH  FLOWS FROM INVESTING ACTIVITIES**              |       |       |       |       |       |       |       |
| Proceeds from sale of assets                           |       | —     |       | 31,802     |       | 8,450      |       |
| Purchase of property and equipment                     |       | (1,427,059 | )          | (1,451,928 | )          | (1,420,519 | )          |
| Net cash used by investing activities                  |       | (1,427,059 | )          | (1,420,126 | )          | (1,412,069 | )          |
| **CASH  FLOWS FROM FINANCING ACTIVITIES**              |       |       |       |       |       |       |       |
| Net change in checks written in excess of bank balance |       | 250,000    |       | 700,000    |       | (50,000    | )          |
| Net change in line of credit                           |       | (3,294,824 | )          | 1,615,867  |       | 1,484,336  |       |
| Proceeds from notes payable                            |       | 636,502    |       | 788,944    |       | 674,248    |       |
| Payments on notes payable                              |       | (1,111,995 | )          | (922,373   | )          | (777,436   | )          |
| Issuance of stock, net of repurchase of stock          |       | 188,305    |       | 22,013     |       | 24,390     |       |
| Net cash provided by (used in) financing activities    |       | (3,332,012 | )          | 2,204,451  |       | 1,355,538  |       |
| Effect of exchange rate changes on cash                |       | (76,740    | )          | (5,591     | )          | (2,581     | )          |
| **INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS**   |       | 284,340    |       | 454,604    |       | (347,572   | )          |
| Cash and cash equivalents—beginning of year       |       | 555,783    |       | 101,179    |       | 448,751    |       |
| **CASH  AND CASH EQUIVALENTS—END OF YEAR**        |       | $          | 840,123    |       | $          | 555,783    |       | $ | 101,179 |   |

 

See accompanying Notes to Consolidated Financial Statements.

25

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2005, 2004, AND 2003**

**NOTE1   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES**

***Nature of Business***

We manufacture wire harnesses, cables andelectromechanical assemblies, printed circuit boards and higher-levelassemblies for a wide range of commercial and defense industries. We provide afull “turn-key” contract manufacturing service to our customers. All productsare built to the customer’s design specifications. Products are sold tocustomers both domestically and internationally. We also provide repair serviceon circuit boards used in machines in the medical industry.

Our manufacturing facilities are located in Bemidji,Fairmont, Blue Earth, Merrifield and Baxter, Minnesota as well as Augusta,Wisconsin, and Monterrey, Mexico.

A summary of oursignificant accounting policies follows:

***Use of Estimates***

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires us to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements. Estimates also affect the reported amounts of revenue and expenseduring the reporting period. Significant items subject to estimates and assumptionsinclude the valuation allowance for inventories and estimated future cash flowsused in the impairment test of intangible assets. Actual results could differfrom those estimates.

***Principles of Consolidation***

The consolidated financialstatements include the accounts of our wholly owned subsidiary, ManufacturingAssembly Solutions of Monterrey, Inc. All significant intercompanyaccounts and transactions have been eliminated.

***Cash and Cash Equivalents***

For purposes of reportingcash flows, we consider cash equivalents to be short-term, highly liquidinterest-bearing accounts readily convertible to cash. The carrying amountapproximates fair value.

***Accounts Receivable andAllowance for Doubtful Accounts***

Wegrant credit to customers in the normal course of business. Accounts receivableare unsecured and are presented net of an allowance for uncollectible accounts.The allowance for uncollectible accounts was $297,000 and $280,000 at December 31,2005 and 2004, respectively. We determine our allowance by considering a numberof factors, including the length of time trade accounts receivable are pastdue, our previous loss history, the customer’s current ability to pay itsobligation to us, and the condition of the general economy and the industry asa whole. We write-off accounts receivable when they become uncollectible, andpayments subsequently received on such receivables are credited to theallowance for uncollectible accounts. We do not accrue interest on past dueaccounts receivable.

26

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2005, 2004, AND 2003**

**NOTE 1   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANTACCOUNTING POLICIES (Continued)**

***Inventories***

Inventoriesare stated at the lower of cost (first-in, first-out method) or market (basedon the lower of replacement cost or net realizable value). Costs include material, labor, and overheadrequired in the warehousing and production of our products. Inventory reservesare maintained for the estimated value of the inventory that may have a lowervalue than stated or quantities in excess of future production needs. Inventoryis shown net of reserve for excess and obsolete inventory as follows:

| ** **      | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-----------------|------------|------------|------------|------------|------------|
| Raw materials   |       | $          | 10,616,894 |       | $          | 10,662,571 |   |
| Work in process |       | 4,423,892  |       | 2,418,850  |       |
| Finished goods  |       | 2,027,118  |       | 2,373,495  |       |
| Reserves        |       | (1,218,434 | )          | (1,219,200 | )          |
| Total           |       | $          | 15,849,470 |       | $          | 14,235,716 |   |

 

***Property, Equipment and Depreciation***

Propertyand equipment are stated at cost less accumulated depreciation. Additions,improvements and major renewals are capitalized, while maintenance, repairs andminor renewals are expensed as incurred. When assets are retired or disposedof, the assets and related accumulated depreciation are removed from theaccounts and the resulting gain or loss is reflected in operations. Leaseholdimprovements are depreciated over the shorter of the estimated use life or theremaining lease term. All other property and equipment are depreciated by thestraight-line method of depreciation over their estimated useful lives.

| Buildings                  | 39  Years  |
|----------------------------|------------|
| Leasehold improvements     | 3-7  Years |
| Manufacturing equipment    | 5-7  Years |
| Office and other equipment | 3-7 Years  |

 

Depreciation expense was $1,185,599, $1,112,210 and$1,259,175, for the years ended December 31, 2005, 2004 and 2003,respectively.

27

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2005, 2004, AND 2003**

**NOTE 1   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANTACCOUNTING POLICIES (Continued)**

***Goodwill and Finite Life Intangible Assets***

Weaccount for goodwill and other intangible assets in accordance with Statementof Financial Accounting Standards Board No. (“SFAS”) 142, “Goodwill andOther Intangible Assets,” which requires that goodwill and certainindefinite-lived assets not be amortized but evaluated annually for impairment.Finite life intangible assets are amortized on a straight-line basis over theirestimated useful lives, which range from three to four years. Finite lifeintangible assets at December 31, 2005 and 2004 are as follows:

| ** **        | ** ** | **December 31, 2005** | ** ** |
|-------------------|------------|---------------------------------|------------|
| ** **        | ** ** | **Estimated**                   | ** ** | **Gross** | ** ** | **Accumulated** | ** ** | **Net Book** | ** ** |
| ** **        | ** ** | **Lives**                       | ** ** | **Carrying** | ** ** | **Amortization** | ** ** | **Value** | ** ** |
| ** **        | ** ** | **(Years)**                     | ** ** | **Amount** | ** ** | **Amount** | ** ** | **Amount** | ** ** |
| Non-compete       |       |                            | 4          |   |   | $ | 1,526,384 |   |   | $ | 1,335,600 |   |   | $ | 190,784 |   |
| Other intangibles |       |                            | 3          |   |   | 37,059 |   |   | 18,536 |   |   | 18,523 |   |
| Totals            |       |                            |       |   |   | $ | 1,563,443 |   |   | $ | 1,354,136 |   |   | $ | 209,307 |   |

 

| ** **        | ** ** | **December 31, 2004** | ** ** |
|-------------------|------------|---------------------------------|------------|
| ** **        | ** ** | **Estimated**                   | ** ** | **Gross** | ** ** | **Accumulated** | ** ** | **Net Book** | ** ** |
| ** **        | ** ** | **Lives**                       | ** ** | **Carrying** | ** ** | **Amortization** | ** ** | **Value** | ** ** |
| ** **        | ** ** | **(Years)**                     | ** ** | **Amount** | ** ** | **Amount** | ** ** | **Amount** | ** ** |
| Non-compete       |       |                            | 4          |   |   | $ | 1,526,384 |   |   | $ | 954,000 |   |   | $ | 572,384 |   |
| Other intangibles |       |                            | 3          |   |   | 37,059 |   |   | 6,176 |   |   | 30,883 |   |
| Totals            |       |                            |       |   |   | $ | 1,563,443 |   |   | $ | 960,176 |   |   | $ | 603,267 |   |

 

Amortization expenserelated to these assets is as follows:

| ***Year ended December 31, 2005 *** |   | $       | 393,960 |   |
|-----------------------------------------------|--------|---------|---------|--------|
| Year ended  December 31, 2004            |   | 387,776 |    |
| Year ended  December 31, 2003            |   | 381,600 |    |

 

Estimatedamortization expense related to these assets is as follows:

| 2006 |   | $     | 203,000 |   |
|------|--------|-------|---------|--------|
| 2007 |   | 6,000 |    |

 

***Impairment Analysis***

We evaluate property and equipment and intangibleassets with finite lives for impairment, as well as the related amortizationperiods, to determine whether adjustments to these amounts or useful lives arerequired based on current events and circumstances. The evaluation is based onour projection of the undiscounted future operating cash flows of theunderlying assets. To the extent such projections indicate that futureundiscounted cash flows are not sufficient to recover the carrying amounts ofrelated assets, a charge is recorded to reduce the carrying amount to the asset’sestimated fair value.

28

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2005, 2004, AND 2003**

**NOTE 1   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANTACCOUNTING POLICIES (Continued)**

***Preferred Stock***

Preferred stock issued isnon-cumulative and nonconvertible. The holders of the preferred stock areentitled to a non-cumulative dividend of 12% when and as declared. Inliquidation, holders of preferred stock have preference to the extent of $1.00per share plus dividends accrued but unpaid. No preferred stock dividends weredeclared or paid during the years ended December 31, 2005, 2004, and 2003.

***Revenue Recognition***

Werecognize revenue upon shipment of products to customers, when title haspassed, all contractual obligations have been satisfied and collection of theresulting receivable is reasonably assured. In the normal course of business weenter into a number of contracts with customers under which we provideengineering services on a per project basis. Revenue for these services isrecognized upon completion of the engineering process, usually upon initialshipment of the product. Revenues from repair services are recognized uponshipment of related equipment to customers. Our shipping and handlingcosts charged to our customers are included in net sales, while thecorresponding shipping expenses are included in cost of goods sold.

***Estimated Warranty Claims***

The sales of our productsinclude warranties that provide for repairs or replacement of defectiveproducts. The warranty periods range from one to two years, depending on theproduct, following the sale. We estimate a warranty reserve based on actualhistorical warranty claims coupled with an analysis of unfulfilled claims atthe balance sheet date.  Warranty claimshave been minimal in the past and are anticipated to remain low. Estimatedwarranty liabilities of approximately $3,000 are included in Other AccruedLiabilities at December 31, 2005 and 2004.

***Advertising***

Advertising costs arecharged to operations as incurred. Total amount charged to expense was$173,464, $197,914 and $106,873, for the years ended December 31, 2005,2004 and 2003, respectively.

***Income Taxes***

We account for incometaxes under the asset and liability method. Deferred income tax assets andliabilities are recognized annually for differences between the financialstatement and tax bases of assets and liabilities that will result in taxableor deductible amounts in the future based on enacted tax laws and ratesapplicable to the periods in which the differences are expected to affecttaxable income. Valuation allowances are established when necessary to reducedeferred tax assets to the amount expected to be realized.

***Fair Value of Financial Instruments***

The carrying amounts forall financial instruments approximate fair values. The carrying amounts forcash, receivables, payables, accrued liabilities and the line of creditapproximate fair value because of the 

29

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2005, 2004, AND 2003**

**NOTE 1   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANTACCOUNTING POLICIES (Continued)**

shortmaturity of these instruments. Based on the borrowing rates currently availableto us for bank loans with similar terms and average maturities, the carryingvalue of long-term debt and the line of credit materially approximates fairvalue.

***Stock Based Compensation***

As of December 31, 2005, we account forstock-based compensation arrangements in accordance with the provisions ofAccounting Principles Board Opinion (“APB”) No. 25, “Accounting for StockIssued to Employees,” and related interpretations. Under APB No. 25,compensation cost is determined based on the difference, if any, on the grantdate between the fair value of our stock and the amount an employee must pay toacquire the stock. Compensation expense is recognized over the vesting period.

***For the years ended December 31,2005, 2004, and 2003, we have adopted the disclosure-only provisions ofStatement of Financial Accounting Standards No. 123, “Accounting forStock-Based Compensation.”  Accordingly,no compensation costs were charged to operations for the years ended December 31,2005, 2004, and 2003.***

Hadcompensation cost for the our stock option plan been determined pursuant to SFASNo. 123, net earnings and earnings per common share would have been asfollows:

| ** **                                                                                                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net income, as  reported                                                                                                             |       | $        | 928,781    |     | $          | 587,329  |       | $ | 633,448 |   |
| Deduct: Total  stock-based compensation expense determined under fair value based method for  all awards, net of related tax effects |       | (500,196 | )          | (125,450 | )          | (127,826 | )          |
| Pro forma net income                                                                                                                 |       | $        | 428,585    |     | $          | 461,879  |       | $ | 505,622 |   |
| Earnings per  common share:                                                                                                          |       |     |       |     |       |     |       |
| Basic—as reported                                                                                                               |       | $        | 0.36       |     | $          | 0.23     |       | $ | 0.26 |   |
| Basic—pro forma                                                                                                                 |       | $        | 0.17       |     | $          | 0.18     |       | $ | 0.20 |   |
| Diluted—as reported                                                                                                             |       | $        | 0.36       |     | $          | 0.23     |       | $ | 0.25 |   |
| Diluted—pro forma                                                                                                               |       | $        | 0.16       |     | $          | 0.18     |       | $ | 0.20 |   |

 

30

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2005, 2004, AND 2003**

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

The weighted average fairvalues at grant date of the options granted in fiscal 2005, 2004 and 2003 wereestimated as $4.14, $5.23 and $5.20, respectively, using the Black-Scholesoption-pricing model with the following weighted average assumptions:

| ** **              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected Lives  (Years) |       | 10       |       | 10       |       | 10       |       |
| Dividend Yield          |       | 0.00     | %          | 0.00     | %          | 0.00     | %          |
| Expected  Volatility    |       | 69.5     | %          | 70.5     | %          | 71.6     | %          |
| Risk-Free Interest Rate |       | 4.37     | %          | 4.62     | %          | 4.51     | %          |

 

The pro forma effects on net income and net income pershare are not likely to be representative of the effects on reported net incomefor future years, because options vest over several years and additional awardsare generally made each year.

In December 2004, the Financial Accounting StandardsBoard (“FASB”) published FASB Statement No. 123 (revised 2004), “Share-BasedPayment” (“FAS 123(R)” or the “Statement”). FAS 123(R) requires that thecompensation cost relating to share-based payment transactions, includinggrants of employee stock options, be recognized in financial statements. Thatcost will be measured based on the fair value of the equity or liabilityinstruments issued. FAS 123(R) covers a wide range of share-based compensation arrangementsincluding stock options, restricted share plans, performance-based awards,share appreciation rights, and employee share purchase plans. FAS 123(R) is areplacement of FASB Statement No. 123, *Accountingfor Stock-Based Compensation*, and supersedes APB Opinion No. 25, *Accounting for Stock Issued to Employees*,and its related interpretive guidance (APB 25).

The effect of the Statement will be to requireentities to measure the cost of employee services received in exchange forstock options based on the grant-date fair value of the award, and to recognizethe cost over the period the employee is required to provide services for theaward. FAS 123(R) permits entities to use any option-pricing model that meetsthe fair value objective in the Statement. We are required to adopt FAS123(R) as of January 1, 2006.  Weare evaluating the adoption criteria outlined in SFAS No. 123 (R).  However, we show the pro forma net income effect of using the fair value methodfor the past three fiscal years which is presented in the table under employeestock based compensation above.  The proforma compensation costs presented there and in our prior filings may not beindicative of the actual effect on net income when SFAS No. 123 (R) is adoptedas such effect is dependent upon many factors, including the number of stockoptions granted in the future as well as their related terms.

On November 15, 2005, our Board of Directors tookaction to accelerate vesting of all then outstanding stock options.  As of that date, we had a total of 322,800options outstanding, of which 200,800 were vested and 122,000 were unvested.The Board accelerated the vesting schedule of the 122,000 unvested options, ofwhich 86,000 were underwater and 36,000 were in the money.

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2005, 2004, AND 2003**

**NOTE 1   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANTACCOUNTING POLICIES (Continued)**

Summary informationrelated to these options which were outstanding November 15, 2005 is shownbelow:

| **Option Holders** | ** ** | ** ** | ** ** | **Total** | ** ** | **Vested** | ** ** | **Unvested** | ** ** |
|-------------------------|------------|------------|------------|-----------|------------|------------|------------|--------------|------------|
| Underwater  options     |       | 151,000    |       | 65,000    |       | 86,000     |       |
| In the money  options   |       | 171,800    |       | 135,800   |       | 36,000     |       |
| Total options           |       | 322,800    |       | 200,800   |       | 122,000    |       |

 

The Board took the actionto accelerate the vesting of the options in order to eliminate approximately$370,000 in compensation expense that we would otherwise have incurred overfive years beginning in 2006, upon the adoption of FAS 123(R). Under FAS 123(R),we would have been required to recognize the expense associated with theseoption grants as the options vested.  Wealso determined that no compensation expense needed to be recorded for the36,000 in the money options that were unvested due to the high likelihood ofcontinued employment through the original vesting dates of the individualsinvolved.

***Net Income PerCommon Share***

Basic net income percommon share is computed using the weighted-average number of common sharesoutstanding.  Diluted income per commonshare is computed using the weighted-average number of common shares outstandingand potential common shares from the assumed exercise of stock optionsoutstanding during the period using the treasury stock method.

***Recent AccountingPronouncements***

In November 2004, the FASBissued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4.  The amendments made by the SFAS No. 151require that abnormal amounts of idle facility expense, freight, handling costsand wasted materials (spoilage) be recognized as current-period charges.  This Statement requires that allocation offixed production overhead to inventory based on the normal capacity ofproduction facilities.  SFAS No. 151 iseffective for inventory costs incurred during fiscal years beginning after June15, 2005.  We do not believe the adoptionof SFAS No. 151 will have a material effect on our financial position orresults of operations.

InMarch 2005, the FASB issued Interpretation No.47, or “FIN 47,” which clarifiesterminology in FASB Statement No. 143, *Accounting for AssetRetirement Obligations*.  FIN47 clarifies when an entity has sufficient information to reasonably estimatethe fair value of an asset retirement obligation.  FIN 47 is effective for us in fiscal2006.  We do not believe the adoption ofFIN 47 to have a material impact on our consolidated financial statements.

***Supplemental CashFlow Information***

We paid $30,716 in incometaxes for the year ended December 31, 2005. No income taxes were paid for the year ended December 31, 2004.  We paid income taxes of $148,424 for the yearended December 31, 2003.  We paidinterest expense of $645,513, $488,020 and $389,941 for the years endedDecember 31, 2005, 2004 and 2003, respectively.

32

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2005, 2004, AND 2003**

**NOTE 1   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANTACCOUNTING POLICIES (Continued)**

During 2004, the Companyacquired all of the business assets of Zachariah and Lundbergh, Inc. (Z&L)for $250,000 payable over 4 years. During 2004 and 2003, we exchanged 63,407 shares of our common stock insatisfaction of a note payable to SAE Assembly, LLC, incurred in connectionwith our 2002 acquisition of our manufacturing facility in Mexico.

***Segment ReportingInformation***

Our results of operationsfor the years ended December 31, 2005, 2004 and 2003, represent a singlesegment referred to as Contract Manufacturing. Export sales represent 5%, 5% and 2% of consolidated sales for the yearsended December 31, 2005, 2004 and 2003, respectively.

Long-lived assets bycountry are as follows:

| ** **                 | ** ** | **United States** | ** ** | **Mexico** | ** ** | **Total** | ** ** |
|----------------------------|------------|------------------------|------------|------------|------------|-----------|------------|
| 2005                       |       |                   |       |       |       |      |       |   |   |
| Net property and equipment |       |                   | $          | 5,995,465  |       |      | $          | 686,759 |   | $ | 6,682,224 |   |
| Other assets               |       |                   | 271,529    |       |       | 199,510   |       | 471,039 |   |
| 2004                       |       |                   |       |       |       |      |       |   |   |
| Net property and equipment |       |                   | $          | 5,755,401  |       |      | $          | 669,114 |   | $ | 6,424,515 |   |
| Other assets               |       |                   | 156,889    |       |       | 584,396   |       | 741,285 |   |

 

***Foreign CurrencyTranslation***

Local currency isconsidered the functional currency for our operations outside the UnitedStates.  Assets and liabilities aretranslated at year-end exchange rates. Income and expense items are translated at average rates of exchangeprevailing during the year.  Translationadjustments are recorded as a component of accumulated other comprehensive lossin shareholders' equity.  Foreignexchange transaction gains and losses attributable to exchange rate movementson intercompany receivables and payables not deemed to be of a long-terminvestment nature are recorded in Miscellaneous Income (Expense).

**NOTE2   MAJOR CUSTOMERS AND CONCENTRATION OF CREDIT RISK**

Financialinstruments that potentially subject us to concentrations of credit riskconsist principally of cash and trade accounts receivable.  With regard to cash, we maintain ourexcess cash balances in checking and money market accounts at three high-creditquality financial institutions.  We havenot experienced any losses in any of the short-term investment instruments wehave used for excess cash balances.  Wedo not require collateral on ourreceivables.  Historically, we have notsuffered significant losses with respect to trade accounts receivable.

One customer accounted forapproximately 17%, 15% and 23% of sales for the years ended December 31, 2005,2004, and 2003, respectively, and approximately 12% and 24% of accountsreceivable at December 31, 2005 and 2004, respectively.  A second customer accounted for 10% of netsales for the year ended December 31, 2005, and approximately 9% of accountsreceivable at December 31, 2005.

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2005, 2004, AND 2003**

**NOTE 3   ACCRUEDHEALTH AND DENTAL CLAIMS**

We have partiallyself-insured our employee health and dental plans.  We have contracted with two separateadministrative service companies to supervise and administer the programs andact as representatives.  Our health planinsures for excessive or unexpected claims and is liable for claims not toexceed $80,000 per individual per plan year and an estimated aggregate amountof $3,477,000 for the plan year ending August 2006.  Our dental plan pays claims based on actualamounts incurred.  Estimated unpaidclaims for incurred health and dental services of $271,104 and $250,330 areincluded in Accrued Health and Dental Claims at December 31, 2005 and2004, respectively.

**NOTE 4   NOTES PAYABLE**

We have a revolving line of credit of $8,000,000 atWells Fargo Bank, N.A., (WFB) along with five term notes.  Effective March 4, 2005, the line of creditwas extended to January 31, 2007.  Theseagreements are secured by substantially all of our assets and require us tomaintain certain covenants, which include certain regular reportingrequirements, annual shareholder dividend limitations, the maintenance of certain financial ratios, and limit theamount of annual capital expenditures.

The line of credit bears interest at prime (7.25percent at December 31, 2005). The weighted-average interest rate on our lineof credit was 6.20% and 4.34% for the years ended December 31, 2005 and2004, respectively. We had borrowings of $4,228,234 and $7,523,058 outstandingas of December 31, 2005 and 2004, respectively.

Asummary of other debt balances at December 31, 2005 and 2004 is as follows:

| **Description**                                                                                                                                                                                                                                                                                                                               | ** ** | ** ** | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|-----------|------------|-----------|------------|
| Notes  payable—Wells Fargo Bank Minnesota, N.A., Two notes bear interest at Wells  Fargo prime rate, three notes bear interest at 4.21%, 6.30%, and 7.00%,  respectively; combined monthly payments of $98,387, including principal and  interest; maturities range from October 2006 to July 2008; secured by  substantially all assets |       | $          | 3,338,028  |      | $          | 3,677,177 |       |
| Notes payable—Other, interest at 6.5%; monthly  installment payments through March 2007; secured by substantially all assets                                                                                                                                                                                                             |       | 498,606    |       | 527,878   |       |
| Note payable paid off in 2005                                                                                                                                                                                                                                                                                                                 |       | —     |       | 31,954    |       |
| Other promissory note(1)                                                                                                                                                                                                                                                                                                                      |       | 84,898     |       | 160,016   |       |
| Total notes payable                                                                                                                                                                                                                                                                                                                           |       | 3,921,532  |       | 4,397,025 |       |
| Current maturities of notes payable                                                                                                                                                                                                                                                                                                           |       | (1,207,305 | )          | (997,815  | )          |
| Notes payable—                                                                                                                                                                                                                                                                                                                           |       |       |       |      |       |
| Net of current  maturities                                                                                                                                                                                                                                                                                                                    |       | $          | 2,714,227  |      | $          | 3,399,210 |       |

----

(1)          In June 2004, wepurchased, in exchange for a note payable of $250,000, the business assets ofZachariah & Lundbergh, Inc. (Z&L) a manufacturer of camera powersupplies and cable assemblies used in machine vision systems for theindustrial, medical/scientific and security markets.  The assets purchased were comprised primarilyof inventories with an estimated fair value of $170,000.  We paid 

34

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2005, 2004, AND 2003**

**NOTE 4**   NOTES PAYABLE (Continued)

$75,118, and $89,984 ofthe note payable during 2005 and 2004, respectively.  Repayment of the remaining Z&L debt willbe made through payments at the rate of 20% of the Z&L products sold not toexceed 48 months from the date of closing.

Maturity requirements areas follows:

| **Years Ending December 31,** | ** ** | ** ** | ** ** | **Amount** | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|
| 2006                                         |       | $          | 1,207,305  |       |
| 2007                                         |       | 2,562,141  |       |
| 2008                                         |       | 152,086    |       |
|                                         |       | $          | 3,921,532  |       |

 

**NOTE 5   OPERATINGLEASES**

We have entered into various operating leases forproduction and office equipment, office space and buildings.  We have the option to purchase various piecesof equipment upon lease expiration at fair market value.  We have the option to renew the lease for theBaxter, MN facility for an additional five years upon expiration of the initiallease term in June 2006.  The lease forthe manufacturing facility in Mexico provides us the option of two three-yearrenewals extending the lease through 2010.

Rent expense, which includes amounts for other shortterm leases, for the years ended December 31, 2005, 2004, and 2003, amounted to$754,394, $676,063 and $869,565, respectively. Sublease income amounted to $3,000 for the years ended December 31, 2005and 2004.

Thefuture minimum lease payments are as follows:

| **Years Ending December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|
| 2006                                         |       | $          | 322,614    |       |
| 2007                                         |       | 211,217    |       |
| 2008                                         |       | 142,165    |       |
| 2009                                         |       | 123,391    |       |
| 2010                                         |       | 60,368     |       |
| Total                                        |       | $          | 859,755    |       |

 

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2005, 2004, AND 2003**

**NOTE 6   INCOME TAXES**

Theincome tax expense (benefit) for each of the three years ended December 31,2005 consists of the following:

| ** **                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current taxes—Federal    |       | $        | 580,000    |     | $          | 60,000   |       | $ | (76,000 | ) |
| Current taxes—State      |       | 75,000   |       | 16,000   |       | (33,000  | )          |
| Current taxes—Foreign    |       | 31,000   |       | 26,000   |       | 30,000   |       |
| Deferred taxes—Federal   |       | (204,000 | )          | 163,000  |       | (42,000  | )          |
| Deferred taxes—State     |       | (16,000  | )          | 4,000    |       | (1,000   | )          |
| Deferred taxes—Foreign   |       | (1,000   | )          | (1,000   | )          | (1,000   | )          |
| Income tax  expense (benefit) |       | $        | 465,000    |     | $          | 268,000  |       | $ | (123,000 | ) |

 

Thestatutory rate reconciliation for each of the three years ended December 31,2005 is as follows:

| ** **                                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Statutory federal  tax provision                       |       | $        | 474,000    |     | $          | 291,000  |       | $ | 174,000 |   |
| State income  taxes, net of federal benefit            |       | 63,000   |       | 25,000   |       | 24,000   |       |
| Effect of foreign  operations                          |       | 5,000    |       | (5,000   | )          | 17,000   |       |
| Income tax  credits                                    |       | (81,000  | )          | (84,000  | )          | (93,000  | )          |
| Research and  development tax credits, net of payments |       | —   |       | —   |       | (246,000 | )          |
| Other                                                  |       | 4,000    |       | 41,000   |       | 1,000    |       |
| Income tax  expense (benefit)                          |       | $        | 465,000    |     | $          | 268,000  |       | $ | (123,000 | ) |

 

Incomefrom operations before income taxes was derived from the following sources:

| ** ** | ** ** | **2005**  | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------|------------|-----------|------------|----------|------------|----------|------------|
| Domestic   |       | 1,318,000 |       | 764,000  |       | 471,000  |       |
| Foreign    |       | 76,000    |       | 91,000   |       | 39,000   |       |
| Total      |       | 1,394,000 |       | 855,000  |       | 510,000  |       |

 

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2005, 2004, AND 2003**

**NOTE 6**   INCOME TAXES (Continued)

Deferred tax assets(liabilities) at December 31, 2005 and 2004, consist of the following:

| ** **                         | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|------------------------------------|------------|-----------|------------|-----------|------------|
| Allowance for  doubtful accounts   |       | $         | 113,000    |      | $          | 105,000 |   |
| Inventory  reserves                |       | 463,000   |       | 462,000   |       |
| Accrued vacation                   |       | 316,000   |       | 277,000   |       |
| Health insurance  reserve          |       | 103,000   |       | 94,000    |       |
| Non-compete  amortization          |       | 378,000   |       | 263,000   |       |
| Other                              |       | 16,000    |       | 16,000    |       |
| General business  credits          |       | —    |       | 52,000    |       |
| deferred tax assets                |       | 1,389,000 |       | 1,269,000 |       |
| Prepaid expenses                   |       | (86,000   | )          | (137,000  | )          |
| Property and  equipment            |       | (212,000  | )          | (262,000  | )          |
| Deferred tax liabilities           |       | (298,000  | )          | (399,000  | )          |
| Net deferred tax assets            |       | $         | 1,091,000  |      | $          | 870,000 |   |
| Net short-term deferred tax assets |       | $         | 912,000    |      | $          | 818,000 |   |
| Net long-term  deferred tax assets |       | 179,000   |       | 52,000    |       |
| Total deferred  tax assets         |       | $         | 1,091,000  |      | $          | 870,000 |   |

 

We have determined that itis more likely than not that our deferred tax assets will be realized,principally through anticipated taxable income in future tax years. As aresult, we have determined that establishing a valuation allowance on ourdeferred tax assets is not necessary.

**NOTE 7   COMPREHENSIVEINCOME**

Comprehensiveincome is comprised of net income and other comprehensive income (loss). Othercomprehensive income (loss) includes income (losses) resulting from foreigncurrency translations. The details of comprehensive income are as follows:

| ** **                          | ** ** | **Year Ended  December 31,  2005** | ** ** | **Year Ended  December 31,  2004** | ** ** | **Year Ended  December 31,  2003** | ** ** |
|-------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| Net income, as  reported            |       |                                         | $          | 928,781                                      |       |                                         |       | $ | 587,329 |   |   |   | $ | 633,448 |   |   |
| Other  comprehensive income (loss): |       |                                         | 19,697     |                                         |       |                                         | (14,041    | ) |   |   | (26,688 | ) |   |
| Comprehensive income                |       |                                         | $          | 948,478                                      |       |                                         |       | $ | 573,288 |   |   |   | $ | 606,760 |   |   |

 

**NOTE 8   401(K) RETIREMENT PLAN**

We have a 401(k) profitsharing plan (the “Plan”) for our employees. The Plan is a defined contributionplan covering all of our employees except for employees covered by a collectivebargaining agreement and non-resident aliens earning non-U.S. source income. Employeesare eligible to participate in the Plan after completing six months of serviceand attaining the age of 21. Employees are allowed to contribute up to 60% oftheir wages to the Plan. We match 25% of the employees’ contribution up to 6% 

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2005, 2004, AND 2003**

**NOTE 8**   401(K) RETIREMENT PLAN (Continued)

ofcovered compensation. We made contributions of $153,171, $120,089 and $115,573during the years ended December 31, 2005, 2004, and 2003, respectively.

**NOTE 9   GAINSHARING INCENTIVE AND STOCK OPTIONPLANS**

*Employee Gainsharing*

During 1993, we adopted anemployee gainsharing plan (the “Plan”). The purpose of the Plan is to provide abonus for increased output, improved quality and productivity and reduced costs.We have authorized 50,000 common shares to be available under this Plan. Inaccordance with the terms of the Plan, employees can acquire newly issuedshares of common stock for 90% of the current market value. During 2005, 2004and 2003, 250, 52 and 133 common shares, respectively, were issued inconnection with this plan. Through December 31, 2005, 21,823 common shareshave been issued under this Plan.

*Stock Options*

In 1992, we approved the adoption of a fixed stockbased compensation plan. The purpose of the Plan is to promote our interestsand our shareholders by providing officers, directors and other key employeeswith additional incentive and the opportunity, through common stock ownership,to increase their proprietary interest in us and their personal interest in itscontinued success. In February 2003, we reached the maximum optionsallowed to be granted under the plan.

During 2003, our shareholders approved the adoption ofthe Nortech Systems Incorporated 2003 Stock Option Plan (the “2003 Plan”). Thetotal number of shares of common stock that may be granted under the 2003 Planis 300,000. On May 3, 2005, the shareholders approved the 2005 IncentiveCompensation Plan (the “2005 Plan”) and eliminated the remaining 172,500available option shares under the 2003 Plan effective February 23, 2005. Thetotal number of shares of common stock that may be granted under the 2005 Planis 200,000, of which 180,000 remain available at December 31, 2005. The2005 Plan provides that option shares granted come from our authorized butunissued common stock. The price of the option shares granted under the planwill not be less than 100% of the fair market value of the common shares on thedate of grant. Options are generally exercisable after one or more years andexpire no later than 10 years from the date of grant.

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2005, 2004, AND 2003**

**NOTE 9**   GAINSHARING INCENTIVE AND STOCK OPTION PLANS(Continued)

The following tablesummarizes information about stock options outstanding at December 31,2005:

| Exercise Prices | ** ** | **Outstanding  12/31/2005** | ** ** | **Exercisable  12/31/2005** | ** ** | **Remaining  Contractual Life** | ** ** |
|----------------------|------------|-----------------------------|------------|-----------------------------|------------|--------------------------------------|------------|
| $3.125               |       |                        | 28,000     |                        |       |                                 | 28,000     |   |   |   | 4.16 Years |   |   |
|   4.000    |       |                        | 4,000      |                        |       |                                 | 4,000      |   |   |   | 4.42 Years |   |   |
|   5.000    |       |                        | 60,000     |                        |       |                                 | 60,000     |   |   |   | 1.14 Years |   |   |
|   5.275    |       |                        | 20,000     |                        |       |                                 | 20,000     |   |   |   | 9.38 Years |   |   |
|   5.500    |       |                        | 4,000      |                        |       |                                 | 4,000      |   |   |   | 3.00 Years |   |   |
|   5.740    |       |                        | 20,000     |                        |       |                                 | 20,000     |   |   |   | 8.84 Years |   |   |
|   7.110    |       |                        | 4,000      |                        |       |                                 | 4,000      |   |   |   | 6.81 Years |   |   |
|   7.220    |       |                        | 50,000     |                        |       |                                 | 50,000     |   |   |   | 7.12 Years |   |   |
|   7.460    |       |                        | 20,000     |                        |       |                                 | 20,000     |   |   |   | 8.34 Years |   |   |
|   8.000    |       |                        | 77,000     |                        |       |                                 | 77,000     |   |   |   | 7.95 Years |   |   |
|                      |       |                        | 287,000    |                        |       |                                 | 287,000    |   |   |   |   |   |   |

 

Following is a summary ofthe stock option plan activity during 2005, 2004 and 2003.

| ** **                               | ** ** | **2005**   | ** **  | **2004**                              | ** ** | **2003**   | ** ** |
|------------------------------------------|------------|------------|-------------|---------------------------------------|------------|------------|------------|
| ** **                               | ** ** | **Shares** | ** **  | **Weighted-Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| Options  outstanding, beginning of year  |       | 306,800    |        |                                  | $     | 6.21       |       |   | 272,800 |   |   | $  | 6.10 |   |   | 151,000 |   |   | $  | 4.60 |   |   |
| Options exercised                        |       | (35,800    | )           |                                  | 5.22       |       |       | (6,000 | ) |   | 3.63 |   |   | (7,200 | ) |   | 3.27 |   |   |
| Options cancelled                        |       | (4,000     | )           |                                  | 6.00       |       |       | — |   |   | — |   |   | — |   |   | — |   |   |
| Options granted                          |       | 20,000     |        |                                  | 5.28       |       |       | 40,000 |   |   | 6.60 |   |   | 129,000 |   |   | 7.70 |   |   |
| Options outstanding, end of year         |       | 287,000    |        |                                  | $     | 6.27       |       |   | 306,800 |   |   | $  | 6.21 |   |   | 272,800 |   |   | $  | 6.10 |   |   |
| Option price  range of exercised options |       | $     | 4.00 - 5.25 |                                  |       |       |       |   | $  | 3.63 |   |   |   |   |   | $  | 3.125 - 4.00 |   |   |   |   |   |
|                                          |            |            |             |                                       |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**NOTE 10   COMMITMENTS AND CONTINGENCIES**

*Litigation*

We are subject to various legal proceedings and claimsthat arise in the ordinary course of business. In our opinion, the amount ofany ultimate liability with respect to these actions will not materially affectour consolidated financial statements or results of operations.

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2005, 2004, AND 2003**

**NOTE 10   COMMITMENTS AND CONTINGENCIES(Continued)**

*Executive LifeInsurance Plan*

During 2002, we set up anExecutive Bonus Life Insurance Plan (the “Plan”) for our key employees (“participants”).Pursuant to the Plan, we will pay a bonus to participants equal to 10% of theparticipants’ base annual salary, as well as an additional bonus to coverfederal and state taxes incurred by the participants. The participants arerequired to purchase life insurance and retain ownership of the life insurancepolicy once it is purchased. The Plan provides a five-year graded vestingschedule in which the participants vest at a rate of 20% each year. Should aparticipant terminate employment prior to the fifth year of vesting, thatparticipant may be required to reimburse us for any unvested amounts, undercertain circumstances. Charges to income under the Plan were $228,000, $167,375and $156,091 for the years ended December 31, 2005, 2004 and 2003.

*Change of ControlAgreements*

During 2002, we entered into Change of ControlAgreements (the “Agreement(s)”) with certain key executives (“the Executive(s)”).The Agreements provide an inducement for each Executive to remain as anemployee in the event of any proposed or anticipated change of control in theorganization, including facilitating an orderly transition, and to provideeconomic security for the Executive after a change in control has occurred.

In the event of aninvoluntarily termination, each Executive would receive their base salary,annual bonus at time of termination, and continued participation in health,disability and life insurance plans for a period of three years. Each Executivewould also receive professional outplacement services up to $10,000. EachAgreement remains in full force until the Executive terminates employment or weterminate the employment of the Executive.

*Commitment toPurchase Real Property*

We entered into an agreement in November 2005 tolease 20,000 square feet of a building located in Blue Earth, Minnesota, to beused for manufacturing space effective December 1, 2005. The lease, whichhas a 90-day option to renew, expires as of March 31, 2006. At theend of December 2005, we signed an agreement to purchase the entire140,000 square foot Blue Earth, Minnesota building for $1,350,000, the closingis scheduled for June 2006, with the seller having the option to leaseback from us 50,000 square feet through the first quarter of 2007. We intend toissue an Variable Rate Demand Industrial Development Revenue Bond through theCity of Blue Earth, MN, secured by an Irrevocable Letter of Credit to be issuedby Wells Fargo Bank, National Association.

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2005, 2004, AND 2003**

**NOTE11   EARNINGS PER COMMON SHARE**

Thefollowing is a reconciliation of the numerators and the denominators of thebasic and diluted per common share computations.

| ** **                                                            | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|-----------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| **Basic Earnings Per Common Share**                                   |       |      |       |      |       |      |       |
| Net Income                                                            |       | $         | 928,781    |      | $          | 587,329   |       | $ | 633,448 |   |
| Weighted average  common share outstanding                            |       | 2,583,309 |       | 2,561,419 |       | 2,478,921 |       |
| Basic earnings  per common share                                      |       | $         | 0.36       |      | $          | 0.23      |       | $ | 0.26 |   |
| **Diluted Earnings Per Common  Share**                                |       |      |       |      |       |      |       |
| Net Income                                                            |       | $         | 928,781    |      | $          | 587,329   |       | $ | 633,448 |   |
| Weighted average  common shares outstanding                           |       | 2,583,309 |       | 2,561,419 |       | 2,478,921 |       |
| Stock options                                                         |       | 30,633    |       | 42,992    |       | 49,889    |       |
| Weighted average  common shares for diluted earnings per common share |       | 2,613,942 |       | 2,604,411 |       | 2,528,810 |       |
| Diluted earnings per  common share*                                   |       | $         | 0.36       |      | $          | 0.23      |       | $ | 0.25 |   |

 

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*                    For2005, 2004 and 2003, there were approximately 43,302, 48,409 and 17,350 shares,respectively, which were not “in the money” and therefore were excluded fromthe computation of diluted earnings per share because to include them would beantidilutive.

**NOTE12   QUARTERLY SELECTED FINANCIAL DATA (UNAUDITED)**

| ** **                                        | ** ** | **Quarter Ending** | ** ** | **Quarter Ending** | ** ** | **Quarter Ending** | ** ** | **Quarter Ending** | ** ** | **Total** | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------|------------|-----------|------------|
| ** **                                        | ** ** | **3/31/2005**           | ** ** | **6/30/2005**           | ** ** | **9/30/2005**           | ** ** | **12/31/2005**          | ** ** | **YTD**   | ** ** |
| Net sales                                         |       |                    | $          | 19,067,502              |       |                    |       | $                       | 20,562,916 |      |       |   | $ | 20,919,151 |   |   |   | $ | 23,666,094 |   |   | $ | 84,215,663 |   |
| Gross profit                                      |       |                    | 2,364,533  |                    |       |                    | 2,588,446  |                    |       |      | 2,554,243  |   |   |   | 2,525,006 |   |   | 10,032,228 |   |
| Net income                                        |       |                    | 98,892     |                    |       |                    | 138,961    |                    |       |      | 260,357    |   |   |   | 430,571 |   |   | 928,781 |   |
| Basic earnings  per share of common stock         |       |                    | 0.04       |                    |       |                    | 0.05       |                    |       |      | 0.10       |   |   |   | 0.17 |   |   | 0.36 |   |
| Diluted earnings per  share of common stock  |       |                    | 0.04       |                    |       |                    | 0.05       |                    |       |      | 0.10       |   |   |   | 0.17 |   |   | 0.36 |   |
|                                                   |            |                         |            |                         |            |                         |            |                         |            |           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                        | ** ** | **Quarter Ending** | ** ** | **Quarter Ending** | ** ** | **Quarter Ending** | ** ** | **Quarter Ending** | ** ** | **Total** | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------|------------|-----------|------------|
| ** **                                        | ** ** | **3/31/2004**           | ** ** | **6/30/2004**           | ** ** | **9/30/2004**           | ** ** | **12/31/2004**          | ** ** | **YTD**   | ** ** |
| Net Sales                                         |       |                    | $          | 15,046,085              |       |                    |       | $                       | 18,028,197 |      |       |   | $ | 19,189,852 |   |   |   | $ | 20,410,025 |   |   | $ | 72,674,159 |   |
| Gross Profit                                      |       |                    | 1,504,871  |                    |       |                    | 1,918,523  |                    |       |      | 2,568,674  |   |   |   | 2,546,905 |   |   | 8,538,973 |   |
| Net Income                                        |       |                    | 43,049     |                    |       |                    | 104,984    |                    |       |      | 236,439    |   |   |   | 202,857 |   |   | 587,329 |   |
| Basic earnings  per share of common stock         |       |                    | 0.02       |                    |       |                    | 0.04       |                    |       |      | 0.09       |   |   |   | 0.08 |   |   | 0.23 |   |
| Diluted earnings per  share of common stock  |       |                    | 0.02       |                    |       |                    | 0.04       |                    |       |      | 0.09       |   |   |   | 0.08 |   |   | 0.23 |   |
|                                                   |            |                         |            |                         |            |                         |            |                         |            |           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Report of Independent Registered Public AccountingFirm on Supplementary Information**

To the Board of DirectorsNortech Systems Incorporated and SubsidiaryWayzata, Minnesota

**Ouraudit was made for the purposes of forming an opinion on the basic 2005 and 2004consolidated financial statements of Nortech Systems Incorporated andSubsidiary taken as a whole. The consolidated supplemental schedule II ispresented for purposes of complying the Securities and Exchange Commission’s rules andis not a part of the basic consolidated financial statements. This schedule hasbeen subjected to the auditing procedures applied in our audit of the 2005 and2004 basic consolidated financial statements and, in our opinion, is fairlystated in all material respects in relation to the basic consolidated financialstatements taken as a whole.**

/s/ McGLADREY & PULLEN, LLP

Minneapolis, MinnesotaFebruary 24, 2006

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**Report of Independent Registered Public AccountingFirm on Supplementary Information**

Board of Directors and ShareholdersNortech Systems Incorporated:

Under date of February 13, 2004, except as tonote 4 which is as of March 9, 2004, we reported on Nortech SystemsIncorporated and Subsidiary’s consolidated statements of income, shareholders’equity and cash flows for the year ended December 31, 2003, which areincluded in the Annual Report on Form 10-K for the year 2005. Inconnection with our audit of the aforementioned consolidated financialstatements, we also audited the related financial statement schedule as listedin the accompanying index for the year ended December 31, 2003. Thisfinancial statement schedule is the responsibility of the Company’s management.Our responsibility is to express an opinion on this financial statementschedule based on our audit.

In our opinion, suchfinancial statement schedule, when considered in relation to the 2003 basicconsolidated financial statements taken as a whole, presents fairly, in allmaterial respects, the information set forth therein.

/s/  KPMG LLP

Minneapolis, MinnesotaFebruary 13, 2004

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**NORTECHSYSTEMS INCORPORATED AND SUBSIDIARYSCHEDULE II—Valuation and Qualifying AccountsFOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003**
|                                      | ** ** | ** **          | ** ** | **Additions**      | ** ** | ** **            | ** ** | ** **            | ** ** |
|--------------------------------------|------------|---------------------|------------|--------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **Balance at** | ** ** | **Charged**        | ** ** | ** **            | ** ** | **Balance at**   | ** ** |
| ** **                           | ** ** | **Beginning**       | ** ** | **to Costs**  | ** ** | ** **            | ** ** | **End of**       | ** ** |
| **Classification**                   | ** ** | ** **          | ** ** | **of Period** | ** ** | **And Expenses** | ** ** | **Add (Deduct)** | ** ** | **Period** | ** ** |
| Year Ended  December 31, 2005:  |       |                |       |               |       |                  |       |                  |       |   |   |   |   |
| Allowance for Uncollectible Accounts |       | $                   | 280,146    |               |       | 122,088               |       |                  |       | (105,671 | ) |   | $ | 296,563 |   |
| Inventory Reserve                    |       | $                   | 1,219,200  |               |       | 897,199               |       |                  |       | (897,965 | ) |   | $ | 1,218,434 |   |
| Self-insurance Accrual               |       | $                   | 250,330    |               |       | 3,295,566             |       |                  |       | (3,274,792 | ) |   | $ | 271,104 |   |
| Year Ended  December 31, 2004:  |       |                |       |               |       |                  |       |                  |       |   |   |   |   |
| Allowance for Uncollectible Accounts |       | $                   | 371,690    |               |       | 166,989               |       |                  |       | (258,533 | ) |   | $ | 280,146 |   |
| Inventory Reserve                    |       | $                   | 1,319,250  |               |       | 829,918               |       |                  |       | (929,968 | ) |   | $ | 1,219,200 |   |
| Self-insurance Accrual               |       | $                   | 217,514    |               |       | 3,914,882             |       |                  |       | (3,882,066 | ) |   | $ | 250,330 |   |
| Year Ended  December 31, 2003:  |       |                |       |               |       |                  |       |                  |       |   |   |   |   |
| Allowance for Uncollectible Accounts |       | $                   | 488,451    |               |       | (19,694               | )          |                  |       | (97,067 | ) |   | $ | 371,690 |   |
| Inventory Reserve                    |       | $                   | 1,192,255  |               |       | 1,017,580             |       |                  |       | (890,585 | ) |   | $ | 1,319,250 |   |
| Self-insurance  Accrual              |       | $                   | 277,864    |               |       | 3,353,287             |       |                  |       | (3,413,637 | ) |   | $ | 217,514 |   |
|                                      |            |                     |            |                    |            |                       |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**ITEM 9.   CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON**ACCOUNTINGAND FINANCIAL DISCLOSURE

On August 31, 2004, KPMG LLP (“KPMG”) notified usthat the auditor-client relationship between KPMG and us ceased as of that date.The decision to terminate the relationship was made by KPMG; our auditcommittee did not recommend a change in accountants and as a result of KPMG’sresignation began a search for a new independent auditing firm, which resultedin the appointment of McGladrey & Pullen, LLP as our principalaccountant to audit the our financial statements, effective October 20,2004.

In connection with the audits of the two fiscal yearsended December 31, 2003 and 2002, and the review of subsequent interimperiods through August 31, 2004, there were no disagreements with KPMG onany matter of accounting principles or practices, financial statementdisclosure, or auditing scope or procedure, which disagreement(s), if notresolved to the satisfaction of KPMG, would have caused it to make reference tothe subject matter of the disagreement(s) in connection with its report.

The audit reports of KPMG on our consolidatedfinancial statements as of and for the years ended December 31, 2003 and2002 did not contain any adverse opinion or disclaimer of opinion and werenot qualified or modified as to uncertainty, audit scope or accountingprinciples.

During our two recentfiscal years ended December 31, 2003, and the subsequent interim periodsthrough August 31, 2004, there were no “reportable events” (as that termis defined in Item 304(a)(1)(v) of Regulation S-K), except that on August 13,2004, KPMG advised our audit committee that KPMG noted a deficiency related toour ability to forecast financial results accurately enough to determineexpected compliance with debt covenants at future quarter ends. This deficiencywas considered to be a “reportable condition” under the standards establishedby the American Institute of Certified Public Accountants. The subject matterof this deficiency was discussed with the Chairman of the Audit Committee andrepresentatives of our management on August 13, 2004, as were the proposedremedial actions. The Company believes that it has taken appropriate steps toremedy this deficiency by improving and expanding its monthly forecastingprocess put into place in the first week of June 2004. At the August 13,2004 discussion with the Chairman of our audit committee and management, KPMGalso stated that this 

44

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deficiencydid not in its view constitute a “material weakness” within the meaning of thestandards established by the American Institute of Certified PublicAccountants.

**ITEM 9A.   CONTROLS AND PROCEDURES**

We maintain disclosure controls and proceduresdesigned to ensure that information required to be disclosed in reports filedunder the Securities Exchange Act of 1934, as amended, is recorded, processed,summarized and reported within the specified time periods. As of the end of theperiod covered by this report, our management, including the Chief ExecutiveOfficer and Chief Financial Officer, evaluated the effectiveness of ourdisclosure controls and procedures. Based on the evaluation, which disclosed nosignificant deficiencies or material weaknesses, the Chief Executive Officerand Chief Financial Officer each concluded that our disclosure controls andprocedures are effective.

We are currently in theprocess of reviewing and formalizing our internal controls and procedures forfinancial reporting in accordance with the Securities and Exchange Commission’srules implementing the internal control reporting requirements included inSection 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”). Changeshave been and will be made to our internal controls over financial reporting asa result of these efforts. We are dedicating significant resources, includingsenior management time and effort, and incurring substantial costs in connectionwith our ongoing Section 404 assessment. We are currently documenting andtesting internal controls and considering whether any improvements arenecessary for maintaining an effective control environment. The evaluation ofinternal controls is being conducted under the direction of senior managementin consultation with an independent third party consulting firm. In addition,senior management is regularly discussing the results of testing and anyproposed improvements to the control environment with the Audit Committee. Weexpect to assess controls and procedures on a regular basis. We will continueto work to improve controls and procedures and to educate and train employeeson the existing controls and procedures in connection with the efforts to maintainan effective controls infrastructure.

**ITEM 9B.   OTHER INFORMATION**

None.

**PART III**

**ITEM 10.   DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT**

Information regarding thedirectors and executive officers of the Registrant will be included in theRegistrant’s 2005 proxy statement to be filed with the Securities and ExchangeCommission not later than April 30, 2006 and said portions of the proxystatement are incorporated herein by reference.

**ITEM 11.   EXECUTIVE COMPENSATION**

Information regardingexecutive compensation of the Registrant will be included in the Registrant’s2005 proxy statements to be filed with the Securities and Exchange Commissionnot later than April 30, 2006 and said portions of the proxy statement areincorporated herein by reference.

**ITEM 12.   SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS** ANDMANAGEMENT

Information regarding security ownership of certainbeneficial owners and management of the Registrant will be included in theRegistrant’s 2005 proxy statements to be filed with the Securities and ExchangeCommission no later than April 30, 2006 and said portions of the proxystatements are incorporated herein by reference.

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Information regarding executive compensation plans(including individual compensation arrangements) as of the end of the lastfiscal year, on two categories of equity compensation plans (that is, plansthat have been approved by security holders and plans that have not beenapproved by security holders) will be included in the Registrant’s 2005 proxystatements to be filed with the Securities and Exchange Commission no laterthan April 30, 2006 and said portions of the proxy statements areincorporated herein by reference.

Thefollowing table provides information about our equity compensation plans(including individual compensation arrangements) as of December 31, 2005.

| **Plan category**                                           | ** ** | ** ** | ** ** | **Number of securities to  be issued upon the  exercise of outstanding  options, warrants  and rights(1)** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation  plans (excluding securities reflected in the  first column)(2)** | ** ** |
|-------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders     |       | 287,000    |       | $6.273                                                                                                     |       | 180,000                                                                            |       |
| Equity  compensation plans not approved by security holders |       | 0          |       | 0                                                                                                          |       | 0                                                                                  |       |
| Total                                                       |       | 287,000    |       | $6.273                                                                                                     |       | 180,000                                                                            |       |

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(1)          Represents common sharesissuable upon the exercise of outstanding options granted under our 1992Employee Stock Incentive Plan (the “1992 Plan”) and the 2003 Stock Option Plan(the “2003 Plan”) and the 2005 Incentive Compensation Plan (the “2005 Plan”).

(2)          Representscommon shares remaining available under the 2005 Plan.

**ITEM 13.   CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

The information requiredby this Item is included under the captions “Certain Transactions” and “ExecutiveCompensation—Compensation Committee Interlocks and Insider Participation” inthe Proxy Statement and when the Proxy Statement is filed with the Securitiesand Exchange Commission will be incorporated herein by reference.

**ITEM 14.   PRINCIPAL ACCOUNTANT FEES AND SERVICES**

The information requiredby this Item is included under the caption “Miscellaneous—Independent AuditorFees” in the Proxy Statement and, when the Proxy Statement is filed, will beincorporated herein by reference.

**PART IV**

**ITEM 15.   EXHIBITS, CONSOLIDATED FINANCIALSTATEMENTS SCHEDULES**

(a) 1.       ConsolidatedFinancial Statements—consolidated financial statements and related Notes areincluded in Part II, Item 8, and are identified in the Index on Page 20.

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(a) 2.       ConsolidatedFinancial Schedule—The following consolidated financial statement schedulesupporting the consolidated financial statements and the Accountants’ reportthereon is included in this Annual Report on Form 10-K:

|                                                                                                       | ** ** | **PAGE** |
|-------------------------------------------------------------------------------------------------------|------------|----------|
| Reports of Independent  Registered                                                                    |       |     |
| Public Accounting Firms  on Supplementary Information                                                 |       | 42-43    |
| Consolidated Financial Statements Schedule for the  years ended December 31, 2005, 2004 and 2003 |       |     |
| II Valuation and Qualifying Accounts                                                                  |       | 44       |

 

All other schedules are omitted since they are notapplicable, not required, or the required information is included in the financial statements or notesthereto.

Thefollowing exhibits are incorporated by reference to exhibits accompanying theCompany’s Annual Report on Form 10-K for the year ended December 31,2004.

| 10.1 |   | Fifth Amendment to amended and restated Credit and Security  Agreement, Amended and Restated Revolving Note between the Company and Wells  Fargo Bank Minnesota National Association. |
|------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 23.1 |   | Consent of  McGladrey & Pullen, LLP                                                                                                                                          |
| 23.2 |   | Consent of KPMG LLP                                                                                                                                                                   |
| 31.1 |   | Certification of the  Chief Executive Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a), promulgated under the Securities Exchange Act of  1934, as amended.      |
| 31.2 |   | Certification of the  Chief Financial Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a), promulgated under the Securities Exchange Act of  1934, as amended.      |
| 32.1 |   | Certification of the  Chief Executive Officer and Chief Financial Officer, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                |

 

47

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
| NORTECH  SYSTEMS INCORPORATED |   |   |                          |
|-------------------------------|--------|--------|-------------------------------|
| March 9, 2006            | By:    | /s/    | *RICHARD G. WASIELEWSKI*      |
|                          |   |   | Richard G.  Wasielewski       |
|                          |   |   | Chief Financial  Officer      |
|                          |   |   | and                           |
|                          |   |   | Principal  Accounting Officer |
| March 9, 2006            | By:    | /s/    | *MICHAEL J. DEGEN*            |
|                          |   |   | Michael J. Degen              |
|                          |   |   | President, Chief  Executive   |
|                          |   |   | Officer and  Director         |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the followingpersons on behalf of the registrant and in the capacities and on the datesindicated have signed this report.
| March 9, 2006 | /s/    | *MICHAEL J. DEGEN*            |
|--------------------|--------|-------------------------------|
|               |   | Michael J. Degen              |
|               |   | President, Chief  Executive   |
|               |   | Officer and  Director         |
| March 9, 2006 | /s/    | *MYRON KUNIN*                 |
|               |   | Myron Kunin                   |
|               |   | Chairman and  Director        |
| March 9, 2006 | /s/    | *RICHARD W. PERKINS*          |
|               |   | Richard W.  Perkins, Director |
| March 9, 2006 | /s/    | *C. TRENT RILEY*              |
|               |   | C. Trent Riley,  Director     |
| March 9, 2006 | /s/    | *KEN LARSON*                  |
|               |   | Ken Larson,  Director         |

 

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**INDEX TO EXHIBITS**

**DESCRIPTIONS OFEXHIBITS**

| 23.1 |   | Consent of McGladrey & Pullen, LLP                                                                                                                                      |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 23.2 |   | Consent of KPMG LLP                                                                                                                                                              |
| 31.1 |   | Certification of the  Chief Executive Officer pursuant to Rule 13a 14(a) and Rule 15d 14(a),  promulgated under the Securities Exchange Act of 1934, as amended.                 |
| 31.2 |   | Certification of the  Chief Financial Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a), promulgated under the Securities Exchange Act of  1934, as amended. |
| 32.1 |   | Certification of the  Chief Executive Officer and Chief Financial Officer, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                           |

 

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