**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D. C. 20549**

**FORM 10-K**

**(Mark One)**

**x        ANNUAL REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**Forthe fiscal year ended December 31, 2006**

**OR**

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

**Forthe transition period from                to                **

**NORTECH SYSTEMS INCORPORATED**

**Commission file number0-13257**

**State of Incorporation:** Minnesota

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

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

Telephone Number:**(952) 345-2244**

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

Securities registered pursuant to Section12(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 of theSecurities Act.  Yes  o    No  x

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

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes  x    No  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-K or anyamendment to this Form 10-K.  x

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer.  See definition of“accelerated filer and large accelerated filer” in Rule 12b-2 of the ExchangeAct.

| Large Accelerated Filer o |   | Accelerated Filer o |   | Non-accelerated Filer x |
|---------------------------|--------|---------------------|--------|-------------------------|

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

Theaggregate market value of voting stock held by non-affiliates of theregistrant, based on the closing price of $7.20 per share, was $8,591,522 onJune 30, 2006.

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

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**DOCUMENTSINCORPORATED BY REFERENCE**

Thefollowing documents are incorporated by reference to the parts indicated of theAnnual Report on Form 10-K:
| Parts of Annual Report  on Form 10-K | ** ** | ** ** | **Documents  Incorporated by Reference** |
|--------------------------------------|------------|------------|------------------------------------------|
|                                 |       |       |                                     |   |
| Part III                             |       |       |                                     |   |
|                                 |       |       |                                     |   |
| Item                                 | 10         |       |                                     |   |   | Reference is made to  the Registrant’s proxy statements to be used in connection with the 2006  Annual Shareholders’ Meeting and filed with the Securities and Exchange  Commissionno later than April 30, 2007 |
|                                 | 11         |
|                                 | 12         |
|                                 | 13         |

(The remainder of this pagewas intentionally left blank)

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**NORTECH SYSTEMS INCORPORATED**

**ANNUAL REPORT ON FORM 10K**

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

 

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

 

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**NORTECH SYSTEMS INCORPORATED**

#### **FORM 10-K**

**For the Year Ended December 31, 2006**

#### **PART   I**

##### **ITEM1.   BUSINESS**

###### DESCRIPTION OF BUSINESS

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

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

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

GENERAL

We are an EMS (Electronic Manufacturing Service) contract manufacturingcompany with our headquarters in Wayzata, Minnesota, a suburb of Minneapolis,Minnesota.  We maintain manufacturingfacilities in Minnesota including Bemidji, Fairmont, Blue Earth, Baxter, andMerrifield as well as Augusta, Wisconsin, and Monterrey, Mexico.  On February 4, 2007, we acquired amanufacturing operation in Garner, Iowa. We manufacture wire harness and cable assemblies, electronicsub-assemblies, and printed circuit board assemblies.  We provide value added services and technicalsupport including design, testing, prototyping and supply chain management. Thevast majority of our revenue is derived from products built to the customer’sdesign specifications.

We provide a high degree of manufacturing expertise using statisticalprocess controls to ensure product quality, total supply chain solutiontechniques and the systems necessary to effectively manage the business.  This level of sophistication enables us toattract major original equipment manufacturers (OEMs) and to expand and diversifyour customer base.   Our strategy is todevelop a customer base across several markets to avoid the effects offluctuations within a given industry. The markets we serve areIndustrial Equipment, Medical, Military/Defense and Transportation.

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

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

ACQUISITIONS

On February 4, 2007, we acquired the business assets of SuntronCorporation’s Mid-West Operation located in Garner, Iowa.  This acquisition will strengthen ourcapabilities in printed circuit board assemblies and high level complete boxbuild assemblies while opening new market segments in the agriculture and oiland gas industries

On June 28, 2006, we acquired a 140,000 square foot building in Blue Earth, Minnesota from TelexCommunications, Inc.  This acquisitionexpanded our capacity allowing us to better meet the needs of the growingMilitary/Defense market.

On June 23, 2004, we acquired all of the business assets of Zachariahand Lundbergh, Inc. (Z&L).  Thisacquisition of assets allows for further expansion of our InterconOne brand ofspecialty cable and power supplies for use in industrial and medical grade videocameras and ancillary equipment.

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

BUSINESSSEGMENT

All of our operations fall under the Contract Manufacturing segmentwithin the Electronic Manufacturing Services industry.  We strategically direct production amongstour various manufacturing facilities based on a number of considerations tobest meet our customers’ requirements.

###### BUSINESSSTRATEGY

The Electronic Manufacturing Services industry continues to evolve intoa dynamic, higher tech global electronics contract services industry.  We continue to expand our capabilities tobetter meet these changing market requirements. Along with offering technicalexpertise in our quality processes, design, applications and testing, we arealso increasing our focus on supplier-managed inventory services and the costdrivers 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.

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

Our quality systems and processes are based on ISO standards with allour domestic and Monterrey, Mexico facilities certified to the latest versionof the ISO 9001 standards.  We believethese certifications benefit our customer base and increase our chances ofattracting new business opportunities.

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We are committed to quality, cost effectiveness and responsiveness tocustomer requirements.  To achieve theseobjectives 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 are committed to continuous improvement inorder to provide competitive and complete manufacturing service solutions toour 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 industrial equipment,medical, military/defense and transportation industries and with the recentacquisition of our Iowa circuit board operation, we enter into the agricultureand oil and gas markets. Our marketing strategy emphasizes the breadth of ourmanufacturing, supply chain and engineering services and reflects the completeturnkey solution for meeting our customers’ current and future requirements.

Our emphasis continues to be on mature companies, which require acontract manufacturer with a high degree of manufacturing and qualitysophistication, including statistical process control (SPC), statisticalquality control (SQC), International Standards Organization (ISO), MilitarySpecifications (Mill Spec) and Aerospace Systems 9100 (AS).  We continue efforts to penetrate our existingcustomer base and expand new market opportunities in Mexico, Asia and Europe,in addition to participation in industry publications and selected tradeshows.  We target customers who valueproven manufacturing performance, design and application engineering expertiseand who value the flexibility to manage the supply chain of a high mix ofproduct and service. We market our products and services through our in-housesales force and independent manufacturers’ representatives.

###### SOURCES ANDAVAILABILITY OF MATERIALS

On occasion some of our components may be placed on a stringentallocation basis; however, due to the excess manufacturing capacity currentlyavailable at most component manufacturers, we do not anticipate any majormaterial purchasing or availability problems occurring in the foreseeablefuture.

###### PATENTS ANDLICENSES

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

###### COMPETITION

The contract manufacturing EMS industry competitive makeup includessmall closely held contract manufacturing companies, large global full-servicecontract manufacturers, company-owned in-house manufacturing facilities andforeign contract manufacturers.  We donot believe that the small closely held operations pose a significantcompetitive threat in the markets and customers we serve, as they generally donot have the complete manufacturing services or capabilities required by ourtarget customers.  We believe the largerglobal full service and foreign manufacturers do provide a substantialcompetitive environment while the company-owned operations create an increasingopportunity as the trend of more outsourcing continues.

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Technical support from foreign competition has improved greatly alongwith their ability to be more responsive to engineering and schedulechanges.  The willingness of foreignmanufacturers to “stock” finished product at warehouse locations in the UnitedStates is another of their competitive advantages, however, their inability toreact to engineering, product or schedule changes is a disadvantage and playsinto our strength.  To mitigate foreigncompetition, we maintain a contractual agreement allowing us to provide a Chinamanufacturing solution and we operate a manufacturing operation in Mexico tosupport our customers with a “Low Cost” supply chain solution.

###### BACKLOG

Historically, our backlog has beenrunning 60 to 90 days.  However, becauseof the increased emphasis on just-in-time manufacturing (JIT), reduced leadtimes and repetitive scheduling, our historical backlog levels may not beindicative of future results due to customers rescheduling and canceling oforders.  As of December 31, 2006 our 90day backlog was approximately $19.5 million compared to approximately $24.9million on December 31, 2005.  We expecta major portion of the backlog will be realized as revenue during first quarter2007.

###### MAJORCUSTOMERS

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

###### RESEARCH AND DEVELOPMENT

We perform research and development for customers on an as requestedand program basis for development of conceptual engineering and designactivities prior to manufacturing the products. We did not expend significant dollars in 2006, 2005 or 2004 oncompany-sponsored product research and development.

###### ENVIRONMENTALLAW COMPLIANCE

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

###### EMPLOYEES

We have 911 full-time, 80 part-timeand 17 temporary employees as of December 31, 2006.  Manufacturing personnel, including direct,indirect support and sales functions, comprise 967 employees, while generaladministrative employees total 41.

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FOREIGN OPERATIONS AND EXPORT SALES

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

### FORWARD-LOOKING STATEMENTS

### ThisAnnual Report on Form 10-K, including “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” in Item 7,  contains forward-looking statements withinthe meaning of the Private Securities Litigation Reform Act of 1995.  We may also make forward-looking statementsin other reports filed with the SEC, in materials delivered to stockholders andin press releases.  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 oroutcomes.  Although we believe theseforward-looking statements are reasonable, they are based upon a number ofassumptions concerning future conditions, any or all of which may ultimatelyprove to be inaccurate.  Forward-lookingstatements involve a number of risks and uncertainties.  Important factors that could cause actualresults to differ materially from the forward-looking statements include,without limitation:

# ·                  Volatility in the marketplace which mayaffect market supply and demand of our products;

# ·                  Increased competition;

# ·                  Changes in the reliability and efficiency ofour operating facilities or those of third parties;

·                  Risks related to availability of labor;

·                  Increase in certain raw material costs suchas copper

·                  Commodity and Energy cost instability

·                  General economic, financial and businessconditions that could affect our financial condition and results of operations.

 

The factors identified above arebelieved to be important factors (but not necessarily all of the importantfactors) that could cause actual results to differ materially from thoseexpressed in any forward-looking statement made by us.  Discussion of these factors is alsoincorporated in Part I, item 1A, “Risk Factors”, and should be considered anintegral part of Part II, Item 7, “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations”. Unpredictable or unknownfactors not discussed herein could also have material adverse effects onforward-looking statements.  Allforward-looking statements included in this Form 10-K are expressly qualifiedin their entirety by the forgoing cautionary statements.  We undertake no obligations to updatepublicly any forward-looking statement (or its associated cautionary language)whether as a result of new information or future events.

**ITEM1A.   RISK FACTORS**

**In evaluating us as a company,careful consideration should be given to the following risk factors, inaddition to the other information included in this Annual Report on Form 10-K.Each of these risk factors could adversely affect our business, operatingresults and/or financial**

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**condition, as well as adverselyaffect the value of an investment in our common stock. In addition to thefollowing disclosures, please refer to the other information contained in thisreport, including the consolidated financial statements and the related notes.**

*We operate in a in the highlycompetitive EMS (Electronic Manufacturing Services) industry.*

Wecompete against many EMS companies. The larger global competitors have moreresources and greater economics of scale. We also compete with OEM in-houseoperations that are continually evaluating manufacturing products internallyagainst the advantages of outsourcing. We may also be at a competitivedisadvantage with respect to price when compared to manufacturers with excesscapacity, lower cost structures and availability of lower cost labor.

Theavailability of excess manufacturing capacity of our competitors also createscompetitive pressure on price and winning new business. We must continue toprovide services, a quality product, be responsive and flexible to customers’requirements for design and technical support schedule changes and deliver. Ourlack of execution could have an adverse effect on our operations.

*A largepercentage of our sales have been made to a small number of customers, and theloss of a major customer, if not replaced, would adversely affect us.*

We have severalcustomers that are responsible for a significant portion of our net sales.  General Electric Co.’s (G.E.) Medical and Transportation Divisionstogether accounted for 17%, 17% and 15% of net sales for the years endedDecember 31, 2006, 2005 and 2004, respectively. Additionally, Northrop GrummanCorp. accounted for 10% of net sales for the years ended December 31, 2006 and2005. If there is a loss of one or more major customers or a significantdecline in sales to our major customers it could have an adverse effect on ourresults from operations. We will continue to expand our customer base throughour in-house sales efforts and target our acquisitions to reduce thedependence.

*We are dependent on suppliers for electronic components andmay experience shortages, cost premiums and shipment delays that wouldadversely affect our customers and us.*

We purchase raw materials, commodities andcomponents for use in our production. Increased costs of these materials couldhave an adverse effect on our production costs if we are unable to pass alongprice increases or reduce the other cost of goods produced through costimprovement initiatives. Fuel and energy cost increases could also adverselyaffect our freight and operating costs. Due to customer specifications andrequirements, we are dependent on suppliers to provide criticalelectronic components and materials for our operations that could result inshortages of some of the electronic components need for their production.Component shortages may result in expedited freight, overtime premium andincreased component costs. In addition to the financial impact on operationsfrom lost revenue and increased cost, there could potentially be harm to ourcustomer relationships.

*Our customers cancel orders, change order quantity, timingand specifications and if not managed would have an adverse affect on inventorycarrying costs.*

We do face through thenormal course of business excess and obsolete inventory losses as a result ofcustomer order changes, cancellations, product changes and contract terminationthat

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could have an adverseeffect on our operations. We estimate and reserve for any known or potentialimpact from these possibilities.

*Themanufacture and sale of our products carries potential risk for productliability claims. *

We represent andwarrant the goods and services we deliver are free from defects in material andworkmanship for one year (1) from ship date. Unless otherwise agreed to,workmanship shall be in accordance with IPC and ANSI/J- Standards such asIPC-A-610, class 2, IPC—A-620, class 2, ANSI/J-STD001, class 2, C-20.  We make no other guarantees or warranties,expressed or implied, of any nature whatsoever as to the goods includingwithout limitation, warranties to merchantability, fit for a particular purposeor non-infringement of patent or the like unless agreed upon in writing.  If a product liability claim results in ourbeing liable and the amount is in excess of our insurance coverage or there isno insurance coverage for the claim then it could have an adverse effect on ourbusiness and financial position.

*We depend heavilyon our people and may from time to time have difficulty attracting andretaining skilled employees.*

Ouroperations depend upon the continued contributions of our key management,marketing, technical, financial, accounting, productdevelopment engineers, sales people and operational personnel.   We also believe that our continued successwill depend upon our ability to attract, retain and develop highly skilledmanagerial and technical resources within the highly competition EMS industry. Not being able to attract or retain these employees couldhave a material adverse effect on revenues and earnings.

*Operatingin foreign countries expose our operations to risks that could adversely affectour operating results.*

We’ve operated amanufacturing facility in Mexico since 2002 and we may in the future expandinto other foreign countries. The benefits projected for our Mexico operation have taken more time thenexpected to integrate into our marketing strategies and our operationthere is subject to risks, which could adversely impact our financial resultssuch as economic or political volatility, employee turnover, staffing, managingpersonnel in diverse culture, labor instability, transportation delays, andforeign currency flux.

*Non-compliance with environmental laws may result inrestrictions and adverse effects on operations.*

Our operations are regulated under a number of federal, state, andforeign environmental and safety laws and regulations that govern the dischargeof hazardous materials into the air and water, as well as the handling,storage, and disposal of such materials. These laws and regulations include theClean Air Act; the Clean Water Act; the Resource Conservation and Recovery Act;and the Comprehensive Environmental Response, Compensation, and Liability Act;as well as analogous state and foreign laws and compliance with theseenvironmental laws is a major consideration for us because of our manufacturingprocesses and materials. It is possible we may be subject to potentialfinancial liability for costs associated with the investigation and remediationat our sites and may have an adverse effect on operations. We have not incurredsignificant costs related to compliance with environmental laws andregulations, and we believe that our operations comply with all applicableenvironmental laws.

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Environmental laws could also become more stringent over time, imposinggreater compliance costs and increasing risks and penalties associated withviolation. We operate in environmentally sensitive locations and are subject topotentially conflicting and changing regulatory agendas of political, business,and environmental groups. Changes or restrictions on discharge limits;emissions levels; or material storage, handling, or disposal might require ahigh level of unplanned capital investment or relocation. It is possible thatenvironmental compliance costs and penalties from new or existing regulations mayharm our business, financial condition, and results of operations.

*We maybe subject to risks associated with our acquisitions, and the risks could havean adverse effect on our operating results.*Our strategy is to grow our business organically and throughacquisitions, alliances and joint venture arrangements. We will continue topursue and acquire additional businesses in the EMS industry that fit ourlong-term objectives for growth and profitability. The success of ouracquisitions will depend on our ability to integrate the new operations withthe existing operations.

In June2002, we acquired Manufacturing Assembly Solutions of Monterrey, Inc. (MAS), aMexican corporation, located in Monterrey, Mexico.  The benefits of this acquisition has taken moretime then expected to integrate into our marketing strategies. In February2007, we purchased a printed circuit board operation in Garner, Iowa with theexpectation that the results will be accretive to the overall business.

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

Our revolving credit facility and debt agreementscontain financial and operating covenants with which we must comply. As ofDecember 31, 2006, we were in compliance with each of these covenants.  However, among other factors, our continuedcompliance with these covenants is dependent on our financial results, whichare subject to fluctuation as described elsewhere in these risk factors.  If we fail to comply with the covenants inthe future or if our lender does not agree to waive any future non-compliance,we may be unable to borrow funds and any outstanding indebtedness could becomeimmediately due and payable, which could materially harm our business.

*Ourbusiness may be impacted by natural disasters.*

Tornadoes,blizzards and other natural disasters could negatively impact our business andsupply chain. In countries, which we rely on for operations and materials, suchas Mexico, China and Thailand, potential natural disasters could disrupt ourmanufacturing operations; reduce demand for our customers’ products andincrease supply chain costs.

 

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**ITEM1B. UNRESOLVED STAFF COMMENTS**

**Not Applicable**

**ITEM2.   PROPERTIES**

ADMINISTRATION

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

MANUFACTURINGFACILITIES

Ourmanufacturing facilities as described below, are all in reasonably goodoperating condition and are suitable for our needs.   We believe our overall productive capacityis sufficient to handle our foreseeable manufacturing needs.

Weown our Bemidji, Minnesota facility consisting of eight acres of land and abuilding of approximately 69,300 square feet consisting of 55,800 square feetdesignated for manufacturing space, and the remaining space is used foroffices.  We also lease a 6,000 squarefoot warehouse in Bemidji, Minnesota.

Weown three buildings in Fairmont, Minnesota, which together containapproximately 51,000 square feet consisting of 38,000 square feet designatedfor manufacturing space, and the remaining space is used for offices.

OnJune 28, 2006, we purchased a building in Blue Earth, Minnesota, of approximately140,000 square feet consisting of 92,000 square feet designated formanufacturing with 46,000 square feet of the 92,000 manufacturing squarefootage being leased back to the seller through June 30, 2007, per the leaseagreement, and the remaining space is being used for offices and warehouse.

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

Welease two buildings in Baxter, Minnesota where we lease 8,700 square feet inone building and 8,300 square feet in the other building, which togethercontain 13,000 square feet designated for electronic board repair of medicalequipment with the remaining space being used for offices and warehouse.   We are leasing these buildings on amonth-to-month basis.

Weown our Augusta, Wisconsin facility consisting of five acres of land and abuilding of approximately 20,000 square feet which consist of 15,000 squarefeet designated for manufacturing space with the remaining manufacturing spacebeing used as warehouse, and the remaining 5,000 square feet is used foroffices.

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

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

**ITEM3.    LEGAL PROCEEDINGS**

Fromtime to time, we are involved in ordinary, routine or regulatory legalproceedings incidental to the business. When a loss is deemed probable and reasonably estimable an amount isrecorded in our financial statements.  Wecurrently are not a party to any material legal proceeding.

**ITEM 4.   SUBMISSION OF MATTERSTO A VOTE OF SECURITY HOLDERS**

None.

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#### **PART II**

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

Asof March 6, 2007, there were 846 shareholders of record. Our stock is listed onthe National Association of Securities Dealers Automated Quotation System (“NASDAQ”)Small Cap Market under the symbol “NSYS”. We intend to invest our profits into the growth of our operations and,therefore, do not plan to pay out dividends to shareholders in the foreseeablefuture. We did not declare or pay a cash dividend in 2006 or 2005. Futuredividend policy and payments, if any, will depend upon earnings and our financialcondition, our need for funds, any limitations on payments of dividends presentin our current or future debt agreements and other factors.  Stockprice comparisons follow.

Stockprice comparisons (NASDAQ):
| During the Three Months Ended | ** ** | **Low** | ** ** | **High** | ** ** |
|---------------------------------------------------|------------|---------|------------|----------|------------|
| March 31, 2006                                    |       | $       | 6.16       |     | $          | 8.16 |   |
| June 30, 2006                                     |       | $       | 6.52       |     | $          | 9.08 |   |
| September 30, 2006                                |       | $       | 6.59       |     | $          | 7.90 |   |
| December 31, 2006                                 |       | $       | 7.05       |     | $          | 7.94 |   |
|                                              |       |    |       |     |       |
| March 31, 2005                                    |       | $       | 5.52       |     | $          | 6.92 |   |
| June 30, 2005                                     |       | $       | 5.00       |     | $          | 7.00 |   |
| September 30, 2005                                |       | $       | 5.62       |     | $          | 6.60 |   |
| December 31,  2005                                |       | $       | 5.30       |     | $          | 6.25 |   |

###  

Sales of Unregistered Securities:

Wedid not have any unregistered sales of equity securities in 2006.

Purchases of Equity Securities by the Issuerand Affiliated Purchasers:

Wedid not make any purchases of our equity securities in 2006.

###### EQUITYCOMPENSATION PLAN INFORMATION

Certaininformation with respect to our equity compensation plans are contained in PartIII, Item 12 of this Annual Report on Form 10-K.

**ITEM 6. SELECTED FINANCIAL 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, 2006 and 2005and for each of the years in the three year period ended December 31,2006.  The audited consolidated financialstatements of Nortech Systems Incorporated and Subsidiary referred to above areincluded elsewhere herein.  The selectedhistorical financial data set forth below as of December 31, 2004, 2003 and2002 and for each of 

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theyears in the three year period ended December 31, 2003 have been derived fromthe audited consolidated financial statements of Nortech Systems Incorporatedand Subsidiary not included herein.  Theselected financial data set forth below should be read in conjunction with, andare qualified by reference to, “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” and the Consolidated FinancialStatements and accompanying notes thereto of Nortech Systems Incorporated andSubsidiary included elsewhere herein.

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

----

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

*  In 2006, 2005 and 2004, therevolving line of credit was classified in current liabilities.  In the previous years these amounts had beenreflected as long-term.  As of December31, 2006, 2005 and 2004, the revolving line of credit, classified as a currentliability, had outstanding borrowings of $4,694,027, $4,228,234 and $7,523,058,respectively.  For additional financialdata (2006 and 2005 by quarter information), see Note 12 to the ConsolidatedFinancial Statements.

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##### **ITEM7.****                             MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

**OVERVIEW**

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

Thevast majority of our revenue is derived from products that are built to thecustomer’s design specifications.  Weprovide a high degree of manufacturing sophistication.  During 2006, we continued our supplychain initiatives designed to reduce costs, improve asset utilization andincrease responsiveness to customers.  Our strategy has been to expand and diversifyour customer base, and we are focusing our sales and marketing approachto target greater value-added service opportunities.  Our market strength is low-volume, high-mixproduction, particularly with complex products. Our investment in the Mexico operation in 2002 allows for expansion intomedium volume, medium mix and lower cost production and our contractualarrangements with Chinese manufacturers allow us to meet high-volume, low mixand lower cost customer requirements.

During 2006, weexperienced growth in our Sales, Gross Profit, and Net Income.   For the years ended December 31, 2006 we hadsales of $105.1 million, compared to $84.2 million for 2005 and $72.7 millionfor 2004. The increase for 2006 of $20.9 million was a 24.9% improvement over2005.  For the years ended December 31,2006, 2005 and 2004, we had gross profit of $12.8 million, $10.0 million and$8.5 million, respectively.  Grossprofits as a percentage of gross sales were 12.2%, 11.9% and 11.8% for theyears ended December 31, 2006, 2005 and 2004, respectively. The modest grossprofit increase in 2006 was attributed to volume leveraging in our operationsand a favorable mix of products helping offset material and energy costincreases.   Our net income in 2006 was$1,311,778 or $0.49 per diluted common share compared to $928,781 or $0.36 perdiluted common share in 2005.  Our 2004net income was $587,329, or $0.23 per diluted common share.

CRITICALACCOUNTING POLICIES AND ESTIMATES

Oursignificant accounting policies and estimates are summarized in the footnotesto our annual consolidated financial statements.  Some of the accounting policies require us toexercise significant judgment in selecting the appropriate assumptions forcalculating financial estimates. Such judgments are subject to an inherentdegree of uncertainty.  These judgmentsare based on historical experience, known trends in the industry, terms ofexisting contracts and other information from 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.

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Revenue Recognition:

We recognize revenue upon shipment ofproducts to customers, when title has passed, all contractual obligations havebeen satisfied and collection of the resulting receivable is reasonablyassured.  In the normal course ofbusiness we enter into a number of contracts with customers under which weprovide engineering services on a per project basis.  Revenue for these services is recognized uponcompletion of the engineering process, usually upon initial shipment of theproduct.  Revenues from repair servicesare recognized upon shipment of related equipment to customers.

Allowance forUncollectible Accounts:

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 fordoubtful accounts at an amount estimated to be sufficient to provide adequateprotection against losses resulting from collecting less than full payment onreceivables.  A considerable amount of judgmentis required when assessing the realizability of receivables, includingassessing the probability of collection and the current credit-worthiness ofeach customer.  If the financialcondition of our customers was to deteriorate, resulting in an impairment oftheir ability to make payments, an additional provision for uncollectibleaccounts may be required.  We have notexperienced significant bad debts expense and the reserve for uncollectibleaccounts of $220,000 is considered adequate for any exposure to loss in theDecember 31, 2006 accounts receivable.

Inventory Reserves:

Inventory reserves are maintained for the estimatedvalue of the inventory that may have a lower value than stated or quantities inexcess 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 $1.3 million at December 31, 2006 is adequate.

### Long-Lived and IntangibleAsset Impairment:

Weevaluate long-lived assets and intangible assets with finite lives forimpairment, as well as the related amortization periods, to determine whetheradjustments to these amounts or useful lives are required based on currentevents and circumstances.  The evaluationis based on our projection of the undiscounted future operating cash flows ofthe underlying assets.  To the extentsuch projections indicate that future undiscounted cash flows are notsufficient to recover the carrying amounts of related assets, a charge isrecorded to reduce the carrying amount to equal estimated fair value.

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

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Incometaxes:

Ourestimate of the tax rates utilized in the calculation of the deferred taxbalances is based on historical taxable income and expected future taxableincome and corresponding rates.  Further,our consideration of a valuation allowance for deferred tax assets is basedupon estimates of taxable income in future periods and future realizability ofthese assets.

Self-InsuredHealth Claim Accruals:

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

Stock-BasedCompensation:

**Weadopted the provisions of SFAS 123R, Share-Based Payment on January 1,2006. SFAS 123R requires us to measure and recognize in our consolidatedstatements of operations the expense associated with all share-based paymentawards made to employees and directors based on estimated fair values. Weutilize the Black-Scholes option valuation model to measure the amount ofcompensation expense to be recognized for each option award. There are severalassumptions that must be made when using the Black-Scholes model such as theexpected term of each option, the expected volatility of the stock price duringthe expected term of the option, the expected dividends to be paid and the riskfree interest rate expected during the option term. Of these assumptions, theexpected term of the option and expected volatility of our common stock are themost difficult to estimate since they are based on the exercise behavior ofemployees and the expected future performance of our stock. An increase in thevolatility of our stock price or an increase in the average period beforeexercise will increase the amount of compensation expense related to awardsgranted after December 31, 2006.**

Basedon a critical assessment of our accounting policies and the underlyingjudgments and uncertainties affecting the application of those policies, webelieve that our consolidated financial statements provide a meaningful andfair presentation of our financial position. This is not to suggest that other general risk factors, such as changesin worldwide economic conditions, fluctuations in foreign currency exchangerates, changes in materials costs, performance of acquired businesses andothers, could not adversely impact our consolidated financial position, resultsof operations and cash flows in future periods.

Nomatters have come to our attention since December 31, 2006 that would cause theestimates included in the consolidated financial statements to changematerially.

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OPERATINGRESULTS

Thefollowing table presents statement of operations data as percentages of totalrevenues for the indicated year:
|                                      | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net Sales                            |       | 100      | %          | 100      | %          | 100      | %          |
| Cost of Goods  Sold                  |       | 88       | %          | 88       | %          | 88       | %          |
| Gross Profit                         |       | 12       | %          | 12       | %          | 12       | %          |
|                                 |       |     |       |     |       |     |       |
| Selling Expenses                     |       | 4        | %          | 4        | %          | 4        | %          |
| General and  Administrative Expenses |       | 5        | %          | 5        | %          | 6        | %          |
|                                 |       |     |       |     |       |     |       |
| Income from  Operations              |       | 3        | %          | 3        | %          | 2        | %          |
| Other Expenses,  Net                 |       | 1        | %          | 1        | %          | 1        | %          |
| Income Tax  Expense                  |       | 1        | %          | 1        | %          | 0        | %          |
|                                 |       |     |       |     |       |     |       |
| Net Income                           |       | 1        | %          | 1        | %          | 1        | %          |

 

Revenues:

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

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

###### Gross Profit:

For the years ended December 31, 2006, 2005 and 2004, we hadgross profit of $12.8 million, $10.0 million and $8.5 million, respectively.  Gross profits as a percentage of gross saleswere 12.2%, 11.9% and 11.8% for the years ended December 31, 2006, 2005 and2004, respectively.  The 2006gross profit improvement in both dollar and percentage was mainly due to thefavorable impact of volume and leveraging on our operations which more thanoffset energy and commodity (copper and petroleum based products) costpressures throughout all of 2006.

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Selling:

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

General and Administrative:

For the years ended December 31, 2006, 2005 and 2004, generaland administrative expenses were $5.4 million, $4.7 million and $4.1 million,respectively.  The increase in generaland administrative expenses of $0.7 million in 2006 from 2005 is mainlyattributed to the increased employee related expenses of approximately $0.5million to support the growth and services, and the recognition ofapproximately $0.2 million of stock-based compensation expense.  The increase in general and administrativeexpenses of $0.6 million in 2005 from 2004 is attributable to the increasedinvestment in infrastructure and employee related expenses, comprised primarilyof $0.4 million to support the growth and consolidation of corporate sharedservices.  In addition, overall outsideservice costs increased $0.2 million and were related to increased compliancerequirements and process improvements.

OtherIncome (Expense):

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

Interestexpense was approximately $821,000, $652,000, and $490,000 for the years endedDecember 31, 2006, 2005 and 2004, respectively. In 2006 and 2005, a steady increase in interest rates of approximately1% throughout the year and higher average carrying debt levels accounted forthe majority of the increased interest expense. 2004 saw favorable interest rates throughout the year and lower workingcapital requirements that kept interest expenses low.

### Income Taxes:

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

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

###### Net Income:

Our net income in 2006 was $1,311,778 or $0.49 per dilutedcommon share compared to $928,781 or $0.36 per diluted common share in2005.  Our 2004 net income was $587,329,or $0.23 per diluted common share.  Thechanges in net income are the result of the aforementioned factors.

**RECENTLY ISSUED ACCOUNTINGPRONOUNCEMENTS**

In September 2006, theSecurities & Exchange Commission issued Staff Accounting Bulletin 108 (SAB108) *“Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements”*.  SAB 108 requiresthat public companies utilize a “dual-approach” to assessing the quantitativeeffects of financial misstatements.  Thisdual approach includes both an income statement focused assessment and abalance sheet focused assessment.  Theguidance in SAB 108 must be applied to annual financial statements for fiscalyears ending after November 15, 2006. The adoption of SAB 108 did not have a material impact on our financialstatements.

In September 2006, theFinancial Accounting Standards Board (FASB) issued SFAS No. 157 (SFAS 157), *“Fair Value Measurements”*. SFAS 157 establishes a common definition for fair value to be applied toU.S. GAAP guidance requiring use of fair value, establishes a framework formeasuring fair value, and expands disclosure about such fair valuemeasurements. SFAS 157 is effective for fiscal years beginning after November15, 2007. We are currently assessing the impact of SFAS 157 may have on ourconsolidated financial position and results of operations.

In July 2006, the FASB issued Interpretation No. 48 (FIN 48),“*Accounting for Uncertainty in Income Taxes—anInterpretation of FASB Statement 109”*, which clarifies theaccounting for uncertainty in tax positions. FIN 48 provides that the taxeffects from an uncertain tax position can be recognized in our consolidatedfinancial statements, only if the position is more likely than not to besustained on audit, based on the technical merits of the position.  The provisions of FIN 48 are effective forour fiscal 2007 year end, with the cumulative effect of the change inaccounting principle recorded as an adjustment to opening retainedearnings.  We have evaluated the impactof adopting FIN 48 on January 1, 2007 and found that we presently do notanticipate any impact on our consolidated financial statements.

In March 2005, the FASB issued Interpretation No. 47(FIN 47), which clarifies terminology in FASB Statement No. 143, *Accounting for Asset Retirement Obligations*.  FIN 47 clarifies when an entity hassufficient information to reasonably estimate the fair value of an assetretirement obligation.  We adopted FIN 47on January 1, 2006 with no material impact to the consolidated financialstatements.

InDecember 2004, the FASB issued SFAS No. 123R (SFAS 123R), “Share-Based Payment:An Amendment of FASB Statement No. 123,” which requires companies to recognizein the income statement the grant-date fair value of stock options and otherequity-based compensation issued 

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toemployees.  In adopting SFAS 123R, as ofJanuary 1, 2006, we used the modified prospective transition method.  A further discussion of the effects of SFAS123R can be found in Note 9.

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

###### FINANCIALCONDITION AND LIQUIDITY

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

 

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

 

OnApril 28, 2006 we entered into a 6th amendment to our credit agreement with WellsFargo Bank, N.A. (WFB) increasing our line of credit arrangement from $8million to $10 million and extending the maturity dates of the line of creditto April 30, 2008 and our real estate term note to July 30, 2011.  On February 2, 2007, we entered into a 7th amendment to our creditagreement with WFB increasing our line of credit arrangement from $10 millionto $15 million and extending the maturity date of the line of credit to April30, 2009.  Additionally, the 7th amendment increased our realestate term note balance of $1,680,555 at February 2, 2007 to $3,348,750 andextended the maturity date to May 31, 2012. Per the 7th amendment, both the line of credit and realestate term note are subject to variations in the LIBOR rates. The 7th amendment funded the Iowaacquisition on February 4, 2007.

Theline of credit and other installment debt with WFB contain certain covenants,which, among other things, require us to adhere to regular reportingrequirements, abide by annual shareholder dividend limitations, maintaincertain financial ratios, and limit the amount of annual capitalexpenditures.  The availability under theline is subject to borrowing base requirements, and advances are at the discretionof the lender.  The line is secured bysubstantially all of our assets.  Thiscommitment is summarized as described below:
| Other Commercial  Commitment | ** ** | **Total  Amount  Committed** | ** ** | **Outstanding at  December 31, 2006** | ** ** | **Date of  Expiration** | ** ** |
|-----------------------------------|------------|------------------------------|------------|------------------------------------------------------|------------|------------------------------|------------|
| Line of credit                    |       | $                            | 15,000,000 |                                                 | $          | 4,694,027                    |       | April  30, 2009 |   |
|                                   |            |                              |            |                                                      |            |                              |            |  |  |

 

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

OnDecember 31, 2006, we had working capital of approximately $12.7 million ascompared to $12.2 million at the end of 2005. During 2006, we generated approximately $2.8 million of cash flow fromoperating activities.  The cashflow from operations is due primarily to net income of 

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$1.3 million and noncashdepreciation, amortization, foreign currency transaction loss, and the changein deferred taxes, which totaled $1.8 million in net positive adjustments.  The most significant impact on cash due tochanges in operating assets and liabilities was the use of cash to pay incometaxes, which was offset, in part, by increases in accrued payroll andcommissions.

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

Net cash provided by financing activities of $0.4 millionconsisted primarily of drawing $0.5 million on our line of credit along withincreases in long-term debt of $1.1 million from the equipment note and $1.4million from the industrial revenue bond for the Blue Earth, MN facilitypurchase, and issuance of shares of common stock of $0.1 million, which wasoffset by the decrease in our checks in excess of our bank balance of $1.2million, payments of long-term debt of $1.4 million and payments of bond issuecosts $0.1 million.

Setforth below is information about our long-term contractual obligationsoutstanding as of December 31, 2006 as adjusted for the long-term liabilitiesassumed in connection with the acquisition of the Garner, Iowa operation onFebruary 4, 2007.  It brings togetherdata for easy reference from the consolidated balance sheet and from individualnotes to the consolidated financial statements. This information is important in understanding our financial position.
| ** **                      | ** ** | **Payments Due by Period** | ** ** |
|---------------------------------|------------|-------------------------------------------|------------|
| ** **                      | ** ** | **Less than 1 Yr**         | ** ** | **2 - 3 Yrs** | ** ** | **4 - 5 Yrs** | ** ** | **Future** | ** ** |
| Bank Note  Payable              |       | $                                         | 4,694,027  |   | $ | — |   | $ | — |   | $ | — |   |
| Long-Term Debt                  |       | 1,576,612                                 |       | 1,377,761 |   | 696,500 |   | 3,037,215 |   |
| Operating Leases                |       | 391,509                                   |       | 378,251 |   | 60,368 |   | — |   |
| Equipment  Purchase Commitments |       | 532,000                                   |       | — |   | — |   | — |   |
| Total Contractual  Obligations  |       | $                                         | 7,194,148  |   | $ | 1,756,012 |   | $ | 756,868 |   | $ | 3,037,215 |   |

 

**From timeto time, we enter into purchase commitments with our suppliers under customarypurchase order terms.  Any significantlosses implicit in those contracts will be recognized in accordance withgenerally accepted accounting principles. At December 31, 2006, no such losses existed.**

Webelieve that our existing resources and anticipated cash flows from operationswill be sufficient to satisfy our working capital needs for the foreseeablefuture.

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**ITEM7a.        QUALITATIVE AND QUANTITATIVEDISCLOSURE ABOUT**MARKET RISK

**Marketrisk is the potential change in an instrument’s value caused, for example, byfluctuations in 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.  Monitoringand managing these risks is a continual process carried out by seniormanagement.  Market risk is managed basedon an ongoing assessment of trends in interest rates, foreign exchange rates,and economic developments, giving consideration to possible effects on bothtotal return and reported earnings.  Ourfinancial advisors, both internal and external, provide ongoing adviceregarding trends that affect management’s assessment.**

**ExchangeRate Sensitivity:**

**Weconduct operations in Mexico. Accordingly, exposure exists to potentially adverse movements in foreigncurrency rates.  We do not use foreignexchange forward contracts to hedge the risk of change in foreign currencyexchange 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 mattersbecause cash flows from international operations are generally re-investedlocally.  It is estimated that a 10%change in foreign exchange rates would not have a material impact on earnings.**

**InterestRate Sensitivity:**

**Theeffective interest rate on our credit facilities are influenced by the actionsof the Federal Reserve in establishing from time to time the Federal FundsInterest Rate which is the rate banks borrow from the Federal ReserveBank.  During the latter half of 2004 andthroughout 2005 and 2006, the Federal Reserve has been increasing the FederalFunds Interest Rate, causing the effective interest rate on our facilities toincrease.  Based on the balanceoutstanding under our interest-bearing facilities at year-end, a percentagepoint change in the effective interest rate would change interest expense byless than $100,000 annually.**

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27

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**NORTECHSYSTEMS INCORPORATED AND SUBSIDIARY**

**TABLE OFCONTENTS**

**DECEMBER31, 2005, 2004, AND 2003**

**ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA**
|                                                                                                            | ** ** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|------------|
| Reports of Independent Registered Public Accounting  Firm                                                  |       |       |
|                                                                                                       |       |       |
| Consolidated Financial Statements:                                                                         |       |       |
| Consolidated  Balance Sheets as of December 31, 2006 and 2005                                              |       |       |
|                                                                                                       |       |       |
| Consolidated  Statements of Income for the years ended December 31, 2006, 2005 and 2004                    |       |       |
|                                                                                                       |       |       |
| Consolidated Statements of Shareholders’ Equity for  the years ended December 31, 2006, 2005 and 2004 |       |       |
|                                                                                                       |       |       |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2006, 2005 and 2004                |       |       |
|                                                                                                       |       |       |
| Notes to Consolidated Financial Statements                                                                 |       |       |
|                                                                                                       |       |       |
| Reports of Independent Registered Public Accounting  Firm on Supplementary Data                            |       |       |
|                                                                                                       |       |       |
| Schedule II Valuation and Qualifying Accounts                                                              |       |       |

 

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28

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**Reportof Independent Registered Public Accounting Firm**

To the Board ofDirectors

Nortech SystemsIncorporated and Subsidiary

Wayzata, Minnesota

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

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

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

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

/s/  McGladrey & Pullen, LLP

Minneapolis, Minnesota

March 7, 2007

29

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**NORTECH SYSTEMS INCORPORATED ANDSUBSIDIARY**

**CONSOLIDATEDBALANCE SHEETS**

**DECEMBER31, 2006 AND 2005**
| **ASSETS**                                                       | ** ** | **2006**    | ** ** | **2005**   | ** ** |
|------------------------------------------------------------------|------------|-------------|------------|------------|------------|
| CURRENT ASSETS                                                   |       |        |       |       |       |
| Cash and Cash  Equivalents                                       |       | $           | 725,891    |       | $          | 840,123 |   |
| Accounts  Receivable, Less Allowance for Uncollectible Accounts  |       | 14,493,339  |       | 14,447,612 |       |
| Inventories                                                      |       | 15,976,222  |       | 15,849,470 |       |
| Prepaid Expenses                                                 |       | 492,177     |       | 466,083    |       |
| Income Taxes  Receivable                                         |       | 209,025     |       | —     |       |
| Deferred Tax  Assets                                             |       | 856,000     |       | 912,000    |       |
| Total Current  Assets                                            |       | 32,752,654  |       | 32,515,288 |       |
|                                                             |       |        |       |       |       |
| PROPERTY AND EQUIPMENT                                           |       |        |       |       |       |
| Land                                                             |       | 300,000     |       | 151,800    |       |
| Building and  Leasehold Improvements                             |       | 6,063,385   |       | 4,819,919  |       |
| Manufacturing  Equipment                                         |       | 9,092,455   |       | 7,662,699  |       |
| Office and Other  Equipment                                      |       | 3,532,038   |       | 3,413,968  |       |
| Construction in  Progress                                        |       | 90,945      |       | 502,374    |       |
| Total Property  and Equipment                                    |       | 19,078,823  |       | 16,550,760 |       |
| Accumulated  Depreciation                                        |       | (10,823,655 | )          | (9,868,536 | )          |
| Net Property and  Equipment                                      |       | 8,255,168   |       | 6,682,224  |       |
|                                                             |       |        |       |       |       |
| OTHER ASSETS                                                     |       |        |       |       |       |
| Restricted Cash                                                  |       | 427,500     |       | —     |       |
| Finite-Lived  Intangible Assets, Net of Accumulated Amortization |       | 82,890      |       | 209,307    |       |
| Goodwill                                                         |       | 75,006      |       | 75,006     |       |
| Deferred Tax  Assets                                             |       | 277,000     |       | 179,000    |       |
| Other Assets                                                     |       | 7,726       |       | 7,726      |       |
| Total Other  Assets                                              |       | 870,122     |       | 471,039    |       |
| Total Assets                                                     |       | $           | 41,877,944 |       | $          | 39,668,551 |   |

 

*Seeaccompanying Notes to Consolidated Financial Statements.*

30

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY**

**CONSOLIDATED BALANCE SHEETS**

**DECEMBER 31, 2006 AND 2005**
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                               | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| CURRENT LIABILITIES                                                                                                                                                                        |       |       |       |       |       |
| Bank Note  Payable                                                                                                                                                                         |       | $          | 4,694,027  |       | $          | 4,228,234 |   |
| Current  Maturities of Long-Term Debt                                                                                                                                                      |       | 1,524,743  |       | 1,207,305  |       |
| Checks Written  in Excess of Bank Balance                                                                                                                                                  |       | —     |       | 1,200,000  |       |
| Accounts Payable                                                                                                                                                                           |       | 10,018,263 |       | 9,902,998  |       |
| Accrued Payroll  and Commissions                                                                                                                                                           |       | 3,094,092  |       | 2,849,472  |       |
| Accrued Health  and Dental Claims                                                                                                                                                          |       | 325,000    |       | 271,104    |       |
| Other Accrued  Liabilities                                                                                                                                                                 |       | 385,251    |       | 324,360    |       |
| Income Taxes  Payable                                                                                                                                                                      |       | —     |       | 317,487    |       |
| Total Current  Liabilities                                                                                                                                                                 |       | 20,041,376 |       | 20,300,960 |       |
| ** **                                                                                                                                                                                 |       |       |       |       |       |
| LONG-TERM LIABILITIES                                                                                                                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Long-Term Debt  (Net of Current Maturities)                                                                                                                                                |       | 3,509,039  |       | 2,714,227  |       |
| Other Long-Term  Liabilities                                                                                                                                                               |       | 25,670     |       | —     |       |
| Total Long-Term  Liabilities                                                                                                                                                               |       | 3,534,709  |       | 2,714,227  |       |
| ** **                                                                                                                                                                                 |       |       |       |       |       |
| Total  Liabilities                                                                                                                                                                         |       | 23,576,085 |       | 23,015,187 |       |
| ** **                                                                                                                                                                                 |       |       |       |       |       |
| SHAREHOLDERS’ EQUITY                                                                                                                                                                  |       |       |       |       |       |
| Preferred Stock,  $1 par value; 1,000,000 Shares Authorized; 250,000 Shares Issued and Outstanding                                                                                         |       | 250,000    |       | 250,000    |       |
| Common Stock -  $0.01 par value; 9,000,000 Shares Authorized:  2,674,729 Shares Issued and Outstanding at December 31, 2006; 2,618,197 Shares Issued and Outstanding  at December 31, 2005 |       | 26,747     |       | 26,182     |       |
| Additional  Paid-In Capital                                                                                                                                                                |       | 14,644,901 |       | 14,306,602 |       |
| Accumulated  Other Comprehensive Loss                                                                                                                                                      |       | (23,179    | )          | (21,032    | )          |
| Retained  Earnings                                                                                                                                                                         |       | 3,403,390  |       | 2,091,612  |       |
| Total  Shareholders’ Equity                                                                                                                                                           |       | 18,301,859 |       | 16,653,364 |       |
| Total Liabilities and  Shareholders’ Equity                                                                                                                                           |       | $          | 41,877,944 |       | $          | 39,668,551 |   |

* *

*Seeaccompanying Notes to Consolidated Financial Statements.*

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**NORTECHSYSTEMS INCORPORATED AND SUBSIDIARY**

**CONSOLIDATED STATEMENTS OF INCOME**

**FOR THEYEARS ENDED DECEMBER 31, 2006, 2005, AND 2004**
| ** **                                                                                     | ** ** | **2006**   | ** **  | **2005**   | ** ** | **2004**   | ** ** |
|------------------------------------------------------------------------------------------------|------------|------------|-------------|------------|------------|------------|------------|
| Net sales                                                                                      |       | $          | 105,147,228 |       | $          | 84,215,663 |       | $ | 72,674,159 |   |
|                                                                                           |       |       |        |       |       |       |       |
| Cost of goods  sold                                                                            |       | 92,367,508 |        | 74,183,435 |       | 64,135,186 |       |
|                                                                                           |       |       |        |       |       |       |       |
| Gross profit                                                                                   |       | 12,779,720 |        | 10,032,228 |       | 8,538,973  |       |
|                                                                                           |       |       |        |       |       |       |       |
| Operating  expenses:                                                                           |       |       |        |       |       |       |       |
| Selling expenses                                                                               |       | 4,674,826  |        | 3,198,654  |       | 3,157,212  |       |
| General and administrative expenses                                                            |       | 5,456,077  |        | 4,720,860  |       | 4,054,326  |       |
| Total operating expenses                                                                       |       | 10,130,903 |        | 7,919,514  |       | 7,211,538  |       |
|                                                                                           |       |       |        |       |       |       |       |
| Income from  operations                                                                        |       | 2,648,817  |        | 2,112,714  |       | 1,327,435  |       |
|                                                                                           |       |       |        |       |       |       |       |
| Other income  (expense)                                                                        |       |       |        |       |       |       |       |
| Interest income                                                                                |       | 9,061      |        | 2,635      |       | 2,120      |       |
| Miscellaneous income (expense)                                                                 |       | 44,631     |        | (70,059    | )          | 15,839     |       |
| Interest expense                                                                               |       | (820,731   | )           | (651,509   | )          | (490,065   | )          |
| Total other expense                                                                            |       | (767,039   | )           | (718,933   | )          | (472,106   | )          |
|                                                                                           |       |       |        |       |       |       |       |
| Income before  income taxes                                                                    |       | 1,881,778  |        | 1,393,781  |       | 855,329    |       |
|                                                                                           |       |       |        |       |       |       |       |
| Income tax  expense                                                                            |       | 570,000    |        | 465,000    |       | 268,000    |       |
|                                                                                           |       |       |        |       |       |       |       |
| Net income                                                                                     |       | $          | 1,311,778   |       | $          | 928,781    |       | $ | 587,329 |   |
|                                                                                           |       |       |        |       |       |       |       |
| Net income per  common share:                                                                  |       |       |        |       |       |       |       |
|                                                                                           |       |       |        |       |       |       |       |
| Basic                                                                                          |       | $          | 0.50        |       | $          | 0.36       |       | $ | 0.23 |   |
| Weighted average  number of common shares outstanding used for basic earnings per common share |       | 2,628,635  |        | 2,583,309  |       | 2,561,419  |       |
|                                                                                           |       |       |        |       |       |       |       |
| Diluted                                                                                        |       | $          | 0.49        |       | $          | 0.36       |       | $ | 0.23 |   |
| Weighted average  number of common share outstanding plus dilutive common stock options        |       | 2,682,454  |        | 2,613,942  |       | 2,604,411  |       |

* *

*Seeaccompanying Notes to Consolidated Financial Statements.*

32

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**NORTECHSYSTEMS INCORPORATED AND SUBSIDIARY**

**CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY**

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

* *

*Seeaccompanying Notes to Consolidated Financial Statements.*

33

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**NORTECHSYSTEMS INCORPORATED AND SUBSIDIARY**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

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

* *

*Seeaccompanying Notes to Consolidated Financial Statements.*

34

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**NORTECHSYSTEMS INCORPORATED AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER31, 2006, 2005, AND 2004**

**NOTE 1**                            NATURE OFBUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

**Natureof Business**

We manufacture wire harnesses, cables and electromechanicalassemblies, printed circuit boards and higher-level assemblies for a wide rangeof commercial and defense industries. We provide a full “turn-key” contractmanufacturing service to our customers. All products are built to the customer’s design specifications.  Products are sold to customers bothdomestically and internationally. We also provide repair service on circuitboards 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, Garner, Iowa and Monterrey, Mexico.

A summary of our significant accounting policies follows:

**Useof Estimates**

The preparation of financial statements in conformity withaccounting principles generally accepted in the United States of Americarequires us to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements. Estimates also affect the reported amounts of revenue and expense duringthe reporting period.  Significant itemssubject to estimates and assumptions include the valuation allowance forinventories and allowance for doubtful accounts.  Actual results could differ from thoseestimates.

**Principlesof Consolidation**

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

**Cashand Cash Equivalents**

For purposes of reporting cash flows, we consider cashequivalents to be short-term, highly liquid interest-bearing accounts readilyconvertible to cash.

**RestrictedCash**

As of December 31, 2006, restricted cash of $427,500 is to beused for the purchase of equipment and facility upgrades at the Blue Earth,Minnesota facility as required by the Industrial Revenue Bond agreement intowhich we entered on June 28, 2006 to purchase the Blue Earth, Minnesota facility.See Note 4.

35

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**NORTECHSYSTEMS INCORPORATED AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER31, 2006, 2005, AND 2004**

 

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

**AccountsReceivable and Allowance for Doubtful Accounts**

We grant credit to customers in thenormal course of business.  Accountsreceivable are unsecured and are presented net of an allowance foruncollectible accounts.  The allowance for uncollectibleaccounts was $220,000 and $297,000 at December 31, 2006 and 2005,respectively.  We determine our allowance by considering a number of factors, includingthe length of time trade accounts receivable are past due, our previous losshistory, the customers’ current ability to pay their obligations to us, and thecondition of the general economy and the industry as a whole.  We write-off accounts receivable when theybecome uncollectible, and payments subsequently received on such receivablesare credited to the allowance for uncollectible accounts.  We do not accrue interest on past dueaccounts receivable.

**Inventories**

Inventories are stated at the lower of cost (first-in,first-out method) or market (based on the lower of replacement cost or netrealizable value).  Costs include material, labor, and overheadrequired in the warehousing and production of our products.  Inventory reserves are maintained for theestimated value of the inventory that may have a lower value than stated orquantities in excess of future production needs.  Inventory is shown net of reserve for excessand obsolete inventory as follows:

 

|                 | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|-----------------|------------|------------|------------|------------|------------|
|            |       |       |       |       |       |
| Raw materials   |       | $          | 11,161,883 |       | $          | 10,616,894 |   |
| Work in process |       | 3,339,325  |       | 4,423,892  |       |
| Finished goods  |       | 2,770,670  |       | 2,027,118  |       |
| Reserves        |       | (1,295,656 | )          | (1,218,434 | )          |
|            |       |       |       |       |       |
| Total           |       | $          | 15,976,222 |       | $          | 15,849,470 |   |
|            |       |       |       |       |       |

 

36

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**NORTECHSYSTEMS INCORPORATED AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER31, 2006, 2005, AND 2004**

 

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

**                                                                       **Property,Equipment and Depreciation

Property and equipment are stated at cost less accumulateddepreciation. Additions, improvements and major renewals are capitalized, whilemaintenance, repairs and minor renewals are expensed as incurred.  When assets are retired or disposed of, theassets and related accumulated depreciation are removed from the accounts andthe resulting gain or loss is reflected in operations.  Leasehold improvements are depreciated overthe shorter of their estimated use lives or the remaining lease terms.  All other property and equipment aredepreciated by the straight-line method of depreciation over their estimateduseful lives, as follows:

 

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

 

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

We account for goodwill and other intangible assets inaccordance with Statement of Financial Accounting Standards Board No. (“SFAS”)142, “Goodwill and Other Intangible Assets,” which requires that goodwill andcertain indefinite-lived assets not be amortized but evaluated annually forimpairment.  Finite life intangibleassets are amortized on a straight-line basis over their estimated usefullives.  Finite life intangible assets atDecember 31, 2006 and 2005 are as follows:

37

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**NORTECHSYSTEMS INCORPORATED AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER31, 2006, 2005, AND 2004**

 

**NOTE 1****                            NATUREOF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)**
| ** **              | ** ** | **December 31, 2006** | ** ** |
|-------------------------|------------|---------------------------------|------------|
| ** **              | ** ** | **Estimated**                   | ** ** | **Gross** | ** ** | **Accumulated** | ** ** | **Net Book** | ** ** |
|                    |       | **Lives**                       | ** ** | **Carrying** | ** ** | **Amortization** | ** ** | **Value** |   |
|                    |       | **(Years)**                     | ** ** | **Amount** | ** ** | **Amount** | ** ** | **Amount** |   |
|  Bond Issue Costs  |       | 15                              |       | $ | 79,373 |   | $ | 2,649 |   | $ | 76,724 |   |
|  Non-compete       |       | 4                               |       | 1,526,384 |   | 1,526,384 |   | — |   |
|  Other intangibles |       | 3                               |       | 37,059 |   | 30,893 |   | 6,166 |   |
|  Totals            |       |                            |       | $ | 1,642,816 |   | $ | 1,559,926 |   | $ | 82,890 |   |

 

 
| ** **              | ** ** | **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 |   |

 

Amortizationexpense related to these assets is as follows:

Year ended December 31, 2006                        $  205,790

Year ended December 31, 2005                           397,246

Year ended December 31, 2004                           387,776

 

Estimatedfuture annual amortization expense related to these assets is approximately$11,000 in 2007 and $5,000 per year thereafter.

**ImpairmentAnalysis**

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 on our projection ofthe undiscounted future operating cash flows of the underlying assets. To theextent such projections indicate that future undiscounted cash flows are notsufficient to recover the carrying amounts of related assets, a charge isrecorded to reduce the carrying amount to the asset’s estimated fair value.

38

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**NORTECHSYSTEMS INCORPORATED AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER31, 2006, 2005, AND 2004**

 

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

**PreferredStock**

Preferred stock issued is non-cumulative and nonconvertible.The holders of the preferred stock are entitled to a non-cumulative dividend of12% 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 were declared or paid during the yearsended December 31, 2006, 2005, and 2004.

**RevenueRecognition**

We recognize revenue upon shipment ofproducts to customers, when title has passed, all contractual obligations havebeen satisfied and collection of the resulting receivable is reasonablyassured.  In the normal course ofbusiness we enter into a number of contracts with customers under which weprovide engineering services on a per project basis.  Revenue for these services is recognized uponcompletion of the engineering process, usually upon initial shipment of theproduct.  Revenues from repair servicesare recognized upon shipment of related equipment to customers.  Our shipping and handling costs charged to our customers areincluded in net sales, while the corresponding shipping expenses are includedin cost of goods sold.

**Productwarranties**

We provide limited warranty for thereplacement or repair of defective product at no cost to our customers within aspecified time period after the sale.  Wemake no other guarantees or warranties, expressed or implied, of any naturewhatsoever as to the goods including without limitation, warranties tomerchantability, fit for a particular purpose or non-infringement of patent orthe like unless agreed upon in writing. We estimate the costs that may beincurred under our limited warranty and reserve based on actual historicalwarranty claims coupled with an analysis of unfulfilled claims at thebalance sheet date.  Our warranty claimscosts are not material given the nature of our products and services whichnormally result in repair and return in the same accounting period.

**Advertising**

Advertising costs are charged to operations as incurred.  Total amount charged to expense was $168,448,$173,464 and $197,914, for the years ended December 31, 2006, 2005 and 2004,respectively.

39

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**NORTECHSYSTEMS INCORPORATED AND SUBSIDIARY**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER31, 2006, 2005, AND 2004**

 

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

**IncomeTaxes**

We account for income taxes under the asset and liabilitymethod. Deferred income tax assets and liabilities are recognized annually fordifferences between the financial statement and tax bases of assets andliabilities that will result in taxable or deductible amounts in the futurebased on enacted tax laws and rates applicable to the periods in which thedifferences are expected to affect taxable income.  Valuation allowances are established whennecessary to reduce deferred tax assets to the amount expected to be realized.

**FairValue of Financial Instruments**

The carrying amounts of all financial instruments approximatetheir fair values.  The carrying amountsfor cash, restricted cash, receivables, payables, accrued liabilities and theline of credit approximate fair value because of the short maturity of theseinstruments.  Based on the borrowingrates currently available to us for bank loans with similar terms and averagematurities, the carrying value of long-term debt approximate their fair value.

**StockBased Compensation**

Our 2006 consolidated financial statements reflect the impactof SFAS No. 123R, Share-Based Payment (“SFAS 123R”). In accordance withthe modified prospective transition method, our consolidated financialstatements for prior periods have not been restated to reflect, and do notinclude, the impact of SFAS 123R. Stock-based compensation expenserecognized under SFAS 123R was $188,259 ($0.05 per diluted common share) for2006.  See Note 9 for additionalinformation.

**DerivativeFinancial Instruments**

SFAS No.133, “Accounting for Derivative Instruments andHedging Activities,” as amended, defines derivatives and requires that they becarried at fair value on the balance sheet. On June 28, 2006, we entered into an interest rate swap agreement toeffectively convert our industrial revenue bond debt from a variable rate to afixed rate.  The change in market valueof an interest rate swap is recognized on the balance sheet and by a charge orcredit to interest expense.  Furtherinformation related to our interest rate swap is disclosed in Note 4.

 

40

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**Net Income PerCommon Share**

Basicnet income per common share is computed using the weighted-average number ofcommon shares outstanding.  Dilutedincome per common share is computed using the weighted-average number of commonshares outstanding and potential common shares from the assumed exercise ofstock options outstanding during the period using the treasury stock method.

**RecentAccounting Pronouncements**

InSeptember 2006, the Securities & Exchange Commission issued StaffAccounting Bulletin 108 (SAB 108) “Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements”.  SAB 108 requires thatpublic companies utilize a “dual-approach” to assessing the quantitativeeffects of financial misstatements.  Thisdual approach includes both an income statement focused assessment and abalance sheet focused assessment.  Theguidance in SAB 108 must be applied to annual financial statements for fiscalyears ending after November 15, 2006. The adoption of SAB 108 did not have a material impact on our financialstatements.

InSeptember 2006, the Financial Accounting Standards Board (FASB) issued SFAS No.157 (SFAS 157), “Fair Value Measurements”. SFAS 157 establishes a common definition for fair value to be applied toU.S. GAAP guidance requiring use of fair value, establishes a framework formeasuring fair value, and expands disclosure about such fair valuemeasurements. SFAS 157 is effective for fiscal years beginning after November15, 2007. We are currently assessing the impact of SFAS 157 may have on ourconsolidated financial position and results of operations.

InJuly 2006, the FASB issued Interpretation No. 48 (FIN 48), “Accounting forUncertainty in Income Taxes—an Interpretation of FASB Statement 109”, whichclarifies the accounting for uncertainty in tax positions. FIN 48 provides thatthe tax effects from an uncertain tax position can be recognized in ourconsolidated financial statements, only if the position is more likely than notto be sustained on audit, based on the technical merits of the position. Theprovisions of FIN 48 are effective for our fiscal 2007 year end, with thecumulative effect of the change in accounting principle recorded as anadjustment to opening retained earnings. We have evaluated the impact ofadopting FIN 48 on January 1, 2007 and found that we presently do notanticipate any impact on our consolidated financial statements.

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InMarch 2005, the FASB issued Interpretation No. 47, or “FIN 47,” which clarifiesterminology in FASB Statement No. 143, Accounting for Asset RetirementObligations.  FIN 47 clarifies when anentity has sufficient information to reasonably estimate the fair value of anasset retirement obligation.  FIN 47 waseffective for us in fiscal 2006.  Weadopted FIN 47 on January 1, 2006 with no material impact to our consolidatedfinancial statements.

InNovember 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment ofARB No. 43, Chapter 4.  The amendmentsmade by the SFAS No. 151 require that abnormal amounts of idle facilityexpense, freight, handling costs and wasted materials (spoilage) be recognizedas current-period charges.  ThisStatement requires that allocation of fixed production overhead to inventorybased on the normal capacity of production facilities.  SFAS No. 151 is effective for inventory costsincurred during fiscal years beginning after June 15, 2005.  We adopted SFAS No. 151 on January 1, 2006with no material impact to our consolidated financial statements.

**SupplementalCash Flow Information**

We paid $1,090,540 and $30,716in income taxes for the year ended December 31, 2006 and 2005,respectively.  No income taxes were paidfor the year ended December 31, 2004.   We paid interest expense of $746,519, $645,513 and $488,020 for theyears ended December 31, 2006, 2005 and 2004, respectively.

During 2004, we acquired all ofthe business assets of Zachariah and Lundbergh, Inc. (Z&L) for $250,000payable over 4 years.  During 2004, weexchanged 63,407 shares of our common stock in satisfaction of a note payableto SAE Assembly, LLC, incurred in connection with our 2002 acquisition of ourmanufacturing facility in Mexico.

**SegmentReporting Information**

Our results of operations forthe years ended December 31, 2006, 2005 and 2004, represent a single segmentreferred to as Contract Manufacturing. Export sales represent approximately 5% of consolidated sales for theyears ended December 31, 2006, 2005 and 2004.

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Long-lived assets by countryare as follows:
|                            | ** ** | **United States** | ** ** | **Mexico** | ** ** | **Total** | ** ** |
|----------------------------|------------|------------------------|------------|------------|------------|-----------|------------|
| 2006                       |       |                   |       |       |       |      |       |
| Net property and equipment |       | $                      | 7,700,481  |       | $          | 554,687   |       | $ | 8,255,168 |   |
| Other assets               |       | 862,396                |       | 7,726      |       | 870,122   |       |
|                       |       |                   |       |       |       |      |       |
| 2005                       |       |                   |       |       |       |      |       |
| Net property and equipment |       | $                      | 5,995,465  |       | $          | 686,759   |       | $ | 6,682,224 |   |
| Other assets               |       | 271,529                |       | 199,510    |       | 471,039   |       |

 

##### **ForeignCurrency Translation**

Local currency is consideredthe functional currency for our operations outside the United States.  Assets and liabilities are translated atyear-end exchange rates.  Income and expenseitems are translated at average rates of exchange prevailing during theyear.  Translation adjustments arerecorded as a component of accumulated other comprehensive loss in shareholders’equity.  Foreign exchange transactiongains and losses attributable to exchange rate movements on intercompanyreceivables and payables not deemed to be of a long-term investment nature arerecorded in miscellaneous income (expense).

**NOTE2**                            MAJORCUSTOMERS 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 our excess cashbalances in checking and money market accounts at three high-credit qualityfinancial institutions.  We have notexperienced any losses in any of the short-term investment instruments we haveused for excess cash balances.  We do not require collateral on our receivables.  Historically, we have not sufferedsignificant losses with respect to trade accounts receivable.

43

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** **

Twodivisions of General Electric, Co. (G.E.) combined accounted for 10% or more ofour net sales during the past three years. G.E.’s Medical and Transportation Divisions together accounted for 17%,17% and 15% of our net sales for the years ended December 31, 2006, 2005 and2004, respectively.  Accounts receivablefrom G.E.’s Medical and Transportation Divisions at December 31, 2006 and 2005represented 14% and 12% of our total accounts receivable, respectively.  Additionally, Northrop Grumman Corp.accounted for 10% of our net sales for the years ended December 31, 2006 and2005.  Accounts receivable from NorthropGrumman at December 31, 2006 and 2005 represented 15% and 9% of our totalaccounts receivable, respectively. Historically, we have not experienced significant losses on customerreceivable collections in any particular industry or geographic area.

**NOTE 3**                            ACCRUEDHEALTH AND DENTAL CLAIMS

We have partially self-insuredour employee health and dental plans.  Wehave contracted with two separate administrative service companies to superviseand administer the programs and act as representatives.  Our health plan insures for excessive orunexpected claims and is liable for claims not to exceed $80,000 per individualper plan year and an estimated aggregate amount of $3,672,000 for the plan yearending August 2007.  Our dental plan paysclaims based on actual amounts incurred. Estimated unpaid claims for incurred health and dental services of$325,000 and $271,104 are reflected as accrued liabilities on the balance sheetat December 31, 2006 and 2005, respectively.

**NOTE 4**                            LONG-TERMDEBT

OnApril 28, 2006 we entered into a 6th amendment to our credit agreement withWells Fargo Bank, N.A. (WFB) increasing our line of credit arrangement from $8million to $10 million and extending the maturity dates of the line of creditto April 30, 2008 and our real estate term note to July 30, 2011.  On February 2, 2007, we entered into a 7thamendment to our credit agreement with WFB increasing our line of creditarrangement from $10 million to $15 million and extending the maturity date ofthe line of credit to April 30, 2009.

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** **

Additionally,in connection with the acquisition of Suntron’s Midwest Operations discussed inNote 13, the 7th amendment increased our real estate term note balance of$1,680,555 at February 2, 2007 to $3,348,750 and extended the maturity date toMay 31, 2012.  Per the 7th amendment,both the line of credit and real estate term note are subject to variations inthe LIBOR rates. The 7th amendment funded the Iowa acquisition on February 4,2007.  The line of credit and otherinstallment debt with WFB contain certain covenants, which, among other things,require us to adhere to regular reporting requirements, abide by annual shareholderdividend limitations, maintain certain financial ratios, and limit the amountof annual capital expenditures.  Theavailability under the line is subject to borrowing base requirements, andadvances are at the discretion of the lender. The line is secured by substantially all of our assets.

During2006 and 2005 our line of credit bore interest at prime (8.25% at December 31,2006 and 7.25% at December 31, 2005). The weighted-average interest rate on ourline of credit was 7.77% and 6.20% for the years ended December 31, 2006and 2005, respectively. We had borrowings of $4,694,027 and $4,228,234outstanding as of December 31, 2006 and 2005, respectively.

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A summary of long-term debt atDecember 31, 2006 and 2005 is as follows:

 

 
| Description                                                                                                                                                                                                                                                                                                                                                                                                                                         | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| Notes payable -  Wells Fargo Bank Minnesota, N.A., two notes bear interest at Wells Fargo  prime rate, four notes bear interest at 4.21% (which was paid off in 2006),  6.30%, 7.31% and 0.25% below prime (8.00% as of December 31, 2006 and 7.00%  as of December 31, 2005), respectively; combined monthly principal payments  of $112,567 plus interest, maturities range from February 2007 to July 2011;  secured by substantially all assets |       | $          | 3,109,782  |       | $          | 3,338,028 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                |       |       |       |       |       |
| Bonds payable  (1)                                                                                                                                                                                                                                                                                                                                                                                                                                  |       | 1,440,000  |       | —     |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                |       |       |       |       |       |
| Subordinated  notes payable - Other, interest at 6.5%; combined monthly payments of $5,227  through March 2007; secured by substantially all assets                                                                                                                                                                                                                                                                                                 |       | 463,036    |       | 498,606    |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                |       |       |       |       |       |
| Other                                                                                                                                                                                                                                                                                                                                                                                                                                               |       | 20,964     |       | 84,898     |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                |       |       |       |       |       |
| Total long-term debt                                                                                                                                                                                                                                                                                                                                                                                                                                |       | 5,033,782  |       | 3,921,532  |       |
| Current maturities of long-term debt                                                                                                                                                                                                                                                                                                                                                                                                                |       | (1,524,743 | )          | (1,207,305 | )          |
| Long-term debt -  net of current maturities                                                                                                                                                                                                                                                                                                                                                                                                         |       | $          | 3,509,039  |       | $          | 2,714,227 |   |

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(1)          On June 28, 2006, we entered into an industrial revenue bondpayable to the City of Blue Earth, Minnesota. The bond payable of $1,440,000 at December 31, 2006 bears interest basedon the USD-BMA MN Tax Exempt Municipal Bond Swap Index, which we swapped for afixed interest rate and has a maturity date of June 1, 2021 where principal ispayable annually on June 1. The funds from the bond were used to purchase thefacility in Blue Earth, Minnesota.  Theremaining funds of $427,500 are restricted for the purchase of equipment andfacility upgrades per the agreement. Maturity requirements are approximately $130,000 in each of the nextfive years and $800,000 thereafter.

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On June 28, 2006, we enteredinto an interest rate swap agreement with a notional amount of $1,440,000 toeffectively convert our industrial revenue bond debt from a variable rate to afixed rate of 4.07% for five years, maturing on June 28, 2011.  The fair value of the swap at December 31,2006 was recorded as a long-term liability of $25,670 and was additionalinterest expense in the statement of income.

Included in the maturityrequirements schedule below is the new funded debt of approximately $1,669,000as of February 2, 2007 per the 7th amendment to ourcredit agreement with WFB with the adjusted maturity date of May 31, 2012.  Maturity requirements are as follows:

| Years Ending December 31, | ** ** | **Amount** | ** ** |
|------------------------------------------|------------|------------|------------|
| 2007                                     |       | $          | 1,577,000  |   |
| 2008                                     |       | 890,000    |       |
| 2009                                     |       | 488,000    |       |
| 2010                                     |       | 348,000    |       |
| 2011                                     |       | 348,000    |       |
| Future                                   |       | 3,037,000  |       |
|                                     |       | $          | 6,688,000  |   |

 

**NOTE5**                            OPERATINGLEASES

We have entered into variousoperating leases for production and office equipment, office space andbuildings.  We have the option topurchase various pieces of equipment upon lease expiration at fair marketvalue.  We presently lease buildings inBaxter, MN on a month-to-month basis. The lease for the manufacturing facility in Mexico provides us theoption of two three-year renewals extending the lease through 2010.  As part of the acquisition of the Garner,Iowa operations on February 4, 2007, we were assigned the existing buildinglease, which expires in June 2008.

Rent expense, which includesamounts for other short term leases, for the years ended December 31, 2006,2005, and 2004, amounted to $862,955, $754,394 and $676,063, respectively.  Sublease income amounted to $500 for the yearended December 31, 2006 and $3,000 for the years ended December 31, 2005 and2004.

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Approximate future minimumlease payments are as follows:

| Years Ending December 31, | ** ** | **Amount** | ** ** |
|------------------------------------------|------------|------------|------------|
| 2007                                     |       | $          | 392,000    |   |
| 2008                                     |       | 254,000    |       |
| 2009                                     |       | 124,000    |       |
| 2010                                     |       | 60,000     |       |
| Total                                    |       | $          | 830,000    |   |

 

**NOTE6**                            INCOMETAXES

The income tax expense for eachof the three years ended December 31, 2006 consists of the following:

|                                           | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current taxes  -   Federal |       | $        | 506,000    |     | $          | 580,000  |       | $ | 60,000 |   |
| Current taxes  -   State   |       | 75,000   |       | 75,000   |       | 16,000   |       |
| Current taxes  -   Foreign |       | 31,000   |       | 31,000   |       | 26,000   |       |
| Deferred taxes  -  Federal      |       | (47,000  | )          | (204,000 | )          | 163,000  |       |
| Deferred taxes  -  State        |       | 5,000    |       | (16,000  | )          | 4,000    |       |
| Deferred taxes  -  Foreign      |       | —   |       | (1,000   | )          | (1,000   | )          |
|                                      |       |     |       |     |       |     |       |
| Income tax  expense                       |       | $        | 570,000    |     | $          | 465,000  |       | $ | 268,000 |   |

 

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The statutory ratereconciliation for each of the three years ended December 31, 2006 is asfollows:

|                                                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Statutory  federal tax provision                         |       | $        | 640,000    |     | $          | 474,000  |       | $ | 291,000 |   |
| State income  taxes, net of federal benefit              |       | 49,000   |       | 63,000   |       | 25,000   |       |
| Effect of  foreign operations                            |       | 11,000   |       | 5,000    |       | (5,000   | )          |
| Income tax  credits                                      |       | (140,000 | )          | (81,000  | )          | (84,000  | )          |
| Other, including  benefit of income taxed at lower rates |       | 10,000   |       | 4,000    |       | 41,000   |       |
|                                                     |       |     |       |     |       |     |       |
| Income tax  expense                                      |       | $        | 570,000    |     | $          | 465,000  |       | $ | 268,000 |   |

 

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

|          | ** ** | **2006**  | ** ** | **2005**  | ** ** | **2004** | ** ** |
|----------|------------|-----------|------------|-----------|------------|----------|------------|
| Domestic |       | 1,852,000 |       | 1,318,000 |       | 764,000  |       |
| Foreign  |       | 30,000    |       | 76,000    |       | 91,000   |       |
|     |       |      |       |      |       |     |       |
| Total    |       | 1,882,000 |       | 1,394,000 |       | 855,000  |       |

 

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Deferredtax assets (liabilities) at December 31, 2006 and 2005, consist of thefollowing:

|                                     | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|-------------------------------------|------------|-----------|------------|-----------|------------|
| Allowance for  doubtful accounts    |       | $         | 83,000     |      | $          | 113,000 |   |
| Inventory  reserves                 |       | 486,000   |       | 463,000   |       |
| Accrued vacation                    |       | 287,000   |       | 316,000   |       |
| Health insurance  reserve           |       | 144,000   |       | 103,000   |       |
| Non-compete  amortization           |       | 410,000   |       | 378,000   |       |
| Stock-based  compensation           |       | 40,000    |       | —    |       |
| Other                               |       | 42,000    |       | 16,000    |       |
| Deferred tax assets                 |       | 1,492,000 |       | 1,389,000 |       |
|                                |       |      |       |      |       |
| Prepaid expenses                    |       | (167,000  | )          | (86,000   | )          |
| Property and  equipment             |       | (192,000  | )          | (212,000  | )          |
| Deferred tax liabilities            |       | (359,000  | )          | (298,000  | )          |
|                                |       |      |       |      |       |
| Net deferred tax assets             |       | $         | 1,133,000  |      | $          | 1,091,000 |   |
|                                |       |      |       |      |       |
| Net short-term  deferred tax assets |       | $         | 856,000    |      | $          | 912,000 |   |
| Net long-term  deferred tax assets  |       | 277,000   |       | 179,000   |       |
| Net deferred tax  assets            |       | $         | 1,133,000  |      | $          | 1,091,000 |   |

 

We have determined that it ismore likely than not that our deferred tax assets will be realized, principallythrough anticipated taxable income in future tax years.  As a result, we have determined thatestablishing a valuation allowance on our deferred tax assets is not necessary.

50

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**NOTE 7**                            COMPREHENSIVEINCOME

Comprehensive income is comprised of net income andother comprehensive income (loss).  Othercomprehensive income (loss) includes income (loss) resulting from foreigncurrency translations.  The details ofcomprehensive income are as follows:

|                                    | ** ** | **Year Ended**   | ** ** | **Year Ended**   | ** ** | **Year Ended**   | ** ** |
|------------------------------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                         | ** ** | **2006**              | ** ** | **2005**              | ** ** | **2004**              | ** ** |
| Net income, as reported            |       | $                     | 1,311,778  |                  | $          | 928,781               |       | $ | 587,329 |   |
|                               |       |                  |       |                  |       |                  |       |
| Other comprehensive income (loss): |       | (2,147                | )          | 19,697                |       | (14,041               | )          |
|                               |       |                  |       |                  |       |                  |       |
| Comprehensive  income              |       | $                     | 1,309,631  |                  | $          | 948,478               |       | $ | 573,288 |   |

 

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

We have a 401(k) profit sharingplan (the “Plan”) for our employees.  ThePlan is a defined contribution plan covering all of our employees except foremployees covered by a collective bargaining agreement and non-resident aliensearning non-U.S. source income. Employees are eligible to participate in the Plan after completing sixmonths of service and attaining the age of 21. Employees are allowed to contribute up to 60% of their wages to thePlan.  We match 25% of the employees’contribution up to 6% of covered compensation. We made contributions of $167,031, $153,171 and $120,089 during theyears ended December 31, 2006, 2005, and 2004, respectively.

**NOTE 9**                            GAINSHARINGINCENTIVE, STOCK OPTION AND RESTRICTED STOCK PLANS

Employee Gainsharing 

During 1993, we adopted anemployee gainsharing plan (the “Plan”). The purpose of the Plan is to provide a bonus for increased output,improved quality and productivity and reduced costs.  We have authorized 50,000 common shares to beavailable under this Plan.  In accordancewith the terms of the Plan, employees can acquire newly issued shares of commonstock for 90% of the current market value. During 2006, 2005 and 2004, 32, 250 and 52 common shares, respectively,were issued in connection with this plan. Through December 31, 2006, 21,855 common shares have been issued underthis Plan.

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**STOCK OPTIONS AND RESTRICTED STOCK**

In 1992, we approved theadoption of a fixed stock based compensation plan. The purpose of the Plan isto promote our interests and our shareholders interests by providing officers,directors and other key employees with additional incentive and the opportunity,through common stock ownership, to increase their proprietary interest in usand their personal interest in our continued success.  In February 2003, we reached the maximumoptions allowed to be granted under the plan.

During 2003, our shareholdersapproved the adoption of the Nortech Systems Incorporated 2003 Stock OptionPlan (the “2003 Plan”).  The total numberof shares of common stock that may be granted under the 2003 Plan is300,000.  On May 3, 2005, theshareholders approved the 2005 Incentive Compensation Plan (the “2005 Plan”)and eliminated the remaining 172,500 available option shares under the 2003Plan effective February 23, 2005.  Thetotal number of shares of common stock that may be granted under the 2005 Planis 200,000, of which 39,500 remain available for grant at December 31,2006.  The 2005 Plan provides that optionshares granted come from our authorized but unissued common stock.  The price of the option shares granted underthe plan will not be less than 100% of the fair market value of the commonshares on the date of grant.  Options aregenerally exercisable after one or more years and expire no later than 10 yearsfrom the date of grant.

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Thefollowing table summarizes information about stock options outstanding atDecember 31, 2006:

|                          | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** | **Remaining**             | ** ** |
|--------------------------|------------|-----------------|------------|-----------------|------------|---------------------------|------------|
| **Exercise Prices** | ** ** | **12/31/2006**  | ** ** | **12/31/2006**  | ** ** | **Contractual Life** | ** ** |
| $3.125                   |       | 22,000          |       | 22,000          |       | 3.16  Years               |       |
| 4.000                    |       | 2,000           |       | 2,000           |       | 3.42  Years               |       |
| 5.000                    |       | 40,000          |       | 40,000          |       | 0.14  Years               |       |
| 5.275                    |       | 20,000          |       | 20,000          |       | 8.38  Years               |       |
| 5.500                    |       | 4,000           |       | 4,000           |       | 2.00  Years               |       |
| 5.740                    |       | 20,000          |       | 20,000          |       | 7.84  Years               |       |
| 7.110                    |       | 4,000           |       | 4,000           |       | 5.81  Years               |       |
| 7.220                    |       | 50,000          |       | 50,000          |       | 6.12  Years               |       |
| 7.440                    |       | 73,500          |       | 24,500          |       | 9.17  Years               |       |
| 7.460                    |       | 20,000          |       | 20,000          |       | 7.34  Years               |       |
| 7.790                    |       | 67,000          |       | —          |       | 9.84  Years               |       |
| 8.000                    |       | 69,000          |       | 69,000          |       | 6.95  Years               |       |
|                     |       | 391,500         |       | 275,500         |       |                      |       |

 

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Following is a summary of thestock option plan activity during 2006, 2005 and 2004.

|                                         | ** ** | **2006**   | ** **   | **2005**      | ** ** | **2004**   | ** ** |
|-----------------------------------------|------------|------------|--------------|---------------|------------|------------|------------|
| ** **                              | ** ** | ** ** | ** **   | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                              | ** ** | ** ** | ** **   | **Average**   | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                              | ** ** | ** ** | ** **   | **Exercise**  | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                              | ** ** | **Shares** | ** **   | **Price**     | ** ** | **Shares** | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
| Options outstanding, beginning of year  |       | 287,000    |         | $             | 6.27       |       | 306,800    |   | $ | 6.21 |   | 272,800 |   | $ | 6.10 |   |
| Options exercised                       |       | (28,000    | )            | 4.53          |       | (35,800    | )          | 5.22 |   | (6,000 | ) | 3.63 |   |
| Options cancelled                       |       | (8,000     | )            | 8.00          |       | (4,000     | )          | 6.00 |   | — |   | — |   |
| Options granted                         |       | 140,500    |         | 7.61          |       | 20,000     |       | 5.28 |   | 40,000 |   | 6.60 |   |
|                                    |       |       |         |          |       |       |       |   |   |   |   |   |   |
| Options outstanding,  end of year       |       | 391,500    |         | $             | 6.84       |       | 287,000    |   | $ | 6.27 |   | 306,800 |   | $ | 6.21 |   |
|                                    |       |       |         |          |       |       |       |   |   |   |   |   |   |
|                                    |       |       |         |          |       |       |       |   |   |   |   |   |   |
| Option price range of exercised options |       | $          | 3.125 - 5.00 |          |       |       | $          | 4.00 - 5.25 |   |   |   | $ | 3.63 |   |   |   |
|                                         |            |            |              |               |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The Financial AccountingStandards Board (FASB) has issued Statement No. 123R (SFAS 123R), “Share-BasedPayment: An Amendment of FASB Statement No. 123,” which requires companies torecognize in the income statement the grant-date fair value of stock optionsand other equity-based compensation issued to employees. In adopting SFAS 123R,as of January 1, 2006, we used the modified prospective transition method.

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Under the modified prospectivetransition method, awards that are granted, modified or settled after the dateof adoption will be measured and accounted for in accordance withSFAS 123R. Compensation cost for awards granted prior to, but not vested,as of the date SFAS 123R was adopted are based on the grant dateattributes originally used to value those awards for pro forma purposes underSFAS 123.  Our consolidated financial statements as of and for theyear ended December 31, 2006 reflect the impact of SFAS 123R.  Inaccordance with the modified prospective transition method, the consolidatedfinancial statements for prior periods have not been restated to reflect, anddo not include, the impact of SFAS 123R.  Share-based compensation expensebefore income taxes recognized under SFAS 123R for the year ended December 31,2006 was $188,259.

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

On November 15, 2005, our Boardof Directors accelerated the vesting of the then outstanding and unvested stockoptions. Had these vesting periods not been accelerated, under SFAS 123R wewould have recognized approximately $370,000 in cumulative additional expensespread over five years beginning in fiscal 2006.

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Had compensation cost for theour stock option plan been determined pursuant to SFAS 123 in 2005 and2004, net income and earnings per common share on a pro forma basis would havebeen as follows:

 

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

 

SFAS 123R requires companies toestimate the fair value of share-based awards on the date of grant using anoption-pricing model.  The value of the portion of the award that isultimately expected to vest is recognized as expense in the consolidatedstatement of operations on a straight-line basis over the requisite serviceperiods.  Share-based compensation expense for share-based awards grantedprior to, but not yet vested as of December 31, 2005, is based on the grantdate fair value estimated in accordance with the provisions of SFAS 123. For options granted subsequent to December 31, 2005, compensation expense isbased on the grant date fair value estimated in accordance with SFAS123R.  Because share-based compensation expense is based on awards thatare ultimately expected to vest, share-based compensation expense will bereduced to account for estimated forfeitures.  SFAS 123R requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates.  Inthe pro forma information required under SFAS 123 for periods prior to fiscal2006, we accounted for forfeitures as they occurred.

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During 2006, a total of 140,500options were granted to our management and directors with the exercise priceequaling the closing price of the common shares on each respective grantdate.  To calculate the option-basedcompensation under SFAS 123R, we used the Black-Scholes option-pricing model,which we had previously used for the valuation of option-based awards for ourpro forma information required under SFAS 123 for periods prior to fiscal2006.  Our determination of fair value of option-based awards on the dateof grant using the Black-Scholes model is affected by our stock price as wellas assumptions regarding a number of subjective variables as noted in thefollowing table.  These variables include, but are not limited to, ourexpected stock price volatility over the term of the awards, risk-free interestrate, and the expected life of the options.  The risk-free interest rateis based on a treasury instrument whose term is consistent with the expectedlife of our stock options.  The expected volatility, holding period, andforfeitures of options are based on our historical experience.

|                           | ** ** | **2006**        | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------|------------|-----------------|------------|----------|------------|----------|------------|
| Expected  volatility      |       | 52.20% - 61.60% |       | 69.50    | %          | 70.50    | %          |
| Expected  dividends       |       | 0               | %          | 0        | %          | 0        | %          |
| Expected term  (in years) |       | 5 - 6           |       | 10       |       | 10       |       |
| Risk-free rate            |       | 4.55 - 4.85     | %          | 4.37     | %          | 4.62     | %          |

 

Total compensation expense related to stockoptions included in our statement of income for the year ended December 31,2006 was $118,356.  For all grants, the amount of compensation expense tobe recognized is adjusted for an estimated forfeiture rate, which is based onhistorical data.

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A summary of option activityunder the Plan as of December 31, 2006 and changes during the year then endedis presented below.

|                                       | ** ** | **Options** | ** ** | **Weighted-  Average  Exercise  Price Per  Share** | ** ** | **Weighted-  Average  Remaining  Contractual  Term  (in years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|---------------------------------------|------------|-------------|------------|---------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding —  January 1, 2006   |       | 287,000     |       | $                                                       | 6.27       |                                                                  |       |                            |       |   |
| Granted                               |       | 140,500     |       | 7.61                                                    |       |                                                                  |       |                            |       |
| Exercised                             |       | (28,000     | )          | 4.53                                                    |       |                                                                  |       |                            |       |
| Forfeited                             |       | (8,000      | )          | 8.00                                                    |       |                                                                  |       |                            |       |
| Outstanding —  December 31, 2006 |       | 391,500     |       | $                                                       | 6.84       |                                                                  | 6.90       |                            | $          | 357,710 |   |
| Exercisable on December  31, 2006     |       | 275,500     |       | $                                                       | 6.50       |                                                                  | 5.79       |                            | $          | 345,950 |   |

 

The weighted-average grant-datefair values of options granted during 2006, 2005, and 2004 were $4.29, $4.14,and $5.23, respectively.  The totalintrinsic value of options exercised during the years ended December 31, 2006,2005, and 2004 were $78,490, $21,855 and $25,230.

As of December 31, 2006, therewas approximately $477,000 of unrecognized compensation expense related tounvested option awards that we expect to recognize over a weighted average periodof 2.48 years. The total fair value of shares vested during the year endedDecember 31, 2006 was $105,720.

A summary of the status of ournonvested shares as of December 31, 2006, and changes during the year endedDecember 31, 2006, is presented below:

| Nonvested Shares           | ** ** | **Shares** | ** ** | **Weigted-Average  Grant-Date Fair  Value** | ** ** |
|---------------------------------|------------|------------|------------|--------------------------------------------------|------------|
| Nonvested at  January 1, 2006   |       | —     |       | $                                                | —     |   |
| Granted                         |       | 140,500    |       | 4.29                                             |       |
| Vested                          |       | (24,500    | )          | 4.32                                             |       |
| Nonvested at December  31, 2006 |       | 116,000    |       | $                                                | 4.29       |   |

 

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Cash received from optionexercise under all share-based payment arrangements for the year ended December31, 2006 was $126,978. SFAS 123R also requires that the tax benefit from theexercise of options be reflected in the statement of cash flows as a cashinflow from financing activities. Prior to the adoption of SFAS 123R, these taxbenefits have been reflected as a cash inflow from operations. The actual taxbenefit realized for the tax deductions from the option exercise of theshare-based payment arrangements totaled $87,839 for the year ended December31, 2006.

***Restricted Stock***

In March 2006, 28,500 shares ofrestricted common stock were granted to our management and directors. This benefit was valued at the market price of the stock on the date ofgrant.  These awards vest over a three-year term and are expensed ratablyover the same period.  The arrangements contained an accelerationcondition whereby if we attain certain financial measurements, the awards wouldvest in their entirety on December 31, 2006. The acceleration conditions were not met, thus the awards will continueto vest ratably over the full vesting period as stated in the agreement. Totalcompensation expense related to restricted stock included in the statements ofincome for the year ended December 31, 2006 was $69,900.  The following isthe status of our restricted shares as of December 31, 2006, including changesduring the year ended December 31, 2006:

|                                   | ** ** | **Restricted  Shares** | ** ** | **Weighted-Average  Grant Date Fair  Value** | ** ** |
|-----------------------------------|------------|------------------------|------------|--------------------------------------------------------|------------|
| Outstanding -  January 1, 2006    |       | —                 |       | $                                                      | —     |   |
| Granted - March  7, 2006          |       | 28,500                 |       | 7.44                                                   |       |
|                              |       |                   |       |                                                   |       |
| Outstanding -  December 31, 2006  |       | 28,500                 |       | $                                                      | 7.44       |   |
|                              |       |                   |       |                                                   |       |
| Exercisable on December  31, 2006 |       | 9,500                  |       | $                                                      | 7.44       |   |

 

As of December 31, 2006, therewas approximately $140,000 of unrecognized compensation expense related tounvested restricted stock awards, which we expect to recognize over a weightedaverage period of 2.0 years.

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**NOTE 10**                     COMMITMENTSAND CONTINGENCIES

Litigation

We are subject to various legal proceedings and claims thatarise in the ordinary course of business. In our opinion, the amount of any ultimate liability with respect tothese actions will not materially affect our consolidated financial statementsor results of operations.

Executive Life Insurance Plan

During 2002, we set up an Executive Bonus Life Insurance Plan(the “Plan”) for our key employees (“participants”).  Pursuant to the Plan, we will pay a bonus toofficer participants 15% and all other participants 10% of the participants’base annual salary, as well as an additional bonus to cover federal and statetaxes incurred by the participants.  Theparticipants are required to purchase life insurance and retain ownership ofthe life insurance policy once it is purchased. The Plan provides a five-yeargraded vesting schedule in which the participants vest at a rate of 20% eachyear.  Should a participant terminate employmentprior to the fifth year of vesting, that participant may be required toreimburse us for any unvested amounts, under certain circumstances.  Charges to income under the Plan were$290,000, $228,000 and $167,375 for the years ended December 31, 2006, 2005 and2004, respectively.

Change of Control Agreements

During 2002, we entered into Change of Control Agreements(the “Agreement(s)”) with certain key executives (“the Executive(s)”).  The Agreements provide an inducement for eachExecutive to remain as an employee in the event of any proposed or anticipatedchange of control in the organization, including facilitating an orderlytransition, and to provide economic security for the Executive after a changein control has occurred.

In the event of an involuntarily termination, each Executivewould receive their base salary, annual bonus at time of termination, andcontinued participation in health, disability and life insurance plans for aperiod of three years for officers and two years for all other participants.  Participants would also receive professionaloutplacement services up to $10,000 if applicable.  Each Agreement remains in full force untilthe Executive terminates employment or we terminate the employment of theExecutive.

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**NOTE 11**                     EARNINGSPER COMMON SHARE

The following is a reconciliationof the numerators and the denominators of the diluted per common sharecomputations.

|                                                                         | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                                                    |       |       |       |       |       |       |       |
| **Diluted Earnings Per Common  Share**                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                                    |       |       |       |       |       |       |       |
| Net Income                                                              |       | $          | 1,311,778  |       | $          | 928,781    |       | $ | 587,329 |   |
|                                                                    |       |       |       |       |       |       |       |
| Weighted average common  shares outstanding                             |       | 2,628,635  |       | 2,583,309  |       | 2,561,419  |       |
| Stock options                                                           |       | 45,778     |       | 30,633     |       | 42,992     |       |
| Restricted Stock                                                        |       | 8,041      |       | —     |       | —     |       |
| Weighted average common  shares   for diluted earnings per common share |       | 2,682,454  |       | 2,613,942  |       | 2,604,411  |       |
| Diluted earnings per  common share *                                    |       | $          | 0.49       |       | $          | 0.36       |       | $ | 0.23 |   |

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* For2006, 2005 and 2004, there were approximately 42,962, 43,302 and 48,409 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.

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**NOTE12           QUARTERLY SELECTED FINANCIALDATA (UNAUDITED)**
| ** **                       | ** ** | **Quarter Ending** | ** ** | **Quarter Ending** | ** ** | **Quarter Ending** | ** ** | **Quarter Ending** | ** ** | **Total**  | ** ** |
|----------------------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------|------------|------------|------------|
| ** **                       | ** ** | **3/31/2006**           | ** ** | **6/30/2006**           | ** ** | **9/30/2006**           | ** ** | **12/31/2006**          | ** ** | **YTD**    | ** ** |
|                             |       |                    |       |                    |       |                    |       |                    |       |       |       |
| Net sales                        |       | $                       | 26,017,619 |                    | $          | 26,173,559              |       | $                       | 25,288,095 |       | $          | 27,667,955 |   | 105,147,228 |   |
| Gross profit                     |       | 3,158,751               |       | 3,413,640               |       | 2,957,403               |       | 3,249,926               |       | 12,779,720 |       |
| Net income                       |       | 263,948                 |       | 308,665                 |       | 304,587                 |       | 434,578                 |       | 1,311,778  |       |
|                             |       |                    |       |                    |       |                    |       |                    |       |       |       |
| Basic income per common  share   |       | 0.10                    |       | 0.12                    |       | 0.12                    |       | 0.16                    |       | 0.50       |       |
| Diluted income per  common share |       | 0.10                    |       | 0.11                    |       | 0.12                    |       | 0.16                    |       | 0.49       |       |
|                                  |            |                         |            |                         |            |                         |            |                         |            |            |            |  |  |  |  |

 
| ** **                      | ** ** | **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 income per common  share  |       | 0.04                    |       | 0.05                    |       | 0.10                    |       | 0.17                    |       | 0.36       |       |
| Diluted income per common share |       | 0.04                    |       | 0.05                    |       | 0.10                    |       | 0.17                    |       | 0.36       |       |
|                                 |            |                         |            |                         |            |                         |            |                         |            |            |            |  |  |  |  |

 

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**NOTE 13**                     SUBSEQUENTEVENT (UNAUDITED)

**Acquisition of Suntron’sMidwest Operations**

On February 4, 2007, we purchased substantially all ofthe assets and assumed certain liabilities of Suntron’s Midwest Operationslocated in Garner, Iowa. This operation is an Electronics Manufacturer Service(EMS) provider of printed circuit board assemblies, box build assemblies andrepair services. Thisacquisition will strengthen our capabilities in printed circuit boardassemblies and high level complete box build assemblies while opening newmarket segments in the agriculture and oil and gas industries.

The purchase price including the assumption of $845,000 of liabilitiesof the seller, was $5,610,000 and was funded by cash of $4,765,000 and anamendment in our credit agreements with Wells Fargo Bank, National Association,increasing our Real Estate Term Notes and Revolving Line of Credit.  The purchase price at time of close was basedon an estimate of the working capital level and is subject to an adjustment,reducing the purchase price based upon the final settlement of the workingcapital level. In addition, the Purchase agreement calls for a contingent earn-outof up to $600,000 if certain revenue levels are achieved. The earn-outadjustment, if earned would be settled on January 31, 2008.  The Iowa operations results are not includedin the consolidated financial statements since the date of acquisition was afterDecember 31, 2006.

The following tablepresents the acquisition cost of the assets acquired and liabilities assumed,on an unaudited basis, based on the preliminary estimated values at time ofacquisition:

| Accounts receivable                        |   | $         | 1,981,000 |   |
|--------------------------------------------|--------|-----------|-----------|--------|
| Inventories                                |   | 2,143,000 |      |
| Other current  assets                      |   | 11,000    |      |
| Property, plant  and equipment             |   | 442,000   |      |
| Intangibles                                |   | 1,033,000 |      |
| Accounts payable  assumed                  |   | (766,000  | )         |
| Accrued  compensation and benefits assumed |   | (79,000   | )         |
| Net assets acquired                        |   | $         | 4,765,000 |   |

 

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The table below reflects our unaudited pro forma combinedresults of operations as if the acquisition had taken place as of January 1,2006:
|                                    | ** ** | **Pro Forma**                    | ** **  |
|------------------------------------|------------|---------------------------------------|-------------|
| ** **                         | ** ** | **For the Year Ended** | ** **  |
| ** **                         | ** ** | **December 31, 2006**       | ** **  |
| ** **                         | ** ** | **(unaudited)**                       | ** **  |
| Net Sales                          |       | $                                     | 117,745,000 |   |
|                               |       |                                  |        |
| Net Income                         |       | $                                     | 1,398,000   |   |
|                               |       |                                  |        |
| Basic earnings  per common share   |       | $                                     | 0.53        |   |
|                               |       |                                  |        |
| Diluted earnings  per common share |       | $                                     | 0.52        |   |
|                               |       |                                  |        |

**The pro forma unaudited results do not purport to beindicative of the results which would have been obtained had the acquisitionbeen completed as of the beginning of the earliest period presented.  Furthermore, the purchase price allocation ispreliminary and subject to change.  Oncethe final purchase price allocation is determined, the unaudited pro formacombined results of operations presented above may change.**

 

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**Report of Independent RegisteredPublic Accounting Firm on Supplementary Information**

To the Board ofDirectors

Nortech SystemsIncorporated and Subsidiary

Wayzata, Minnesota

Ouraudit were made for the purposes of forming an opinion on the basic 2006, 2005and 2004 consolidated financial statements of Nortech Systems Incorporated andSubsidiary taken as a whole.  Theconsolidated supplemental schedule II is presented for purposes of complyingthe Securities and Exchange Commission’s rules and is not a part of the basicconsolidated financial statements.  Thisschedule has been subjected to the auditing procedures applied in our audits ofthe 2006, 2005 and 2004 basic consolidated financial statements and, in ouropinion, is fairly stated in all material respects in relation to the basicconsolidated financial statements taken as a whole.

/s/ McGLADREY & PULLEN, LLP

Minneapolis, Minnesota

March 7, 2007

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**NORTECHSYSTEMS INCORPORATED AND SUBSIDIARY**

**SCHEDULE II — Valuation and Qualifying Accounts**

**FOR THE YEARS ENDEDDECEMBER 31, 2006, 2005 AND 2004**
| ** **                            | ** ** | ** **          | ** ** | **Additions**         | ** ** | ** **            | ** ** | ** **          | ** ** |
|---------------------------------------|------------|---------------------|------------|-----------------------|------------|-----------------------|------------|---------------------|------------|
| ** **                            | ** ** | **Balance at** | ** ** | **Charged**           | ** ** | ** **            | ** ** | **Balance at** | ** ** |
| ** **                            | ** ** | **Beginning**       | ** ** | **to Costs**     | ** ** | ** **            | ** ** | **End of**     | ** ** |
| **Classification**                    | ** ** | **of Year**    | ** ** | **And Expenses** | ** ** | **Add (Deduct)** | ** ** | **Year**            | ** ** |
|                                  |       |                |       |                  |       |                  |       |                |       |
| Year Ended December 31,  2006:        |       |                |       |                  |       |                  |       |                |       |
| Allowance for  Uncollectible Accounts |       | $                   | 296,563    |                  | 180,877    |                  | (257,750   | )                   | $          | 219,690 |   |
| Inventory  Reserve                    |       | $                   | 1,218,434  |                  | 900,680    |                  | (823,458   | )                   | $          | 1,295,656 |   |
| Self-insurance  Accrual               |       | $                   | 271,104    |                  | 3,861,867  |                  | (3,807,971 | )                   | $          | 325,000 |   |
|                                  |       |                |       |                  |       |                  |       |                |       |
| 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 |   |

 

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**ITEM 9.   CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON****ACCOUNTING AND****FINANCIAL DISCLOSURE**

None.

**ITEM 9A.   CONTROLS AND PROCEDURES**

We maintain disclosure controls and procedures designed to ensure that information required to be disclosed in reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the specified time periods.  As of the end of the period covered by this report, our management, including the Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures.  Based on the evaluation, which disclosed no significant deficiencies or material weaknesses, the Chief Executive Officer and Chief Financial Officer each concluded that our disclosure controls and procedures are effective.

We are currently in the process of reviewing and formalizing our internal controls and procedures for financial reporting in accordance with the Securities and Exchange Commission’s rules implementing the internal control reporting requirements included in Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”).  Changes have been and will be made to our internal controls over financial reporting as a result of these efforts.  We are dedicating significant resources, including senior management time and effort, and incurring substantial costs in connection with our ongoing Section 404 assessment.  We are currently documenting and testing internal controls and considering whether any improvements are necessary for maintaining an effective control environment.  The evaluation of internal controls is being conducted under the direction of senior management in consultation with an independent third party consulting firm.  In addition, senior management is regularly discussing the results of testing and any proposed improvements to the control environment with the Audit Committee.  We expect to assess controls and procedures on a regular basis.  We will continue to work to improve controls and procedures and to educate and train employees on the existing controls and procedures in connection with the efforts to maintain an effective controls infrastructure.

**ITEM 9B.  OTHER INFORMATION**

None.

**PART III**

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

Information regarding the directors and executive officers of theRegistrant will be included in the Registrant’s 2006 proxy statement to befiled with the Securities and Exchange Commission not later than April 30, 2007and said portions of the proxy statement are incorporated herein by reference.

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##### **ITEM 11.   EXECUTIVECOMPENSATION**

Information regarding executive compensation of the Registrant will beincluded in the Registrant’s 2006 proxy statements to be filed with theSecurities and Exchange Commission not later than April 30, 2007 and saidportions of the proxy statement are incorporated herein by reference.

##### **ITEM12.   SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS ANDMANAGEMENT**

 

Information regarding security ownership of certain beneficial ownersand management of the Registrant will be included in the Registrant’s 2006proxy statements to be filed with the Securities and Exchange Commission nolater than April 30, 2007 and said portions of the proxy statements areincorporated herein by reference.

Information regarding executive compensation plans (includingindividual compensation arrangements) as of the end of the last fiscal year, ontwo categories of equity compensation plans (that is, plans that have beenapproved by security holders and plans that have not been approved by securityholders) will be included in the Registrant’s 2006 proxy statements to be filedwith the Securities and Exchange Commission no later than April 30, 2007 andsaid portions of the proxy statements are incorporated herein by reference.

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The following table providesinformation about our equity compensation plans (including individualcompensation arrangements) as of December 31, 2006.
| **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     |       | 391,500                                                                                                                                                          |       | $                                                                                                                       | 6.842      |                                                                                                                                                                                                                   | 39,500     |   |
|                                                        |       |                                                                                                                                                             |       |                                                                                                                    |       |                                                                                                                                                                                                                   |       |
| Equity  compensation plans not approved by security holders |       | 0                                                                                                                                                                |       | 0                                                                                                                       |       | 0                                                                                                                                                                                                                      |       |
|                                                        |       |                                                                                                                                                             |       |                                                                                                                    |       |                                                                                                                                                                                                                   |       |
| Total                                                       |       | 391,500                                                                                                                                                          |       | $                                                                                                                       | 6.842      |                                                                                                                                                                                                                   | 39,500     |   |

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(1)                                 Representscommon shares issuable upon the exercise of outstanding options granted underour 1992 Employee Stock Incentive Plan (the “1992 Plan”) and the 2003 StockOption Plan (the “2003 Plan”) and the 2005 Incentive Compensation Plan (the“2005 Plan”).

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

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**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.

##### **ITEM14.   PRINCIPAL ACCOUNTANT FEES ANDSERVICES**

Theinformation required by this Item is included under the caption “Miscellaneous-IndependentAuditor Fees” in the Proxy Statement and, when the Proxy Statement is filed,will be incorporated herein by reference.

**PART IV**

**ITEM 15. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENTS SCHEDULES**
| (1)    | Consolidated Financial Statements - consolidated  financial statements and related Notes are included in Part II, Item 8, and  are identified in the Index on Page 20. |
|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                   |
| (2)    | Consolidated Financial Schedule:                                                                                                                                       |

 
|                                                                                         | ** ** | **PAGE** | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------|------------|
| Reports of Independent Registered  Public Accounting Firms on Supplementary Information |       | 65       |       |
|                                                                                    |       |     |       |
| Consolidated Supplemental Schedule II - Valuation  and Qualifying Accounts              |       | 66       |       |
|                                                                                    |       |     |       |
|                                                                                    |       |     |       |

 

Allother schedules are omitted since they are not applicable, not required, or therequired information is included in the financial statements or notes thereto.

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The following exhibits accompany our Annual Report on Form 10-K for theyear ended December 31, 2006.

10.2                           Sixth Amendment to amended and restatedCredit and Security Agreement, Amended and Restated Revolving Note between theCompany and Wells Fargo Bank Minnesota National Association.

10.3                           Seventh Amendment to amended and restatedCredit and Security Agreement, Amended and Restated Revolving Note between theCompany and Wells Fargo Bank Minnesota National Association.

23.1                           Consent ofMcGladrey & Pullen, 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, asamended.

31.2                           Certificationof 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                           Certificationof the Chief Executive Officer and Chief Financial Officer, as adopted pursuantto Section 906 of the Sarbanes-Oxley Act of 2002.

The following exhibits are incorporated by reference to exhibitsaccompanying our Annual Report on Form 10-K for the year ended December 31,2004.

10.1                           Fifth Amendment to amended and restatedCredit and Security Agreement, Amended and Restated Revolving Note between theCompany and Wells Fargo Bank Minnesota National Association.

 

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**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

NORTECH SYSTEMS INCORPORATED
| March 8, 2007 |     | By: /s/  | *Richard  G. Wasielewski*     |
|---------------|----------|----------|-------------------------------|
|          | * * | * * | Richard G.  Wasielewski       |
|          | * * | * * | Chief Financial  Officer      |
|          | * * | * * | and                           |
|          | * * | * * | Principal  Accounting Officer |
|          | * * | * * | * *                      |
| March 8, 2007 |     | By: /s/  | *Michael  J. Degen*           |
|          | * * | * * | Michael J. Degen              |
|          | * * | * * | President, Chief  Executive   |
|          | * * | * * | Officer and  Director         |

 

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the following persons onbehalf of the registrant and in the capacities and on the dates indicated havesigned this report.

 

 
| March 8, 2007 |   | /s/    | *Michael  J. Degen*           |
|---------------|--------|--------|-------------------------------|
|          |   |   | Michael J. Degen              |
|          |   |   | President, Chief  Executive   |
|          |   |   | Officer and  Director         |
|          |   |   |                          |
| March 8, 2007 |   | /s/    | *Myron  Kunin*                |
|          |   |   | Myron Kunin                   |
|          |   |   | Chairman and  Director        |
|          |   |   |                          |
| March 8, 2007 |   | /s/    | *Richard  W. Perkins*         |
|          |   |   | Richard W.  Perkins, Director |
|          |   |   |                          |
| March 8, 2007 |   | /s/    | *C.  Trent Riley*             |
|          |   |   | C. Trent Riley,  Director     |
|          |   |   |                          |
| March 8, 2007 |   | /s/    | *Ken  Larson*                 |
|          |   |   | Ken Larson,  Director         |

 

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**INDEX TO EXHIBITS**

##### **DESCRIPTIONSOF EXHIBITS**

|   |   |                                                                                                                                                                                    |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.2   |   | Sixth Amendment to amended and restated Credit and  Security Agreement, Amended and Restated Revolving Note between the Company  and Wells Fargo Bank Minnesota National Association.   |
|   |   |                                                                                                                                                                                    |
| 10.3   |   | Seventh 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                                                                                                                                                  |
|   |   |                                                                                                                                                                                    |
| 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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