**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-K**

**ANNUAL REPORT PURSUANT TO SECTION 13 OR15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

**Forthe fiscal year ended December 31, 2004**

**NORTECH SYSTEMS INCORPORATED**
| **Commission file number** **0-13257**                                           |
|---------------------------------------------------------------------------------------|
| State  of Incorporation: **Minnesota**                                           |
| IRS Employer  Identification No. **41-16810894**                                 |
| Executive  Offices: **1120 Wayzata Blvd E., Suite 201,  Wayzata, MN 55391** |
| Telephone number: **(952) 345-2277**                                             |
| Securities  registered pursuant to Section 12(b) of the Act: **None**  |
| Securities  registered pursuant to Section 12(g) of the Act:                |
| **Common  Stock, Par Value $.01 Per Share**                                           |

 

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

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of regulation S-K is notcontained herein and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. x

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Act) Yes o  No x

The aggregate market valueof voting stock held by non-affiliates of the registrant, based on the closingprice of $7.93 per share, was $9,983,965 on June 30, 2004.

Shares of common stockoutstanding at March 8, 2005: 2,582,147.

(Theremainder of this page was intentionally left blank.)

 

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**DOCUMENTS INCORPORATED 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                                                      |
|                                      | 11         |       | proxy statements to be used in connection                                                        |
|                                      | 12         |       | with the 2004 Annual Shareholders’                                                          |
|                                      | 13         |       | Meeting and filed with the Securities and Exchange  Commission no later than April 30, 2005 |
|                                           |            |            |                                                                                                  |                                         |  |

 

(The remainder of this page was intentionally left blank)

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**NORTECH SYSTEMSINCORPORATEDANNUAL REPORT ON FORM 10KTABLE OF CONTENTS**
|                 | ** ** | ** **                                                                                                          | ** ** | **PAGE** |
|-----------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|----------|
| *PART I*   |       |                                                                                                                |       |     |
| Item 1.         |       | Business                                                                                                            |       | 4-7      |
| Item 2.         |       | Properties                                                                                                          |       | 8        |
| Item 3.         |       | Legal  Proceedings                                                                                                  |       | 8        |
| Item 4.         |       | Submission  of Matters to a Vote of Security Holders                                                                |       | 8        |
| *PART II*  |       |                                                                                                                |       |     |
| Item 5.         |       | Market  For Registrant’s Common Equity, Related Stockholder Matters and Issuer  Purchases of Equity Securities |       | 9        |
| Item 6.         |       | Selected  Financial Data                                                                                            |       | 10       |
| Item 7.         |       | Management’s  Discussion and Analysis                                                                          |       | 11-17    |
| Item  7a        |       | Quantitative  and Qualitative Disclosure about Market Risk                                                          |       | 17       |
| Item 8.         |       | Consolidated  Financial Statements and Supplemental Data                                                            |       | 18-43    |
| Item 9.         |       | Changes in and Disagreements  with Accountants on Accounting and Financial Disclosure                          |       | 44       |
| Item 9A.        |       | Controls and Procedures                                                                                             |       | 44-45    |
| Item 9B.        |       | Other Information                                                                                                   |       | 45       |
| *PART III* |       |                                                                                                                |       |     |
| Item 10.        |       | Directors and Executive  Officers of the Registrant                                                                 |       | 45       |
| Item 11.        |       | Executive Compensation                                                                                              |       | 45       |
| Item 12.        |       | Security Ownership of  Certain Beneficial Owners and Management                                                     |       | 45-46    |
| Item 13.        |       | Certain Relationships and  Related Transactions                                                                     |       | 46       |
| Item 14.        |       | Principal Accountant Fees  and Services                                                                             |       | 46       |
| *PART IV*  |       |                                                                                                                |       |     |
| Item 15.        |       | Exhibits, Consolidated Financial  Statements Schedules                                                              |       | 47       |
|            |       | Signatures                                                                                                          |       | 48       |
|            |       | Index to Exhibits                                                                                                   |       | 49       |

 

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**NORTECH SYSTEMS INCORPORATEDFORM 10-KFor the Year Ended December 31, 2004PART I**

**ITEM 1**.                BUSINESS

**DESCRIPTION OFBUSINESS**

Nortech Systems Incorporated and Subsidiary (the “Company”)is a Minnesota corporation organized in December 1990. Prior to December 1990,the Company operated as DSC Nortech, Inc., which filed a petition forreorganization under Chapter 11 of the United States Bankruptcy Code during1990. The business and assets of DSC Nortech, Inc. were transferred toNortech Systems Incorporated during 1990.

The Company files annual reports, quarterly reports,proxy statements, and other documents with the Securities and ExchangeCommission (SEC) under the Securities Exchange Act of 1934 (Exchange Act). Thepublic may read and copy any materials that the Company files with the SEC atthe SEC’s Public Reference Room at 340 Fifth Street N.W., Washington, D.C.20549. Also, the SEC maintains an Internet website that contains reports, proxyand information statements, and other information regarding issuers, includingthe Company, that file electronically with the SEC. The public can obtain anydocuments that the Company files with the SEC at *http:\\www.sec.gov.*

The Company makesavailable free of charge through its Internet website (*http:\\nortechsys.com*)the Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q,Press Releases, and Current Reports on Form 8-K.

**GENERAL**

The Company’s headquarters are in Wayzata, Minnesota,a suburb of Minneapolis, Minnesota. The Company maintains manufacturingfacilities in Minnesota including Bemidji, Fairmont, Baxter, and Merrifield aswell as Augusta, Wisconsin, and Monterrey, Mexico. The Company manufactureswire harnesses, cables, electronic sub-assemblies and components, and printedcircuit board assemblies. The Company provides a full “turnkey” contractmanufacturing service to its customers. A majority of revenue is derived fromproducts that are built to the customer’s design specifications.

The Company provides a high degree of manufacturingsophistication using statistical process controls to insure product quality,state-of-the-art materials management techniques, allowing just-in-time (JIT)delivery of products, and the systems necessary to effectively manage thebusiness. This level of sophistication enables the Company to attract majororiginal equipment manufacturers (OEM).

The strategy of the Company is to expand and diversifyits customer base. The Company has added several new customers from variousindustries, some of which produce medical products, computers for businesssystems, products in the automotive and defense industries and industrialproducts. The Company’s strategy is to develop a customer base spanning severalindustry segments to avoid the effects of fluctuations within a given industry.Some of the Company’s major customers are G.E. Medical Systems, Raytheon, SPXCorporation, Kodak, Thermo King, Polaris, Cubic, Comtech Mobile, RestaurantTechnology Inc., Allen-Bradley, Semitool, Silicon Graphics, Graco, Nilfisk,Medical Reseach Labs, Northrop Grumman and United Defense.

The Company believes thecurrent trend for contract manufacturing to grow and expand in the UnitedStates and overseas will continue because contract manufacturing provides OEMswith a quality product at a price well below what is in their own facilities. Thisis due primarily to the specialization available 

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throughthe contract manufacturer with significantly lower overhead costs and abilityto solve logistical problems with offshore manufacturing.

**ACQUISITIONS**

On June 23, 2004, the Company acquired all of thebusiness assets of Zachariah and Lundbergh, Inc. (Z&L) for $250,000with the assets being added to the consolidated financial statements in thesecond quarter and revenues of approximately $130,000 reported since theacquisition. This acquisition of assets allows for further expansion of theCompany’s InterconOne brand of specialty cable and power supplies for use inindustrial and medical grade video cameras and ancillary equipment.

In June 2002, theCompany acquired 100 percent of the outstanding common shares of ManufacturingAssembly Solutions of Monterrey, Inc. (MAS), a Mexican corporation,located in Monterrey, Mexico. The results of operations since this acquisitionhave been included in the consolidated financial statements. The primary reasonfor the acquisition was to enhance the Company’s manufacturing capabilities ina low cost country. See Note 10 to the consolidated financial statements formore detail on this acquisition.

**BUSINESS SEGMENTS**

At December 31, 1998,the Company had reported segment information of its then three identifiablesegments: Contract Manufacturing, Display Products and Medical Management. However,on June 30, 1999, the Company formally adopted a plan to dispose of two ofthe segments including Display Products and Medical Management. During 2002,Display Products and Medical Management segments were sold. Thus, at December 31,2003 and 2004, the Company’s continuing operations fall within the ContractManufacturing segment.

**BUSINESS STRATEGY**

The Company believes the electronic manufacturingsub-contracting business is emerging from a small job shop oriented businessinto a dynamic, high technology global electronics and wire/harness industry. TheCompany operates mainly in the wire harness and cable assemblies, and printedcircuit board assemblies markets, and intends to expand from this marketsegment into complete electromechanical assemblies. Many companies no longerperform this type of work on a captive, in-house basis, as they are findingthat independent subcontractors can more cost effectively perform thisspecialized work. Nortech’s goal is to help its clients become more competitivethrough help in design, rapid prototyping, and provides a full-servicemanufacturing solution in the small to mid-size market needs. The Company isalso continuing to expand their international operations and partnerships toprovide lower cost alternatives as a competitive edge and meet their customerdemands in this area.

In accordance with the Company’s total commitment toquality, a quality system based on the ISO 9000 standards has been adopted andimplemented Company-wide. Certification to the ISO standard began in 1995 atthe Bemidji, MN facility and has continued to the point at which all fivedomestic facilities have now been certified to the latest version of the ISO9001 standard. The newest facility, Manufacturing Assembly Solutions ofMonterrey, Inc. in Mexico, passed certification in October 2003. Currentlyall Company operating facilities are under ISO 9001:2000. The Company believesthese certifications benefit its current customer base as well as attract newbusiness opportunities.

The Company will continueits commitment to quality, cost effectiveness and responsiveness to customer requirements.To achieve these objectives, the Company has adopted lean manufacturing supplychain management techniques at its facilities. The Company is committed tocontinuous improvement in order to provide world-class complete manufacturingservices to its customers. The Company will also continue its efforts todiversify its customer base and expand into other segments of the electronicmanufacturing subcontract business.

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**MARKETING**

The Company concentratesits marketing activities in the medical, industrial, automotive and militarymanufacturing industries. The emphasis continues to be on mature companies,which require a contract manufacturer with a high degree of manufacturing andquality sophistication, including statistical process control (SPC), statisticalquality control (SQC), International Standards Organization (ISO) and AerospaceSystems 9100 (AS). The Company has initiated efforts to expand its marketsbeyond the Upper Midwest area. New market opportunities are being pursued inMexico, Asia and Europe, as well as increased participation in industrypublications and selected trade shows. The Company markets its products andservices through internal sales people and manufacturers’ representatives. TheCompany’s marketing strategy emphasizes the sophistication of its manufacturingservices. The basic systems, procedures, and disciplines normally associatedwith a mature corporate environment are in place. The Company’s employees arewell trained in SPC and SQC. Nortech is launching a new branding effort in 2005to better reflect the value-added solutions that it offers to the marketplace. Thenew theme, “The Connection Has Been Made,” reflects the fact that Nortech is aone-stop solution that can handle their customers’ current and future needs asthey grow.

**SOURCES ANDAVAILABILITY OF MATERIALS**

The Company is notdependent on any one supplier for materials for products sold to customers. Componentsutilized in the assembly of wire harnesses, cable assemblies and printedcircuit assemblies are purchased directly from the component manufacturers orfrom their distributors. On occasion some components may be placed on astringent allocation basis; however, due to the excess manufacturing capacitycurrently available at most component manufacturers, the Company does notanticipate any major material purchasing or availability problems occurring inthe foreseeable future.

**PATENTS ANDLICENSES**

The Company is notpresently dependent on a proprietary product requiring licensing, 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 manufacturingindustry is characterized by competition among a variety of sources, includingsmall closely held companies, larger full-service manufacturers, company-ownedfacilities and foreign manufacturers. The Company does not believe that thesmall closely held operations pose significant competitive threat, as theygenerally do not appear to have the manufacturing capabilities required bytarget customers of the Company. The Company believes that foreignmanufacturers do provide a substantial competitive threat as shown by thecommoditization of PC/printer cable and “bargain basement” prices. Many OEM’shave moved their manufacturing to foreign soil and in doing so have minimizedfreight costs to ship to their foreign locations. Technical support fromforeign competition has improved greatly along with their ability to be moreresponsive to engineering and schedule changes. The willingness of foreignmanufacturers to “stock” finished product at warehouse locations in the UnitedStates is another competitive advantage. To mitigate foreign competition, theCompany maintains a contractual agreement that allows its products to bemanufactured in China. The Company also acquired a Mexican manufacturingfacility in 2002, thereby making itself competitive with other foreign low costproviders.

The Company will pursueacquisitions, mergers, or joint ventures of manufacturing companies in low costcountries and as opportunities come available in the United States, to retainand grow its 

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customer/revenuebase and support its strategic vision to be a competitive world classElectronic Manufacturing Services provider.

**BACKLOG**

Historically, the Company’s backlog has been running60 to 90 days. However, because of the increased emphasis on just in timemanufacturing (JIT), many of the Company’s major customers are now looking totake advantage of the Company’s ability to service them adequately under theJIT concept. Additionally, because of the Company’s quality history withcustomers, many products now go directly from the Company’s shipping dock tothe customer’s production line.

The Company’s 90-dayorder backlog was approximately $14.5 million on December 31, 2004compared to approximately $11.2 million on December 31, 2003. The Companyexpects a major portion of the backlog will be realized as revenue during firstquarter 2005. The Company’s backlog is impacted by pending large orders as wellas varying customer delivery requirements. Therefore, backlog at one point intime may not be indicative of future results.

**MAJOR CUSTOMERS**

The Company sells its products to companies in thecomputer, medical, governmental and various other industries. Historically, theCompany has not experienced significant losses on customer receivablecollections in any particular industry or geographic area.

One customer, G.E.Medical, accounted for 15%, 23% and 31% of sales for the years ended December 31,2004, 2003 and 2002, respectively. This decline of G.E. Medical revenue hasbeen offset by increased business with existing and new customers.

**RESEARCH ANDDEVELOPMENT**

The Company expended nodollars in 2004, 2003 or 2002 on Company-sponsored product research anddevelopment. However, the Company performs research and development forcustomers on an as requested basis for development of conceptual engineeringand design activities prior to manufacturing the products.

**ENVIRONMENTAL LAWCOMPLIANCE**

Management believes thatits manufacturing facilities are currently operating under compliance withlocal, state, and federal environmental laws. The Company has made, and plansto continue making, necessary expenditures for compliance with applicable laws.Any environmental-oriented equipment is capitalized and depreciated over aseven-year period. The annualized depreciation expense for this type ofenvironmental equipment on a Company-wide basis is insignificant.

**EMPLOYEES**

The Company has 663full-time, 117 part-time and 145 temporary employees as of December 31,2004. Manufacturing personnel, including direct, indirect support and salesfunctions, comprise 878 employees, while general administrative employees total47.

**FOREIGN OPERATIONSAND EXPORT SALES**

The Company has a leasedmanufacturing facility in Monterrey, Mexico with approximately $1.2 million inlong-term assets. Export sales represent 5%, 2% and 1% of consolidated salesfor the years ended December 31, 2004, 2003 and 2002, respectively.

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**ITEM 2**.                PROPERTIES

**ADMINISTRATION**

The Company’s CorporateHeadquarters consist of approximately 3,648 square feet located in Wayzata,Minnesota, a western suburb of Minneapolis, Minnesota. The CorporateHeadquarters has a lease with a five-year term that expires on July 31,2005. A portion of the Bemidji facility is used for corporate financial andinformation technology functions and services.

**MANUFACTURINGFACILITIES**

The Company owns its Bemidji, Minnesota facilityconsisting of eight acres of land and 60,000 square feet of office andmanufacturing space.

The Company owns its Augusta, Wisconsin cable &wire facility consisting of five acres of land and 20,000 square feet of officeand manufacturing space, which the Company exercised its option to purchase in December 2003.

The Company owns three buildings, which togethercontain approximately 46,900 square feet, located in Fairmont, Minnesota. Thebuildings contain the manufacturing activities of Aerospace Systems operation,including custom designed, high technology electronic cable assemblies.

The Company owns another 45,800 square feet buildingin Merrifield, Minnesota. This facility is used for the building ofsurface-mount printed circuit board assemblies and electro-mechanicalassemblies.

The Company leases two 7,500 square foot buildings inBaxter, Minnesota for electronic board repair for medical equipment. The leasesare scheduled to expire on June 30, 2006 and January 31, 2007.

The Company leases a 15,000 square foot building inits Monterrey, Mexico location for office and manufacturing space. The leaseexpires in June 2007, and the Company plans on exercising the additionalthree-year option at that time.

The Company believes thateach of these locations is adequate and that space is available if needed inthe foreseeable future for their manufacturing needs. The Company’s facilitiesare highly suitable for the purposes for which they were designed.

**ITEM 3**.                LEGALPROCEEDINGS

From time to time, theCompany is involved in ordinary, routine or regulatory legal proceedingsincidental to the business. When a loss is deemed probable and reasonablyestimable an amount is recorded in our financial statements. As of March 8,2005, we were not a party to any material legal proceeding.

**ITEM 4**.                SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

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**PART II**

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

As of February 14, 2005, there were approximately882 shareholders of record. The Company’s stock is listed on the NationalAssociation of Securities Dealers Automated Quotation System (“NASDAQ”) SmallCap Market under the symbol “NSYS”. The Company intends to invest its profitsinto the growth of the Company and, therefore, does not plan to pay outdividends to shareholders in the foreseeable future. Stock price comparisonsfollow.

Stockprice comparisons (NASDAQ):
| **During the Three Months Ended** | ** ** | ** ** | ** ** | **Low** | ** ** | **High** | ** ** |
|-------------------------------------------------------|------------|------------|------------|---------|------------|----------|------------|
| March 31,  2004                                  |       | $          | 6.33       |    | $          | 9.13     |       |
| June 30,  2004                                   |       | $          | 6.55       |    | $          | 8.21     |       |
| September 30,  2004                              |       | $          | 4.83       |    | $          | 7.93     |       |
| December 31,  2004                               |       | $          | 5.00       |    | $          | 6.53     |       |
| March 31, 2003                                   |       | $          | 6.72       |    | $          | 7.75     |       |
| June 30,  2003                                   |       | $          | 5.25       |    | $          | 7.10     |       |
| September 30,  2003                              |       | $          | 6.19       |    | $          | 7.40     |       |
| December 31, 2003                                |       | $          | 6.69       |    | $          | 8.49     |       |

 

**EQUITY COMPENSATIONPLAN INFORMATION**

Certain information withrespect to the Company’s equity compensation plans are contained in Part III,Item 12 of this Annual Report on Form 10-K.

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**ITEM 6**.                SELECTEDFINANCIAL DATA

Thefollowing selected historical financial data set forth below have been derivedfrom, and are qualified by reference to the audited Consolidated FinancialStatements of Nortech Systems Incorporated and Subsidiary as of December 31,2004 and 2003 and for each of the three years ended December 31, 2004,2003 and 2002. The audited consolidated financial statements of Nortech SystemsIncorporated and Subsidiary referred to above are included elsewhere herein. Theselected historical financial data set forth below as of December 31,2002, 2001 and 2000 and for each of the years ended December 31, 2001 and2000 have been derived from the audited consolidated financial statements ofNortech Systems Incorporated and Subsidiary not included herein. The selectedfinancial data set forth below should be read in conjunction with, and arequalified by reference to, “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and the Consolidated Financial Statementsand accompanying notes thereto of Nortech Systems Incorporated and Subsidiaryincluded elsewhere herein.

**Year ended December 31:**
| ** **                                                             | ** ** | **2004**    | ** ** | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** | **2000**   | ** ** |
|------------------------------------------------------------------------|------------|-------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| Net Sales                                                              |       | $           | 72,674,159 |       | 57,958,698 |       | $          | 60,655,579 |       | $          | 58,460,589 |   | $ | 54,775,279 |   |
| Gross Profit                                                           |       | 8,538,973   |       | 6,494,976  |       | 10,519,536 |       | 10,446,345 |       | 10,355,945 |       |
| Net Income From Continuing Operations                                  |       | 587,329     |       | 633,448    |       | 2,403,112  |       | 2,102,863  |       | 2,043,573  |       |
| Basic Earnings From Continuing Operations Per Share  of Common Stock   |       | .23         |       | .26        |       | 1.00       |       | .89        |       | .86        |       |
| Diluted Earnings From Continuing Operations Per  Share of Common Stock |       | .23         |       | .25        |       | .95        |       | .86        |       | .83        |       |
| **At  December 31:**                                              |       |        |       |       |       |       |       |       |       |       |       |
| Total Assets                                                           |       | 36,881,608  |       | 31,580,790 |       | 29,602,400 |       | 29,507,538 |       | 28,652,949 |       |
| Working Capital                                                        |       | *11,749,991 |       | 16,723,263 |       | 14,266,058 |       | 14,459,344 |       | 9,633,539  |       |
| Total Long-Term Debt                                                   |       | *3,399,210  |       | 9,643,336  |       | 8,580,944  |       | 9,791,722  |       | 7,665,536  |       |
| Shareholders’  Equity                                             |       | 15,516,581  |       | 14,321,280 |       | 13,090,130 |       | 10,571,793 |       | 8,447,566  |       |
|                                                                        |            |             |            |            |            |            |            |            |            |            |            |  |  |  |  |

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*                    In2004, the revolving line of credit, with outstanding borrowings of $7,523,058,has been classified in current maturities. In the previous years these amountshave been reflected as long-term.

For additional financialdata (2004 and 2003 by quarter information), see Note 13 of the ConsolidatedFinancial Statements.

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

**FORWARD-LOOKINGSTATEMENTS**

This Annual Reporton Form 10-K contains forward-looking statements within the meaning of thePrivate Securities Litigation Reform Act of 1995. Such statements generallywill be accompanied by words such as “anticipate,” “believe,” “estimate,” “expect,”“forecast,” “intend,” “possible,” “potential,” “predict,” “project,” or othersimilar words that convey the uncertainty of future events or outcomes. AlthoughNortech Systems Incorporated believes these forward-looking statements arereasonable, they are based upon a number of assumptions concerning futureconditions, any or all of which may ultimately prove to be inaccurate. Forward-lookingstatements involve a number of risks and uncertainties. Important factors thatcould cause actual results to differ materially from the forward-lookingstatements include, without limitation:

·       Volatilityin the marketplace which may affect market supply and demand of the Company’sproducts;

·       Increasedcompetition;

·       Changesin the reliability and efficiency of the Company’s operating facilities orthose of third parties;

·       Risksrelated to availability of labor;

·       Increasein certain raw material costs such as cooper

·       Commodityand Energy cost instability

·       Generaleconomic, financial and business conditions that could affect the Company’sfinancial condition and results of operations.

The factors identifiedabove are believed to be important factors (but not necessarily all of theimportant factors) that could cause actual results to differ materially fromthose expressed in any forward-looking statement made by the Company. Unpredictableor unknown factors not discussed herein could also have material adverseeffects on forward-looking statements. All forward-looking statements includedin this Form 10-K are expressly qualified in their entirety by theforgoing cautionary statements. The Company undertakes no obligations to updatepublicly any forward-looking statement (or its associated cautionary language)whether as a result of new information or future events.

**OVERVIEW**

Nortech Systems, Inc., based in Wayzata,Minnesota, is a full-service electronics manufacturing services (EMS) providerof wire and cable assemblies, printed circuit board assemblies, higher-levelassemblies and box builds for a wide range of industries. Markets servedinclude medical, automotive, defense, computer, peripheral, commercial,telecom, government and consumer. In Minnesota, Nortech Systems has facilitiesin Baxter, Bemidji, Fairmont and Merrifield. The Company also has facilities inAugusta, Wisconsin, and Monterrey, Mexico.

A majority of revenue is derived from products thatare built to the customer’s design specifications. The Company believes itprovides a high degree of manufacturing sophistication. The strategy of theCompany has been to expand and diversify its customer base. The Companybelieves the electronic manufacturing sub-contracting business is emerging froma small job shop oriented business into a dynamic, high technology globalelectronics industry

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During 2004, Nortechcontinued their supply chain initiatives designed to reduce costs, improveasset utilization and increase responsiveness to customers. Moving forward,Nortech Systems has begun to expand its sales and marketing approach to targetgreater value-added opportunities that exploit broader, corporate-widecapabilities. The Company’s market strength is low-volume, high-mix production,particularly with complex products. The 2002 investment in the Mexico operationallows for expansion into med-volume, med-mix and lower cost production and thepartnership in China meets our high-volume, low mix and lower cost customerrequirements.

**CRITICAL ACCOUNTINGPOLICIES AND ESTIMATES**

The Company’s significantaccounting policies and estimates are summarized in the footnotes to the annualconsolidated financial statements. Some of the accounting policies requiremanagement to exercise significant judgment in selecting the appropriateassumptions for calculating financial estimates. Such judgments are subject toan inherent degree of uncertainty. These judgments are based on historicalexperience, known trends in the industry, terms of existing contracts and otherinformation from outside sources, as appropriate. Actual results may differfrom these estimates under different assumptions and conditions. Certain of themost critical policies that require significant judgment are as follows:

**Revenue Recognition:**

TheCompany recognizes revenue upon shipment of products to customers, when titlehas passed, all contractual obligations have been satisfied and collection ofthe resulting receivable is reasonably assured. In the normal course ofbusiness the Company enters into a number of contracts with customers underwhich we provide engineering services on a per project basis. Revenue for theseservices is recognized upon completion of the engineering process, usually uponinitial shipment of the product. Revenues from repair services are recognizedupon shipment of related equipment to customers.

**Allowance forUncollectible Accounts:**

Management analyzesaccounts receivable, historical write-offs of bad debts, customerconcentrations, customer credit-worthiness, current economic trends and changesin customer payment terms when evaluating the adequacy of the allowance foruncollectible accounts. The Company maintains an allowance for doubtfulaccounts at an amount estimated to be sufficient to provide adequate protectionagainst losses resulting from collecting less than full payment on receivables.A considerable amount of judgment is required when assessing the realizabilityof receivables, including assessing the probability of collection and thecurrent credit-worthiness of each customer. If the financial condition of theCompany’s customers were to deteriorate, resulting in an impairment of theirability to make payments, an additional provision for uncollectible accountsmay be required. The Company has not experienced significant bad debts expenseand the reserve for uncollectible accounts of $280,000 is considered adequatefor any exposure to loss in the December 31, 2004 accounts receivable.

**Inventory Reserves:**

Inventoryreserves are maintained for the estimated value of the inventory that may havea lower value than stated or quantities in excess of future production needs. TheCompany has an evaluation process that is used to assess the value of theinventory that is slow moving, excess or obsolete and is reviewed on a quarterlybasis. Management believes the total reserve of $1.2 million at December 31,2004 is adequate.

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**Long-Lived andIntangible Asset Impairment:**

The Company evaluateslong-lived assets and intangible assets with finite lives for impairment, aswell as the related amortization periods, to determine whether adjustments tothese amounts or useful lives are required based on current events andcircumstances. The evaluation is based on the Company’s projection of theundiscounted 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 equal estimated fair value.

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

**Income taxes:**

Management’s estimate ofthe tax rates utilized in the calculation of the deferred tax balances is basedon historical taxable income and expected future taxable income andcorresponding rates. Further, management’s consideration of a valuationallowance for deferred tax assets is based upon estimates of taxable income infuture periods and future realizability of these assets.

**Self-Insured Health Claim Accruals:**

Management estimates itsreserve for employee health claims based on health claims incurred, historicallag times and an analysis of claims activity during the period, while takinginto consideration insurance limits and coverage. Management believes the totalaccrual of $250,000 at December 31, 2004 is adequate.

Based on a criticalassessment of its accounting policies and the underlying judgments anduncertainties affecting the application of those policies, management believesthat the Company’s consolidated financial statements provide a meaningful andfair perspective of the Company. This is not to suggest that other general riskfactors, such as changes in worldwide economic conditions, fluctuations inforeign currency exchange rates, changes in materials costs, performance ofacquired businesses and others, could not adversely impact the Company’sconsolidated financial position, results of operations and cash flows in futureperiods.

No matters have come toManagement’s attention since December 31, 2004 that would cause theestimates included in the consolidated financial statements to changematerially.

**OPERATING RESULTS**

The following tablepresents statement of operations data as percentages of total revenues for theindicated year-end:
| ** **                          | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net Sales                      |       | 100      | %          | 100      | %          | 100      | %          |
| Cost of Goods Sold                  |       | 88       | %          | 89       | %          | 83       | %          |
| Gross Profit                        |       | 12       | %          | 11       | %          | 17       | %          |
| Selling Expenses                    |       | 4        | %          | 4        | %          | 4        | %          |
| General and Administrative Expenses |       | 6        | %          | 6        | %          | 6        | %          |
| Income from Operations              |       | 2        | %          | 1        | %          | 7        | %          |
| Other Expenses, Net                 |       | 1        | %          | 0        | %          | 1        | %          |
| Income Tax Expense                  |       | 0        | %          | 0        | %          | 2        | %          |
| Net Income                          |       | 1        | %          | 1        | %          | 4        | %          |

 

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**Revenues:**

For the years ended December 31,2004 and 2003, the Company had sales of $72.7 million and $58.0 million,respectively, an increase of $14.7 million or 25.4%. The Aerospace and Defensebusiness lead the strong revenue growth in 2004 and accounts for 37% of theoverall increase, followed by increased revenue in circuit board assemblyservices accounting for 27% of the growth and the international cable and wireoperations accounting for 22% of the overall increase. For the year ended December 31,2002 the Company had sales of $60.7 million. The approximate 4.4% decrease in2003 sales was attributable primarily to the general effects of the sloweconomy, customers adjusting their inventory levels, a shift in revenue mix tothe lower margin product and customers demanding reduced pricing. The Companyexpects revenue growth to be in the 8-10% range for the year 2005. The Company’semphasis and focus continues to be mature companies seeking total solutioncontract manufacturers with a high degree of manufacturing and qualitysophistication.

**Gross Profit:**

For the years ended December 31, 2004 and 2003,the Company had gross profit of $8.5 million and $6.5 million respectively. Grossprofits as a percentage of gross sales were 11.8% and 11.2%, for the yearsended December 31, 2004 and 2003, respectively.

The 2004 gross profit improvement came from afavorable mix of primarily Aerospace and Defense business accounting for $.8million of the increase in gross profit dollars and increased volume accountingfor $1.6 million in additional gross profit dollars. The favorable mix helpedoffset energy (Oil & Gas) and commodity (Copper) cost pressuresthroughout all of 2004, which accounted for $.4 million in cost offsets. Thecable and wire business continues to face strong competitive pressures fromoutsourcing to lower cost producing countries.

The gross profitpercentage decline in 2003 to 11.2% from 17.3% in 2002 was due primarily to theshortfall in expected manufacturing volume along with additional start up costsrelated to our Mexico facility. These factors accounted for 5% of the overalldecline with the remaining decrease coming from higher than planned health carecost in our self-insured plan.

**Selling:**

Selling expenses were $3.2million (4.3% of total revenues), $2.4 million (4.1% of total revenues), and$2.5 million (4.1% of total revenues) for the years ended December 31,2004, 2003 and 2002, respectively. The increase in selling expenses in 2004 wasa result of increased commissions associated with the increase in revenuegrowth and investments made in branding and selling infrastructure.

**General andAdministrative:**

For the years ended December 31, 2004, 2003 and2002, general and administrative expenses were $4.1 million, $3.3 million and$3.8 million, respectively.

The increased G&Aexpenses related to investments made in infrastructure of $.4 million,incentive compensation of $.5 million and a reduction of other expenses of $.1million. The reduction in expenses from 2002 to 2003 reflected cost cuttingmeasures taken and reduced administrative incentive expenses.

**Other Income(Expense):**

Interest income for the years ended December 31,2004, 2003 and 2002 was approximately $2,000, $25,000, and $5,000,respectively. Miscellaneous income (loss) was $16,000, $86,000 and ($18,000)for the years ended December 31, 2004, 2003 and 2002, respectively. Miscellaneousincome results primarily from 

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charges for miscellaneousservices that vary by year. In 2003 the Company had income from salescommissions for product sold in China by one of our vendors.

Interest expense wasapproximately $490,000, $386,000, and $432,000 for the years ended December 31,2004, 2003 and 2002, respectively. In 2004, the combination of increased lineof credit and working capital borrowings to support the revenue growth and asteady increase in interest rates throughout the year accounted for the increasedinterest expense. 2003 saw favorable interest rates throughout the year andlower working capital requirements that kept interest expenses below 2002amounts.

**Income Taxes:**

Income tax expense(benefit) amounted to $268,000, ($123,000), and $1.4 million for the yearsended December 31, 2004, 2003 and 2002, respectively. In 2004 the incometax rate was 31% and was impacted favorably by 2004 R & D tax creditsof $129,000. During 2003, the Company recorded $246,000 of net benefit for arefund claim relating to federal and state research and development tax creditsfor tax years 1999, 2000 and 2001. A reconciliation of income tax expense(benefit) for the years ending December 31, 2004, 2003 and 2002 isincluded in Note 6 to the consolidated financial statements.

**Net Income:**

The Company’s net incomein 2004 was $587,329 or $0.23 per diluted common share compared to $633,448, or$0.25 per diluted common share in 2003. The Company’s 2002 net income was$2,403,112, or $0.95 per diluted common share.

**RECENTLY ISSUEDACCOUNTING PRONOUNCEMENTS**

In December 2004, the FASB issued SFAS No. 123R,Share-Based Payment. This statement revises SFAS No. 123, Accounting forStock-Based Compensation, and requires companies to expense the value ofemployee stock options and similar awards using the fair value method. Theeffective date of this standard is interim and annual periods beginning after June 15,2005. FAS 123(R) allows two methods for determining the effects of thetransition: the modified prospective transition method and the modifiedretrospective method of transition. Although management has not fully analyzedthe effect this new statement will have on the consolidated financialstatements in the future, the pro forma net income effect of using a fair valuemethod for the past three fiscal years is presented in Note 1 to theconsolidated financial statements.

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

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**FINANCIAL CONDITIONAND LIQUIDITY**

Thefollowing unaudited ratios are not required under the SEC guidelines oraccounting principles generally accepted in the United States of America,however, we believe they are meaningful measures and are useful to our readers.
| ** **                                          | ** ** | December 31,  2004 | ** ** | **December 31,  2003** | ** ** | **December 31,  2002** | ** ** |
|-----------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Current Ratio                                       |       | 1.65                    |       | 3.20                        |       | 2.80                        |       |
| (Current Assets / Current  Liabilities)             |       |                    |       |                        |       |                        |       |
| Working Capital                                     |       | $                       | 11,749,991 |                        | $          | 16,723,263                  |       | $ | 14,266,058 |   |
| (Current Assets—Current Liabilities)           |       |                    |       |                        |       |                        |       |
| Quick Ratio                                         |       | .77                     |       | 1.44                        |       | 1.02                        |       |
| (Cash + Accounts Receivable  / Current Liabilities) |       |                    |       |                        |       |                        |       |
| Accounts Receivable to  Working Capital             |       | 1.03                    |       | 0.55                        |       | 0.59                        |       |
| (Average Accounts Receivable / Working Capital)     |       |                    |       |                        |       |                        |       |
| Inventory to Working Capital                        |       | 1.10                    |       | 0.72                        |       | 0.87                        |       |
| (Average Inventory / Working  Capital)              |       |                    |       |                        |       |                        |       |
|                                                     |            |                         |            |                             |            |                             |            |  |  |  |

 
| ** **                                                 | ** ** | **December 31,**

**2004** | ** ** | **December 31,**

**2003** | ** ** | **December 31,**

**2002** | ** ** |
|------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| Cash flows provided by (used in):                          |       |                       |       |                       |       |                       |       |
| Operating Activities                                       |       | $                          | (324,130   | )                          | $          | (288,460                   | )          | $ | 2,880,099 |   |
| Investing Activities                                       |       | (1,420,126                 | )          | (1,412,069                 | )          | (1,729,040                 | )          |
| Financing Activities                                       |       | 2,204,451                  |       | 1,355,538                  |       | (884,038                   | )          |
| Effect of exchange rate  changes on cash                   |       | (5,591                     | )          | (2,581                     | )          | —                     |       |
| Net increase (decrease) in cash and cash equivalents  |       | $                          | 454,604    |                       | $          | (347,572                   | )          | $ | 267,021 |   |

 

Overall, the changes in the above liquidity ratios for2004 relate primarily to the change in the classification of the Company’soperating line of credit from long-term to current as of December 31, 2004.This line of credit had an original maturity date of June 30, 2005,however, on March 4, 2005 the Company reached an agreement with WellsFargo Bank (WFB) for a renewal and extension of the revolving line of credit.

Inaddition to the extension of the maturity date, the financial covenants weremodified and include minimum working capital, tangible net worth and net incomerequirements, along with certain other ratios. The availability under the lineis subject to borrowing base requirements, and advances are at the discretionof the lender. The line is secured by substantially all of the Company’s assets.This commitment is summarized as described below:
| **Other Commercial Commitment** | ** ** | ** ** | ** ** | **Total Amount     Committed   ** | ** ** | **Outstanding at  December 31, 2004** | ** ** | **Date of Expiration** | ** ** |
|-------------------------------------------|------------|------------|------------|----------------------------------------------------------------------|------------|------------------------------------------------------|------------|----------------------------------|------------|
| Line of credit                            |       |       | $          | 8,000,000                                                            |       |                                                 |       | $                                | 7,523,058  |   |   | January 31, 2007 |   |
|                                           |            |            |            |                                                                      |            |                                                      |            |                                  |            |  |  |  |  |  |  |

 

As of December 31, 2004, the Company’s cash andcash equivalent balances totaled $555,783.

On December 31, 2004, the Company had workingcapital of approximately $11.7 million. During 2004, the Company usedapproximately $324,000 of cash flow for operating activities. This use of cashwas primarily attributable to the increases in accounts receivable andinventory levels. These increases were significantly greater than increases inaccounts payable and pre-depreciation income as a result of the increase salesvolume and backlog. The Company’s net investing activities decreased cash by$1.4 million, resulting from capital asset acquisitions. The Company’savailable line of credit was used to fund the 

16

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capital acquisitions,which was the primary cause for the increase in the net financing activities of$2.2 million.

The Company’s liquidity and capital resources arestrong, and the Company believes that its future financial requirements can bemet with funds generated from the operating activities and its recently renewedoperating line of credit.

Setforth below is information about the Company’s long-term contractualobligations outstanding as of December 31, 2004. It brings together datafor easy reference from the consolidated balance sheet and from individualnotes to the consolidated financial statements. This information is importantin understanding the financial position of the Company.
| ** **                    | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------|------------|-------------------------------------------|------------|
| ** **                    | ** ** | **Less than 1 Yr**         | ** ** | **2 - 3 Yrs** | ** ** | **4 - 5 Yrs** | ** ** |
| Long-Term Debt                |       |                                      | $          | 997,815 |   |   | 3,378,294 |   | 20,916 |   |
| Operating Leases              |       |                                      | 273,372    |   |   | 308,651 |   | 60,708 |   |
| Total Contractual Obligations |       |                                      | $          | 1,271,187  |   |   | $ | 3,686,945 |   | $ | 81,624 |   |
|                               |            |                                           |            |  |  |  |  |  |  |  |  |  |

 

**ITEM 7a**.         QUALITATIVEAND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK

Market risk is thepotential change in an instrument’s value caused, for example, by fluctuationsin interest and currency exchange rates. The Company’s primary market riskexposures are interest rate and unfavorable movements in exchange rates betweenthe U.S. dollar and the Mexican peso. Monitoring and managing these risks is acontinual process carried out by senior management. Market risk is managedbased on an ongoing assessment of trends in interest rates, foreign exchangerates, and economic developments, giving consideration to possible effects onboth total return and reported earnings. The Company’s financial advisors, bothinternal and external, provide ongoing advice regarding trends that affectmanagement’s assessment.

**Exchange RateSensitivity:**

The Company conductsoperations in Mexico. Accordingly, exposure exists to potentially adversemovements in foreign currency rates. The Company does not use foreign exchangeforward contracts to hedge the risk of change in foreign currency exchangerates. The Company’s consolidated financial statements are denominated in U.S.dollars and accordingly, changes in the exchange rates between the Mexicosubsidiary’s local currency and the U.S. dollar will affect the translation ofthe subsidiary’s financial results into U.S. dollars for the purposes ofreporting the consolidated financial results. The Company does not hedge thesematters because cash flows from international operations are generallyre-invested locally. It is estimated that a 10% change in foreign exchangerates would not have a material impact on earnings.

**Interest RateSensitivity:**

The effective interestrate on the Company’s credit facilities are influenced by the actions of theFederal Reserve in establishing from time to time the Federal Funds InterestRate which is the rate banks borrow from the Federal Reserve Bank. During 2003and 2002, the Federal Reserve implemented a number of reductions in the FederalFunds Interest Rate in an effort to stimulate the U.S. economy. As a result theeffective interest rate that the Company paid on its borrowings under thefacilities declined, leading to a corresponding reduction in interest expense. However,in the latter half of 2004 the Federal Reserve increased the Federal FundsInterest Rate, causing the effective interest rate on the Company’s facilitiesto increase. Based on the balance outstanding under our interest-bearingfacilities at year-end, a percentage point change in the effective interestrate would have changed interest expense by approximately $100,000.

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**NORTECH SYSTEMSINCORPORATED AND SUBSIDIARYTABLE OF CONTENTSDECEMBER 31, 2004, 2003, and 2002**

**ITEM 8**.                FINANCIALSTATEMENTS AND SUPPLEMENTAL DATA
|                                                                                                                  | ** ** | ** ** | **PAGE** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|------------|----------|------------|
| Reports of Independent  Registered Public Accounting Firms                                                       |       | 19-20      |     |
| Consolidated  Financial Statements:                                                                              |       |       |     |
| Consolidated  Balance Sheets as of December 31, 2004 and 2003                                               |       | 21         |     |
| Consolidated  Statements of Income for the years ended December 31, 2004, 2003 and  2002                    |       | 22         |     |
| Consolidated  Statements of Shareholders’ Equity for the years ended December 31,  2004, 2003 and 2002 |       | 23         |     |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002            |       | 24         |     |
| Notes  to Consolidated Financial Statements                                                                      |       | 25-40      |     |
| Reports  of Independent Registered Public Accounting Firms on Supplementary Data                                 |       | 41-42      |     |
| Schedule II—Valuation  and Qualifying Accounts                                                              |       | 43         |     |

 

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

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**Report of Independent Registered Public AccountingFirm**

To the Board of DirectorsNortech Systems Incorporated and SubsidiaryWayzata, Minnesota

We have audited the consolidated balance sheet ofNortech Systems Incorporated and Subsidiary as of December 31, 2004, andthe related consolidated statements of income, shareholders’ equity and cashflows for the year then ended. These consolidated financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these consolidated financial statements based on our audit.

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

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Nortech Systems Incorporated andSubsidiary as of December 31, 2004, and the results of their operationsand their cash flows for the year then ended, in conformity with U.S. generallyaccepted accounting principles.

Minneapolis, Minnesota

February 18,2005, except Note 4, as towhich the date is March 4, 2005

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**Report of Independent Registered Public AccountingFirm**

Board of Directors andShareholdersNortech Systems Incorporated:

We have audited the accompanying consolidated balancesheet of Nortech Systems Incorporated and subsidiary (the Company) as of December 31,2003, and the related consolidated statements of income, shareholders’ equityand cash flows for the each of the years in the two-year period ended December 31,2003. These consolidated financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.

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

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Nortech Systems Incorporated andsubsidiary as of December 31, 2003, and the results of their operationsand their cash flows for the each of the years in the two-year period ended December 31,2003, in conformity with U.S. generally accepted accounting principles.
| /s/ KPMG LLP                                                                    |
|---------------------------------------------------------------------------------|
| Minneapolis, Minnesota                                                          |
| February 13,  2004, except as to note 4  which is as of March 9, 2004 |

 

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**NORTECH SYSTEMSINCORPORATED AND SUBSIDIARYCONSOLIDATED BALANCE SHEETSDECEMBER 31, 2004 AND 2003**
| ** **                                                                                                                                                                                              | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **ASSETS**                                                                                                                                                                                              |       |       |       |       |       |
| CURRENT ASSETS                                                                                                                                                                                          |       |       |       |       |       |
| Cash and Cash Equivalents                                                                                                                                                                               |       | $          | 555,783    |       | $          | 101,179 |   |
| Accounts Receivable, Less  Allowance for Uncollectible Accounts                                                                                                                                         |       | 13,355,730 |       | 10,835,696 |       |
| Inventories                                                                                                                                                                                             |       | 14,235,716 |       | 11,594,557 |       |
| Prepaid Expenses                                                                                                                                                                                        |       | 399,210    |       | 423,371    |       |
| Income Taxes Receivable                                                                                                                                                                                 |       | 351,369    |       | 419,634    |       |
| Deferred Tax Assets                                                                                                                                                                                     |       | 818,000    |       | 965,000    |       |
| Total Current Assets                                                                                                                                                                                    |       | 29,715,808 |       | 24,339,437 |       |
| PROPERTY AND  EQUIPMENT                                                                                                                                                                                 |       |       |       |       |       |
| Land                                                                                                                                                                                                    |       | 151,800    |       | 151,800    |       |
| Building and Leasehold  Improvements                                                                                                                                                                    |       | 4,720,518  |       | 4,768,813  |       |
| Manufacturing Equipment                                                                                                                                                                                 |       | 7,222,437  |       | 6,557,159  |       |
| Office and Other  Equipment                                                                                                                                                                             |       | 3,010,793  |       | 2,803,819  |       |
| Total Property and  Equipment                                                                                                                                                                           |       | 15,105,548 |       | 14,281,591 |       |
| Accumulated Depreciation                                                                                                                                                                                |       | (8,681,033 | )          | (8,191,274 | )          |
| Net Property and  Equipment                                                                                                                                                                             |       | 6,424,515  |       | 6,090,317  |       |
| OTHER ASSETS                                                                                                                                                                                            |       |       |       |       |       |
| Non-Compete, Net of  Accumulated Amortization                                                                                                                                                           |       | 603,267    |       | 953,984    |       |
| Goodwill                                                                                                                                                                                                |       | 75,006     |       | 75,006     |       |
| Deferred Tax Assets                                                                                                                                                                                     |       | 52,000     |       | 71,000     |       |
| Other Assets                                                                                                                                                                                            |       | 11,012     |       | 51,046     |       |
| Total Other Assets                                                                                                                                                                                      |       | 741,285    |       | 1,151,036  |       |
| Total Assets                                                                                                                                                                                            |       | $          | 36,881,608 |       | $          | 31,580,790 |   |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| CURRENT  LIABILITIES                                                                                                                                                                                    |       |       |       |       |       |
| Bank Note Payable                                                                                                                                                                                       |       | $          | 7,523,058  |       | $          | — |   |
| Current Maturities of Notes  Payable                                                                                                                                                                    |       | 997,815    |       | 1,360,935  |       |
| Checks Written in Excess  of Bank Balance                                                                                                                                                               |       | 950,000    |       | 250,000    |       |
| Accounts Payable                                                                                                                                                                                        |       | 5,602,913  |       | 4,068,148  |       |
| Accrued Payroll and  Commissions                                                                                                                                                                        |       | 2,375,939  |       | 1,281,319  |       |
| Accrued Health and Dental  Claims                                                                                                                                                                       |       | 250,330    |       | 217,514    |       |
| Other Accrued Liabilities                                                                                                                                                                               |       | 265,762    |       | 438,258    |       |
| Total Current Liabilities                                                                                                                                                                               |       | 17,965,817 |       | 7,616,174  |       |
| LONG-TERM  LIABILITIES                                                                                                                                                                                  |       |       |       |       |       |
| Bank Note Payable                                                                                                                                                                                       |       | —     |       | 5,907,191  |       |
| Notes Payable (Net of  Current Maturities)                                                                                                                                                              |       | 3,399,210  |       | 3,736,145  |       |
| Total Liabilities                                                                                                                                                                                       |       | 21,365,027 |       | 17,259,510 |       |
| COMMITMENTS  AND CONTINGENCIES                                                                                                                                                                          |       |       |       |       |       |
| SHAREHOLDERS’  EQUITY                                                                                                                                                                              |       |       |       |       |       |
| Preferred Stock, $1 par  value; 1,000,000 Shares Authorized; 250,000 Shares Issued and Outstanding                                                                                                      |       | 250,000    |       | 250,000    |       |
| Common Stock—$0.01 par  value; 9,000,000 Shares Authorized; 2,582,147 Shares Issued and Outstanding  at December 31, 2004; 2,512,687 Shares Issued and Outstanding at  December 31, 2003 |       | 25,821     |       | 25,127     |       |
| Additional Paid-In  Capital                                                                                                                                                                             |       | 14,118,658 |       | 13,497,339 |       |
| Accumulated Other  Comprehensive Loss                                                                                                                                                                   |       | (40,729    | )          | (26,688    | )          |
| Retained Earnings                                                                                                                                                                                       |       | 1,162,831  |       | 575,502    |       |
| Total Shareholders’  Equity                                                                                                                                                                        |       | 15,516,581 |       | 14,321,280 |       |
| Total Liabilities and Shareholders’ Equity                                                                                                                                                         |       | $          | 36,881,608 |       | $          | 31,580,790 |   |

 

See accompanying Notes to Consolidated Financial Statements.

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**NORTECH SYSTEMSINCORPORATED AND SUBSIDIARYCONSOLIDATED STATEMENTS OF INCOMEFOR THE YEAR ENDED DECEMBER 31, 2004, 2003, AND 2002**
| ** **                                                                            | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Net Sales                                                                             |       | $          | 72,674,159 |       | $          | 57,958,698 |       | $ | 60,655,579 |   |
| Cost of Goods Sold                                                                    |       | 64,135,186 |       | 51,463,722 |       | 50,136,043 |       |
| Gross Profit                                                                          |       | 8,538,973  |       | 6,494,976  |       | 10,519,536 |       |
| Operating  Expenses:                                                                  |       |       |       |       |       |       |       |
| Selling Expenses                                                                      |       | 3,157,212  |       | 2,377,311  |       | 2,466,460  |       |
| General and Administrative Expenses                                                   |       | 4,054,326  |       | 3,332,474  |       | 3,835,885  |       |
| Total Operating Expenses                                                              |       | 7,211,538  |       | 5,709,785  |       | 6,302,345  |       |
| Income From Operations                                                                |       | 1,327,435  |       | 785,191    |       | 4,217,191  |       |
| Other Income  (Expense)                                                               |       |       |       |       |       |       |       |
| Interest Income                                                                       |       | 2,120      |       | 24,624     |       | 5,231      |       |
| Miscellaneous Income (Expense)                                                        |       | 15,839     |       | 86,386     |       | (17,660    | )          |
| Interest Expense                                                                      |       | (490,065   | )          | (385,753   | )          | (431,650   | )          |
| Total Other Expense                                                                   |       | (472,106   | )          | (274,743   | )          | (444,079   | )          |
| Income Before Income Taxes                                                            |       | 855,329    |       | 510,448    |       | 3,773,112  |       |
| Income Tax Expense (Benefit)                                                          |       | 268,000    |       | (123,000   | )          | 1,370,000  |       |
| Net Income                                                                            |       | $          | 587,329    |       | $          | 633,448    |       | $ | 2,403,112 |   |
| Earnings Per  Common Share:                                                           |       |       |       |       |       |       |       |
| Basic                                                                                 |       | $          | 0.23       |       | $          | 0.26       |       | $ | 1.00 |   |
| Average Number of  Common Shares Outstanding Used for Basic Earnings Per Common Share |       | 2,561,419  |       | 2,478,921  |       | 2,410,890  |       |
| Diluted                                                                               |       | $          | 0.23       |       | $          | 0.25       |       | $ | 0.95 |   |
| Average Number of Common  Share Outstanding Plus Dilutive Common Stock Options        |       | 2,604,411  |       | 2,528,810  |       | 2,517,482  |       |

 

See accompanying Notes to Consolidated Financial Statements.

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**NORTECH SYSTEMSINCORPORATED AND SUBSIDIARYCONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITYFOR THE YEARS ENDED DECEMBER 31, 2004, 2003, AND 2002**
| ** **                     | ** ** | ** **    | ** ** | ** ** | ** ** | ** **     | ** ** | ** **                   | ** ** | **Retained**     | ** ** | ** **             | ** ** |
|--------------------------------|------------|---------------|------------|------------|------------|----------------|------------|------------------------------|------------|------------------|------------|------------------------|------------|
| ** **                     | ** ** | ** **    | ** ** | ** ** | ** ** | **Additional** | ** ** | **Accumulated**              | ** ** | **Earnings**     | ** ** | **Total**              | ** ** |
| ** **                     | ** ** | **Preferred** | ** ** | **Common** | ** ** | **Paid-In**    | ** ** | **Other Comprehensive** | ** ** | **(Accumulated** | ** ** | **Shareholders’** | ** ** |
| ** **                     | ** ** | **Stock**     | ** ** | **Stock**  | ** ** | **Capital**    | ** ** | **Loss**                     | ** ** | **Deficit)**     | ** ** | **Equity**             | ** ** |
| **BALANCE  DECEMBER 31, 2001** |       | $             | 250,000    |       | $          | 23,612         |       | $                            | 12,179,399 |             |       | $                      | —     |   |   | $ | (1,881,218 | ) | $ | 10,571,793 |   |
| 2002 Net Income                |       | —        |       | —     |       | —         |       |                         | —     |             |       | 2,403,112              |       | 2,403,112 |   |
| Issuance of Stock              |       | —        |       | 1,592      |       | 694,258        |       |                         | —     |             |       | —                 |       | 695,850 |   |
| Repurchase of  Stock           |       | —        |       | (785       | )          | —         |       |                         | —     |             |       | (579,840               | )          | (580,625 | ) |
| **BALANCE  DECEMBER 31, 2002** |       | 250,000       |       | 24,419     |       | 12,873,657     |       |                         | —     |             |       | (57,946                | )          | 13,090,130 |   |
| 2003 Net Income                |       | —        |       | —     |       | —         |       |                         | —     |             |       | 633,448                |       | 633,448 |   |
| Issuance of Stock              |       | —        |       | 708        |       | 623,682        |       |                         | —     |             |       | —                 |       | 624,390 |   |
| Translation Loss               |       | —        |       | —     |       | —         |       |                         | (26,688    | )                |       | —                 |       | (26,688 | ) |
| **BALANCE  DECEMBER 31, 2003** |       | 250,000       |       | 25,127     |       | 13,497,339     |       |                         | (26,688    | )                |       | 575,502                |       | 14,321,280 |   |
| 2004 Net Income                |       | —        |       | —     |       | —         |       |                         | —     |             |       | 587,329                |       | 587,329 |   |
| Issuance of Stock              |       | —        |       | 694        |       | 621,319        |       |                         | —     |             |       | —                 |       | 622,013 |   |
| Translation Loss               |       | —        |       | —     |       | —         |       |                         | (14,041    | )                |       | —                 |       | (14,041 | ) |
| **BALANCE  DECEMBER 31, 2004** |       | $             | 250,000    |       | $          | 25,821         |       | $                            | 14,118,658 |             |       | $                      | (40,729    | ) |   | $ | 1,162,831 |   | $ | 15,516,581 |   |

 

See accompanying Notes to Consolidated Financial Statements.

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**NORTECH SYSTEMSINCORPORATED AND SUBSIDIARYCONSOLIDATED STATEMENTS OF CASH FLOWSDECEMBER 31, 2004, 2003, AND 2002**
| ** **                                                | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|-----------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **CASH FLOWS FROM OPERATING  ACTIVITIES**                 |       |       |       |       |       |       |       |
| Net Income                                                |       | $          | 587,329    |       | $          | 633,448    |       | $ | 2,403,112 |   |
| Adjustments to  Reconcile Net Income to Net               |       |       |       |       |       |       |       |
| Cash Provided  (Used) By Operating Activities:            |       |       |       |       |       |       |       |
| Debt Refinance Charges                                    |       | —     |       | —     |       | 58,000     |       |
| Depreciation                                              |       | 1,112,210  |       | 1,259,175  |       | 1,189,699  |       |
| Amortization                                              |       | 387,776    |       | 381,600    |       | 190,800    |       |
| Deferred Taxes                                            |       | 166,000    |       | (44,000    | )          | 439,000    |       |
| Gain on Disposal of Assets                                |       | (17,169    | )          | (1,491     | )          | (942       | )          |
| Other                                                     |       | 18,786     |       | (12,237    | )          | —     |       |
| Changes in  Current Operating Items:                      |       |       |       |       |       |       |       |
| Accounts Receivable                                       |       | (2,520,034 | )          | (3,221,380 | )          | 1,573,155  |       |
| Inventories                                               |       | (2,641,159 | )          | 725,760    |       | 175,775    |       |
| Prepaid Expenses and Other Assets                         |       | 24,161     |       | (93,642    | )          | (62,824    | )          |
| Income Taxes Receivable                                   |       | 68,265     |       | 64,337     |       | (1,022,677 | )          |
| Accounts Payable                                          |       | 1,534,765  |       | 770,370    |       | (1,567,968 | )          |
| Accrued Payroll and Commissions                           |       | 1,094,620  |       | (837,966   | )          | (77,863    | )          |
| Accrued Health and Dental Claims                          |       | 32,816     |       | (60,350    | )          | (113,547   | )          |
| Other Accrued Liabilities                                 |       | (172,496   | )          | 147,916    |       | (303,621   | )          |
| Net Cash Provided (Used) by Operating Activities          |       | (324,130   | )          | (288,460   | )          | 2,880,099  |       |
| **CASH  FLOWS FROM INVESTING ACTIVITIES**                 |       |       |       |       |       |       |       |
| Proceeds from Sale of Discontinued Operations             |       | —     |       | —     |       | 2,000      |       |
| Proceeds from Sale of Assets                              |       | 31,802     |       | 8,450      |       | 400        |       |
| Acquisition of Equipment and Leasehold Improvements       |       | (1,451,928 | )          | (1,420,519 | )          | (1,081,440 | )          |
| Acquisition of Subsidiary                                 |       | —     |       | —     |       | (650,000   | )          |
| Net Cash Used by Investing Activities                     |       | (1,420,126 | )          | (1,412,069 | )          | (1,729,040 | )          |
| **CASH  FLOWS FROM FINANCING ACTIVITIES**                 |       |       |       |       |       |       |       |
| Checks Written in Excess of Cash                          |       | 700,000    |       | (50,000    | )          | 300,000    |       |
| Net Change in Line of Credit                              |       | 1,615,867  |       | 1,484,336  |       | (606,843   | )          |
| Debt Refinance Charges                                    |       | —     |       | —     |       | (58,000    | )          |
| Proceeds from Notes Payable                               |       | 788,944    |       | 674,248    |       | 4,879,017  |       |
| Payments on Notes Payable                                 |       | (922,373   | )          | (777,436   | )          | (5,513,437 | )          |
| Issuance of Stock, Net of Repurchase of Stock             |       | 22,013     |       | 24,390     |       | 115,225    |       |
| Net Cash Provided (Used) by Financing Activities          |       | 2,204,451  |       | 1,355,538  |       | (884,038   | )          |
| Effect of Exchange Rate Changes on Cash                   |       | (5,591     | )          | (2,581     | )          | —     |       |
| **NET INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS** |       | 454,604    |       | (347,572   | )          | 267,021    |       |
| Cash and Cash Equivalents—Beginning of Year          |       | 101,179    |       | 448,751    |       | 181,730    |       |
| **CASH AND CASH EQUIVALENTS—END OF YEAR**            |       | $          | 555,783    |       | $          | 101,179    |       | $ | 448,751 |   |

 

See accompanying Notes to Consolidated Financial Statements.

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2004, 2003, AND 2002**

**NOTE 1**       NATURE OF BUSINESS AND SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES

***Nature of Business***

Nortech Systems Incorporated (together with its whollyowned subsidiary, the “Company”) manufactures wire harnesses, cables andelectromechanical assemblies, printed circuit boards and higher-levelassemblies for a wide range of commercial and defense industries. The Companyprovides a full “turn-key” contract manufacturing service to its customers. Allproducts are built to the customer’s design specifications. Products are soldto customers both domestically and internationally. The Company also providesrepair service on circuit boards used in machines in the medical industry.

The Company’s manufacturing facilities are located inBemidji, Fairmont, Merrifield and Baxter, Minnesota as well as Augusta,Wisconsin. During 2002 the Company acquired a business and its relatedmanufacturing operations in Monterrey, Mexico, as described in Note 10.

A summary of the Company’ssignificant accounting policies follows:

***Use of Estimates***

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements. Estimates also affect the reported amounts of revenue and expenseduring the reporting period. Significant items subject to estimates andassumptions include the valuation allowance for inventories and estimatedfuture cash flows used in the impairment test of intangible assets. Actualresults could differ from those estimates.

***Principles of Consolidation***

The consolidated financialstatements include the accounts of the Company and its wholly owned subsidiary,Manufacturing Assembly Solutions of Monterrey, Inc. All significantintercompany accounts and transactions have been eliminated.

***Cash and Cash Equivalents***

For purposes of reportingcash flows, the Company considers cash equivalents to be short-term, highlyliquid interest-bearing accounts readily convertible to cash. The carryingamount approximates fair value.

***Accounts Receivable***

TheCompany grants credit to customers in the normal course of business. Accountsreceivable are unsecured and are presented net of an allowance foruncollectible accounts. The allowance for uncollectible accounts was$280,000 and $372,000 at December 31, 2004 and 2003, respectively. The Company determines its allowance byconsidering a number of factors, including the length of time trade accountsreceivable are past due, the Company’s previous loss history, the customer’scurrent ability to pay its obligation to the Company, and the condition of thegeneral economy and the industry as a whole. The Company writes-off accountsreceivable when they become uncollectible and payments subsequently received onsuch receivables are credited to the allowance for uncollectible accounts. TheCompany does not accrue interest on past due accounts receivable.

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2004, 2003, AND 2002**

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

***Inventories***

Inventoriesare stated at the lower of cost (first-in, first-out method) or market (basedon the lower of replacement cost or net realizable value). Costs include material, labor, and overheadrequired in the warehousing and production of the Company’s products. Inventoryreserves are maintained for the estimated value of the inventory that may havea lower value than stated or quantities in excess of future production needs. Inventoryis shown net of reserve for excess and obsolete inventory as follows:
| ** **      | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-----------------|------------|------------|------------|------------|------------|
| Raw Materials   |       | $          | 10,662,571 |       | $          | 9,843,268 |   |
| Work in Process |       | 2,418,850  |       | 1,591,389  |       |
| Finished Goods  |       | 2,373,495  |       | 1,479,150  |       |
| Reserves        |       | (1,219,200 | )          | (1,319,250 | )          |
| Total           |       | $          | 14,235,716 |       | $          | 11,594,557 |   |

 

***Property, Equipment and Depreciation***

Propertyand equipment are stated at cost less accumulated depreciation. Additions,improvements and major renewals are capitalized, while maintenance, repairs andminor renewals are expensed as incurred. When assets are retired or disposedof, the assets and related accumulated depreciation are removed from theaccounts and the resulting gain or loss is reflected in operations. Leaseholdimprovements are depreciated over the shorter of the estimated use life or theremaining lease term. All other property and equipment are depreciated by thestraight-line method of depreciation over their estimated useful lives.
| Buildings                  |   | 39 Years  |   |
|----------------------------|--------|-----------|--------|
| Leasehold Improvements     |   | 3-7 Years |   |
| Manufacturing Equipment    |   | 5-7 Years |   |
| Office and Other Equipment |   | 3-7 Years |   |

 

Depreciation expense was$1,109,235, $1,260,175 and $1,182,227, for the three years ended December 31,2004, 2003 and 2002, respectively.

***Goodwill and OtherIntangible Assets***

The Company accounts for goodwill and other intangibleassets in accordance 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 intangible assets are amortized on a straight-linebasis over their estimated useful lives, which range from four to seven years. SeeNote 10 for more detail on the Company’s intangible assets.

The Company evaluates long-lived assets 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 onthe Company’s projection 

26

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2004, 2003, AND 2002**

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

of the undiscounted futureoperating cash flows of the underlying assets. To the extent such projectionsindicate that future undiscounted cash flows are not sufficient to recover thecarrying amounts of related assets, a charge is recorded to reduce the carryingamount to equal estimated fair value.

Goodwill is tested forimpairment annually, or if an event occurs or circumstances change that mayreduce the fair value of the reporting unit below its book value. Theimpairment test is conducted at the reporting unit level by comparing the fairvalue of the reporting unit with its carrying value. Fair value is primarilydetermined by computing the future discounted cash flows expected to begenerated by the reporting unit. If the carrying value exceeds the fair value,goodwill may be impaired. If this occurs, the fair value of the reporting unitis then allocated to its assets and liabilities in a manner similar to apurchase price allocation in order to determine the implied fair value of thereporting unit goodwill. This implied fair value is then compared with thecarrying amount of the reporting unit goodwill, and if it is less, the Companywould then recognize an impairment loss.

***Preferred Stock***

Preferred stock issued isnon-cumulative and nonconvertible. The holders of the preferred stock areentitled to a non-cumulative dividend of 12% when and as declared. Inliquidation, holders of preferred stock have preference to the extent of $1.00per share plus dividends accrued but unpaid. No preferred stock dividends weredeclared or paid during the years ended December 31, 2004, 2003, and 2002.

***Revenue Recognition***

TheCompany recognizes revenue upon shipment of products to customers, when titlehas passed, all contractual obligations have been satisfied and collection ofthe resulting receivable is reasonably assured. In the normal course ofbusiness the Company enters into a number of contracts with customers underwhich it provides engineering services on a per project basis. Revenue forthese services is recognized upon completion of the engineering process,usually upon initial shipment of the product. Revenues from repair services arerecognized upon shipment of related equipment to customers.

***Shipping and Handling Costs***

The Company’s shipping andhandling costs charged to its customers are included in net sales, while thecorresponding shipping expenses are included in cost of goods sold.

***Estimated Warranty Claims***

The sales of the Company’s products include warrantiesthat provide for repairs or replacement of defective products. The warrantyperiods range from one to two years, depending on the product, following thesale. A warranty reserve is estimated by management based on actual historicalwarranty claims coupled with an analysis of unfulfilled claims at the balancesheet date. Estimated warrantyliabilities of approximately $2,900 are includedin Other Accrued Liabilities at December 31, 2004 and 2003.

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2004, 2003, AND 2002**

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

A tabular reconciliationof the changes in the Company’s product warranty liability for the years ended December 31,2004, 2003, and 2002 is as follows:
| ** ** | ** ** | **Balance at  Beginning of Year** | ** ** | **Warranty  Provisions** | ** ** | **Change in  Estimate** | ** ** | **Warranty  Claims** | ** ** | **Balance at  End of Year** | ** ** |
|------------|------------|--------------------------------------------------|------------|--------------------------|------------|------------------------------|------------|----------------------|------------|--------------------------------------------|------------|
| 2004       |       |                                             | $          | 2,900                    |       |                         |       | —               |       |                                       | —     |   |   | — |   |   |   | $ | 2,900 |   |   |
| 2003       |       |                                             | $          | 40,000                   |       |                         |       | —               |       |                                       | (34,100    | ) |   | 3,000 |   |   |   | $ | 2,900 |   |   |
| 2002       |       |                                             | $          | 51,000                   |       |                         |       | 8,886                |       |                                       | —     |   |   | 19,886 |   |   |   | $ | 40,000 |   |   |

 

The change in estimate for2003 was the result of certain products no longer being sold.

***Advertising***

Advertising costs arecharged to operations as incurred. Total amount charged to expense was$197,914, $106,873 and $118,017, for the three years ended December 31,2004, 2003 and 2002, respectively.

***Income Taxes***

The Company accounts forincome taxes under the asset and liability method. Deferred income tax assetsand liabilities are recognized annually for differences between the financialstatement and tax bases of assets and liabilities that will result in taxable ordeductible amounts in the future based on enacted tax laws and rates applicableto the periods in which the differences are expected to affect taxable income. Valuationallowances are established when necessary to reduce deferred tax assets to theamount expected to be realized.

***Fair Value of Financial Instruments***

The carrying amounts forall financial instruments approximate fair values. The carrying amounts forcash, receivables, accounts payable and accrued liabilities approximate fairvalue because of the short maturity of these instruments. Based on theborrowing rates currently available to the Company for bank loans with similarterms and average maturities, the carrying value of long-term debt materiallyapproximates fair value.

***Stock Based Compensation***

The Company accounts forstock-based compensation arrangements in accordance with the provisions ofAccounting Principles Board Opinion (“APB”) No. 25, “Accounting for StockIssued to Employees,” and complies with the disclosure provisions of SFAS No. 148and 123, “Accounting for Stock-Based Compensation”. Under APB No. 25,compensation cost is determined based on the difference, if any, on the grantdate between the fair value of the Company’s stock and the amount an employeemust pay to acquire the stock. Compensation expense is recognized over thevesting period.

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2004, 2003, AND 2002**

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

The Company has adoptedthe disclosure-only provisions of Statement of Financial Accounting Standards No. 123,“Accounting for Stock-Based Compensation.” Accordingly, no compensation costswere charged to operations for the years ended December 31, 2004, 2003,and 2002. Had compensation cost for the Company’s stock option plan beendetermined pursuant to SFAS No. 123, net earnings and earnings per commonshare would have been as follows:
| ** **                                                                                                                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net income, as  reported                                                                                                             |       | $        | 587,329    |     | $          | 633,448  |       | $ | 2,403,112 |   |
| Deduct: Total  stock-based compensation expense determined under fair value based method for  all awards, net of related tax effects |       | (125,450 | )          | (127,826 | )          | (68,529  | )          |
| Pro forma net income                                                                                                                 |       | $        | 461,879    |     | $          | 505,622  |       | $ | 2,334,583 |   |
| Earnings per common share:                                                                                                           |       |     |       |     |       |     |       |
| Basic—as reported                                                                                                               |       | $        | 0.23       |     | $          | 0.26     |       | $ | 1.00 |   |
| Basic—pro forma                                                                                                                 |       | $        | 0.18       |     | $          | 0.20     |       | $ | 0.97 |   |
| Diluted—as reported                                                                                                             |       | $        | 0.23       |     | $          | 0.25     |       | $ | 0.95 |   |
| Diluted—pro forma                                                                                                               |       | $        | 0.18       |     | $          | 0.20     |       | $ | 0.93 |   |

 

Theweighted average fair values at grant date of the options granted in fiscal2004, 2003 and 2002 were estimated as $5.23, $5.20 and $5.49, respectively,using the Black-Scholes option-pricing model with the following weightedaverage assumptions:
| ** **              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected Lives  (Years) |       | 10       |       | 10       |       | 10       |       |
| Dividend Yield          |       | 0.00     | %          | 0.00     | %          | 0.00     | %          |
| Expected  Volatility    |       | 70.5     | %          | 71.6     | %          | 68.0     | %          |
| Risk-Free Interest Rate |       | 4.62     | %          | 4.51     | %          | 4.00     | %          |

 

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

The effect of the Statement will be to requireentities to measure the cost of employee services received in exchange forstock options based on the grant-date fair value of the award, and to recognizethe cost over the period the employee is required to provide services for theaward. FAS 123(R) permits 

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2004, 2003, AND 2002**

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

entities to use anyoption-pricing model that meets the fair value objective in the Statement. TheCompany will be required to apply FAS 123(R) as of the beginning of itsthird quarter in 2005.

FAS 123(R) allows twomethods for determining the effects of the transition: the modified prospectivetransition method and the modified retrospective method of transition. TheCompany has not yet completed its study of the transition methods or made anydecisions about how it will adopt FAS 123(R). However, the pro forma net income effect ofusing the fair value method for the past three fiscal years is presented in thetable under employee stock based compensation above. The pro forma compensationcosts presented there and in prior filings for the Company have been calculatedusing a Black-Scholes option pricing model and may not be indicative of amountswhich should be expected in future years. No decisions have been made bymanagement as to which option-pricing model is most appropriate for the Companyfor future awards.

***Net Income Per Common Share***

Basic net income percommon share is computed using the weighted-average number of common sharesoutstanding. Diluted income per common share is computed using theweighted-average number of common shares outstanding and potential commonshares from the assumed exercise of stock options outstanding during the periodusing the treasury stock method.

***Recent Accounting Pronouncement***

In November 2004, theFASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43,Chapter 4. The amendments made by the SFAS No. 151 require that abnormalamounts of idle facility expense, freight, handling costs and wasted materials (spoilage)be recognized as current-period charges. This Statement requires thatallocation of fixed production overhead to inventory based on the normalcapacity of production facilities. SFAS No. 151 is effective for inventorycosts incurred during fiscal years beginning after June 15, 2005. Managementdoes not believe the adoption of SFAS No. 151 will have a material effecton the Company’s financial position or results of operations.

***Supplemental Cash Flow Information***

The Company paid income taxes of $148,424 and$1,998,677 for the years ended December 31, 2003 and 2002, respectively. Noincome taxes were paid for the year ended December 31, 2004. The Companypaid interest expense of $488,020, $389,941 and $514,031 for the years ended December 31,2004, 2003 and 2002, respectively.

During 2004, the Company acquired all of the businessassets of Zachariah and Lundbergh, Inc. (Z&L) for $250,000 payableover 4 years. During 2004 and 2003, the Company exchanged 63,407 and 63,408shares of its common stock for $600,000 and $600,000, respectively, of notepayable to SAE Assembly, LLC.

During 2002, the Companyincurred a note payable to SAE Assembly, LLC in the amount of $1,200,000 aspart of the purchase price for certain assets, as described in Note 10.

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2004, 2003, AND 2002**

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

***Segment Reporting Information***

The Company’s results of operations for the yearsended December 31, 2004, 2003 and 2002, represent a single segmentreferred to as Contract Manufacturing. Export sales represent 5%, 2% and 1% ofconsolidated sales for the years ended December 31, 2004, 2003 and 2002,respectively.

Long-livedassets by country are as follows:
| ** **                 | ** ** | ** United States ** | ** ** | **Mexico** | ** ** | **Total** | ** ** |
|----------------------------|------------|------------------------------------|------------|------------|------------|-----------|------------|
| 2004                       |       |                               |       |       |       |      |       |   |   |
| Net Property and Equipment |       |                               | $          | 5,755,401  |       |      | $          | 669,114 |   | $ | 6,424,515 |   |
| Other Assets               |       |                               | 156,889    |       |       | 584,396   |       | 741,285 |   |
| 2003                       |       |                               |       |       |       |      |       |   |   |
| Net Property and Equipment |       |                               | $          | 5,642,639  |       |      | $          | 447,678 |   | $ | 6,090,317 |   |
| Other Assets               |       |                               | 185,040    |       |       | 965,996   |       | 1,151,036 |   |

 

***Foreign Currency Translation***

Local currency isconsidered the functional currency for the Company’s operations outside theUnited States. Assets and liabilities are translated at year-end exchange rates.Income and expense items are translated at average rates of exchange prevailingduring the year. Translation adjustments are recorded as a component ofaccumulated other comprehensive loss in stockholders’ equity. Foreign exchangetransaction gains and losses attributable to exchange rate movements onintercompany receivables and payables not deemed to be of a long-terminvestment nature are recorded in Miscellaneous Income (Expense).

***Discontinued Operations***

On June 30, 1999, the Company adopted a formalplan to sell one of their operating segments known as Medical Management. During2002, certain assets of the Medical Management segment were sold for $2,000 toa private party. Through the sale in 2002, the results of operations forMedical Management were recorded against the reserve established to absorbdisposal losses. Reserve levels established for disposal losses were adequatein all material respects. Included in Miscellaneous Income for the year ended December 31,2003 is the reversal of a $50,000 reserve for discontinued operations.

31

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2004, 2003, AND 2002**

**NOTE2**                    MAJORCUSTOMERS AND CONCENTRATION OF CREDIT RISK

Financial instruments thatpotentially subject the Company to concentrations of credit risk consistprincipally of cash and trade accounts receivable. With regard to cash, theCompany maintains its excess cash balances in checking and money marketaccounts at three high-credit quality financial institutions. The Company hasnot experienced any losses in any of the short-term investment instruments ithas used for excess cash balances. TheCompany does not require collateral on its receivables. Historically, theCompany has not suffered significant losses with respect to trade accountsreceivable.

One customer accounted forapproximately****24% of accountsreceivable at December 31, 2004 and 2003, and approximately 15%, 23% and31% of sales for the years ended December 31, 2004, 2003, and 2002,respectively.

**NOTE3**                    ACCRUEDHEALTH AND DENTAL CLAIMS

The Company hasself-insured its employee health and dental plans. It has contracted with twoseparate administrative service companies to supervise and administer theprograms and act as representatives. The Company’s health plan insures forexcessive or unexpected claims and is liable for claims not to exceed $80,000per individual per plan year and an estimated aggregate amount of $3,425,000for the plan year ending August 2005. The Company’s dental plan paysclaims based on actual amounts incurred. Estimated unpaid claims for incurredhealth and dental services of $250,330 and $217,514 are included in Accrued Healthand Dental Claims at December 31, 2004 and 2003, respectively.

**NOTE 4**                    NOTESPAYABLE

The Company has a revolving line of credit of$8,000,000 at Wells Fargo Bank, N.A., (WFB) along with two term notes.Effective March 4, 2005, the line of credit was extended to January 31,2007. These agreements are secured by substantially all assets of the Companyand require the Company maintain certain covenants, which include certainregular reporting requirements, annual shareholder dividend limitations, themaintenance of certainfinancial ratios, and limit the amount of annual capital expenditures.

The line of credit bearsinterest at prime (5.25 percent at December 31, 2004). Theweighted-average interest rate on the Company’s line of credit was 4.34% and4.12% for the years ended December 31, 2004 and 2003, respectively. TheCompany had borrowings of $7,523,058 and $5,907,191 outstanding as of December 31,2004 and 2003, respectively.

32

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2004, 2003, AND 2002**

**NOTE 4       NOTES PAYABLE (Continued)**

A summary of other debtbalances at December 31, 2004 and 2003 is as follows:
| **Description**                                                                                                                                                                                                                                                                                                             | ** ** | ** ** | ** ** | **2004**   | ** ** | **2003**  | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|-----------|------------|
| Notes Payable—Wells  Fargo Bank Minnesota, N.A., Two Notes Bear Interest at Prime Rate of Wells  Fargo, One Note Bears Interest at 4.21%; Combined Monthly Payments of  $78,937, Including Principal and Interest; Maturities Range from  October 2006 to February 2007; Secured by Substantially All Assets |       | $          | 3,677,177  |       | $          | 3,941,769 |       |
| Promissory Note—SAE Assembly, LLC, (See Discussion Below  Describing Payment Terms); Secured by Shares of Nortech Common Stock                                                                                                                                                                                         |       | —     |       | 600,000    |       |
| Notes Payable—Other, Interest at 6.5%; Monthly  Installment Payments Through March 2007; Secured by Substantially All  Assets                                                                                                                                                                                     |       | 527,878    |       | 555,311    |       |
| Note Payable—Vehicle Loan, Interest at 14.9% Monthly  Installment Payments Though November 2007; Secured by Vehicle                                                                                                                                                                                               |       | 31,954     |       | —     |       |
| Promissory Note—Zachariah and Lundbergh, Inc.,  (See Note 10  for more information)                                                                                                                                                                                                                               |       | 160,016    |       | —     |       |
| Total Notes Payable                                                                                                                                                                                                                                                                                                         |       | 4,397,025  |       | 5,097,080  |       |
| Current Maturities of Notes Payable                                                                                                                                                                                                                                                                                         |       | (997,815   | )          | (1,360,935 | )          |
| Notes Payable—Net  of Current Maturities                                                                                                                                                                                                                                                                               |       | $          | 3,399,210  |       | $          | 3,736,145 |       |

 

Repayment of SAE Assembly,LLC (SAE) debt was made through semi-annual installments ending June 2004.Each installment on the note was satisfied with the issuance of 31,704 sharesof Nortech stock. During 2003, 63,408 shares comprising the first and secondinstallments were issued. During 2004, the remaining 63,407 shares comprisingthe third and fourth installments were issued.

Maturity requirements are as follows:
| **Years Ending December 31,** | ** ** | ** ** | ** ** | **Amount** | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|
| 2005                                         |       | $          | 997,815    |       |
| 2006                                         |       | 985,441    |       |
| 2007                                         |       | 2,392,853  |       |
| 2008                                         |       | 20,916     |       |
|                                         |       | $          | 4,397,025  |       |

 

33

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2004, 2003, AND 2002**

**NOTE 5**                    OPERATINGLEASES

The Company has entered into various operating leasesfor production and office equipment, office space and buildings. The Companyhas the option to purchase various pieces of equipment upon lease expiration atfair market value. The Company has the option to renew the lease for theBaxter, MN facility for an additional five years upon expiration of the initiallease term in July 2006. The lease for the manufacturing facility inMexico provides the Company the option of two three-year renewals extending thelease through 2010.

Rent expense, which includes amounts for other shortterm leases, for the years ended December 31, 2004, 2003, and 2002,amounted to $676,063, $869,565 and $799,571, respectively. Sublease incomeamounted to $3,000 for the years ended December 31, 2004 and 2003.

The future minimum leasepayments are as follows:
| ** **                                   | ** ** | **Lease**  | ** ** | **  Sublease  ** | ** ** | ** **                         | ** ** |
|----------------------------------------------|------------|------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **Years Ending December 31,** | ** ** | ** ** | ** ** | **Commitment**                       | ** ** | **  Income  ** | ** ** | **Net** | ** ** |
| 2005                                         |       |       | $          | 275,122                              |       |                               |       | $ | 1,750 |   |   | $ | 273,372 |   |
| 2006                                         |       |       | 197,274    |                                 |       |                               | —     |   |   | 197,274 |   |
| 2007                                         |       |       | 111,377    |                                 |       |                               | —     |   |   | 111,377 |   |
| 2008                                         |       |       | 40,805     |                                 |       |                               | —     |   |   | 40,805 |   |
| 2009                                         |       |       | 19,903     |                                 |       |                               | —     |   |   | 19,903 |   |
| Total                                        |       |       | $          | 644,481                              |       |                               |       | $ | 1,750 |   |   | $ | 642,731 |   |
|                                              |            |            |            |                                      |            |                                    |            |  |  |  |  |  |  |  |  |  |

 

**NOTE 6**                    INCOME TAXES

Theincome tax expense (benefit) for each of the three years ended December 31,2004 consists of the following:
| ** **                       | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current Taxes––Federal |       | $        | 60,000     |     | $          | (76,000  | )          | $ | 763,000 |   |
| Current Taxes—State         |       | 16,000   |       | (33,000  | )          | 151,000  |       |
| Current Taxes—Foreign       |       | 26,000   |       | 30,000   |       | 17,000   |       |
| Deferred Taxes—Federal      |       | 163,000  |       | (42,000  | )          | 374,000  |       |
| Deferred Taxes—State        |       | 4,000    |       | (1,000   | )          | 65,000   |       |
| Deferred Taxes—Foreign      |       | (1,000   | )          | (1,000   | )          | —   |       |
| Income Tax  Expense (Benefit)    |       | $        | 268,000    |     | $          | (123,000 | )          | $ | 1,370,000 |   |

 

34

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2004, 2003, AND 2002**

**NOTE 6       INCOME TAXES (Continued)**

The statutory ratereconciliation for each of the three years ended December 31, 2004 is asfollows:
| ** **                                               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Statutory Tax  Provision                                 |       | $        | 291,000    |     | $          | 174,000  |       | $ | 1,283,000 |   |
| State Income  Taxes, Net of Federal Benefit              |       | 25,000   |       | 24,000   |       | 153,000  |       |
| Effect of Foreign  Operations                            |       | (5,000   | )          | 17,000   |       | 1,000    |       |
| Income Tax  Credits                                      |       | (84,000  | )          | (93,000  | )          | (82,000  | )          |
| Research and  Development Tax Credits, Net of Payments   |       | —   |       | (246,000 | )          | —   |       |
| Other, including  Benefit of Income taxed at lower rates |       | 41,000   |       | 1,000    |       | 15,000   |       |
| Income Tax  (Benefit) Expense                            |       | $        | 268,000    |     | $          | (123,000 | )          | $ | 1,370,000 |   |

 

Incomefrom operations before income taxes was derived from the following sources:
| ** ** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002**  | ** ** |
|------------|------------|----------|------------|----------|------------|-----------|------------|
| Domestic   |       | 764,000  |       | 471,000  |       | 3,726,000 |       |
| Foreign    |       | 91,000   |       | 39,000   |       | 47,000    |       |
| Total      |       | 855,000  |       | 510,000  |       | 3,773,000 |       |

 

Deferredtax assets (liabilities) at December 31, 2004 and 2003, consist of thefollowing:
| ** **                         | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|------------------------------------|------------|-----------|------------|-----------|------------|
| Allowance for  Doubtful Accounts   |       | $         | 105,000    |      | $          | 140,000 |   |
| inventory  Reserves                |       | 462,000   |       | 495,000   |       |
| Accrued Vacation                   |       | 277,000   |       | 228,000   |       |
| Accrued Warranty                   |       | 1,000     |       | 1,000     |       |
| Health Insurance  Reserve          |       | 94,000    |       | 82,000    |       |
| Accrued Bonuses                    |       | 15,000    |       | —    |       |
| Non-Compete  Amortization          |       | 263,000   |       | 157,000   |       |
| Property and  Equipment            |       | 26,000    |       | 16,000    |       |
| General Business  Credits          |       | 52,000    |       | —    |       |
| Other Reserves                     |       | —    |       | 19,000    |       |
| Deferred Tax Assets                |       | 1,295,000 |       | 1,138,000 |       |
| Prepaid Expenses                   |       | (137,000  | )          | —    |       |
| Property and  Equipment            |       | (288,000  | )          | (102,000  | )          |
| Deferred Tax Liabilities           |       | (425,000  | )          | (102,000  | )          |
| Net Deferred Tax Assets            |       | $         | 870,000    |      | $          | 1,036,000 |   |
| Net Short-Term Deferred Tax Assets |       | $         | 818,000    |      | $          | 965,000 |   |
| Net Long-Term  Deferred Tax Assets |       | 52,000    |       | 71,000    |       |
| Total Deferred Tax  Assets         |       | $         | 870,000    |      | $          | 1,036,000 |   |

 

35

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2004, 2003, AND 2002**

**NOTE 6       INCOME TAXES (Continued)**

The Company has determinedthat it is more likely than not that its deferred tax assets will be realized,principally through carry backs to prior tax years and anticipated taxableincome in future tax years. As a result, management has determined thatestablishing a valuation allowance on the Company’s deferred tax assets is notnecessary.

**NOTE 7**                    COMPREHENSIVEINCOME

Comprehensiveincome is comprised of net income and other comprehensive loss. Othercomprehensive loss includes losses resulting from foreign currency translations.The details of comprehensive income are as follows:
| ** **                | ** ** | **Year Ended**   | ** ** | **Year Ended**   | ** ** | **   Year Ended   ** | ** ** |
|---------------------------|------------|-----------------------|------------|-----------------------|------------|---------------------------------------------------------|------------|
| ** **                | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **December 31,**                                   | ** ** |
| ** **                | ** ** | **2004**              | ** ** | **2003**              | ** ** | **2002**                                                | ** ** |
| Net Income, As  Reported  |       |                  | $          | 587,329               |       |                                                    |       | $ | 633,448 |   |   |   | $ | 2,403,112 |   |   |
| Other Comprehensive Loss: |       |                  |       |                  |       |                                                    |       |   |   |   |   |   |   |
| Translation Loss          |       |                  | (14,041    | )                     |       |                                                    | (26,688    | ) |   |   | — |   |   |
| Comprehensive  Income     |       |                  | $          | 573,288               |       |                                                    |       | $ | 606,760 |   |   |   | $ | 2,403,112 |   |   |

 

**NOTE 8**                    401(K) RETIREMENTPLAN

The Company has a 401(k) profitsharing plan (the “Plan”) for its employees. The Plan is a defined contributionplan covering all employees of the Company except for employees covered by acollective bargaining agreement and non-resident aliens earning non-U.S. sourceincome. Employees are eligible to participate in the Plan after completing sixmonths of service and attaining the age of 21. Employees are allowed tocontribute up to 60% of their wages to the Plan. The Company matches 25% of theemployees’ contribution up to 6% of covered compensation. The Company madecontributions of $120,089, $115,573 and $117,509 during the years ended December 31,2004, 2003, and 2002, respectively.

**NOTE 9**                    GAINSHARINGINCENTIVE AND STOCK OPTION PLANS

*EmployeeGainsharing*

During 1993, the Companyadopted an employee gainsharing plan (the “Plan”). The purpose of the Plan isto provide a bonus for increased output, improved quality and productivity andreduced costs. The Company has authorized 50,000 common shares to be availableunder this Plan. In accordance with the terms of the Plan, employees canacquire newly issued shares of common stock for 90% of the current market value.During 2004 and 2003, 52 and 133 common shares, respectively, were issued inconnection with this plan. Through December 31, 2004, 21,573 common shareshave been issued under this Plan.

36

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2004, 2003, AND 2002**

**NOTE 9**                    GAINSHARINGINCENTIVE AND STOCK OPTION PLANS (Continued)

*Stock Options*

In 1992, the Company approved the adoption of a fixedstock based compensation plan. The purpose of the Plan is to promote theinterests of the Company and its shareholders by providing officers, directorsand other key employees with additional incentive and the opportunity, throughcommon stock ownership, to increase their proprietary interest in the Companyand their personal interest in its continued success. In February 2003,the Company reached the maximum options allowed to be granted under the plan.

During 2003, the Company’s shareholders approved theadoption of the Nortech Systems Incorporated 2003 Stock Option Plan (the “Plan”).The total number of shares of common stock that may be granted under the planis 300,000, of which 172,500 and 212,500 option shares remain available at December 31,2004 and 2003, respectively. The plan provides that option shares granted comefrom the Company’s authorized but unissued common stock. The price of theoption shares granted under the plan will not be less than 100% of the fairmarket value of the common shares on the date of grant. Options are generallyexercisable after one or more years and expire no later than 10 years from thedate of grant.

The following tablesummarizes information about stock options outstanding at December 31,2004:
| ** **               | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** | **Remaining**  | ** ** |
|--------------------------|------------|-----------------|------------|-----------------|------------|----------------|------------|
| **Exercise Prices** | ** ** | ** **      | ** ** | **12/31/2004**  | ** ** | **12/31/2004** | ** ** | **Contractual Life** | ** ** |
| $3.125                   |       |            | 28,000     |            |       |           | 23,200     |   |   |   | 5.16 Years |   |   |
|   4.000        |       |            | 6,800      |            |       |           | 5,440      |   |   |   | 5.42 Years |   |   |
|   5.000        |       |            | 60,000     |            |       |           | 60,000     |   |   |   | 2.14 Years |   |   |
|   5.250        |       |            | 35,000     |            |       |           | 35,000     |   |   |   | 0.92 Years |   |   |
|   5.500        |       |            | 4,000      |            |       |           | 4,000      |   |   |   | 4.00 Years |   |   |
|   5.740        |       |            | 20,000     |            |       |           | —     |   |   |   | 9.84 Years |   |   |
|   7.110        |       |            | 4,000      |            |       |           | 4,000      |   |   |   | 7.81 Years |   |   |
|   7.220        |       |            | 50,000     |            |       |           | 10,000     |   |   |   | 8.12 Years |   |   |
|   7.460        |       |            | 20,000     |            |       |           | —     |   |   |   | 9.34 Years |   |   |
|   8.000        |       |            | 79,000     |            |       |           | 26,200     |   |   |   | 8.95 Years |   |   |
|                     |       |            | 306,800    |            |       |           | 167,840    |   |   |   |   |   |   |
|                          |            |                 |            |                 |            |                |            |  |  |  |  |  |  |  |  |

 

37

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2004, 2003, AND 2002**

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

Following is a summary ofthe stock option plan activity during 2004, 2003 and 2002.
| ** **                              | ** ** | **2004**   | ** ** | **2003**      | ** ** | **2002**   | ** ** |
|-----------------------------------------|------------|------------|------------|---------------|------------|------------|------------|
| ** **                              | ** ** | ** ** | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                              | ** ** | ** ** | ** ** | **Average**   | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                              | ** ** | ** ** | ** ** | **Exercise**  | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                              | ** ** | **Shares** | ** ** | **Price**     | ** ** | **Shares** | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
| Options  Outstanding, Beginning of Year |       | 272,800    |       |          | $          | 6.10       |       |   | 151,000 |   |   | $ | 4.60 |   |   | 297,500 |   |   | $ | 4.39 |   |   |
| Options Exercised                       |       | (6,000     | )          |          | 3.63       |       |       | (7,200 | ) |   | 3.27 |   |   | (146,900 | ) |   | 4.28 |   |   |
| Options Forfeited                       |       | —     |       |          | —     |       |       | — |   |   | — |   |   | (3,600 | ) |   | 3.13 |   |   |
| Options Granted                         |       | 40,000     |       |          | 6.60       |       |       | 129,000 |   |   | 7.70 |   |   | 4,000 |   |   | 7.11 |   |   |
| Options Outstanding, End of Year        |       | 306,800    |       |          | $          | 6.21       |       |   | 272,800 |   |   | $ | 6.10 |   |   | 151,000 |   |   | $ | 4.60 |   |   |
| Option Price  Range of Exercised Shares |       | $          | 3.63       |          |       |       |       |   | $ | 3.125 - 4.00 |   |   |   |   |   | $ | 1.625 - 5.25 |   |   |   |   |   |
|                                         |            |            |            |               |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**NOTE 10**             ACQUISITIONS

On June 27, 2002, the Company acquired 100percent of the outstanding common shares of Manufacturing Assembly Solutions ofMonterrey, Inc. (MAS), a Mexican corporation, located in Monterrey, Mexico.The results of operations since June 27, 2002, have been included in theconsolidated financial statements. The primary reason for this acquisition wasto enhance the Company’s manufacturing capabilities in a low cost country. Theaggregate purchase price was $1,850,000, including $650,000 paid in cash in July 2002and a $1,200,000 promissory note (see Note 4) to SAE Assembly, LLC.

The following tablesummarizes the estimated fair values of the assets acquired and liabilitiesassumed at the date of the acquisition:
| Current Assets              |   | $         | 152,148   |   |
|-----------------------------|--------|-----------|-----------|--------|
| Net Property and  Equipment |   | 186,761   |      |
| Other Assets                |   | 11,012    |      |
| Intangible Assets           |   | 1,526,384 |      |
| Total Assets Acquired       |   | 1,876,305 |      |
| Current Liabilities Assumed |   | 26,305    |      |
| Net Assets  Acquired        |   | $         | 1,850,000 |   |

 

Intangible assets acquired consist principally ofnon-compete agreements, which are being amortized on a straight-line basis overthe four-year term of the agreements. The Company has recorded relatedamortization expense of $381,600, $381,600 and $190,800 for the year ended December 31,2004, 2003 and 2002, respectively. Accumulated amortization on the non-competearrangements amounted to $954,000 and $572,400 at December 31, 2004 and2003, respectively. The Company will record amortization expenses of $381,600and $190,784 for the years ended December 31, 2005 and 2006, respectively.

38

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2004, 2003, AND 2002**

**NOTE 10**             ACQUISITIONS(Continued)

In June 2004, theCompany purchased, in exchange for a note payable of $250,000, the businessassets of Zachariah & Lundbergh, Inc. (Z&L) a manufacturer ofcamera power supplies and cable assemblies used in machine vision systems forthe industrial, medical/scientific and security markets. The assets purchasedwere comprised primarily of inventories with an estimated fair value of$170,000. The Company paid $89,984 of the note payable during 2004. Repaymentof the remaining Z&L debt will be made through payments at the rate of 20%of the Z&L products sold not to exceed 48 months from the date of closing.

**NOTE 11**             COMMITMENTSAND CONTINGENCIES

*Litigation*

The Company is subject tovarious legal proceedings and claims that arise in the ordinary course ofbusiness. In the opinion of management, the amount of any ultimate liabilitywith respect to these actions will not materially affect the Company’sconsolidated financial statements or results of operations.

*Executive LifeInsurance Plan*

During 2002, the Companyset up an Executive Bonus Life Insurance Plan (the “Plan”) for its keyemployees (“participants”). Pursuant to the Plan, the Company will pay a bonusto participants equal to 10% of the participants’ base annual salary, as wellas an additional bonus to cover federal and state taxes incurred by theparticipants. The participants are required to purchase life insurance andretain ownership of the life insurance policy once it is purchased. The Planprovides a five-year graded vesting schedule in which the participants vest intheir bonus at a rate of 20% each year. Should a participant terminateemployment prior to the fifth year of vesting, that participant must reimbursethe Company for any unvested amounts. Charges to income under the Plan were$167,375, $156,091 and $135,759 for the years ended December 31, 2004,2003 and 2002.

*Change of ControlAgreements*

During 2002, the Company entered into Change ofControl Agreements (the “Agreement(s)”) with certain key executives (“theExecutive(s)”). The Agreements provide an inducement for each Executive toremain as an employee of the Company in the event of any proposed oranticipated change of control in the organization, including facilitating anorderly transition, and to provide economic security for the Executive after achange in control has occurred.

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

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) DECEMBER 31, 2004, 2003, AND 2002**

**NOTE 12**             EARNINGSPER COMMON SHARE

Thefollowing is a reconciliation of the numerators and the denominators of thebasic and diluted per common share computations.
| ** **                                                            | ** ** | **2004**  | ** ** | **2003**  | ** ** | **2002**  | ** ** |
|-----------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| **Basic Earnings Per Common Share**                                   |       |      |       |      |       |      |       |
| Net Income                                                            |       | $         | 587,329    |      | $          | 633,448   |       | $ | 2,403,112 |   |
| Weighted average common share outstanding                             |       | 2,561,419 |       | 2,478,921 |       | 2,410,890 |       |
| Basic earnings per common share                                       |       | $         | 0.23       |      | $          | 0.26      |       | $ | 1.00 |   |
| **Diluted Earnings Per Common Share**                                 |       |      |       |      |       |      |       |
| Net Income                                                            |       | $         | 587,329    |      | $          | 633,448   |       | $ | 2,403,112 |   |
| Weighted average common shares outstanding                            |       | 2,561,419 |       | 2,478,921 |       | 2,410,890 |       |
| Stock options                                                         |       | 42,992    |       | 49,889    |       | 106,592   |       |
| Weighted average  common shares for diluted earnings per common share |       | 2,604,411 |       | 2,528,810 |       | 2,517,482 |       |
| Diluted earnings  per common share*                                   |       | $         | 0.23       |      | $          | 0.25      |       | $ | 0.95 |   |

----

*                    For2004, 2003 and 2002, there were approximately 48,409, 17,350 and 0 shares,respectively, excluded from the computation of diluted earnings per sharebecause to include them would be antidilutive.

**NOTE13**             SUPPLEMENTARYFINANCIAL INFORMATION (UNAUDITED)
| ** **                                  | ** ** | **Quarter Ending  3/31/2004** | ** ** | **Quarter Ending  6/30/2004** | ** ** | **Quarter Ending  9/30/2004** | ** ** | **Quarter Ending  12/31/2004** | ** ** | **Total  YTD** | ** ** |
|---------------------------------------------|------------|------------------------------------|------------|------------------------------------|------------|-------------------------------|------------|--------------------------------|------------|----------------|------------|
| Net Sales                                   |       |                               | $          | 15,046,085                         |       |                          |       | $                              | 18,028,197 |           |       |   | $ | 19,189,852 |   |   |   | $ | 20,410,025 |   |   | 72,674,159 |   |
| Gross Profit                                |       |                               | 1,504,871  |                               |       |                          | 1,918,523  |                           |       |           | 2,568,674  |   |   |   | 2,546,905 |   |   | 8,538,973 |   |
| Net Income                                  |       |                               | 43,049     |                               |       |                          | 104,984    |                           |       |           | 236,439    |   |   |   | 202,857 |   |   | 587,329 |   |
| Basic Earnings per Share of Common Stock    |       |                               | 0.02       |                               |       |                          | 0.04       |                           |       |           | 0.09       |   |   |   | 0.08 |   |   | 0.23 |   |
| Diluted Earnings  per Share of Common Stock |       |                               | 0.02       |                               |       |                          | 0.04       |                           |       |           | 0.09       |   |   |   | 0.08 |   |   | 0.23 |   |

 
| ** **                                         | ** ** | **Quarter Ending  3/31/2003** | ** ** | **Quarter Ending  6/30/2003** | ** ** | **Quarter Ending  9/30/2003** | ** ** | **Quarter Ending  12/31/2003** | ** ** | **Total  YTD** | ** ** |
|----------------------------------------------------|------------|-------------------------------|------------|-------------------------------|------------|-------------------------------|------------|--------------------------------|------------|----------------|------------|
| Net Sales                                          |       |                          | $          | 13,770,288                    |       |                          |       | $                              | 14,486,982 |           |       |   | $ | 14,060,224 |   |   |   | $ | 15,641,204 |   |   | 57,958,698 |   |
| Gross Profit                                       |       |                          | 1,649,500  |                          |       |                          | 1,734,735  |                           |       |           | 1,824,228  |   |   |   | 1,286,513 |   |   | 6,494,976 |   |
| Net Income (Loss)                                  |       |                          | 121,524    |                          |       |                          | 226,786    |                           |       |           | 440,679    |   |   |   | (155,541 | ) |   | 633,448 |   |
| Basic Earnings (Loss) per Share of Common Stock    |       |                          | 0.05       |                          |       |                          | 0.09       |                           |       |           | 0.18       |   |   |   | (0.06 | ) |   | 0.26 |   |
| Diluted Earnings (Loss)  per Share of Common Stock |       |                          | 0.05       |                          |       |                          | 0.09       |                           |       |           | 0.17       |   |   |   | (0.06 | ) |   | 0.25 |   |

 

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**Reportof Independent Registered Public Accounting Firm on Supplementary Information**

To the Board of DirectorsNortech Systems Incorporated and SubsidiaryWayzata, Minnesota

Ouraudit was made for the purposes of forming an opinion on the basic consolidatedfinancial statements of Nortech Systems Incorporated and Subsidiary taken as awhole. The consolidated supplemental schedule II is presented for purposes ofcomplying the Securities and Exchange Commission’s rules and is not a partof the basic consolidated financial statements. This schedule has beensubjected to the auditing procedures applied in our audit of the basicconsolidated financial statements and, in our opinion, is fairly stated in allmaterial respects in relation to the basic consolidated financial statementstaken as a whole.
| /s/ McGLADREY &  PULLEN, LLP        |
|----------------------------------------------|
| Minneapolis, Minnesota                       |
| February 18, 2005, except Note 4, as to |
| which the date is  March 4, 2005        |

 

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

Board of Directors andShareholdersNortech Systems Incorporated:

Under date of February 13, 2004, except as tonote 4 which is as of March 9, 2004, we reported on the consolidatedbalance sheet of Nortech Systems Incorporated and subsidiary as of December 31,2003, and related consolidated statements of income, shareholders’ equity andcash flows for each of the years in the two-year period ended December 31,2003, which are included in the Annual Report on Form 10-K for theyear 2004. In connection with our audits of the aforementioned consolidatedfinancial statements, we also audited the related financial statement scheduleas listed in the accompanying index for each of the years in the two-yearperiod ended December 31, 2003. This financial statement schedule is theresponsibility of the Company’s management. Our responsibility is to express anopinion on this financial statement schedule based on our audits.

In ouropinion, such financial statement schedule, when considered in relation to the2003 and 2002 basic consolidated financial statements taken as a whole,presents fairly, in all material respects, the information set forth therein.
| /s/ KPMG LLP           |
|------------------------|
| Minneapolis, Minnesota |
| February 13, 2004 |

 

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**NORTECH SYSTEMS INCORPORATED AND SUBSIDIARYSCHEDULE II—Valuationand Qualifying AccountsFOR THE YEARS ENDED DECEMBER 31, 2004, 2003, AND 2002**
| **Classification**                   | ** ** | ** ** | ** ** | **Balance at  Beginning  of Period** | ** ** | **Additions  Charged  to Costs  And Expenses** | ** ** | **Add (Deduct)** | ** ** | **Balance at  End of  Period** | ** ** |
|--------------------------------------|------------|------------|------------|------------------------------------------------|------------|----------------------------------------------------------|------------|-----------------------|------------|------------------------------------------|------------|
| Year Ended  December 31, 2004:  |       |       |       |                                           |       |                                                     |       |                  |       |                                     |       |
| Allowance for Uncollectible Accounts |       | $          | 371,690    |                                           |       | 166,989                                                  |       |                  | (258,533   | )                                        | $          | 280,146 |   |
| Inventory Reserve                    |       | $          | 1,319,250  |                                           |       | 829,918                                                  |       |                  | (929,968   | )                                        | $          | 1,219,200 |   |
| Self-insurance Accrual               |       | $          | 217,514    |                                           |       | 3,914,882                                                |       |                  | (3,882,066 | )                                        | $          | 250,330 |   |
| Year Ended  December 31, 2003:  |       |       |       |                                           |       |                                                     |       |                  |       |                                     |       |
| Allowance for Uncollectible Accounts |       | $          | 488,451    |                                           |       | (19,694                                                  | )          |                  | (97,067    | )                                        | $          | 371,690 |   |
| Inventory Reserve                    |       | $          | 1,192,255  |                                           |       | 1,017,580                                                |       |                  | (890,585   | )                                        | $          | 1,319,250 |   |
| Self-insurance Accrual               |       | $          | 277,864    |                                           |       | 3,353,287                                                |       |                  | (3,413,637 | )                                        | $          | 217,514 |   |
| Year Ended  December 31, 2002:  |       |       |       |                                           |       |                                                     |       |                  |       |                                     |       |
| Allowance for Uncollectible Accounts |       | $          | 318,557    |                                           |       | 231,500                                                  |       |                  | (61,606    | )                                        | $          | 488,451 |   |
| Inventory Reserve                    |       | $          | 1,354,050  |                                           |       | 1,577,120                                                |       |                  | (1,738,915 | )                                        | $          | 1,192,255 |   |
| Self-insurance  Accrual              |       | $          | 391,413    |                                           |       | 3,597,202                                                |       |                  | (3,710,751 | )                                        | $          | 277,864 |   |

 

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

On August 31, 2004, KPMG LLP (“KPMG”) notifiedNortech Systems Incorporated (“the Company”) that the client-auditorrelationship between the Company and KPMG ceased as of that date. The decisionto terminate the relationship was made by KPMG; the Company’s audit committeedid not recommend a change in accountants and as a result of KPMG’s resignationbegan a search for a new independent auditing firm which resulted in theappointment of McGladrey & Pullen, LLP as the Company’s principalaccountant to audit the Company’s financial statements, effective October 20,2004.

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

The audit reports of KPMG on the Company’sconsolidated financial statements as of and for the years ended December 31,2003 and 2002 did not contain any adverse opinion or disclaimer of opinionand were not qualified or modified as to uncertainty, audit scope or accountingprinciples.

During the Company’s twomost recent fiscal years ended December 31, 2003, and the subsequentinterim periods through August 31, 2004, there were no “reportable events”(as that term is defined in Item 304(a)(1)(v) of Regulation S-K), exceptthat on August 13, 2004, KPMG advised the Company’s audit committee thatKPMG noted a deficiency related to the Company’s ability to forecast financialresults accurately enough to determine expected compliance with debt covenantsat future quarter ends. This deficiency was considered to be a “reportablecondition” under the standards established by the American Institute ofCertified Public Accountants. The subject matter of this deficiency wasdiscussed with the Chairman of the Audit Committee and representatives of theCompany’s management on August 13, 2004, as were the proposed remedialactions. The Company believes that it has taken appropriate steps to remedythis deficiency by improving and expanding its monthly forecasting process putinto place in the first week of June 2004. At the August 13, 2004discussion with the Chairman of the Company’s audit committee and management,KPMG also stated that this deficiency did not in its view constitute a “materialweakness” within the meaning of the standards established by the AmericanInstitute of Certified Public Accountants.

**ITEM 9A.**        CONTROLS AND PROCEDURES

The Company maintains disclosure controls andprocedures designed to ensure that information required to be disclosed inreports filed under the Securities Exchange Act of 1934, as amended, isrecorded, processed, summarized and reported within the specified time periods.As of the end of the period covered by this report, the Company’s management,including the Chief Executive Officer and Chief Financial Officer, evaluatedthe effectiveness of the Company’s disclosure controls and procedures. Based onthe evaluation, which disclosed no significant deficiencies or materialweaknesses, the Chief Executive Officer and Chief Financial Officer eachconcluded that the Company’s disclosure controls and procedures are effective.

The Company is currentlyin the process of reviewing and formalizing its internal controls andprocedures for financial reporting in accordance with the Securities andExchange Commission’s rules implementing the internal control reportingrequirements included in Section 404 of the Sarbanes-Oxley Act of2002 (“Section 404”). Changes have been and will be made to our internalcontrols over financial reporting as a result of these efforts. The Company isdedicating significant resources, including senior management time and effort,and incurring substantial costs in connection with its ongoing Section 404assessment. The Company is currently documenting and testing internal controlsand 

44

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consideringwhether any improvements are necessary for maintaining an effective controlenvironment at the Company. The evaluation of internal controls is beingconducted under the direction of senior management in consultation with anindependent third party consulting firm. In addition, senior management isregularly discussing the results of testing and any proposed improvements tothe control environment with the Audit Committee. The Company expects to assesscontrols and procedures on a regular basis. It will continue to work to improvecontrols and procedures and to educate and train employees on the existingcontrols and procedures in connection with the efforts to maintain an effectivecontrols infrastructure at the Company.

**ITEM 9B.**       OTHER INFORMATION

None.

**PART III**

**ITEM 10.**         DIRECTORS AND EXECUTIVEOFFICERS OF THE REGISTRANT

Information regarding thedirectors and executive officers of the Registrant will be included in theRegistrant’s 2004 proxy statement to be filed with the Securities and ExchangeCommission not later than April 30, 2005 and said portions of the proxystatement are incorporated herein by reference.

**ITEM 11.**         EXECUTIVE COMPENSATION

Information regardingexecutive compensation of the Registrant will be included in the Registrant’s2004 proxy statements to be filed with the Securities and Exchange Commissionnot later than April 30, 2005 and said portions of the proxy statement areincorporated herein by reference.

**ITEM 12.**         SECURITY OWNERSHIP OFCERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Information regarding security ownership of certainbeneficial owners and management of the Registrant will be included in theRegistrant’s 2004 proxy statements to be filed with the Securities and ExchangeCommission no later than April 30, 2005 and said portions of the proxystatements are incorporated herein by reference.

Information regarding executive compensation plans(including individual compensation arrangements) as of the end of the lastfiscal year, on two categories of equity compensation plans (that is, plansthat have been approved by security holders and plans that have not beenapproved by security holders) will be included in the Registrant’s 2004 proxystatements to be filed with the Securities and Exchange Commission no laterthan April 30, 2005 and said portions of the proxy statements areincorporated herein by reference.

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Thefollowing table provides information about the Company’s equity compensationplans (including individual compensation arrangements) as of December 31,2004.
| **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     |       |       | 306,800    |                                                                                                                                                 |       |                                                                                                    | $          | 6.212                                                                                                                                                                                                      |       |   |   | 172,500 |   |   |
| Equity compensation plans not approved by security  holders |       |       | 0          |                                                                                                                                                 |       |                                                                                                    | 0          |                                                                                                                                                                                                       |       |   | 0 |   |   |
| Total                                                       |       |       | 306,800    |                                                                                                                                                 |       |                                                                                                    | $          | 6.212                                                                                                                                                                                                      |       |   |   | 172,500 |   |   |

----

(1)          Represents common sharesissuable upon the exercise of outstanding options granted under the Company’s1992 Employee Stock Incentive Plan (the “1992 Plan”) and the 2003 Stock OptionPlan (the “2003 Plan”).

(2)          Representscommon shares remaining available under the 2003 Plan. The Company’s Board ofDirectors intends to terminate this plan if the proposed 2005 IncentiveCompensation Plan is approved by the shareholders at the annual meeting.

**ITEM 13.**         CERTAIN RELATIONSHIPS ANDRELATED TRANSACTIONS

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

**ITEM 14.**         PRINCIPAL ACCOUNTANT FEESAND SERVICES

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

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**PART IV**

**ITEM15.**         EXHIBITS,CONSOLIDATED FINANCIAL STATEMENTS SCHEDULES

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

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

|                                                                                                            | ** ** | ** ** | **PAGE** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|------------|----------|------------|
| Reports  of Independent Registered Public Accounting Firms on Supplementary  Information    |       |       | 41-42    |       |
| Consolidated Financial  Statements Schedule for the years ended December 31, 2004, 2003 and 2002      |       |       |     |       |
| II Valuation and  Qualifying Accounts                                                                 |       |       | 43       |       |

 

All other schedules are omitted since they are notapplicable, not required, or the required information is included in thefinancial statements or notes thereto.

Thefollowing exhibits are incorporated by reference to exhibits accompanying theCompany’s Annual Report on Form 10-K for the year ended December 31,2004.
| 23.1 |   | Consent of McGladrey & Pullen, LLP.                                                                                                                                     |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 23.2 |   | Consent of KPMG LLP.                                                                                                                                                             |
| 31.1 |   | Certification of the  Chief Executive Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a), promulgated under the Securities Exchange Act of  1934, as amended. |
| 31.2 |   | Certification of the  Chief Financial Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a), promulgated under the Securities Exchange Act of  1934, as amended. |
| 32.1 |   | Certification of the  Chief Executive Officer and Chief Financial Officer, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                           |

 

Thefollowing exhibits are incorporated by reference to exhibits accompanying theCompany’s Annual Report on Form 10-K for the year ended December 31,2003.
| 10.1 |   | Fifth Amendment to amended and restated Credit and  Security Agreement, Amended and Restated Revolving Note between the Company  and Wells Fargo Bank Minnesota National Association. |
|------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

47

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
|                     | NORTECH  SYSTEMS INCORPORATED |
|---------------------|-------------------------------|
| March 15, 2005 | By:                           | /s/  *RICHARD  G. WASIELEWSKI* |
|                |                          | Richard G.  Wasielewski |
|                |                          | *Chief  Financial Officer* |
|                |                          | *and* |
|                |                          | *Principal  Accounting Officer* |
| March 15, 2005 | By:                           | /s/  *MICHAEL  J. DEGEN* |
|                |                          | Michael J. Degen |
|                |                          | *President,  Chief Executive* |
|                |                          | *Officer  and Director* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the followingpersons on behalf of the registrant and in the capacities and on the datesindicated have signed this report.
| March 15, 2005 |   | /s/ *MICHAEL J. DEGEN*          |
|---------------------|--------|---------------------------------|
|                |   | Michael J. Degen                |
|                |   | *President,  Chief Executive*   |
|                |   | *Officer  and Director*         |
| March 15, 2005 |   | /s/  *MYRON  KUNIN*             |
|                |   | Myron Kunin                     |
|                |   | *Chairman  and Director*        |
| March 15, 2005 |   | /s/  *RICHARD  W. PERKINS*      |
|                |   | Richard W.  Perkins, *Director* |
| March 15, 2005 |   | /s/  *C. TRENT  RILEY*          |
|                |   | C. Trent Riley, *Director*      |
| March 15, 2005 |   | /s/  *KEN  LARSON*              |
|                |   | Ken Larson, *Director*          |

 

48

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**INDEX TO EXHIBITS**

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

 

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