NORTECH SYSTEMS INC - 10-K Annual Report

NORTECH SYSTEMS INCORPORATED
FORM 10-K
For the Year Ended December 31, 2004
PART I

DESCRIPTION OF BUSINESS

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 for reorganization under Chapter 11 of the United States Bankruptcy Code during 1990. The business and assets of DSC Nortech, Inc. were transferred to Nortech Systems Incorporated during 1990.

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

The Company makes available 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 manufacturing facilities in Minnesota including Bemidji, Fairmont, Baxter, and Merrifield as well as Augusta, Wisconsin, and Monterrey, Mexico. The Company manufactures wire harnesses, cables, electronic sub-assemblies and components, and printed circuit board assemblies. The Company provides a full “turnkey” contract manufacturing service to its customers. A majority of revenue is derived from products that are built to the customer’s design specifications.

The Company provides a high degree of manufacturing sophistication 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 the business. This level of sophistication enables the Company to attract major original equipment manufacturers (OEM).

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

The Company believes the current trend for contract manufacturing to grow and expand in the United States and overseas will continue because contract manufacturing provides OEMs with a quality product at a price well below what is in their own facilities. This is due primarily to the specialization available

through the contract manufacturer with significantly lower overhead costs and ability to solve logistical problems with offshore manufacturing.

ACQUISITIONS

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

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

BUSINESS SEGMENTS

At December 31, 1998, the Company had reported segment information of its then three identifiable segments: Contract Manufacturing, Display Products and Medical Management. However, on June 30, 1999, the Company formally adopted a plan to dispose of two of the 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 Contract Manufacturing segment.

BUSINESS STRATEGY

The Company believes the electronic manufacturing sub-contracting business is emerging from a small job shop oriented business into a dynamic, high technology global electronics and wire/harness industry. The Company operates mainly in the wire harness and cable assemblies, and printed circuit board assemblies markets, and intends to expand from this market segment into complete electromechanical assemblies. Many companies no longer perform this type of work on a captive, in-house basis, as they are finding that independent subcontractors can more cost effectively perform this specialized work. Nortech’s goal is to help its clients become more competitive through help in design, rapid prototyping, and provides a full-service manufacturing solution in the small to mid-size market needs. The Company is also continuing to expand their international operations and partnerships to provide lower cost alternatives as a competitive edge and meet their customer demands in this area.

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

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

MARKETING

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

SOURCES AND AVAILABILITY OF MATERIALS

The Company is not dependent on any one supplier for materials for products sold to customers. Components utilized in the assembly of wire harnesses, cable assemblies and printed circuit assemblies are purchased directly from the component manufacturers or from their distributors. On occasion some components may be placed on a stringent allocation basis; however, due to the excess manufacturing capacity currently available at most component manufacturers, the Company does not anticipate any major material purchasing or availability problems occurring in the foreseeable future.

PATENTS AND LICENSES

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

COMPETITION

The contract manufacturing industry is characterized by competition among a variety of sources, including small closely held companies, larger full-service manufacturers, company-owned facilities and foreign manufacturers. The Company does not believe that the small closely held operations pose significant competitive threat, as they generally do not appear to have the manufacturing capabilities required by target customers of the Company. The Company believes that foreign manufacturers do provide a substantial competitive threat as shown by the commoditization of PC/printer cable and “bargain basement” prices. Many OEM’s have moved their manufacturing to foreign soil and in doing so have minimized freight costs to ship to their foreign locations. Technical support from foreign competition has improved greatly along with their ability to be more responsive to engineering and schedule changes. The willingness of foreign manufacturers to “stock” finished product at warehouse locations in the United States is another competitive advantage. To mitigate foreign competition, the Company maintains a contractual agreement that allows its products to be manufactured in China. The Company also acquired a Mexican manufacturing facility in 2002, thereby making itself competitive with other foreign low cost providers.

The Company will pursue acquisitions, mergers, or joint ventures of manufacturing companies in low cost countries and as opportunities come available in the United States, to retain and grow its

customer/revenue base and support its strategic vision to be a competitive world class Electronic Manufacturing Services provider.

BACKLOG

Historically, the Company’s backlog has been running 60 to 90 days. However, because of the increased emphasis on just in time manufacturing (JIT), many of the Company’s major customers are now looking to take advantage of the Company’s ability to service them adequately under the JIT concept. Additionally, because of the Company’s quality history with customers, many products now go directly from the Company’s shipping dock to the customer’s production line.

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

MAJOR CUSTOMERS

The Company sells its products to companies in the computer, medical, governmental and various other industries. Historically, the Company has not experienced significant losses on customer receivable collections 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 has been offset by increased business with existing and new customers.

RESEARCH AND DEVELOPMENT

The Company expended no dollars in 2004, 2003 or 2002 on Company-sponsored product research and development. However, the Company performs research and development for customers on an as requested basis for development of conceptual engineering and design activities prior to manufacturing the products.

ENVIRONMENTAL LAW COMPLIANCE

Management believes that its manufacturing facilities are currently operating under compliance with local, state, and federal environmental laws. The Company has made, and plans to continue making, necessary expenditures for compliance with applicable laws. Any environmental-oriented equipment is capitalized and depreciated over a seven-year period. The annualized depreciation expense for this type of environmental equipment on a Company-wide basis is insignificant.

EMPLOYEES

The Company has 663 full-time, 117 part-time and 145 temporary employees as of December 31, 2004. Manufacturing personnel, including direct, indirect support and sales functions, comprise 878 employees, while general administrative employees total 47.

FOREIGN OPERATIONS AND EXPORT SALES

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

ITEM 2. PROPERTIES

ADMINISTRATION

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

MANUFACTURING FACILITIES

The Company owns its Bemidji, Minnesota facility consisting of eight acres of land and 60,000 square feet of office and manufacturing space.

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

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

The Company owns another 45,800 square feet building in Merrifield, Minnesota. This facility is used for the building of surface-mount printed circuit board assemblies and electro-mechanical assemblies.

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

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

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

ITEM 3. LEGAL PROCEEDINGS

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

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

None.

PART II

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

As of February 14, 2005, there were approximately 882 shareholders of record. The Company’s stock is listed on the National Association of Securities Dealers Automated Quotation System (“NASDAQ”) Small Cap Market under the symbol “NSYS”. The Company intends to invest its profits into the growth of the Company and, therefore, does not plan to pay out dividends to shareholders in the foreseeable future. Stock price comparisons follow.

Stock price 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 COMPENSATION PLAN INFORMATION

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

ITEM 6. SELECTED FINANCIAL DATA

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

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

		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

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