NSYS

Nortech Systems Inc. 10-K Summary (Fiscal Year Ended Dec 31, 2007)

Business Context and Reporting Period

Nortech Systems Inc. is an Electronic Manufacturing Services (EMS) contract manufacturer headquartered in Wayzata, Minnesota. The company manufactures wire harnesses, cable assemblies, electronic sub-assemblies, and printed circuit board assemblies for industrial, medical, military/defense, and transportation markets. This report covers the fiscal year ended December 31, 2007. During the period, the company expanded its capabilities through the acquisition of Suntron Corporation's Mid-West Operation in Garner, Iowa, entering the agriculture and oil/gas sectors.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased by 12.4% ($13.0 million) driven primarily by the February 2007 acquisition of the Garner, Iowa operation ($13.1 million in circuit board sales) and increased Aerospace Systems activity ($4.2 million). This offset a decline in Cable and Wire sales ($1.9 million) and other circuit board sales ($3.4 million) due to softness in the industrial customer base.
• Profitability: Gross margin improved from 12.2% to 13.7% due to volume leverage and operational efficiencies, which offset rising energy and commodity costs (copper, petroleum). Net income rose 20.4% to $1.58 million.
• Expenses: General and Administrative expenses increased by $2.0 million, attributed to personnel costs, the new Iowa operation, and consulting fees. Interest expense rose to $1.12 million due to higher debt levels associated with the acquisition.
• Liquidity: Working capital increased by $2.1 million. Cash flow from operations improved significantly to $4.34 million, aided by a $1.1 million reduction in accounts receivable.

Guidance, Outlook, Risks, and Unusual Items

• Outlook: Management expects a major portion of the $27.3 million backlog to be realized as revenue in the first quarter of 2008. The company continues to pursue organic growth and acquisitions to diversify its customer base.
• Customer Concentration: Significant reliance on major customers exists. General Electric (Medical and Transportation divisions) accounted for 17% of net sales, and Northrop Grumman Corp. accounted for 16% of net sales in 2007.
• Risks: Key risks include competition from global manufacturers with lower cost structures, supply chain disruptions (component shortages), raw material cost volatility (copper), and foreign currency fluctuations affecting the Mexico operation.
• Debt Covenants: The company is subject to financial covenants under its revolving credit facility with Wells Fargo Bank. As of year-end, the company was in compliance, but failure to comply could accelerate debt repayment.
• Unusual Items: The company adopted FIN 48 (Accounting for Uncertainty in Income Taxes) in 2007, resulting in a $32,000 cumulative adjustment to retained earnings and an additional $8,000 tax expense.

Investor Verification Checklist

• Customer Concentration: Verify the stability of contracts with General Electric and Northrop Grumman, which collectively represent 33% of revenue.
• Acquisition Integration: Assess the performance of the Garner, Iowa acquisition against the projected accretive results and the $200,000 earn-out liability.
• Debt Capacity: Review the $15 million line of credit utilization ($5.6 million outstanding) and the impact of LIBOR rate fluctuations on interest expense.
• Inventory Valuation: Confirm the adequacy of the $1.3 million inventory reserve given the mix of slow-moving or obsolete items in a high-mix manufacturing environment.
• Stock-Based Compensation: Note the $1.99 million in unrecognized compensation expense related to performance-based stock options, which depends on achieving specific Return on Sales (ROS) targets.