UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549

FORM 10-Q

(Mark One)

x   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2007

OR

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

For the transition period from              to

NORTECH SYSTEMS INCORPORATED

 

Commission file number 0-13257

State of Incorporation: Minnesota

IRS Employer Identification No. 41-1681094

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

Telephone number: (952) 345-2244

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o No x

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

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

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

Number of shares of $.01 par value common stock outstanding at August 10, 2007 - 2,714,812

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

TABLE OF CONTENTS

PART I  - FINANCIAL INFORMATION

				PAGE
Item 1    -		Condensed Financial Statements
		Consolidated Balance Sheets		3 - 4
		Consolidated Statements of Income		5 - 6
		Consolidated Statements of Cash Flows		7
		Notes to Condensed Consolidated Financial Statements		8 - 16
Item 2    -		Management’s Discussion and Analysis of Financial Condition And Results of Operations		16 - 22
Item 3    -		Quantitative and Qualitative Disclosures About Market Risk		23
Item 4    -		Controls and Procedures		23
PART II - OTHER INFORMATION
Item 1    -		Legal Proceedings		24
Item 1A -		Item 1A - Risk Factors		24
Item 6    -		Exhibits		24
SIGNATURES				25
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1

 

2

PART 1

ITEM 1.  FINANCIAL STATEMENTS

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

JUNE 30, 2007 AND DECEMBER 31, 2006

 

		JUNE 30			DECEMBER 31
		2007			2006
		(Unaudited)
ASSETS
Current Assets
Cash and Cash Equivalents		$	946,308		$	725,891
Accounts Receivable, Less Allowance for Uncollectible Accounts of $238,000 and $220,000, respectively		16,804,900			14,493,339
Inventories:
Raw Materials		13,989,999			11,161,883
Work In Process		4,160,840			3,339,325
Finished Goods		2,855,297			2,770,670
Reserves		(1,624,088		)	(1,295,656		)
Total Inventories		19,382,048			15,976,222
Prepaid Expenses		362,694			492,177
Income Taxes Receivable		—			209,025
Deferred Income Tax Assets		1,092,000			856,000
Total Current Assets		38,587,950			32,752,654
Property and Equipment
Land		300,000			300,000
Building and Leasehold Improvements		6,120,696			6,063,385
Manufacturing Equipment		9,723,059			9,092,455
Office and Other Equipment		3,581,556			3,532,038
Construction in Progress		266,397			90,945
Total Property and Equipment		19,991,708			19,078,823
Accumulated Depreciation		(11,350,073		)	(10,823,655		)
Net Property and Equipment		8,641,635			8,255,168
Other Assets
Restricted Cash		427,500			427,500
Finite Life Intangibles		1,135,329			82,890
Goodwill		75,006			75,006
Deferred Income Tax Assets		288,000			277,000
Deposits		7,726			7,726
Total Other Assets		1,933,561			870,122
Total Assets		$	49,163,146		$	41,877,944

 

See Accompanying Notes to Condensed Consolidated Financial Statements

3

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

JUNE 30, 2007 AND DECEMBER 31, 2006

 

		JUNE 30			DECEMBER 31
		2007			2006
		(Unaudited)
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities
Bank Note Payable		$	8,631,496		$	4,694,027
Current Maturities of Long-Term Debt		970,449			1,524,743
Accounts Payable		11,537,851			10,018,263
Accrued Payroll and Commissions		3,112,256			3,094,092
Accrued Health and Dental Claims		343,000			325,000
Other Accrued Liabilities		598,321			385,251
Income Taxes Payable		116,226			—
Total Current Liabilities		25,309,599			20,041,376
Long-Term Liabilities
Long-Term Debt (Net of Current Maturities)		4,586,244			3,509,039
Other Long-Term Liabilities		14,386			25,670
Total Long-Term Liabilities		4,600,630			3,534,709
Total Liabilities		29,910,229			23,576,085
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: 2,714,754 and 2,674,729 Shares Issued and Outstanding at June 30, 2007 and December 31, 2006, respectively		27,148			26,747
Additional Paid-In Capital		14,972,180			14,644,901
Accumulated Other Comprehensive Loss		(22,195		)	(23,179		)
Retained Earnings		4,025,784			3,403,390
Total Shareholders’ Equity		19,252,917			18,301,859
Total Liabilities and Shareholders’ Equity		$	49,163,146		$	41,877,944

 

See Accompanying Notes to Condensed Consolidated Financial Statements

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

JUNE 30, 2007 AND 2006

(UNAUDITED)

 

		THREE MONTHS ENDED
		JUNE 30
		2007			2006
Net Sales		$	31,136,314		$	26,173,559
Cost of Goods Sold		26,883,177			22,759,919
Gross Profit		4,253,137			3,413,640
Operating Expenses:
Selling Expenses		1,375,314			1,127,525
General and Administrative Expenses		2,037,669			1,658,616
Total Operating Expenses		3,412,983			2,786,141
Income From Operations		840,154			627,499
Other Income (Expense)
Interest Income		6,162			669
Miscellaneous Income (Expense), net		(33,590		)	9,283
Interest Expense		(260,226		)	(190,786		)
Total Other Expense		(287,654		)	(180,834		)
Income Before Income Taxes		552,500			446,665
Income Tax Expense		185,000			138,000
Net Income		$	367,500		$	308,665
Earnings Per Common Share:
Basic		$	0.14		$	0.12
Weighted Average Number of Common Shares Outstanding Used for Basic Earnings Per Common Share		2,695,754			2,619,281
Diluted		$	0.13		$	0.11
Weighted Average Number of Common Shares Outstanding Plus Effect of Dilutive Common Stock Options		2,735,654			2,682,244

 

See Accompanying Notes to Condensed Consolidated Financial Statements

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

JUNE 30, 2007 AND 2006

(UNAUDITED)

 

		SIX MONTHS ENDED
		JUNE 30
		2007			2006
Net Sales		$	59,130,776		$	52,191,178
Cost of Goods Sold		51,240,292			45,618,787
Gross Profit		7,890,484			6,572,391
Operating Expenses:
Selling Expenses		2,569,676			2,248,176
General and Administrative Expenses		3,829,275			3,095,746
Total Operating Expenses		6,398,951			5,343,922
Income From Operations		1,491,533			1,228,469
Other Income (Expense)
Interest Income		13,715			1,002
Miscellaneous Income (Expense), net		(39,167		)	14,346
Interest Expense		(487,687		)	(366,204		)
Total Other Expense		(513,139		)	(350,856		)
Income Before Income Taxes		978,394			877,613
Income Tax Expense		324,000			305,000
Net Income		$	654,394		$	572,613
Earnings Per Common Share:
Basic		$	0.24		$	0.22
Weighted Average Number of Common Shares Outstanding Used for Basic Earnings Per Common Share		2,685,469			2,618,742
Diluted		$	0.24		$	0.21
Weighted Average Number of Common Shares Outstanding Plus Effect of Dilutive Common Stock Options		2,724,808			2,683,587

 

See Accompanying Notes to Condensed Consolidated Financial Statements

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

JUNE 30, 2007 AND 2006

(UNAUDITED)

 

		SIX MONTHS ENDED
		JUNE 30
		2007			2006
Cash Flows From Operating Activities
Net Income		$	654,394		$	572,613
Adjustments to Reconcile Net Income to Net Cash
Provided by Operating Activities:
Depreciation		772,007			662,953
Amortization		91,159			196,964
Compensation on Restricted Stock and Stock Option Grants		127,506			66,207
Other		(11,284		)	—
Deferred Taxes		(247,000		)	(264,000		)
Loss on Disposal of Assets		10,492			867
Foreign Currency Transaction Loss (Gain)		1,188			(6,210		)
Changes in Current Operating Items, net of effect of business acquisition:
Accounts Receivable		(327,902		)	314,227
Inventories		(1,123,100		)	(1,304,787		)
Prepaid Expenses and Other Assets		217,883			39,127
Income Taxes Payable		293,017			(204,017		)
Accounts Payable		700,741			(130,674		)
Accrued Payroll and Commissions		(64,880		)	255,826
Accrued Health and Dental Claims		18,000			128,896
Other Accrued Liabilities		12,632			(95,088		)
Net Cash Provided by Operating Activities		1,124,853			232,904
Cash Flows from Investing Activities:
Proceeds from Sale of Assets		1,161			275
Business Acquisition (Note 9)		(4,807,699		)	—
Restricted Cash		—			(427,500		)
Purchase of Property and Equipment		(758,607		)	(2,421,637		)
Net Cash Used in Investing Activities		(5,565,145		)	(2,848,862		)
Cash Flows from Financing Activities:
Net Change in Line of Credit		3,937,469			1,875,750
Proceeds from Long-Term Debt		1,668,195			2,540,926
Payments of Long-Term Debt		(1,145,284		)	(751,394		)
Issuance of Stock Upon Exercise of Options		200,173			8,228
Checks in Excess of Bank Balance		—			(1,200,000		)
Net Cash Provided by Financing Activities		4,660,553			2,473,510
Effect of Exchange Rate Changes on Cash		156			(1,562		)
Net Increase (Decrease) in Cash and Cash Equivalents		220,417			(144,010		)
Cash and Cash Equivalents - Beginning		725,891			840,123
Cash and Cash Equivalents - Ending		$	946,308		$	696,113
Supplemental disclosure of cash flow information:
Cash paid during the period for interest		$	493,533		$	363,153
Cash paid during the period for income taxes		282,929			771,000
Supplemental schedule of noncash operating activity:
Cumulative effect of FIN 48 adoption		$	32,000		$	—
Supplemental schedule of noncash investing activity:
Accrual for estimated earnout payment on business acquisition		$	200,000		$	—
Supplemental schedule of noncash financing activity:
Issuance of Common Stock on a restricted basis		$	—		$	212,040

 

See Accompanying Notes to Condensed Consolidated Financial Statements

7

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

NOTE 1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying condensed unaudited consolidated financial statements for the interim periods have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and in accordance with the rules and regulations of the Securities and Exchange Commission.  Accordingly, they do not include all of the financial information and footnotes required by GAAP for complete financial statements, although we believe the disclosures are adequate to make the information presented not misleading.  These statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2006.  The operating results for the interim periods presented are not necessarily indicative of the results expected for the full year or for any other interim period.  In our opinion, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included.

The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  In preparing these consolidated financial statements, we have made our best estimates and judgments of certain amounts included in the consolidated financial statements, giving due consideration to materiality.  Changes in the estimates and assumptions used by us could have a significant impact on our financial results, since actual results could differ from those estimates.

Summary of Significant Accounting Policies

In preparing the consolidated financial statements in conformity with accounting principles generally accepted in the United States, we must make decisions, which impact the reported amounts and related disclosures. Such decisions include the selection of the appropriate principles to be applied and the assumptions on which to base accounting estimates. In reaching such decisions, we apply judgment based on our understanding and analysis of the relevant circumstances.

The accounting principles followed in the preparation of the condensed consolidated financial information contained on Form 10-Q are the same as those described in our Annual Report on Form 10-K for the year ended December 31, 2006, some of which have been included herein.

Cash and Cash Equivalents

For purposes of reporting cash flows, we consider cash equivalents to be short-term, highly liquid interest-bearing accounts readily convertible to cash.  The carrying amount approximates fair value.

Restricted Cash

As of both June 30, 2007 and December 31, 2006, restricted cash of $427,500 is to be used for the purchase of equipment and facility upgrades at our Blue Earth, Minnesota facility as required by the Industrial Revenue Bond agreement into which we entered on June 28, 2006 to purchase the Blue Earth, Minnesota facility, see Note 4.

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Stock Based Compensation

We have two types of stock-based compensation awards consisting of restricted stock and stock options.  Following is a summary of the key terms and methods of valuation for our stock-based compensation awards.

Restricted Stock

On March 7, 2006, 28,500 shares of restricted common stock were granted to our management and directors.  This benefit was valued at the market price of the stock on the date of grant.  These awards vest over a three-year term and are expensed ratably over the same period.  We recorded compensation expense of $17,475 and $22,075 for the three months ended June 30, 2007 and 2006, respectively.  Total compensation expense related to restricted stock included in the statements of income for the six months ended June 30, 2007 and 2006 was $34,950 and $25,754, respectively.  The following is the status of our restricted shares as of June 30, 2007, including changes during the six months then ended:

		Restricted Shares		Weighted- Average Grant Date Fair Value
Outstanding - January 1, 2007		28,500		$	7.44
Granted		—		—
Outstanding - June 30, 2007		28,500		$	7.44
Exercisable on June 30, 2007		9,500		$	7.44

 

As of June 30, 2007 and 2006, there was approximately $105,000 and $186,000 of unrecognized compensation expense related to unvested restricted stock awards being recognized over a weighted average period of 1.50 years and 2.50 years, respectively.

Stock Options

To calculate the option-based compensation under SFAS 123R, we used the Black-Scholes option-pricing model, which we had previously used for the valuation of option-based awards for our pro forma information required under SFAS 123 for periods prior to fiscal 2006.  Our determination of fair value of option-based awards on the date of grant using the Black-Scholes model is affected by our stock price as well as assumptions regarding a number of subjective variables.  These variables include, but are not limited to, our expected stock price volatility over the term of the awards, risk-free interest rate, and the expected life of the options.  The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected life of our stock options.  The expected volatility, holding period, and forfeitures of options are based on our historical experience.

Total compensation expense related to stock options included in our statements of income for the three months ended June 30, 2007 and 2006 were $46,278 and $32,276, respectively.  Total compensation expense related to stock options included in our statements of income for the six months ended June 30, 2007 and 2006 was $92,556 and $40,453, respectively.  For all grants, the amount of compensation expense to be recognized is adjusted for an estimated forfeiture rate, which is based on historical data.

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Following is the status of our stock option plan as of June 30, 2007, including changes during the six-month period then ended:

		Options		Weighted- Average Exercise Price Per Share			Weighted- Average Remaining Contractual Term (in years)			Aggregate Intrinsic Value
Outstanding – January 1, 2007		391,500		$	6.84
Granted		—		$	—
Exercised		(40,000	)	$	5.00
Forfeited		(2,000	)	$	8.00
Outstanding – June 30, 2007		349,500		$	7.05		$	7.19		$	196,750
Exercisable on June 30, 2007		233,500		$	6.75		$	6.25		$	196,750

 

As of June 30, 2007 and 2006, there was approximately $384,000 and $275,000, respectively, of unrecognized compensation expense related to unvested option awards that we expect to recognize over a weighted average period of 1.98 years and 2.50 years, respectively.  For the six months ended June 30, 2007, there were no options that became vested.

 Segment Reporting Information

Our results of operations for the three months and six months ended June 30, 2007 and 2006 represent a single segment referred to as Contract Manufacturing.  Export sales represented 1% and 2% of consolidated net sales for the three-month and six-month periods ended June 30, 2007, respectively.  Export sales represented 5% of consolidated net sales for the three-month and six-month periods ended June 30, 2006.

Long-lived assets by country are as follows:

		United States			Mexico			Total
June 30, 2007
Net Property and Equipment		$	8,126,352		$	515,283		$	8,641,635
Other Assets		1,925,835			7,726			1,933,561
December 31, 2006
Net Property and Equipment		$	7,700,481		$	554,687		$	8,255,168
Other Assets		862,396			7,726			870,122

 

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Finite Life Intangible Assets

Finite life intangible assets at June 30, 2007 and December 31, 2006 are as follows:

		June 30, 2007
		Estimated		Gross
		Lives		Carrying			Accumulated			Net Book
		(Years)		Amount			Amortization			Value
Deferred Bond Issue Costs		15		$	79,373		$	5,291		$	74,082
Preliminary Estimated Intangible
Value from Acquisition (Note 9)		5		1,143,597			82,350			1,061,247
Other Intangibles		3		37,059			37,059			—
Totals				$	1,260,029		$	124,700		$	1,135,329

 

		December 31, 2006
		Estimated		Gross
		Lives		Carrying			Accumulated			Net Book
		(Years)		Amount			Amortization			Value
Deferred Bond Issue Costs		15		$	79,373		$	2,649		$	76,724
Non-Compete		4		1,526,384			1,526,384			—
Other Intangibles		3		37,059			30,893			6,166
Totals				$	1,642,816		$	1,559,926		$	82,890

 

Amortization expense related to these assets is as follows:

Quarter ended June 30, 2007		$	59,246
Quarter ended June 30, 2006		$	98,474
Six months ended June 30, 2007		$	91,159
Six months ended June 30, 2006		$	196,964

 

Estimated future amortization expense related to these assets is as follows:

Remainder of 2007		$	117,000
2008		234,000
2009		234,000
2010		234,000
2011		234,000
Thereafter		82,000
Total		$	1,135,000

 

As discussed in Note 9, the estimated future amortization expense presented above may change once the final purchase price allocation of the acquisition is completed.

NOTE 2.  PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of Nortech Systems Incorporated (“Nortech”) and its wholly owned subsidiary, Manufacturing Assembly Solutions of Monterrey, Inc.  All significant intercompany accounts and transactions have been eliminated.

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NOTE 3. MAJOR CUSTOMERS AND CONCENTRATION OF CREDIT RISK

Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash and trade accounts receivable.  With regard to cash, we maintain our excess cash balances in checking accounts at three financial institutions.  We do not require collateral on our receivables.  Historically, we have not suffered significant losses with respect to trade accounts receivable.

Two customers accounted for 10% or more of our net sales for the three-month and six-month periods ended June 30, 2007 and 2006.  For the three-month and six-month periods ended June 30, 2007 and 2006, G.E.’s Medical and Transportation Divisions together accounted for 18% and 14% of net sales respectively.  Accounts receivable from G.E.’s Medical and Transportation Divisions at June 30, 2007 and 2006, represented 12% and 13% of total accounts receivable, respectively.  Additionally, Northrop Grumman Corp. accounted for 14% and 15% of net sales for the three-month periods ended June 30, 2007 and 2006, respectively.  For the six-month periods ended June 30, 2007 and 2006, Northrop Grumman Corp. accounted for 14% and 12% of net sales, respectively.  Accounts receivable from Northrop Grumman Corp. at June 30, 2007 and 2006 represented 11% and 16% of total accounts receivable, respectively.

NOTE 4. LONG TERM DEBT

On June 28, 2006, we received $1,440,000 million in exchange for an industrial revenue bond with our trustee, Wells Fargo Bank (WFB), where the City of Blue Earth, Minnesota is issuer of the bond.  The bond, which matures on June 1, 2021, bears a variable interest rate.  In connection with the bond, we have a standby letter of credit of $1,458,000 with WFB of which none has been drawn upon.  The bond agreement contains certain covenants, which, among other things, require us to furnish reports, records, etc. upon request of the trustee and/or issuer as described in the agreement.  With WFB, we entered into an interest rate swap agreement with a notional amount of $1,440,000 million to effectively convert our industrial revenue bond debt from a variable rate to a fixed rate of 4.07% for five years, maturing on June 28, 2011.  The fair value of the swap at June 30, 2007 was recorded as a long-term liability of $14,386.  The bond is payable in annual installments per the agreement with WFB.  Our first bond principal payment on June 1, 2007 was $130,000.  The proceeds of the bond were used to purchase the facility in Blue Earth, Minnesota as well as facility upgrades and equipment to support the Blue Earth operations.

On February 2, 2007, in connection with the acquisition of Suntron’s Midwest Operations located in Garner, Iowa, we entered into a 7th amendment to our credit agreement with WFB, increasing our line of credit arrangement from $10 million to $15 million and extending the maturity date of the line of credit to April 30, 2009.   Additionally, the 7th amendment increased our real estate term note balance of $1,680,555 to $3,348,750 and extended the maturity date to May 31, 2012.  Per the 7th amendment, both the line of credit and real estate term note are subject to variations in LIBOR rates.  The line of credit and other installment debt with WFB contain certain covenants, which, among other things, require us to adhere to regular reporting requirements, abide by annual shareholder dividend limitations, maintain certain financial ratios, and limit the amount of annual capital expenditures.  On June 30, 2007, we had an outstanding balance of $8.6 million under the line of credit and unused availability of $6.0 million supported by the borrowing base level.  The line of credit is secured by substantially all of our assets.

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NOTE 5. NET INCOME PER COMMON SHARE

The following is a reconciliation of the numerators and the denominators of the basic and diluted per common share computations.

		Three Months Ended						Six Months Ended
		June 30,						June 30,
		2007			2006			2007			2006
Basic Earnings Per Common Share
Net income, as reported		$	367,500		$	308,665		$	654.394		$	572,613
Weighted average common shares outstanding		2,695,754			2,619,281			2,685,469			2,618,742
Basis earnings per common share		$	0.14		$	0.12		$	0.24		$	0.22
Diluted Earnings Per Common Share
Net income, as reported		$	367,500		$	308,665		$	654,394		$	572,613
Weighted average common shares outstanding		2,695,754			2,619,281			2,685,469			2,618,742
Effect of Stock options		34,209			58,895			33,769			52,265
Effect of Restricted stock		5,691			4,068			5,570			12,580
Weighted average common shares for diluted earnings per common share		2,735,654			2,682,244			2,724,808			2,683,587
Diluted earnings per common share		$	0.13		$	0.11		$	0.24		$	0.21

 

For the six-month periods ended June 30, 2007 and 2006, 51,373 and 26,159 shares, respectively, were excluded from the computation of diluted earnings per share because to include them would be antidilutive.

NOTE 6. FOREIGN CURRENCY TRANSLATION

Local currency is considered the functional currency for operations outside the United States.  Assets and liabilities are translated at period-end exchange rates.  Income and expense items are translated at average rates of exchange prevailing during the period.  Translation adjustments are recorded as a component of accumulated other comprehensive loss in shareholders’ equity.  Foreign currency exchange transaction gains and losses attributable to exchange rate movements on intercompany receivables and payables not deemed to be of a long-term investment nature are recorded in miscellaneous income (expense).  The Mexican peso is the only foreign currency being translated.

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NOTE 7. COMPREHENSIVE INCOME

Comprehensive income is comprised of net income and other comprehensive income (loss).  Other comprehensive income (loss) includes gains and losses resulting from foreign currency translations.  The details of comprehensive income are as follows:

		Three Months Ended						Six Months Ended
		June 30, 2007			June 30, 2006			June 30, 2007			June 30, 2006
Net Income, as reported		$	367,500		$	308,665		$	654,394		$	572,613
Other Comprehensive Income (Loss):
Currency Translation Adjustment		11,083			(10,746		)	984			(20,001		)
Comprehensive Income		$	378,583		$	297,919		$	655,378		$	552,612

 

NOTE 8.  RECENTLY ISSUED ACCOUNTING STANDARDS

We adopted the provisions of FASB Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement 109”, on January 1, 2007.  As required by FIN 48, we recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit.  For tax positions meeting the more-likely-than-not threshold, the amount recognized in the financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant tax authority.  At the adoption date, we applied FIN 48 to all tax positions for which the statute of limitations remained open.  As a result of the implementation of FIN 48, we recognized $32,000 in the liability for unrecognized income tax benefits, which is included in income taxes payable, as a cumulative change to opening retained earnings as prescribed.  We have also recorded an additional $5,000 of income taxes payable and expense for unrecognized 2007 income tax benefits.

The $32,000 of unrecognized tax benefits as of January 1, 2007 and the additional $5,000 as of June 30, 2007, includes unrecognized tax benefits, which, if ultimately recognized, will reduce our annual effective tax rate.

We are subject to income taxes in the U.S. federal jurisdiction and various state jurisdictions.  Tax regulations within each jurisdiction are subject to the interpretation of the related tax laws and regulations and require significant judgment to apply.  With few exceptions, we are no longer subject to U.S. federal, state or local income tax examinations by tax authorities for the years before 2003.  We are not currently under examination by any taxing jurisdiction.

In September 2006, the FASB issued SFAS No. 157 (SFAS 157), “Fair Value Measurements”.  SFAS 157 establishes a common definition for fair value to be applied to U.S. GAAP guidance requiring use of fair value, establishes a framework for measuring fair value, and expands disclosure about such fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. We are currently assessing the impact of SFAS 157 on its consolidated financial position and results of operations.

In February 2007, the FASB issued SFAS No. 159 (SFAS 159), “The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115”.  SFAS 159 allows organizations to measure and report the fair market value of many financial instruments and certain other items. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of adopting SFAS 159 on our consolidated financial statements.

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NOTE 9.  ACQUISITION

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

The following table presents further information on the aforementioned business acquisition and the preliminary estimate of the allocation of the purchase price.  Because the acquisition was recently completed the estimated allocation of purchase is preliminary in nature.  The purchase agreement calls for a contingent earn-out of up to $600,000 if certain revenue levels are achieved.  Based on our review of both actual and projected revenue levels of the acquired business, we believe it is probable that $200,000 of the possible earn-out payment will be earned. Accordingly, at June 30, 2007, such amount has been recorded in other accrued liabilities and accounted for as additional consideration. At the conclusion of the earn-out period on December 31, 2007, we will reassess this contingency and adjust the accrued earn-out accordingly.

Assets acquired and liabilities assumed:

Accounts receivable		$	1,981,000
Inventories		2,283,000
Other current assets		88,000
Property, plant and equipment		412,000
Finite lived intangibles		944,000
Accounts payable assumed		(819,000		)
Accrued compensation and
other liabilities assumed		(81,000		)
Cash consideration paid		4,808,000
Accrual for estimated earnout payment		200,000
Net assets acquired and liabilities assumed		$	5,008,000

 

The finite life intangibles have been estimated to include non-competition agreements and a customer base, which are being amortized over an estimated life of five years.

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The table below reflects our unaudited pro forma combined results of operations as if the acquisition had taken place as of January 1, 2006:

		Pro Forma						Pro Forma
		Three Months Ended						Six Months Ended
		June 30, 2007			June 30, 2006			June 30, 2007			June 30, 2006
		(unaudited)						(unaudited)
Net Sales		$	31,136,000		$	29,584,000		$	60,289,000		$	58,861,000
Net Income		$	368,000		$	399,000		$	631,000		$	732,000
Basic earnings per common share		$	0.14		$	0.15		$	0.23		$	0.28
Diluted earnings per common share		$	0.13		$	0.15		$	0.23		$	0.27

 

The pro forma unaudited results do not purport to be indicative of the results which would have been obtained had the acquisition been completed as of the beginning of the earliest period presented.  Furthermore, the purchase price allocation is preliminary and subject to change.  Once the final purchase price allocation is determined, the unaudited pro forma combined results of operations presented above may change.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview:

We are a Wayzata, Minnesota based full-service Electronics Manufacturing Services (EMS) contract manufacturer of wire and cable assemblies, printed circuit board assemblies, higher-level assemblies and box builds for a wide range of industries.  Major markets served include industrial equipment and transportation, medical and military/defense. We have operating facilities in Baxter, Bemidji, Blue Earth, Fairmont and Merrifield, Minnesota, Garner, Iowa, Augusta, Wisconsin, and Monterrey, Mexico.

Summary:

For the quarter ended June 30, 2007, we reported net sales of $31.1 million, up 19% over the $26.2 million we reported in the same quarter of 2006.  For the six months ended June 30, 2007, we reported net sales of $59.1 million, up 13% over the $52.2 million we reported for the first six months of 2006.  Our sales increase was primarily attributed to our acquisition during the year, with the new Garner, Iowa facility accounting for $6.1 million of the increase in the first six months.  The gross profit percentage was 14% and 13% for the second quarters of 2007 and 2006, respectively.  For the first six months of 2007 and 2006, the gross profit percentage was 13%.  Income from operations for the second quarter of 2007 totaled $840,154, an increase of 34% above the $627,499 reported in the second quarter of 2006.  Income from operations for the first six months of 2007 totaled $1,491,533, an increase of 21% above the $1,228,469 reported in the first six months of 2006.  Net income for the second quarter of 2007 totaled $367,500, or $0.13 per diluted common share, is up 19% compared to $308,665, or $0.11 per diluted common share, reported in the second quarter of 2006.  Net income for the first six months of 2007 totaled $654,394, or $0.24 per diluted common share, and was above the $572,613, or $0.21 per diluted common share, reported in the first six months of 2006.

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(1.)         Results of Operations:

The following table presents statement of operations data as percentages of total revenues for the periods indicated:

		Three Months Ended				Six Months Ended
		June 30,				June 30,
		2007		2006		2007		2006
Net Sales		100	%	100	%	100	%	100	%
Cost of Good Sold		86	%	87	%	87	%	87	%
Gross Profit		14	%	13	%	13	%	13	%
Selling Expenses		4	%	5	%	4	%	4	%
General and Administrative Expenses		7	%	6	%	6	%	6	%
Income from Operations		3	%	2	%	3	%	3	%
Other Expenses, Net		1	%	1	%	1	%	1	%
Income Tax Expense		1	%	0	%	1	%	1	%
Net Income		1	%	1	%	1	%	1	%

 

Net Sales:

We reported net sales of $31.1 million and $26.2 million for the second quarter ended June 30, 2007 and 2006, respectively, a 19% increase year over year.  The increase in net sales of $4.9 million for the second quarter is attributable to the acquisition of the Garner, Iowa Electronic Circuit Board Assemblies facility accounting for $4.1 million of the increase, our Merrifield, Minnesota Electronic Circuit Board Assemblies facility accounting for $0.8 million of the increase, and our Aerospace Systems sales was up $0.3 million and these increases were offset by a slight decline in our Cable and Wire sales of $0.3 million.  We reported net sales of $59.1 million and $52.2 million for the six months ended June 30, 2007 and 2006, respectively.  The increase in net sales of $6.9 million for the first six months is due to the acquisition of the Garner, Iowa Electronic Circuit Board Assemblies facility of $6.1 million and our Merrifield, Minnesota Electronic Circuit Board Assemblies facility of $1.1 million, while our Cable and Wire, and Aerospace Systems sales remained relatively flat to last year.  Our 90-day order backlog as of June 30, 2007 was approximately $22.6 million, compared to approximately $26.7 million at the beginning of the quarter. Our Garner, Iowa facility accounts for approximately $2.7 million of the backlog at both the end and the beginning of the quarter or about 12% and 10% of the backlog, respectively.

Gross Profit:

Our gross profit for the second quarter of 2007 was $4.3 million or 14% of net sales compared to gross profit of $3.4 million or 13% of net sales for the second quarter of 2006. A favorable mix of product and manufacturing cost improvements account for the gross profit percentage improvement. Our gross profit for the first six months of 2007 was $7.9 million compared to gross profit of $6.6 million for the first six months of 2006, both representing 13% of net sales.

Selling Expense:

We had selling expenses of $1.4 million or 4% of net sales for the second quarter of 2007 compared to $1.1 million or 5% of net sales for the second quarter of 2006.  For the first six months ended June 30, 2007 and 2006, we had selling expenses of $2.6 million and $2.2 million, respectively, representing 4% of net sales.  The selling expenses for the quarter and first six months were relatively flat as we spend at the rate of growth and continue to invest in sales infrastructure and expand marketing initiatives in order to maintain a high level of customer service and support.

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General and Administrative Expense:

Our general and administrative expenses were $2.0 million or 7% of net sales for the second quarter of 2007 and $1.7 million or 6% of net sales reported for the second quarter of 2006. The increase in general and administrative expenses for the quarter of $0.3 million was a result of $0.2 million for the support of our new Garner, Iowa facility and $0.1 million in personnel and related costs to support the business.  For the first six months ended June 30, 2007 and 2006, we had general and administrative expenses of $ 3.8 million and $3.1 million, respectively, representing 6% of net sales.  The increase in general and administrative expenses for the first six months of $0.7 million was a result of $0.3 million for the support of our new Garner, Iowa facility, $0.3 million in personnel and related costs to support the business and $0.1 million due to increased compliance costs and higher share based compensation expenses over the prior year.

Other Expense:

Other expenses, net were $287,654 for the quarter ended June 30, 2007 compared to $180,834 for the second quarter of 2006.  Other expenses, net were $513,139 for the six months ended June 30, 2007 compared to $350,856 for the first six months of 2006.  The increase in interest expense for the quarter and the first six months of $69,440 and $121,483 resulted from increased debt levels related to the acquisition above as well as the Blue Earth, Minnesota expansion that occurred in June 2006.  Higher interest rates have also impacted overall interest charges compared to prior year.  For the quarter and the first six months, interest income was positively impacted by $5,493 and $12,713, respectively, as the result of carrying the $427,500 of restricted cash related to the Blue Earth, Minnesota expansion.  The remaining miscellaneous expense increase from 2006 resulted from experiencing less favorable currency exchange rates.

Income Tax:

Income tax expense for the three months ended June 30, 2007 was $185,000, compared to an income tax expense of $138,000 for the three months ended June 30, 2006.  Income tax expense for the six months ended June 30, 2007 was $324,000 compared to an income tax expense of $305,000 for the six months ended June 30, 2006.  The effective tax rate for 2007 is expected to approximate 33%, and the effective rate for 2006 was 30% due to the recognition of tax credits and other tax adjustments that occurred during 2006.

(2.) Liquidity and Capital Resources:

We have satisfied our liquidity needs over the past several years through revenue generated from operations and an operating line of credit through Wells Fargo Bank, N.A. (WFB).  On February 2, 2007, we entered into a 7th amendment to our credit agreement with WFB increasing our line of credit arrangement from $10 million to $15 million and extending the maturity date of the line of credit to April 30, 2009.  Additionally, the 7th amendment increased our real estate term note balance of $1,680,555 at February 2, 2007 to $3,348,750 and extended the maturity date to May 31, 2012.  Per the 7th amendment, both the line of credit and real estate term note are subject to variations in the LIBOR rates. The 7th amendment funded the Iowa acquisition on February 4, 2007.

The line of credit and other installment debt with WFB contain certain covenants, which, among other things, require us to adhere to regular reporting requirements, abide by annual shareholder dividend limitations, maintain certain financial ratios, and limit the amount of annual capital expenditures.  The availability under the line is subject to borrowing base requirements, and advances are at the discretion of the lender.  The line is secured by substantially all of our assets.  On June 30, 2007, we had an outstanding balance of $8.6 million under the line of credit and unused availability of $6.0 million supported by our borrowing base level.

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