NORTECH SYSTEMS INC

CONDENSED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

(UNAUDITED)

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

***Basis of Presentation and Principles of Consolidation ***

The accompanying unaudited condensed consolidated financial statements for the interim periods have been prepared in accordance with Generally Accepted Accounting Principles in the United States of America (“GAAP”) for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, the Company has omitted footnote disclosures that would substantially duplicate the disclosures contained in the Company’s audited consolidated financial statements. These unaudited condensed consolidated financial statements should be read together with the audited consolidated financial statements for the year ended December 31, 2023, and notes thereto included in our Annual Report on Form 10-K as filed with the SEC.

The condensed consolidated financial statements include the accounts of Nortech Systems Incorporated and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. All dollar amounts are stated in thousands of U.S. dollars.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of our consolidated financial statements. Estimates also affect the reported amounts of net sales and expenses during each reporting period. Significant items subject to estimates and assumptions include the valuation allowance for inventories, accounts receivable allowances, realizability of deferred tax assets and long-lived asset recovery. Actual results could differ from those estimates.

Recently Issued New Accounting Standards

In November 2023, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”)2023-07, Segment Reporting Topic (280):Improvements to Reportable Segment Disclosure. The ASU supplements reportable segment disclosure requirements, primarily through enhanced disclosures about significant segment expenses. The amendments in this ASU are effective for fiscal years beginning after December 15, 2023, and interim periods within fiscal years beginning after December 15, 2024 on a retrospective basis. Early adoption is permitted. The Company is currently evaluating the impact of this ASU on its Consolidated Financial Statements and related disclosures.

In December 2023, the FASB issued ASU 2023-09, Income Taxes (Topic 740):Improvements to Income Tax Disclosures. The ASU enhances the transparency and decision usefulness of income tax disclosures and is effective for annual periods beginning after December 15, 2024 on a prospective basis. Early adoption is permitted. The Company is currently evaluating the impact of this ASU on its Consolidated Financial Statements and related disclosures.

Out-of-Period Correction

During the first quarter of 2024, we identified an error that understated our accrued liabilities by approximately $178 as of December 31, 2023. We corrected the error on a prospective basis during the first quarter of 2024 through an out of period adjustment lowering our net income by $178 in both the three and six months ended June 30, 2024. We assessed the materiality of the error and concluded that the error was not material to the results of operations or financial condition or for the prior annual and interim periods, and the correction is not expected to be material to the full year results for fiscal year 2024.

Inventories

Inventories are as follows:

Other Intangible Assets

Other intangible assets as of June 30, 2024 and December 31, 2023 are as follows:

Intangible assets are amortized on a straight-line basis over their estimated useful lives. The weighted average remaining amortization period of our intangible assets is 5.5 years. Of the patents value as of June 30, 2024, $98 are being amortized and $85 are in process and a patent has not yet been issued.

Amortization expense of finite life intangible assets for both the three months ended June 30, 2024 and 2023 was $40. Amortization expense of finite life intangible assets for both the six months ended June 30, 2024 and 2023 was $80.

As of June 30, 2024, estimated future annual amortization expense (except projects in process) related to these assets is as follows:

NOTE 2. CONCENTRATION OF CREDIT RISK AND MAJOR CUSTOMERS

Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash, accounts receivable, and contract assets. With regard to cash, we maintain our excess cash balances in checking accounts at primarilytwo financial institutions, one in the United States andone in China. The account in the United States may at times exceed federally insured limits. The Company’s $1,542 cash balance as of June 30, 2024 included approximately $1,141 and $32 that was held at banks located in China and Mexico, respectively. We grant credit to customers in the normal course of business and generally do not require collateral on our accounts receivable.

We have certain customers whose revenue individually represented 10% or more of net sales, or whose accounts receivable balances individually represented 10% or more of gross accounts receivable. One customer accounted for 26% and 25% of net sales for the three and six months ended June 30, 2024, respectively. Two customers accounted for 39% of net sales for both the three and six months ended June 30, 2023.

As of June 30, 2024, three customers represented approximately 39% of our gross accounts receivable. As of December 31, 2023, two customers represented approximately 35% of our gross accounts receivable.

Contract assets forthree customers accounted for 43% of gross contract assets as of June 30, 2024. Contract assets fortwo customers accounted for 34% of gross contract assets as of December 31, 2023.

Export sales from the U.S. represented approximately 3% and 2% of net sales for the three and six months ended June 30, 2024, respectively. Export sales represented approximately 3% of net sales for both three and six month ended June 30, 2023.

NOTE 3. REVENUE

Revenue Recognition

Revenue under contract manufacturing agreements that was recognized over time accounted for approximately 74% of net sales for both the three and six months ended June 30, 2024 and approximately 73% and 74% of net sales for the three and six months ended June 30, 2023, respectively.

The following tables summarize our net sales by market for the three months ended June 30, 2024 and 2023, respectively:

The following tables summarize our net sales by market for the six months ended June 30, 2024 and 2023, respectively:

Contract Assets

Contract assets, recorded as such in the Condensed Consolidated Balance Sheet, consist of unbilled amounts related to revenue recognized over time. Significant changes in the contract assets balance during the six months ended June 30, 2024 were as follows:

We expect substantially all of the remaining performance obligations for the contract assets recorded as of June 30, 2024 to be transferred to receivables within 90 days, with any remaining amounts to be transferred within 180 days. We bill our customers upon shipment with payment terms of up to 120 days.

NOTE 4. FINANCING ARRANGEMENTS

We had a credit agreement with Bank of America, which was entered into on June 15, 2017 and provides for a line of credit arrangement of $16,000 that was to expire on June 15, 2026.

On February 29, 2024, we replaced the asset backed line of credit agreement with a $15,000 Senior Secured Revolving Line of Credit with Bank of America (the “Revolver”). The Revolver allows for borrowings at a defined base rate, or at the one, three or six month Secured Overnight Finance Rate, also known as “SOFR”, plus a defined margin. If the Company prepays SOFR borrowings before their contractual maturity, the Company has agreed to compensate the bank for lost margin, as defined in the Revolver agreement. The Company is required to quarterly pay a 20-basis point fee on the unused portion of the Revolver.

The Revolver requires the Company to maintain no more than 2.5 times leverage ratio and at least a 1.25 times minimum fixed charges coverage ratio, both of which are defined in the Revolver agreement. The Company met the covenants for the period ended June 30, 2024. There are no subjective acceleration clauses under the Revolver that would accelerate the maturity of outstanding borrowings. The Revolver contains certain covenants which, among other things, require the Company to adhere to regular reporting requirements, abide by shareholder dividend limitations, maintain certain financial performance, and limit the amount of annual capital expenditures. The Revolver is secured by substantially all the Company’s assets and expires on February 28, 2027. We were in compliance with all the financial covenants related to this agreement as of and for the period ended June 30, 2024, except for the covenant related to operating expense contributions to our Mexican operations in excess of the amounts allowed under the Revolver. We have received a waiver of this event of default from the bank.

Under the amended Bank of America credit agreement signed February 29, 2024, the line of credit is subject to variations in the SOFR index rate. Under the prior credit agreement with Bank of America, the line of credit borrowing availability was restricted by a defined asset borrowing base, and interest was based on variations in the Bloomberg Short-Term Bank Yield (BSBY) index rate. Our line of credit bears interest at a weighted-average interest rate of 8.0% and 8.3% as of June 30, 2024 and December 31, 2023, respectively. We had borrowings on our line of credit of $8,360 and $5,846 outstanding as of June 30, 2024 and December 31, 2023, respectively. As of June 30, 2024 we had unused availability on the line of credit of $6,440.

The line of credit is shown net of debt issuance costs of $46 and $31 on the condensed consolidated balance sheet as of June 30, 2024 and December 31, 2023, respectively.

NOTE 5. LEASES

We have operating leases for certain manufacturing sites, office space, and equipment. Most leases include the option to renew, with renewal terms that can extend the lease term fromone tofive years or more. Right-of-use lease assets and lease liabilities are recognized at the commencement date based on the present value of the remaining lease payments over the lease term which includes renewal periods we are reasonably certain to exercise. Our leases do not contain any material residual value guarantees or material restrictive covenants. As of June 30, 2024, we do not have material lease commitments that have not commenced. We extended our operating leases for part of our manufacturing facility in China and our corporate office in Maple Grove, MN during the first six months of 2024 which extended the lease through August of 2033 with monthly lease payments of $14 to $18.

The components of lease expense were as follows:

Supplemental condensed consolidated balance sheet information related to leases was as follows:

Supplemental condensed consolidated statement of cash flows information for the six months ended June 30, 2024 related to leases was as follows:

Future payments of lease liabilities as of June 30, 2024 were as follows:

The lease term and discount rate as of June 30, 2024 were as follows:

NOTE 6. STOCK BASED AWARDS

Stock-based compensation expense was reported as follows in the condensed consolidated statements of income within general and administrative expenses of $126 and $93 for the three months ended June 30, 2024 and 2023, respectively and $206 and $192 for the six months ended June 30, 2024 and 2023, respectively.

Stock Options

In May 2017, the shareholders approved the 2017 Stock Incentive Plan which authorized the issuance of 350,000 shares. An additional 50,000,175,000 100,000 and 100,000 shares were authorized in March 2020, May 2022, May 2023 and May 2024, respectively.

We granted 22,000 service-based stock options during the three and six months ended June 30, 2024. The weighted-average grant-date fair value of options granted during the six months ended June 30, 2024 was $8.22. We granted 29,000 service-based stock options during the three and six months ended June 30, 2023. Weighted average stock option fair value assumptions and the weighted average grant date fair value of stock options granted were as follows:

Total compensation expense related to stock options was $65 and $121 for the three and six months ended June 30, 2024, respectively. Total compensation expense related to stock options was $55 and $123 for the three and six months ended June 30, 2023, respectively. As of June 30, 2024, there was $844 of unrecognized compensation related to stock options which will be recognized over a weighted average period of 3.8 years.

Following is the status of option activity for the six months ended and as of June 30, 2024:

Restricted Stock Units

During the three and six month periods ended June 30, 2024 and 2023, we granted 15,141 and 18,000 restricted stock units (“RSUs”), respectively, at an average grant price per share of $11.06 and $9.37, respectively, under our 2017 Stock Incentive Plan to non-employee directors which vest overtwo years. Total compensation expense related to the RSUs was $61 and $85 for the three and six months ended June 30, 2024 and 2023, respectively. Total compensation expense related to the RSUs was $38 and $69 for the three and six months ended June 30, 2023, respectively. As of June 30, 2024, total unrecognized compensation expense related to the RSUs was $220, which will vest over a weighted average period of 0.9 years.

Following is the status of restricted stock activity for the six months ended and as of June 30, 2024:

NOTE 7. NET INCOME PER SHARE DATA

Basic net income per common share is calculated by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per common share is computed by dividing net income by the weighted average number of common shares outstanding using the treasury stock method during the period. The Company’s potentially dilutive common shares are those that result from dilutive common stock options and non-vested stock relating to restricted stock units.

The calculation of diluted income per shared excluded 31,611 and 45,453 in weighted average shares for the three and six months ended June 30, 2024, respectively, and 60,728 and 47,182 in weighted average shares for the three and six months ended June 30, 2023, respectively, as their effect was anti-dilutive. Basic and diluted weighted average shares outstanding were as follows:

NOTE 8. INCOME TAXES

On a quarterly basis, we estimate what our effective tax rate will be for the full fiscal year and record a quarterly income tax provision based on the anticipated rate. As the year progresses, we refine our estimate based on the facts and circumstances, including discrete events.

Our effective tax rate for the three and six months ended June 30, 2024 was 12% and 21%, respectively. Our effective tax rate for the three and six months ended June 30, 2023 was 35% and 31%. The decrease in the effective tax rate is attributable to the application of a valuation allowance during the three and six month periods ended June 30, 2023 and inclusion of estimated research and development tax credits in the three and six months ended June 30, 2024, partially offset by increased taxes on foreign entities.

NOTE 9. RESTRUCTURING CHARGES

During the first six months of 2024, we accrued restructuring charges of $91 related to the closure and consolidation of our Blue Earth, Minnesota production facility, which is planned to be completed in the fourth quarter of 2024. There were no restructuring charges or amounts accrued in the six months ended June 30, 2023.

**NOTE 10. PAYROLL TAX DEFERRAL **

On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) was signed into law which allowed for the deferral of the employer portion of social security taxes incurred through the end of calendar 2020. During the year ended December 31, 2023, the Company remitted $1,158 to the Internal Revenue Service (“IRS”) related to the deferral of payroll taxes, of which $785 was recorded as a refund receivable as of December 31, 2023, with a corresponding liability due. These amounts were settled during the first quarter of 2024.

NOTE 11. RELATED PARTY TRANSACTIONS

David Kunin, our Chairman, is a minority owner of Abilitech Medical, Inc. We have accounts receivable related to Abilitech of $85. Abilitech has ceased operations and therefore we do not believe that Abilitech will pay the Company for outstanding accounts receivable, and we have recorded a full allowance against the gross amount. The Company believes that transactions with Abilitech were on terms comparable to those that the Company could reasonably expect in an arm’s length transaction with an unrelated third party.

David Kunin, our Chairman, is a minority owner (less than 10%) of Marpe Technologies, LTD an early-stage medical device company dedicated to the early detection of skin cancer through full body scanners. Mr. Kunin is also a member of the Board of Directors of Marpe Technologies. The Company has an agreement with Marpe Technologies to apply for a grant from the Israel-United States Binational Industrial Research and Development Foundation, a legal entity created by Agreement between the Government of the State of Israel and the Government of the United States of America (“BIRD Foundation”). The parties were successful in receiving approval for a $1,000 conditional grant. The Company and Marpe Technologies will each receive $500 from the BIRD Foundation and, among other obligations under the grant, each is required to contribute $500 to match grant funds from the BIRD Foundation. The Company has met its obligation by providing certain services at cost or with respect to administrative services at no cost to Marpe Technologies. The total value of the Company’s contribution will not exceed $500. Marpe is engaged in raising funds for its operations, which funds are necessary to pay for the Company’s services beyond its contribution. The Company will receive a 10-year exclusive right to manufacture the products of Marpe Technologies. There can be no assurances that Marpe Technologies’ medical device operations will be commercially successful, that Marpe Technologies will be successful in raising additional funds to finance its operations or, if commercially successful, the Company will recover the value of services provided to Marpe if not paid when the services are provided. The transactions between the Company and Marpe Technologies have been approved by the Audit Committee pursuant to the Company Related-Party Transactions Policy. During the three and six months ended June 30, 2024 and 2023, we recognized net sales to Marpe Technologies of $0 and $67, respectively. As of June 30, 2024 and December 31, 2023, we have recorded an unbilled receivable of $21 and $39, respectively, related to expected reimbursement from the BIRD Foundation and have outstanding accounts receivable of $0 and $20, respectively. The Company believes that transactions with Marpe are on terms comparable to those that the Company could reasonably expect in an arm’s length transaction with an unrelated third party.