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TMCNet:  COMMUNICATIONS SYSTEMS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

[August 07, 2014]

COMMUNICATIONS SYSTEMS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) Overview Communications Systems, Inc. provides physical connectivity infrastructure and services for global deployments of broadband networks through the following business units: • Suttle manufactures and markets copper and fiber connectivity systems, enclosure systems, xDSL filters and splitters, and active technologies for voice, data and video communications under the Suttle brand in the United States and internationally; • Transition Networks manufactures network interface devices (NIDs), media converters, network interface cards (NICs), Ethernet switches, and other connectivity products that offer customers the ability to affordably integrate fiber optics into any data network; and • JDL Technologies provides technology solutions including virtualization, managed services, wired and wireless network design and implementation, HIPAA-compliant IT services, and converged infrastructure configuration and deployment.


Second Quarter 2014 Summary • Consolidated sales rose 4% to $33.2 million from $31.9 million in Q2 2013.

† Suttle sales grew 37% from Q2 2013 † Transition Networks sales rose 11% from Q2 2013 † JDL Technologies sales declined 65% from Q2 2013 • Gross profit improved to $12.1 million, or 36.4% of revenues, from $11.5 million, or 36.1% of revenues, in Q2 2013.

• Operating income was $2.4 million compared to $2.6 million in Q2 2013.

† Suttle operating income grew $1.8 million to $2.9 million † Transition Networks declined $0.3 million to an operating loss of $0.2 million † JDL Technologies declined $1.6 million to an operating loss of $0.3 million • Net income was $1.4 million, or $0.17 per diluted share, compared to net income of $1.6 million, or $0.19 per diluted share, in Q2 2013.

• At June 30, 2014, cash, cash equivalents, and investments were $31.5 million.

19 -------------------------------------------------------------------------------- Table of Contents Forward-looking statements In this report and, from time to time, in reports filed with the Securities and Exchange Commission, in press releases, and in other communications to shareholders or the investing public, the Company may make "forward looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 concerning possible or anticipated future financial performance, business activities, plans, pending claims, investigations or litigation which are typically preceded by the words "believes," "expects," "anticipates," "intends" or similar expressions. For these forward-looking statements, the Company claims the protection of the safe harbor for forward-looking statements contained in federal securities laws. Shareholders and the investing public should understand that these forward-looking statements are subject to risks and uncertainties that could cause actual performance, activities, anticipated results, outcomes or plans to differ significantly from those indicated in the forward-looking statements. These risks and uncertainties include, but are not limited to: General Risks and Uncertainties; • The success of the holding company restructuring plan that we implemented in September 2013; • the ability of the CSI parent to oversee the Company's three operating units function in an efficient and cost-effective manner; • the ability of our three business operating units to operate profitably; and • the impact of changing economic circumstances on government expenditures in our markets.

Suttle Risks and Uncertainties: • Suttle's dependence upon its sales to major communication service providers and their continued investment and deployment into building out their networks; • Suttle's ability to continue to introduce and sell new G.hn products and FTTx (fiber-to-the-home or node) products; and • the continued recovery of the housing market in the United States.

Transition Networks Risks and Uncertainties: • The ability of Transition Networks to develop and introduce new products into new and existing markets at a level adequate to counter the decline from its traditional products and markets; • Transition Networks' ability to profitably penetrate certain international markets.

JDL Technologies Risks and Uncertainties: • JDL's ability to continue to obtain business from its traditional South Florida school districts; • JDL's ability to profitably expand outside its South Florida education market to small and medium sized commercial businesses; and • JDL's ability to establish and maintain a productive and efficient workforce in light of revenues that have fluctuated significantly from period to period, in part due to the uncertainty and timing of federal government funding of school initiatives.

In addition, the Company will discuss other factors from time to time in its filings with the Securities and Exchange Commission, including risk factors presented under Item 1A of the Company's most recently filed annual report on Form 10-K or quarterly reports on Form 10-Q.

20 -------------------------------------------------------------------------------- Table of Contents Company Results Three Months Ended June 30, 2014 Compared to Three Months Ended June 30, 2013 Consolidated sales increased 4% in 2014 to $33,209,000 compared to $31,937,000 in 2013. Consolidated operating income in 2014 decreased to $2,406,000 compared to $2,567,000 in the second quarter of 2013. Net income in 2014 decreased to $1,437,000 or $0.17 per share compared to $1,639,000 or $0.19 per share in the second quarter of 2013.

Method of Presentation Effective January 1, 2014, the Company realigned the financial reporting for its business units to reflect its move to a holding company business structure that supports self-sustaining business units and to provide increased focus on opportunities to cut indirect corporate charges. As a result of this realignment, all corporate general and administrative expenses that were previously categorized as "Other" in Company financial statements are now included within the business unit level as fully allocated costs in this Form 10-Q. The Company has reclassified its 2013 results to conform to this new format.

Suttle Results Suttle sales increased 37% in the second quarter of 2014 to $19,006,000 compared to $13,852,000 in the same period of 2013 due to revenue generated from new FTTx (fiber to the home or node) product platforms. Sales by customer groups in the second quarter of 2014 and 2013 were: Suttle Sales by Customer Group 2014 2013 Communication service providers $ 15,964,000 $ 10,630,000 Distributors 1,573,000 1,580,000 International 1,314,000 1,536,000 Other 155,000 106,000 $ 19,006,000 $ 13,852,000 Suttle's sales by product groups in second quarter of 2014 and 2013 were: Suttle Sales by Product Group 2014 2013 Modular connecting products $ 3,176,000 $ 3,549,000 Structured cabling products 8,499,000 6,372,000 DSL products 1,811,000 2,369,000 FTTx products 5,363,000 510,000 Other products 157,000 1,052,000 $ 19,006,000 $ 13,852,000 Sales to the major communication service providers increased 50% in 2014 due to growth in core high-speed copper connectivity products and success in securing new business in multiple FTTx domains. Sales to major communication service providers accounted for 84% of Suttle's sales in the second quarter of 2014 compared to 77% of sales in 2013. Sales to distributors remained flat in 2014.

This customer segment accounted for 8% and 11% of sales in the second quarters of 2014 and 2013, respectively. International sales decreased 14% and accounted for 7% of Suttle's second quarter 2014 sales, due to a reduction in revenue from Austin Taylor legacy products, in part due to the Company's termination of a non-profitable OEM contract.

21 -------------------------------------------------------------------------------- Table of Contents Sales of structured cabling products increased 33%. Sales of DSL products decreased 24% and modular connecting products sales decreased 11% due to shifts in technology.

Suttle's gross margin increased 62% in the second quarter of 2014 to $6,275,000 compared to $3,862,000 in the same period of 2013. Gross margin as a percentage of sales increased to 33% from 28% in the same period of 2013 due to the introduction of new FTTx products, focused value engineering and cost optimization efforts, and economies of scale. Selling, general and administrative expenses increased 23% to $3,358,000 in the second quarter of 2014 compared to $2,727,000 in the same period in 2013 due to investment and recruitment of expertise in sales, operations, technology, product management, and engineering. Suttle's operating income was $2,917,000 in the second quarter of 2014 compared to $1,135,000 in 2013.

Transition Networks Results Transition Networks sales increased 11% to $11,567,000 in the second quarter of 2014 compared to $10,462,000 in 2013 due to increased activity in the North American and Rest of World markets. Transition Networks organizes its sales force by channel to market and segments its customers geographically. Second quarter sales by region are presented in the following table: Transition Networks Sales by Region 2014 2013 North America $ 8,215,000 $ 7,332,000 Europe, Middle East, Africa ("EMEA") 1,115,000 1,257,000 Rest of World 2,237,000 1,873,000 $ 11,567,000 $ 10,462,000 The following table summarizes Transition Networks' 2014 and 2013 second quarter sales by its major product groups: Transition Networks Sales by Product Group 2014 2013 Media converters $ 7,181,000 $ 6,249,000 Ethernet switches 1,484,000 1,368,000 Ethernet adapters 958,000 796,000 Other products 1,944,000 2,049,000 $ 11,567,000 $ 10,462,000 Sales in North America increased 12% or $883,000 due to improving conditions at key customers. International sales increased $222,000, or 7%, mainly due to increased sales in Latin America. Sales of media converters increased 15% or $932,000 due to several North and Latin America projects that closed in the quarter.

Gross margin on second quarter Transition Networks' sales decreased 5% to $5,386,000 in 2014 from $5,675,000 in 2013. Gross margin as a percentage of sales decreased to 47% in 2014 from 54% in 2013 due to unfavorable product mix and pricing pressure. Selling, general and administrative expenses increased 1% to $5,609,000 in 2014 compared to $5,572,000 in 2013 due to additional costs associated with the closing of our China facility. Operating loss was $223,000 in 2014 compared to operating income of $103,000 in 2013.

22 -------------------------------------------------------------------------------- Table of Contents JDL Technologies, Inc. Results JDL Technologies, Inc. sales decreased 65% to $2,635,000 in the second quarter of 2014 compared to $7,623,000 in 2013.

JDL's revenues by customer group were as follows: JDL Revenue by Customer Group 2014 2013 Broward County FL schools $ 2,025,000 $ 3,205,000 Miami Dade County FL schools 0 3,970,000 All other 610,000 448,000 $ 2,635,000 $ 7,623,000 Revenues earned from Broward County Public Schools, Florida decreased $1,180,000 or 37% in the second quarter of 2014 as compared to the 2013 second quarter due to the Federal government's decision to withhold all priority two E-Rate funding for the current fiscal year, which required the district to find alternate funding sources for planned projects. Revenues earned from Miami-Dade County Public Schools in the second quarter of 2013 are related to the district's "Bringing Wireless to the Classroom" initiative for which the district received federal funding under the E-Rate program to expand wireless connectivity for students and staff. This was completed in the first quarter of 2014. Revenue from JDL Technologies' sales to small and medium-sized commercial businesses (SMBs) increased by 36% to $610,000 as a result of an ongoing initiative to expand its reach in the South Florida commercial and healthcare markets.

Gross margin decreased 78% to $433,000 in the second quarter of 2014 compared to $1,991,000 in the same period in 2013. Gross margin as a percentage of sales decreased to 16% in 2014 from 26% in 2013 due to a change in the mix of revenue, with an increase in Broward Schools infrastructure sales, which have lower margins. Selling, general and administrative expenses increased 9% in 2014 to $721,000 compared to $663,000 in 2013. JDL Technologies reported an operating loss of $288,000 in the second quarter of 2014 compared to operating income of $1,328,000 in the same period of 2013.

Other The Company's income before income taxes decreased to $2,275,000 in 2014 compared to $2,578,000 in 2013. The Company's effective income tax rate was 36.8% in 2014 and 36.4% in 2013. This effective tax rate differs from the federal tax rate of 35% due to state income taxes, foreign losses not deductible for U.S. income tax purposes, provisions for interest charges for uncertain income tax positions, and settlement of uncertain tax positions.

23 -------------------------------------------------------------------------------- Table of Contents Six Months Ended June 30, 2014 Compared to Six Months Ended June 30, 2013 Consolidated sales decreased 2% in 2014 to $58,407,000 compared to $59,389,000 in 2013. Consolidated operating income in 2014 decreased to $2,154,000 compared to $2,938,000 in the first six months of 2013. Net income in 2014 decreased to $1,297,000 or $0.15 per share compared to net income of $1,881,000 or $0.22 per share in the first six months of 2013.

Suttle Results Suttle sales increased 21% in the first six months of 2014 to $31,889,000 compared to $26,265,000 in the same period of 2013 due to revenue generated from new FTTx (fiber to the home or node) product platforms. Sales by customer groups in the first six months of 2014 and 2013 were: Suttle Sales by Customer Group 2014 2013 Communication service providers $ 26,722,000 $ 20,025,000 Distributors 3,013,000 3,157,000 International 1,992,000 2,849,000 Other 162,000 234,000 $ 31,889,000 $ 26,265,000 Suttle's sales by product groups in first six months of 2014 and 2013 were: Suttle Sales by Product Group 2014 2013 Modular connecting products $ 6,390,000 $ 6,899,000 Structured cabling products 15,775,000 12,076,000 DSL products 2,984,000 4,508,000 FTTx products 6,557,000 1,420,000 Other products 183,000 1,362,000 $ 31,889,000 $ 26,265,000 Sales to the major communication service providers increased 33% in 2014 due to growth in core high-speed copper connectivity products and success in securing new business in multiple FTTx domains. Sales to major communication service providers accounted for 84% of Suttle's sales in the first six months of 2014 compared to 76% of sales in 2013. Sales to distributors decreased 5% in 2014.

This customer segment accounted for 9% and 12% of sales in the first six months of 2014 and 2013, respectively. International sales decreased 30% and accounted for 6% of Suttle's first six months 2014 sales, due to a reduction in revenue from Austin Taylor legacy products, in part due to the Company's termination of a non-profitable OEM contract.

Sales of structured cabling products increased 31%. Sales of DSL products decreased 34% and modular connecting products sales decreased 7% due to shifts in technology.

Suttle's gross margin increased 36% in the first six months of 2014 to $9,765,000 compared to $7,178,000 in the same period of 2013. Gross margin as a percentage of sales increased to 31% from 27% in 2013 due to introduction of new FTTx products, focused value engineering and cost optimization efforts, and economies of scale. Selling, general and administrative expenses increased 21% to $6,496,000 in the first six months of 2014 compared to $5,355,000 in the same period in 2013 due to investment and recruitment of expertise in sales, operations, technology, product management, and engineering. Suttle's operating income was $3,270,000 in the first six months of 2014 compared to $1,823,000 in 2013.

24 -------------------------------------------------------------------------------- Table of Contents Transition Networks Results Transition Networks sales remained stable at $21,317,000 in the first six months of 2014 compared to $21,275,000 in 2013. Transition Networks organizes its sales force by channel to market and segments its customers geographically. First six months sales by region are presented in the following table: Transition Networks Sales by Region 2014 2013 North America $ 15,112,000 $ 14,032,000 Europe, Middle East, Africa ("EMEA") 2,321,000 2,753,000 Rest of World 3,884,000 4,490,000 $ 21,317,000 $ 21,275,000 The following table summarizes Transition Networks' 2014 and 2013 first six months sales by its major product groups: Transition Networks Sales by Product Group 2014 2013 Media converters $ 13,443,000 $ 13,711,000 Ethernet switches 2,417,000 2,435,000 Ethernet adapters 1,797,000 1,525,000 Other products 3,660,000 3,604,000 $ 21,317,000 $ 21,275,000 Sales in North America increased 8% or $1,080,000 due to increased sales into the Federal government channel. International sales decreased $1,038,000, or 14%, due mainly to a weaker first quarter of this year compared to last year, with several customers mainly in northern Europe. Sales of media converters decreased 2% or $268,000 due to continued competitive pressures and delays in new product introduction.

Gross margin on first six months Transition Networks' sales decreased 11% to $10,092,000 in 2014 from $11,396,000 in 2013. Gross margin as a percentage of sales decreased to 47% in 2014 from 54% in 2013 due to unfavorable product mix and competitive prices. Selling, general and administrative expenses decreased 7% to $10,789,000 in the first half of 2014 compared to $11,617,000 in 2013 due to restructuring of certain go-to-market functions in the last three quarters of 2013 and higher ERP related expenses in the same period. Operating loss increased to $935,000 in 2014 compared to an operating loss of $221,000 in 2013, primarily as a result of a much weaker 2014 first quarter.

JDL Technologies, Inc. Results JDL Technologies, Inc. sales decreased 56% to $5,202,000 in the first six months of 2014 compared to $11,850,000 in 2013.

Revenues by customer group were as follows: JDL Revenue by Customer Group 2014 2013 Broward County FL schools $ 3,955,000 $ 3,901,000 Miami Dade County FL schools 99,000 7,138,000 All other 1,148,000 811,000 $ 5,202,000 $ 11,850,000 25 -------------------------------------------------------------------------------- Table of Contents Revenues earned through sales to Broward County Public Schools, increased $54,000 in the first six months of 2014 as compared to the 2013 first six months due to the combination of a multi-school network refresh initiative that started in late 2013 and was completed in the first quarter of 2014, along with several key network core infrastructure upgrades during the 2014 first quarter. Revenues earned through sales to Miami-Dade County Public Schools in the first six months of both 2014 and 2013 are related to the district's "Bringing Wireless to the Classroom" initiative for which the district received federal funding under the E-Rate program to expand wireless connectivity for students and staff. This was completed in the first quarter of 2014. Revenue from JDL Technologies' sales to small and medium sized commercial businesses (SMBs) increased by 42% or $337,000 as a result of continued successful marketing and sales efforts.

Gross margin decreased 55% to $1,224,000 in the first six months of 2014 compared to $2,731,000 in the same period in 2013. Gross margin as a percentage of sales increased to 24% in 2014 from 23% in 2013 reflecting the fact that a significant portion of its 2013 revenue was hardware-based, rather than the more traditional value-added service. Selling, general and administrative expenses remained flat in 2014 at $1,406,000 compared to $1,395,000 in 2013. JDL Technologies reported an operating loss of $181,000 in the first six months of 2014 compared to operating income of $1,336,000 in the same period of 2013.

Because federal and local funding for investments in IT infrastructure and services for K-12 schools varies substantially from year to year, JDL Technologies has experienced large swings in quarterly and annual revenues. We expect this volatility in revenues to continue in the balance of 2014 and future years. Based on recent indications from the federal government, we anticipate that the E-Rate program will be insufficiently funded to enable the Miami-Dade and Broward school districts to complete all the IT projects slated for 2014.

While additional federal government funding may still materialize in 2014 and 2015, if it does not we may experience delay or cancellation of present or future wireless infrastructure projects in the districts. As previously reported, our 2013 results included approximately $23.0 million in revenue from a wireless connectivity project for the Miami- Dade County Public School district.

To reduce dependence on government funding, JDL Technologies continues to aggressively pursue opportunities to provide managed services, migration to the cloud, virtualization HIPAA-compliant IT services, and other network services to SMBs with a focus on healthcare, legal and financial services and logistics markets. As part of this initiative, JDL Technologies has adopted HIPAA standards that enable it to serve healthcare providers as a compliant Business Associate.

Other The Company's income before income taxes decreased to $2,010,000 in 2014 compared to $2,959,000 in 2013. The Company's effective income tax rate was 35.5% in 2014 and 36.4% in 2013. This effective tax rate differs from the federal tax rate of 35% due to state income taxes, foreign losses not deductible for U.S. income tax purposes, provisions for interest charges for uncertain income tax positions, and settlement of uncertain tax positions. The effect of the foreign operations is an overall rate increase of approximately 3.5% in the first six months of 2014.

26 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources As of June 30, 2014, the Company had approximately $31,453,000 in cash, cash equivalents and investments. Of this amount, $5,198,000 was invested in short-term money market funds that are not considered to be bank deposits and are not insured or guaranteed by the FDIC or other government agency. These money market funds seek to preserve the value of the investment at $1.00 per share; however, it is possible to lose money investing in these funds. The remainder in cash and cash equivalents is operating cash and certificates of deposit which are fully insured through the FDIC. The Company also had $16,501,000 in investments consisting of certificates of deposit and corporate notes and bonds that are traded on the open market and are classified as available-for-sale at June 30, 2014.

The Company had working capital of $61,766,000, consisting of current assets of approximately $76,181,000 and current liabilities of $14,415,000 at June 30, 2014 compared to working capital of $70,599,000, consisting of current assets of $83,672,000 and current liabilities of $13,073,000 at December 31, 2013. The Company's working capital at June 30, 2014 decreased slightly from year-end due to the fact that the Company increased its ownership of long-term investments to $10,624,000 from $3,921,000.

Cash flow provided by operating activities was approximately $7,553,000 in the first six months of 2014 compared to $9,279,000 used in the same period of 2013.

Significant working capital changes from December 31, 2013 to June 30, 2014 included a decrease in receivables of $3,743,000 due to the receipt of outstanding receivables at JDL Technologies related to the Miami Dade project primarily completed in 2013, partially offset by an increase in sales at Suttle during the quarter and an increase in Suttle-related inventory and related accounts payable.

Net cash used in investing activities was $9,332,000 in the first six months of 2014 compared to $4,538,000 provided in the same period of 2013. The Company continued to make capital investments and purchases of certificates of deposit and other marketable securities, moving more of its capital into longer term investments.

Net cash used by financing activities was $3,353,000 in the first six months of 2014 compared to $1,529,000 in the same period of 2013. The Company made $566,000 in contingent consideration payments related to the Patapsco acquisition. Cash dividends paid on common stock increased to $2,801,000 in 2014 ($0.32 per common share) from $1,364,000 in 2013 due to an accelerated payment of the dividend declared and paid in December 2012. Proceeds from common stock issuances, principally shares sold to the Company's Employee Stock Ownership Plan and under the Company's Employee Stock Purchase Plan, totaled approximately $180,000 in 2014 and $206,000 in 2013. The Company did not repurchase any shares in 2014 or 2013 under the Board authorized program. At June 30, 2014, Board of Director authority to purchase approximately 411,910 additional shares remained in effect. The Company acquired $2,000 and $0 in 2014 and 2013, respectively, of Company stock from employees in order to satisfy withholding tax obligations related to share-based compensation, pursuant to terms of Board and shareholder-approved compensation plans.

The Company has a $10,000,000 line of credit from Wells Fargo Bank. Interest on borrowings on the credit line is at LIBOR plus 1.1% (1.3% at June 30, 2014).

There were no borrowings on the line of credit during the first six months of 2014 or 2013. The credit agreement expires October 31, 2014 and is secured by assets of the Company. The Company intends to renew the agreement in 2014.

In the opinion of management, based on the Company's current financial and operating position and projected future expenditures, sufficient funds are available to meet the Company's anticipated operating and capital expenditure needs.

27 -------------------------------------------------------------------------------- Table of Contents Enterprise Resource Planning On April 4, 2013, our Transition Networks business unit and the parent Communications Systems, Inc. "went live" on a new Enterprise Resource Planning ("ERP") system. Due to the restructuring of the Company into a holding company structure with greater focus on our three operating business units, we are moving more deliberately to implement the new ERP system in the rest of the Company. We expect Suttle to adopt the new ERP system in 2015.

Critical Accounting Policies Our critical accounting policies, including the assumptions and judgments underlying them, are discussed in our 2013 Form 10-K in Note 1 Summary of Significant Accounting Policies included in our Consolidated Financial Statements. There were no significant changes to our critical accounting policies during the six months ended June 30, 2014.

The Company's accounting policies have been consistently applied in all material respects and disclose such matters as allowance for doubtful accounts, sales returns, inventory valuation, warranty expense, income taxes, revenue recognition, asset impairment recognition and foreign currency translation. On an ongoing basis, we evaluate our estimates based on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the result of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Results may differ from these estimates due to actual outcomes being different from those on which we based our assumptions. Management reviews these estimates and judgments on an ongoing basis.

Recently Issued Accounting Pronouncements We do not believe there are any recently issued accounting standards that have not yet been adopted that will have a material impact on the Company's financial statements.

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