SUNE

Business Context and Reporting Period

Company: Communications Systems, Inc. (CSI)

Filing Type: Form 10-K (Annual Report)

Period Ended: December 31, 1998

CSI is a manufacturer of modular connecting and wiring devices for voice and data communications. The company operates through three primary segments: Suttle (U.S. standard modular devices), Austin Taylor (British standard devices), and Transition Networks (media and rate conversion products). In 1998, CSI acquired Transition Networks, Inc. (TNI) and JDL Technologies, Inc. (JDL). The company also signed an agreement in March 1999 to acquire LANart Corporation for approximately $6 million.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Decline: Consolidated sales decreased 6% to $71.16 million. The primary driver was an 11% decline in Suttle segment sales, attributed to inventory reduction programs by major telephone company customers ("Big 6") and a 26% drop in retail sales to Radio Shack.
• Profitability Compression: Operating income fell 31% to $8.56 million. Suttle's gross margin percentage declined to 32.7% from 33.8% due to excess production capacity and inventory obsolescence provisions. Austin Taylor's operating income dropped 45% due to reduced cable television construction activity in the U.K.
• Acquisition Impact: While TNI and JDL were acquired in 1998, they contributed operating losses of $334,000 and $675,000 respectively for the periods included in the fiscal year.
• Liquidity Shift: Working capital decreased by $11.25 million, and the current ratio dropped significantly from 6.9 to 2.8. This was primarily due to the utilization of a $10 million line of credit to finance the acquisition of TNI.
• Share Repurchases: The company repurchased and retired 790,400 shares of common stock in 1998 at a cost of $13.27 million.

Outlook, Risks, and Management Commentary

• Future Acquisitions: Management expects to complete the acquisition of LANart Corporation in April 1999 for approximately $6 million. The company continues to search for acquisition candidates to expand product offerings.
• Capital Expenditures: The company expects to spend $3.5 million on capital additions in 1999.
• Year 2000 (Y2K) Compliance: The company estimates total Y2K compliance costs at $150,000, with $100,000 already spent. Management does not believe Y2K issues will cause material disruption, though they monitor supplier and customer compliance.
• Tax Exposure: The company benefits from the Puerto Rico possessions tax credit (Section 936), which is being phased out. The credit is expected to apply to business income through 2001, with limitations thereafter. Without this credit, income tax expense would have been significantly higher.
• Supply Chain Risk: The company relies on a single supplier, Raychem Corporation, for moisture-resistant gel-filled figs used in its corrosion-resistant products. Unavailability of this component could have a material adverse effect.

Investor Verification Checklist

• Customer Concentration: Verify the stability of the "Big 6" telephone company customers, which accounted for approximately 60% of Suttle's sales in 1998.
• Acquisition Integration: Monitor the financial performance of TNI and JDL in 1999 to determine if they achieve the projected positive contributions.
• Debt Servicing: Confirm the repayment or refinancing of the $9.08 million notes payable (line of credit) maturing in 1999.
• Inventory Levels: Assess whether inventory obsolescence provisions in 1998 were a one-time event or indicative of ongoing demand issues.
• LANart Acquisition: Review the terms and financial impact of the pending LANart Corporation acquisition upon closing.