SUNE

Business Context and Reporting Period

Company: Communications Systems, Inc. (CSI)

Filing Type: Form 10-Q (Quarterly Report)

Period Ended: September 30, 2007

Business Overview: CSI operates through four primary segments: Suttle (modular connecting/wiring devices), Transition Networks (data transmission/media conversion), JDL Technologies (telecom contracting for schools), and Austin Taylor (UK telephone equipment). The company is headquartered in Minnesota.

Key Financial Metrics (Nine Months Ended Sept 30, 2007)

Note: Total debt increased significantly due to the assumption of a $4.38M mortgage in July 2007 for a new building acquisition.

Material Changes vs. Prior Period

• Revenue Growth: Consolidated sales increased 4% year-over-year. Suttle segment sales grew 14%, driven by structured cabling products. Transition Networks sales remained flat.
• Profitability Surge: Operating income increased 102% and Net Income increased 66%. This was primarily driven by the recognition of $2.555 million in revenue from JDL Technologies for services provided in 2006 but approved for E-RATE funding in 2007.
• JDL Segment Turnaround: JDL reported an operating income of $1.78 million in 2007 compared to a $2.54 million loss in 2006, largely due to the timing of revenue recognition and cost reductions (restructuring expenses of $161,000).
• Capital Expenditures: Investing cash outflows increased to $3.16 million (from $61k inflow in 2006) due to the acquisition of a new corporate building ($1.37M cash paid) and expansion of operations in China.
• Share Repurchases: The company repurchased 279,119 shares for $3.01 million during the period.

Guidance, Outlook, Risks, and Unusual Items

Management Commentary & Outlook

• JDL Revenue Recognition: Management continues to defer revenue recognition for JDL's U.S. Virgin Islands Department of Education (VIDE) contracts until E-RATE funding approval is received. Approximately $862,000 of revenue for Q3 2007 services was not recognized pending approval.
• Building Acquisition: The company acquired a new building in July 2007, assuming a $4.38M mortgage. They expect to sell their current Minnetonka facility before year-end.
• China Expansion: A new engineering and sales office in China opened in Q3 2007, with expected total spending of $700,000 for the year.

Risks and Contingencies

• DOJ Investigation: JDL Technologies is under a civil investigation by the U.S. Department of Justice regarding potential false claims under the E-RATE program involving VIDE. While management believes it acted ethically, an adverse outcome could have material financial consequences.
• Internal Controls: The CEO and CFO concluded that disclosure controls and procedures were not effective as of September 30, 2007, due to deficiencies in financial close and reporting processes at the JDL Technologies subsidiary.
• Customer Concentration: JDL relies on two major customers (VIDE and Broward County schools). Loss of either could trigger goodwill impairment.
• Tax Liability: The company has accrued approximately $1.69 million in tollgate taxes on prior earnings distributed from a Costa Rican subsidiary, expected to be paid in 2007.

Investor Verification Checklist

• E-RATE Funding Status: Verify the status of the pending E-RATE approvals for JDL's 2007-2008 VIDE contracts, as $862,000 in revenue is currently deferred.
• DOJ Investigation Outcome: Monitor updates on the Department of Justice investigation into JDL Technologies to assess potential liability or sanctions.
• Internal Control Remediation: Review future filings for the remediation plan regarding the ineffective internal controls at JDL Technologies.
• Real Estate Transaction: Confirm the sale of the existing Minnetonka facility and the final costs associated with the new building build-out.
• Goodwill Impairment: Assess JDL's future cash flows; if margins do not improve as projected, the $704,000 goodwill balance may be impaired.