SUNE

Business Context and Reporting Period

Company: Communications Systems, Inc. (CSI)

Filing Type: Form 10-K (Annual Report)

Period Ended: December 31, 1996

Business Overview: CSI manufactures and sells modular connecting and wiring devices for voice and data communications ("telephone station apparatus"). Operations are conducted in the U.S. (including Puerto Rico), the U.K., and Costa Rica. The company operates as a single business segment.

Key Strategic Actions in 1996:

• Acquisition: Acquired Automatic Tool and Connector Company, Inc. (ATC) on January 4, 1996, for $3.19 million (cash and stock) to enter the fiber optic connector market.
• Divestiture: Sold its contract manufacturing subsidiary, Zercom Corporation, to Nortech Systems, Inc. on November 4, 1996, for $1.5 million cash and a $4.87 million note.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Revenues from continuing operations increased 4% to $68.7 million. U.S. sales rose 11%, driven by the new ATC fiber optic products and the CorroShield line. Conversely, U.K. subsidiary (Austin Taylor) sales declined 18% due to lost contracts with British Telecom.
• Profitability: Net income decreased 9% to $8.2 million, primarily due to a $0.7 million loss from discontinued operations (Zercom) and increased selling/administrative expenses related to the ATC acquisition. Operating income from continuing operations increased slightly by 2%.
• Margins: Gross margin percentage improved to 31% from 28%, aided by a favorable product mix (higher-margin CorroShield and fiber optic products) and lower raw material costs. However, Austin Taylor's margins declined to 19% due to reduced volume.
• Liquidity: Cash flow from operations increased significantly to $10.6 million (from $6.9 million) due to inventory reductions of $1.6 million. The company retired 255,495 shares of common stock at a cost of $3.3 million.

Outlook, Risks, and Management Commentary

• Capital Allocation: Management expects to spend approximately $2.5 million on capital additions in 1997. The company maintains a $2.0 million bank line of credit and has no outstanding long-term debt.
• Tax Risks: A significant portion of the company's tax advantage relies on the U.S. possessions tax credit for Puerto Rico operations. While the credit was repealed for new companies in 1996, CSI retains grandfathered rights through 2005, though limitations apply. Full U.S. taxation on Puerto Rico earnings would have increased 1996 tax expense by $1.9 million.
• Supply Chain Risk: The company relies on a single supplier, Raychem Corporation, for moisture-resistant gel-filled fittings used in its CorroShield line. Unavailability of this component could have a material adverse effect.
• Market Competition: The company faces strong competition from larger entities like Lucent Technologies, Ortronics, and Leviton, particularly in sales to the "Big 8" telephone companies.

Investor Verification Checklist

• Discontinued Operations: Verify the final settlement of the Zercom divestiture and the collectability of the $4.87 million note receivable.
• ATC Integration: Assess the performance of the newly acquired ATC subsidiary (fiber optics) against the $4.8 million revenue target and $129,000 operating income reported for 1996.
• U.K. Recovery: Monitor Austin Taylor's ability to regain market share with British Telecom and the performance of new cable television products.
• Tax Credit Status: Confirm the ongoing eligibility and calculation of the Puerto Rico possessions tax credit under the Small Business Job Protection Act of 1996.
• Supplier Dependency: Evaluate contingency plans regarding the single-source supply of Raychem gel-filled fittings.