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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended MARCH 31, 2003
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OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR
15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
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Commission File Number: 0-10355
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COMMUNICATIONS SYSTEMS, INC.
.................................................................................
(Exact name of registrant as specified in its charter)
MINNESOTA 41-0957999
.................................................................................
(State or other jurisdiction of (Federal Employer
incorporation or organization) Identification No.)
213 South Main Street, Hector, MN 55342
.................................................................................
(Address of principal executive offices) (Zip Code)
(320) 848-6231
.................................................................................
Registrant's telephone number, including area code
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES [X] NO [ ]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). YES [ ] NO [X]
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
CLASS Outstanding at April 30, 2003
- -------------------------------------- -----------------------------
Common Stock, par value $.05 per share 8,161,216
Total Pages (20)
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COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES
INDEX
Page No.
Part I. Financial Information
Item 1. Financial Statements
Consolidated Balance Sheets 3
Consolidated Statements of Income and 4
Comprehensive Income
Consolidated Statements of Changes in
Stockholders' Equity 5
Consolidated Statements of Cash Flows 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 11
Item 3. Quantitative and Qualitative Disclosures
about Market Risk 13
Item 4. Controls and Procedures 14
Part II. Other Information 17
SIGNATURES
CERTIFICATIONS
2
PART I. FINANCIAL INFORMATION
COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES
Item 1. Financial Statements
CONSOLIDATED BALANCE SHEETS
(unaudited)
March 31 December 31
Assets: 2003 2002
------------ ------------
Current assets:
Cash $ 7,224,040 $ 19,816,328
Trade receivables, net 21,732,637 19,128,399
Related party receivables 295,070 412,930
Inventories 33,978,241 28,958,291
Deferred income taxes 3,354,568 3,354,568
Other current assets 1,168,025 1,339,024
------------ ------------
Total current assets 67,752,581 73,009,540
Property, plant and equipment 34,245,325 33,974,215
less accumulated depreciation (27,092,791) (26,549,665)
------------ ------------
Net property, plant and equipment 7,152,534 7,424,550
Other assets:
Excess of cost over net assets acquired 5,253,793 5,253,793
Deferred income taxes 2,796,978 2,796,978
Other assets 376,241 273,631
------------ ------------
Total other assets 8,427,012 8,324,402
------------ ------------
Total Assets $ 83,332,127 $ 88,758,492
============ ============
Liabilities and Stockholders' Equity:
Current liabilities:
Notes payable $ 7,000,000
Accounts payable $ 6,596,808 5,291,706
Accrued compensation and benefits 2,365,883 2,655,056
Other accrued liabilities 2,574,847 1,797,656
Dividends payable 326,947 325,714
Income taxes payable 2,099,904 2,817,082
------------ ------------
Total current liabilities 13,964,389 19,887,214
Stockholders' Equity 69,367,738 68,871,278
------------ ------------
Total Liabilities and Stockholders' Equity $ 83,332,127 $ 88,758,492
============ ============
See notes to consolidated financial statements.
3
COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
(unaudited)
Three Months Ended March 31
-----------------------------------
2003 2002
------------ ------------
Sales $ 26,575,150 $ 23,920,340
Costs and expenses:
Cost of sales 19,169,361 17,543,729
Selling, general and
administrative expenses 6,221,891 5,725,262
------------ ------------
Total costs and expenses 25,391,252 23,268,991
------------ ------------
Operating income 1,183,898 651,349
Other income and (expense):
Investment income 22,574 75,904
Interest expense (33,401) (92,397)
------------ ------------
Other expense, net (10,827) (16,493)
Income before income taxes 1,173,071 634,856
Income taxes 450,000 165,000
------------ ------------
Net income 723,071 469,856
------------ ------------
Other comprehensive loss:
Foreign currency translation adjustment (59,513) (67,650)
------------ ------------
Comprehensive income $ 663,558 $ 402,206
============ ============
Basic net income per share $ .09 $ .06
Diluted net income per share $ .09 $ .06
Average Basic Shares Outstanding 8,160,931 8,285,662
Average Dilutive Shares Outstanding 8,171,868 8,296,917
See notes to consolidated financial statements.
4
COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(unaudited)
Cumulative
Common Stock Additional Other
---------------------- Paid-in Retained Comprehensive
Shares Amount Capital Earnings Income (Loss) Total
--------- --------- ----------- ----------- ----------- -----------
BALANCE AT DECEMBER 31, 2001 8,262,314 $ 413,116 $27,855,529 $39,463,137 $ (423,781) $67,308,001
Net income 2,336,672 2,336,672
Issuance of common stock under
Employee Stock Purchase Plan 36,276 1,814 188,744 190,558
Issuance of common stock to
Employee Stock Ownership Plan 25,000 1,250 187,250 188,500
Issuance of common stock under
Employee Stock Option Plan 1,700 85 11,645 11,730
Purchase of stock (182,574) (9,130) (630,005) (553,737) (1,192,872)
Shareholder dividends (325,714) (325,714)
Other comprehensive gain 354,403 354,403
--------- --------- ----------- ----------- ----------- -----------
BALANCE AT DECEMBER 31, 2002 8,142,716 $ 407,135 $27,613,163 $40,920,358 $ (69,378) $68,871,278
Net income 723,071 723,071
Issuance of common stock to
Employee Stock Ownership Plan 32,000 1,600 253,440 255,040
Purchase of stock (13,500) (675) (45,781) (48,735) (95,191)
Shareholder dividends (326,947) (326,947)
Other comprehensive loss (59,513) (59,513)
--------- --------- ----------- ----------- ----------- -----------
BALANCE AT MARCH 31, 2003 8,161,216 $ 408,060 $27,820,822 $41,267,747 $ (128,891) $69,367,738
========= ========= =========== =========== =========== ===========
See notes to consolidated financial statements.
5
COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
Three Months Ended March 31
---------------------------
2003 2002
----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 723,071 $ 469,856
Adjustments to reconcile net income
to net cash provided by operating activities:
Depreciation and amortization 663,551 665,674
Changes in assets and liabilities net of
effects of the purchase of MiLAN Technology
Corporation:
Trade receivables (2,457,451) (324,030)
Inventories (4,896,469) 872,127
Other current assets 217,783 226,689
Accounts payable 1,327,906 667,719
Accrued expenses 491,736 126,246
Income taxes payable (717,173) (199,561)
----------- -----------
Net cash (used in) provided by
operating activities (4,647,046) 2,504,720
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures (424,081) (269,664)
Collection of note receivable 2,765,390
Other assets (182,151) (79,893)
Payment for purchase of MiLAN Technology
Corporation (8,058,932)
----------- -----------
Net cash used in investing activities (606,232) (5,643,099)
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of notes payable (7,000,000)
Dividends paid (325,714)
Proceeds from issuance of common stock 11,730
Purchase of stock (675) (7,675)
----------- -----------
Net cash (used in) provided by
financing activities (7,326,389) 4,055
----------- -----------
EFFECT OF FOREIGN EXCHANGE RATE CHANGES ON CASH (12,621) (17,247)
----------- -----------
NET (DECREASE) IN CASH AND CASH EQUIVALENTS (12,592,288) (3,151,571)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 19,816,328 22,239,883
----------- -----------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 7,224,040 $19,088,312
=========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Income taxes paid $ 1,159,892 $ 274,008
Interest paid 53,188 153,921
See notes to consolidated financial statements.
6
COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - CONSOLIDATED FINANCIAL STATEMENTS
The consolidated balance sheet and statements of changes in stockholders' equity
as of March 31, 2003, the consolidated statements of income and comprehensive
income and the consolidated statements of cash flows for the three-month periods
ended March 31, 2003 and 2002 have been prepared by Communications Systems, Inc.
and Subsidiaries (the Company) without audit. In the opinion of management, all
adjustments (which include only normal recurring adjustments) necessary to
present fairly the financial position, results of operations, and cash flows at
March 31, 2003 and 2002 and for the three months then ended have been made.
Certain information and footnote disclosures normally included in consolidated
financial statements prepared in accordance with generally accepted accounting
principles in the United States of America have been condensed or omitted. It is
suggested these condensed consolidated financial statements be read in
conjunction with the financial statements and notes thereto included in the
Company's December 31, 2002 Annual Report to Shareholders. The results of
operations for the periods ended March 31 are not necessarily indicative of the
operating results for the entire year.
In February 2003 the Company issued 32,000 shares of the Company's common stock
to the Employee Stock Ownership Plan in payment of its 2002 obligation. In a
noncash transaction, the Company recorded additional stockholders' equity of
$255,040 (reflecting the market value of the stock at the time of the
contribution) and reduced accrued expenses by the same amount.
NOTE 2 - ACQUISITIONS
Effective March 25, 2002 the Company acquired substantially all of the assets
and assumed certain liabilities of Digi International Inc.'s MiLAN legacy
business. The business has been reincorporated as MiLAN Technology Corporation.
Located in Sunnyvale, California, MiLAN is a growing provider of leading edge
wireless telecommunications products for businesses and residences, managed and
unmanaged LAN switches, media conversion products and print servers. The Company
expects the MiLAN acquisition will be both complementary and supplementary to
its Transition Networks business by increasing the product offerings and
expanding the customer bases of both business units.
The operations of MiLAN, which were not material to the Company's financial
statements, are included in the Company's financial results from the purchase
date. In the acquisition, the following assets were acquired and liabilities
assumed:
Accounts receivable $ 2,426,713
Inventory 5,121,936
Plant and equipment 5,120
Identifiable intangible asset (royalty agreement) 201,341
Excess of cost over net assets acquired 635,046
Accrued expenses (262,405)
--------------
Total purchase price $ 8,127,751
==============
7
NOTE 3 - INVENTORIES
Inventories summarized below are priced at the lower of first-in, first-out cost
or market:
March 31 December 31
2003 2002
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Finished goods $ 16,607,025 $ 14,188,306
Raw and processed materials 17,371,216 14,769,985
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Total $ 33,978,241 $ 28,958,291
============ ============
NOTE 4 - EXCESS OF COST OVER NET ASSETS ACQUIRED (GOODWILL)
AND OTHER INTANGIBLE ASSETS
Goodwill represents the amount by which the purchase price and transaction costs
of business the Company has acquired exceed the estimated fair value of the net
tangible assets and separately identifiable assets of these businesses. The
Company adopted Statement of Financial Accounting Standards (SFAS) No. 142
"Goodwill and Other Intangible Assets" on January 1, 2002. Under SFAS No. 142,
goodwill and intangible assets with indefinite useful lives are not amortized,
but are tested at least annually for impairment. We reassess the value of our
business units and related goodwill balances at the beginning of the first
quarter of each fiscal year and at other times if events have occurred or
circumstances exist that indicate the carrying amount of goodwill may not be
recoverable. Accordingly, we have determined that there was no impairment as of
January 1, 2003 and no events occurred during the quarter ended March 31, 2003
that indicated our remaining goodwill was not recoverable. As of March 31, 2003
the Company had net goodwill of $5,393,000. Intangible assets with definite
useful lives (consisting of a royalty agreement) will continue to be amortized
over its remaining life of five years. Amortization included in costs and
expenses was $17,000 for the quarter ended March 31, 2003.
NOTE 5 - WARRANTY
We provide reserves for the estimated cost of product warranties at the time
revenue is recognized. We estimate the costs of our warranty obligations based
on our warranty policy or applicable contractual warranty, historical experience
of known product failure rates, and use of materials and service delivery costs
incurred in correcting product failures. Management reviews the estimated
warranty liability on a quarterly basis to determine its adequacy.
The following table presents the changes in the Company's warranty liability for
the three months ended March 31, 2003, the majority of which relates to a
five-year obligation to provide for potential future liabilities for network
equipment sales.
Beginning Balance $ 662,672
Actual warranty costs paid (77,726)
Amounts charged to expense 430,229
-----------
Ending balance $ 1,015,175
===========
8
NOTE 6 - STOCK BASED COMPENSATION PLANS
The Company has adopted the disclosure provisions of SFAS No. 123, "Accounting
for Stock-Based Compensation," but applies APB Opinion No. 25, "Accounting for
Stock Issued to Employees" for measurement and recognition of stock-based
transactions with its employees and accordingly no stock-based employee
compensation cost is reflected in net income. If the Company had elected to
recognize compensation cost for its stock based transactions using the method
prescribed by SFAS No. 123, pro forma net income and net income per share would
have been as follows:
Quarter Ended March 31
2003 2002
----------- -----------
Net Income
As reported $ 723,000 $ 470,000
Compensation expense, net of tax 50,300 120,500
Pro forma $ 672,700 $ 349,500
Earnings Per Share-Basic
As reported $ . 09 $ .06
Pro forma $ . 08 $ .04
Earnings Per Share-Diluted
As reported $ . 09 $ .06
Pro forma $ . 08 $ .04
NOTE 7 - SEGMENT INFORMATION
The Company classifies its businesses into four segments: Suttle, which
manufactures U.S. standard modular connecting and wiring devices for voice and
data communications; Austin Taylor, which manufactures British standard line
jacks, patch panels, wiring harness assemblies, metal boxes, distribution
cabinets and distribution and central office frames; Transition Networks and
MiLAN Technology (substantially all assets purchased March 25, 2002) which
designs and markets data transmission ,computer network and media conversion
products and print servers; and JDL Technologies, (JDL), which provides
telecommunications network design, specification and training services to
educational institutions. Information concerning the Company's continuing
operations in the various segments is as follows:
9
SEGMENT INFORMATION
Transition
Austin Networks/ JDL
Suttle Taylor MiLAN Technolgies Corporate Consolidated
----------- ----------- ----------- ----------- ----------- ------------
Three Months Ended March 31, 2003
Sales $ 8,142,850 $ 1,574,111 $12,381,343 $ 4,476,846 $ 26,575,150
Cost of sales 6,678,963 1,660,585 7,803,336 3,026,477 19,169,361
----------- ----------- ----------- ----------- ------------
Gross profit 1,463,887 (86,474) 4,578,007 1,450,369 7,405,789
Selling, general and
administrative expenses 1,200,702 324,367 3,419,585 891,002 $ 386,235 6,221,891
----------- ----------- ----------- ----------- ----------- ------------
Operating (loss) income $ 263,185 $ (410,841) $ 1,158,422 $ 559,367 $ (386,235) $ 1,183,898
=========== =========== =========== =========== =========== ============
Depreciation and amortization $ 417,570 $ 80,172 $ 79,291 $ 45,180 $ 41,338 $ 663,551
=========== =========== =========== =========== =========== ============
Assets $38,988,611 $ 5,085,054 $25,312,068 $ 7,388,535 $ 6,557,859 $ 83,332,127
=========== =========== =========== =========== =========== ============
Capital expenditures $ 263,207 $ 61,302 $ 19,318 $ 78,873 $ 1,381 $ 424,081
=========== =========== =========== =========== =========== ============
Three Months Ended March 31, 2002
Sales $ 8,283,022 $ 1,896,395 $ 9,553,083 $ 4,187,840 $ 23,920,340
Cost of sales 7,047,397 1,653,067 6,088,843 2,754,422 17,543,729
----------- ----------- ----------- ----------- ------------
Gross profit 1,235,625 243,328 3,464,240 1,433,418 6,376,611
Selling, general and
administrative expenses 1,547,727 217,647 2,624,618 930,505 $ 404,765 5,725,262
----------- ----------- ----------- ----------- ----------- ------------
Operating income (loss) $ (312,102) $ 25,681 $ 839,622 $ 502,913 $ (404,765) $ 651,349
=========== =========== =========== =========== =========== ============
Depreciation and amortization $ 468,405 $ 76,911 $ 66,358 $ 30,000 $ 24,000 $ 665,674
=========== =========== =========== =========== =========== ============
Assets $42,335,073 $ 5,274,676 $26,779,326 $ 7,283,834 $ 7,916,326 $ 89,589,235
=========== =========== =========== =========== =========== ============
Capital expenditures $ 176,265 $ 7,985 $ 80,649 $ - $ 4,765 $ 269,664
=========== =========== =========== =========== =========== ============
NOTE 8 - INCOME TAXES
In the preparation of the Company's consolidated financial statements,
management calculates income taxes based upon the estimated effective rate
applicable to operating results for the full fiscal year. This includes
estimating current tax liability as well as assessing temporary differences
resulting from different treatment of items for tax and book accounting
purposes. These differences result in deferred tax assets and liabilities, which
are recorded on the balance sheet. These assets and liabilities are analyzed
regularly and management assesses the likelihood that deferred tax assets will
be recovered from future taxable income.
NOTE 9 - NET INCOME PER SHARE
Basic net income per common share is based on the weighted average number of
common shares outstanding during each year. Diluted net income per common share
takes into effect the dilutive effect of potential common shares outstanding.
The Company's only potential common shares outstanding are stock options, which
resulted in a dilutive effect of 10,937 shares and 11,255 shares for the periods
ended March 31, 2003 and 2002, respectively. The Company calculates the dilutive
effect of outstanding options using the treasury stock method.
10
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations
- -----------------------------------------------------------
Three Months Ended March 31, 2003 Compared to
Three Months Ended March 31, 2002
---------------------------------------------
Consolidated sales in 2003 increased 11% to $26,575,000 compared to $23,920,000
in 2002. Consolidated operating income in 2003 increased to $1,184,000 compared
to $651,000 in first quarter 2002. The sales increase was attributable to the
Company's media conversion and network products business segment Transition
Networks/MiLAN Technology and from JDL Technologies (network design and training
services for educational institutions) compared to the previous year. The 2003
first quarter sales include $3.5 million in sales contributed from the MiLAN
business unit compared to MiLAN sales of $900,000 in the first quarter of 2002.
MiLAN was acquired in the first quarter of 2002. The Company continues to be
adversely affected by the general economic downturn particularly in the
communications equipment industry as reflected in sales declines by the
Company's voice and data connectivity products manufacturing units, Suttle and
United Kingdom subsidiary Austin Taylor Communications Ltd.
Suttle sales decreased 2% in the first quarter of 2003 to $8,143,000 compared to
$8,283,000 in the same period of 2002. Sales to the major telephone companies
(the Regional Bell Operating Companies ("RBOCs" which are Verizon Logistics,
Bell South, SBC Communications and Qwest) increased 7% to $4,320,000 in 2003.
Sales to these customers accounted for 53% and 46% of Suttle's U.S. customer
sales in 2003 and 2002 respectively. Sales to distributors, original equipment
manufacturers (OEMs), and electrical contractors decreased 13% to $1,895,000 in
2003. Suttle's export sales decreased to $366,000 in the first quarter of 2003
from $1,010,000 in 2002. Contract manufacturing sales totaled $1,164,000 in the
first quarter of 2003.
Suttle's gross margins increased 18% in the first quarter of 2003 to $1,464,000
compared to $1,236,000 in the same period of 2002. Gross margin percentage
increased to 18.0% in 2003 from 15% in 2002. The gross margin percentage
increase was due to cost reduction measures implemented in 2002. Selling,
general and administrative expenses decreased $347,000 or 22% in the first
quarter of 2003 compared to the same period in 2002. The Company has downsized
operations by closing two of three manufacturing facilities in Puerto Rico in
2002 to align production capacities and overhead with current business volumes.
In addition, the Company has continued to outsource more manufacturing in Asia,
shifted manufacturing to the lower cost plant in Costa Rica and effective May
31, 2003 will close the final building in Puerto Rico with 25 employees. These
actions are anticipated to have a positive impact on future gross margin and
operating results. Suttle's operating income was $263,000 in the first quarter
of 2003 compared to and operating loss of $312,000 in 2002. Suttle has continued
to implement a telesales strategy to sell voice, data and fiber optic products
to the nation's thousands of telecom and electrical installation companies.
These firms are supplanting the RBOCs in the area of commercial and residential
installations.
11
Austin Taylor's sales decreased 17% to $1,574,000 in 2003 compared to $1,896,000
for the three months ended March 31, 2002. Austin Taylor's gross margin declined
by $330,000 in 2003. Gross margin as a percentage of sales declined 18% to a
negative 5% in 2003 compared to 12.8% in the first quarter of 2002. Selling,
general and administrative expenses increased $107,000 from the 2002 amount. The
Company has announced and is implementing a 30% reduction in the Austin Taylor
workforce and has accrued severance pay of approximately $100,000 in the first
quarter of 2003. This will align overhead costs and production with existing
volumes. Operating income decreased by $437,000 in 2003 compared to the first
quarter of 2002.
JDL Technologies, Inc. reported 2003 first quarter sales of $4,477,000 compared
to $4,188,000 in 2002. JDL completed several large educational institutional
projects in the first quarter of 2003 consisting of hardware and software sales
as well as design and network management services. JDL gross margins increased
by $17,000 in the first quarter of 2003 compared to the same period in 2002.
Gross margin as a percentage of sales in 2003 decreased to 32% in 2003 from 34%
in 2002. Hardware and software sales were $2,324,000 in 2003 compared to
$3,535,000 in 2002. Sales of consulting and training services increased in 2003
to $2,144,000 from $652,000 in 2002. Selling, general and administrative
expenses decreased by 4% in 2003 to $891,000 compared to $931,000 in 2002.
Operating income was $559,000 in 2003 compared to $503,000 in the first quarter
of 2002.
Transition Networks / MiLAN Technology segment sales increased by 30% to
$12,381,000 in the first quarter of 2003 compared to $9,553,000 in the same
period in 2002. Sales for this segment include a $3,500,000 and $900,000
contribution in 2003 and 2002 respectively from MiLAN Technology, which CSI
purchased substantially all the assets from Digi International on March 25,
2002. The demand for media conversion and related products has remained strong
in the first quarter of 2003 and is expected to remain a growth market for some
time. Gross margin increased to $4,578,000 in 2003 from $3,464,000 in 2002.
Gross margin as a percentage of sales increased to 37% in 2003 compared to 36%
in 2002. Selling, general and administrative expenses increased to $3,420,000 in
2003 compared to $2,625,000 in 2002. Operating income increased to $1,158,000 in
2003 compared to $840,000 in 2002.
Consolidated investment income decreased $53,000 in 2003 compared to 2002 due to
decreased cash and investment balances, lower earnings on invested funds and
collection of the balance of a note receivable and accrued interest in the first
quarter of 2002 related to the sale of assets of discontinued operations.
Interest expense decreased by $59,000 in 2003 compared to 2002 due to lower
interest expense on the line of credit. The Company paid in full the balance of
the line of credit of $7,000,000 in March of 2003. Income before income taxes
increased to $1,173,000 in 2003 compared to $635,000 in 2002. The Company's
effective income tax rate was 38% in 2003 compared to 26% in the first quarter
of 2002. The increase in the tax rate was due to a higher percentage of company
earnings coming from U.S. sources which is taxed at a higher rate than that of
Puerto Rico earnings. Distributions by Suttle Caribe, Inc. to the parent company
of income earned prior to December 31, 2000 are subject to a tollgate tax at
rates which, depending on various factors, range from 3.5% to 10%. The Company
has provided for and prepaid tollgate taxes at a 1.75% rate on its Puerto Rico
earnings for each year since 1993. The Company has recognized tollgate tax
expense at the 3.5% rate on earnings from years prior to 1993 only to the extent
distributions were received from Suttle Caribe, Inc. Net income increased to
$723,000 in 2003 compared to $470,000 in 2002.
12
Liquidity and Capital Resources
-------------------------------
At March 31, 2003, the Company had approximately $7,224,000 of cash and cash
equivalents compared to $19,816,000 of cash and cash equivalents at December 31,
2002. The Company had working capital of approximately $53,788,000 and a current
ratio of 4.8 to 1 compared to working capital of $53,122,000 and a current ratio
of 3.7 to 1 at the end of 2002.
Net cash used in operating activities was approximately $4,647,000 in the first
three months of 2003 compared to net cash provided by operating activities of
$2,505,000 in the same period in 2002. The decrease was due primarily to
supporting higher levels of accounts receivable, inventory and payment of
federal and state income taxes.
Net cash used in investing activities was $593,000 in the first three months in
2003 compared to $5,643,000 in the same period in 2002. In March 2002, the
Company acquired substantially all of the assets of MiLAN Technology for
approximately $8,058,000 in cash. Also in the first quarter of 2002, the Company
received the balance of $2,765,000 of the note receivable related to the sale of
assets of a previously discontinued business unit. In 2003 cash investments in
new plant and equipment totaled $411,000 compared to $270,000 in 2002. Plant and
equipment purchases in both years were financed by internal cash flows. The
Company expects to spend $1,500,000 on capital additions in 2003.
Net cash used in financing activities was $7,339,000 in 2003 compared to net
cash provided by financing activities in 2002 of $4,100. In March 2003, the
Company paid in full the balance of the line of credit, which was $7,000,000 at
December 31, 2002. The Company purchased and retired 13,500 shares of its stock
in open market transactions during the 2003 period. At March 31, 2003 Board
authorizations are outstanding to purchase an additional 283,565 shares. Cash
dividends paid in the first quarter of 2003 was $326,000. There were no
additional borrowings on the line of credit during the first quarter of 2003.
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.
Critical Accounting Policies
----------------------------
Our critical accounting policies, including the assumptions and judgements
underlying them, are discussed in our 2002 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 three months ended March 31, 2003. These 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 are
believed to be reasonable under the circumstances, the result of which form the
basis for making judgements 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 on an ongoing basis reviews these estimates and
judgements.
13
Recently Issued Accounting Pronouncements
-----------------------------------------
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others" (FIN 45). FIN 45 establishes accounting and disclosure
requirements for a company's obligations under certain guarantees that it has
issued. A guarantor is required to recognize a liability for the obligation it
has undertaken in issuing a guarantee, including the ongoing obligation to stand
ready to perform over the term of the guarantee in the event that the specified
triggering events or conditions occur. The objective of the initial measurement
of that liability is the fair value of the guarantee at its inception. The
initial recognition and measurement provisions of this Interpretation are
applicable on a prospective basis to guarantees issued or modified after
December 31, 2002. FIN 45 also requires expanded disclosure of information
related to product warranty amounts recorded in the financial statements. The
disclosure provisions are effective for interim and annual periods ending after
December 15, 2002. The adoption of FIN 45 is further discussed with appropriate
disclosures in Note 5 of the consolidated financials statements.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure", an amendment to SFAS No. 123. This
standard provides alternative methods of transition for any voluntary changes to
the fair value based method of accounting for stock-based employee compensation.
It also amends the disclosure requirements to require prominent disclosure in
both the annual and interim financial statements about the method of accounting
for stock-based employee compensation and the effect of the method used on
reported results. The new disclosure requirements will be effective for interim
periods beginning after December 15, 2002. We will continue to apply the
principles of APB Opinion No. 25 and related interpretations in accounting for
our stock based compensation plans.
Item 3. Quantitative and Qualitative Disclosures about Market Risk.
- -------------------------------------------------------------------
The Company has no freestanding or embedded derivatives. All
contracts that contain provisions meeting the definition of a derivative also
meet the requirements of, and have been designated as normal purchases or sales.
The Company's policy is to not use freestanding derivatives and to not enter
into contracts with terms that cannot be designated as normal purchases or
sales.
The vast majority of our transactions are denominated in U.S. dollars; as such,
fluctuations in foreign currency exchange rates have historically not been
material to the Company. At March 31, 2003 our bank line of credit carried a
variable interest rate based on the London Interbank Offered Rate (Libor) plus
2%. The Company's investments are money market type of investments that earn
interest at prevailing market rates and as such do not have material risk
exposure.
Based on the Company's operations, in the opinion of management, no material
future losses or exposure exist relative to market risk.
14
Item 4. Controls and Procedures
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Quarterly evaluation of the Company's Disclosure Controls and Internal Controls.
- --------------------------------------------------------------------------------
Within the 90 days prior to the date of this Quarterly Report on Form 10-Q, the
Company evaluated the effectiveness of the design and operation of its
"disclosure controls and procedures" (the "Disclosure Controls"), and its
"internal controls and procedures for financial reporting" (the "Internal
Controls"). This evaluation (the "Controls Evaluation") was done under the
supervision and with the participation of management, including the Chief
Executive Officer ("CEO") and Chief Financial Officer ("CFO"). Rules adopted by
the Securities and Exchange Commission (the "SEC" or "Commission") require that
in this section of the Quarterly Report we present the conclusions of the CEO
and the CFO about the effectiveness of the Company's Disclosure Controls and
Internal Controls based on and as of the date of the Controls Evaluation.
CEO and CFO Certifications.
- ---------------------------
Appearing in this Quarterly Report are two separate forms of "Certifications" of
the CEO and the CFO. The first form of Certification, immediately following the
Signatures section, is required in accord with Section 302 of the Sarbanes-Oxley
Act of 2002 (the "Section 302 Certification"). This section of Form 10-Q
contains information concerning the Controls Evaluation referred to in the
Section 302 Certifications and this information should be read in conjunction
with the Section 302 Certifications for a more complete understanding of the
topics presented. The second Certification is pursuant to Section 906 of
Sarbanes-Oxley and concerns compliance and disclosure under the Securities
Exchange Act of 1934.
Disclosure Controls and Internal Controls.
- ------------------------------------------
Disclosure Controls are procedures that are designed to ensure that information
required to be disclosed in our reports filed under the Securities Exchange Act
of 1934 (the "Exchange Act"), such as this Quarterly Report, is recorded,
processed, summarized and reported within the time periods specified in the
SEC's rules and forms. Disclosure Controls are also designed to ensure that such
information is accumulated and communicated to the Company's management,
including the CEO and CFO, as appropriate to allow timely decisions regarding
required disclosure. Internal Controls are procedures designed to provide
reasonable assurance that (1) the Company's transactions are properly
authorized; (2) the Company's assets are safeguarded against unauthorized or
improper use; and (3) the Company's transactions are properly recorded and
reported, all of which assists the preparation of financial statements in
conformity with generally accepted accounting principles.
Limitations on the Effectiveness of Controls.
- ---------------------------------------------
The Company's management, including the CEO and CFO, does not expect that the
Disclosure Controls or the Internal Controls will prevent all error and all
fraud. A control system, no matter how well conceived and operated, can provide
only reasonable, not absolute, assurance that the objectives of the control
system are met. Further, the design of a control system must reflect the fact
that there are resource constraints, and the benefits of controls must be
considered relative to their costs. Because of the inherent limitations in all
control systems no evaluation of controls can provide absolute assurance that
all control issues and instances of fraud, if any, within the Company have been
detected. These inherent limitations include the realities that judgments in
decision-making can be faulty, and that breakdowns can occur because of simple
error or mistake. Additionally, controls can be circumvented by the individual
acts of some persons, by collusion of two or more people, or by management
override of the control. The design of any system of controls also is based in
part upon certain assumptions about the likelihood of future events, and there
can be no assurance that any design will succeed in achieving its stated goals
under all potential future conditions; over time, control may become inadequate
because of changes in conditions, or the degree of compliance with the policies
or procedures may deteriorate. Because of the inherent limitations in a
cost-effective control system, misstatements due to error or fraud may occur and
not be detected.
15
Scope of the Controls Evaluation.
- ---------------------------------
The CEO/CFO evaluation of Disclosure Controls and Internal Controls included a
review of the controls' objectives and design, the controls' implementation by
the Company and the effect of the controls on the information generated for use
in this Quarterly Report. In the course of the Controls Evaluation, we sought to
identify data errors, controls problems or acts of fraud and to confirm that
appropriate corrective action, including process improvements, were being
undertaken. This type of evaluation will be done on a quarterly and annual basis
so that the conclusions concerning controls effectiveness can be reported in the
Company's Quarterly Reports on Form 10-Q and in the Company's Annual Reports on
Form 10-K. Internal Controls are also evaluated on an ongoing basis by our
Accounting Department, by other personnel in the Company and by the Company's
independent auditors in connection with their audit and review activities. The
overall goals of these various evaluation activities are to monitor our
Disclosure Controls and our Internal Controls and to make modifications as
necessary; the Company's intent in this regard is that the Disclosure Controls
and the Internal Controls will be maintained as dynamic systems that change
(including with improvements and corrections) as conditions warrant.
Among other matters, the Company sought in the evaluation to determine whether
there were any "significant deficiencies" or "material weakness" in the
Company's Internal Controls, or whether the Company had identified any acts of
fraud involving personnel who a have significant role in the Company's Internal
Controls. This information was important both for the Controls Evaluation
generally and because items 5 and 6 in the Section 302 Certifications of the CEO
and CFO require that the CEO and CFO disclose such information to our Board's
Audit Committee and to the independent auditors and to report on related matters
in this section of the Quarterly Report. In the professional auditing
literature, "significant deficiencies" are referred to as "reportable
conditions"; these are control issues that could have a significant adverse
effect on the ability to record, process, summarize and report financial data in
the financial statements. A "material weakness" is defined as a particularly
serious reportable condition where the internal control does not reduce to a
relatively low level the risk that misstatements caused by error or fraud may
occur in amounts that would be material in relation to the financial statements
and not be detected within a timely period by employees in the normal course of
performing their assigned functions. The Company has sought to deal with other
controls matters in the Controls Evaluation, and in each case if a problem was
identified, the Company considered what revision, improvement and/or correction
to make in accord with its on-going procedures.
In accord with SEC requirements, the CEO and CFO note that, since the date of
the Controls Evaluation to the date of this Quarterly Report, there have been no
significant changes in Internal Controls or in other factors that could
significantly affect Internal Controls, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Conclusions.
- ------------
Based upon the Controls Evaluation, the CEO and CFO have concluded that, subject
to the limitations noted above, the Company's Disclosure Controls are effective
to ensure that material information relating to the Company and its consolidated
subsidiaries is made known to management, including the CEO and CFO,
particularly during the period when periodic reports are being prepared, and
that the Company's Internal Controls are effective to provide reasonable
assurance that the financial statements are fairly presented in conformity with
generally accepted accounting principles.
16
PART II. OTHER INFORMATION
Items 1 - 6. Not Applicable
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereto duly authorized.
Communications Systems, Inc.
By /s/ Curtis A. Sampson
--------------------------------
Curtis A. Sampson
Date: May 14, 2003 Chairman and Chief Executive Officer
By /s/ Paul N. Hanson
--------------------------------
Paul N. Hanson
Date: May 14, 2003 Vice President and Chief Financial Officer
17
CERTIFICATION
--------------
I, Curtis A. Sampson certify that:
1. I have reviewed this quarterly report on Form 10-Q of Communications Systems,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period covered
by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly
report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of
the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
By /s/ Curtis A. Sampson
--------------------------------
Curtis A. Sampson
Date: May 14, 2003 Chairman and Chief Executive Officer
18
CERTIFICATION
--------------
I, Paul N. Hanson, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Communications Systems,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period covered
by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly
report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of
the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
By /s/ Paul N. Hanson
--------------------------------
Paul N. Hanson
Date: May 14, 2003 Vice President and Chief Financial Officer
19
CERTIFICATION
-------------
The undersigned certify pursuant to 18 U.S.C.ss.1350, that:
(1) The accompanying Quarterly Report on Form 10-Q for the period ended
March 31, 2003 , fully complies with the requirements of Section 13(a) or
15(d) of the Securities Exchange Act of 1934; and
(2) The information contained in the accompanying Report fairly presents, in all
material respects, the financial condition and results of operations of the
Company.
By /s/ Curtis A. Sampson
--------------------------------
Curtis A. Sampson
Date: May 14, 2003 Chairman and Chief Executive Officer
By /s/ Paul N. Hanson
--------------------------------
Paul N. Hanson
Date: May 14, 2003 Vice President and Chief Financial Officer
20