FORM 10-K

For the fiscal year ended December 31, 2006

Commission File Number: 001-31588

COMMUNICATIONS SYSTEMS, INC.
(Exact name of registrant as specified in its charter)

213 South Main Street, Hector MN 55342
(Address of principal executive offices and zip code)

Registrant’s telephone number, including area code: (320) 848-6231

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
YES o   NO x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. YES o
NO x

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 o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). YES o   NO x

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant (shareholders other than officers and directors) was approximately $69,067,000 based upon the closing sale price of the Company’s common stock on the American Stock Exchange (“AMEX”) on June 30, 2006.

As of April 30, 2007 there were outstanding 8,858,459 shares of the Registrant’s common stock.

PART I

(a) GENERAL DEVELOPMENT OF BUSINESS

Communications Systems, Inc. (herein collectively called “CSI”, “our” or the “Company”) is a Minnesota corporation organized in 1969 which operates directly and through its subsidiaries located in the United States, Costa Rica and the United Kingdom. CSI is principally engaged through its Suttle and Austin Taylor business units in the manufacture and sale of modular connecting and wiring devices for voice and data communications, digital subscriber line filters, and structured wiring systems and through its Transition Networks business unit the manufacture of media and rate conversion products for telecommunications networks. CSI also provides through its JDL Technologies business unit network design, training services, general contracting of computer infrastructure installations, provisioning of high-speed internet access and maintenance support of network operation centers for K-12 schools.

The Company maintains a website at www.commsystems.com. Our annual reports on Form 10-K, our quarterly reports on Form 10-Q and our periodic reports on Form 8-K (and any amendments to these reports) are available free of charge by linking from our website to the Securities & Exchange Commission website.

(b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS

The Company classifies its businesses into four segments: Suttle, which manufactures U.S. standard modular connecting and wiring devices for voice and data communications; Transition Networks subsidiary that design and market data transmission, computer network and media conversion products and print servers; Austin Taylor, which manufactures British standard line jacks, patch panels, metal boxes, distribution and central office frames; and JDL Technologies, (JDL), which provides telecommunications network design, specification and training services to educational institutions; Non-allocated general and administrative expenses are separately accounted for as “Other” is the Company’s segment reporting. There are no material intersegment revenues. Further information regarding operations in the various segments is set forth in Note 10 of the Notes to Consolidated Financial Statements under Item 8, herein.

(c) NARRATIVE DESCRIPTION OF BUSINESS

(1) Information Regarding Business Segments

(i) Suttle

Suttle manufactures and markets connectors and wiring devices for voice, data and video communications under the Suttle brand name in the United States (U.S.) and internationally. Suttle also manufactures and markets a line of residential structured wiring products under the SOHO (Small Office Home Office) Access ™ brand name. Suttle also markets a line of DSL (Digital Subscriber Line) filters for the telecommunications market. Substantially all of Suttle’s products are manufactured at its plants in Hector, Minnesota (Suttle Apparatus Minnesota Division), and San Jose, Costa Rica (Suttle Costa Rica, S.A.). Certain products are purchased from offshore contract manufacturers. Segment sales were $42,690,000 (37% of consolidated revenues) in 2006 and $47,324,000 (40% of consolidated revenues) in 2005.

          Products

Suttle’s products are used in on-premise connection of voice, data, and video devices. The core product line consists primarily of modular connecting devices and includes numerous types of jacks, connecting blocks and assemblies, adapters, cords and related equipment, which are offered in a variety of colors, styles and wiring configurations. Many of the products are used in voice applications but Suttle continues to develop an expanding line of products for full communications and entertainment connectivity. A significant portion of Suttle’s revenue is derived from sales of a line of corrosion-resistant connectors, which utilize a water-resistant gel to offer superior performance in harsh environments. Station apparatus products generally range in price from $0.70 to $25.00 per unit. A majority of Suttle’s sales volume, both in units and revenues, is derived from products selling for under $5.00 per unit.

2

Suttle produces a full product line of residential structured wiring equipment used for customer premise applications for voice, data, video, and entertainment distribution. This line of products consists of structured wiring enclosures which are recessed or surface mounted in a residence or small business, and a series of plug-and-play modules which snap into the enclosures to complete the system. The modules selected determine the application of service and the number of ports or connections can be scaled up by adding more modules. These products are marketed under the SOHO AccessÔ line of products. Suttle’s residential wiring systems range in price from $40.00 to $250.00.

Suttle is also a manufacturer and seller of DSL filters for home and business applications. Suttle resells DSL filter products procured from offshore sources. These filters permit the user to receive both analog and digital signals simultaneously and allow a single telephone line to support uninterrupted voice, fax and internet capabilities.

          Markets and Marketing

Suttle competes in all major areas of the telecommunications connector market utilizing traditional modular jacks as well as dual provider switch jacks. Switch jacks allows for a method to switch between two competing telephone service providers without the expense of rewiring.

Suttle markets DSL filtering devices to telephone companies for use with their DSL home install kits. The products include both inline filters for deployment in the home and DSL splitters which are typically mounted outside the home near the telephone demarcation point.

Suttle markets residential structured cabling system products which are an increasingly important part of its product line. Service providers such as the telephone and cable companies have extended their traditional services to include comprehensive communications and entertainment offerings which require enhanced premise cabling. Suttle markets its products to meet these applications to service providers, residential builders, and low voltage installers through distributors, and through the company’s sales staff.

Customers represent the major communication companies including both telephone and cable service provider companies. The major telephone companies include Verizon, ATT (formerly Bell South and SBC Communications), and Qwest. Major telephone companies are served directly by Suttle’s sales staff and through a select group of distributors. As a group, sales to the major telephone companies (including DSL), both directly and through distribution, represented 42% of Suttle’s sales in 2006 and 55% in 2005. The cable companies include Comcast, Time Warner, Cox Communications, and Charter as well as other cable companies. Other customers include smaller telephone companies, electrical/low voltage contractors, home builders, original equipment manufacturers, and retailers. These customers are served primarily through distributors but are also served directly by Suttle’s sales staff. Sales to cable customers and original equipment manufacturers (OEM) are made through a nationwide network of distributors and through the Suttle sales staff. Sales to cable television distributors represented 12% of Suttle’s sales in 2006 and 8% in 2005. Sales to OEMS and other distributors were 26% of Suttle’s sales in 2006 and 21% in 2005. Sales to international customers and other customers represented 13% of Suttle’s sales in 2006 and 11% in 2005.

The Company’s “Suttle” brand name is important to its business. Suttle regularly supports this name by trade advertising and believes it is well known in the marketplace.

          Competition

Suttle encounters strong competition in all its product lines and competes primarily on the basis of the broad lines of products offered, product performance, quality, price and delivery. In addition, distributors of Suttle’s products also market products for one or more of these competitors.

3

          Order Book

Suttle manufactures its products on the basis of estimated customer requirements. Outstanding customer orders at March 1, 2007 were approximately $2,082,000 compared to approximately $1,720,000 at March 1, 2006. New orders are generally filled within 30 days. Suttle does not believe its order book is a significant indicator of future results.

          Manufacturing and Sources of Supply

Suttle’s products are manufactured using plastic parts, wire sub-assemblies, fasteners, brackets, electronic circuit boards and other components, most of which are fabricated by Suttle. There are multiple sources of supply for the materials and parts required and the Company is not dependent upon any single supplier, except that Suttle’s corrosion-resistant products utilize a moisture-resistant gel-filled fig available only from Tyco Electronics. Suttle has not generally experienced significant problems in obtaining its required supplies, although from time to time spot shortages are experienced and additional order lead times are required from the offshore suppliers.

          Research and Development; Patents

Suttle continually monitors industry requirements and creates new products to improve its existing product line. Historically, Suttle has generally not relied on patents to protect its competitive position in its market. However, duplication of its designs by foreign apparatus manufacturers has caused Suttle to apply for design patents on a number of products.

(ii) Transition Networks

Transition Networks, Inc. (“Transition”) has business operations in Eden Prairie, Minnesota and Sunnyvale, California. Transition designs, assembles and markets media converters, baluns, transceivers, network interface cards, and fiber hubs under the Transition Networks and MiLAN Technologies brand names. Transition sells its product through distributors, resellers, integrators, and OEMs. These media converter and rate conversion products permit voice and data networks to move information between copper-wired equipment and fiber-optic cable. Sales by Transition Networks were $52,863,000 (46% of consolidated sales) in 2006 compared to $46,952,000 (41% of consolidated sales) in 2005. International sales accounted for 28% of Transition’s sales or $14,675,000 in 2006, compared to $12,589,000 or 27% of Transition’s sales in 2005.

          Products

Transition Networks designs, assembles and sells media converter devices, Ethernet switches and wireless access points and bridges that make it possible to transmit telecommunications signals between systems using different types of media (for example, between copper and fiber optic networks). These products are used to support legacy systems as customers’ networks grow, integrate fiber optics into a network, and extend the reach of networks. Protocols supported include Gigabit Ethernet, Fast Ethernet, Ethernet, T1/E1, DS3, RS232, RS485, ATM, OC3, OC12, and more. The company uses proprietary Application Specific Integrated Circuits (ASIC) for development of some products, as well as ASICs from IC manufacturers such as Marvell® and Broadcomm® for the development of new products. Product hardware and software development is done internally. The software that Transition Networks utilizes to manage its products is provided free with the product. Transition Networks product development is focused on hardware, with software developed to support hardware sales. The Company has been developing and marketing Ethernet based networking products for approximately 14 years. Transition Networks continues to develop products that address the enterprise, service provider, and industrial markets and in addition targets specific vertical markets of government and education. Product hardware and software development is performed internally and is expensed when incurred.

          Manufacturing and Sources of Supply

Transition Networks outsources most of its manufacturing operations. In 2006, approximately 16% of its products were manufactured offshore, principally in the Far East. The offshore sources of supply are subject to certain risks, including foreign currency fluctuations and interference from political sources. The balance of its product is manufactured in the United States. The Company has alternate sources of supply for its products and to date has not had problems obtaining necessary supplies.

4

          Markets and Marketing

Transition Networks’ products are used in a broad array of markets including enterprise networks, service providers’ networks, and industrial environments such as in manufacturing processes. Transition Networks has a broad customer base and applications for its products.

The media conversion product line addresses and is utilized in a variety of applications. The chassis based system, the Point SystemÔ, is used primarily in telecommunication closets for high-density applications and when multiple protocols need to be supported. Stand alone media converters are used typically at a workstation or for lower density applications.

Marketing primarily consists of direct marketing utilizing a telesales force, tradeshows, trade magazine advertising, public relations activities, and direct mail. Transition Networks also provides and participates in advertising and cooperative marketing campaigns with distribution partners. The Company also offers products in the newest and potentially high growth wireless market.

The Company’s “Transition Networks” and “MiLAN” brand names are important to its business. The Company regularly supports these names by trade advertising and believes them to be well known in the marketplace.

          Research and Development

The Transition Networks segment continues to develop products that address the enterprise, service provider, security and industrial markets. This includes developing converters for emerging protocols and existing protocols in new markets. Some of these products include video for CCTV, remote management devices built on the IEEE® 802.3AH standard, and Power Over Ethernet based on the IEEE® 802.3AF standard. Some design efforts are paced by the development of critical components such as integrated circuits and optical transceivers.

Research and development consists primarily of testing, equipment and supplies associated with enhancing existing products and developing new products. Research and development costs are expensed when incurred and were $578,000 in 2006 compared to $547,000 in 2005.

Through 2006 all of Transition’s research and development operations have been conducted in the United States. Transition is in the process of opening an engineering and sales office in China. The Company expects this operation to focus initially on providing software support for anticipated new product development. The office is expected to open in the third quarter of 2007.

          Competition

The Transition Networks segment faces strong competition across its entire product line. A large number of competitors exist for the highest volume products in the Ethernet and Fast Ethernet family. Low cost competitors from China and Taiwan are strongest in the developing Asian markets, but have had limited success in the North American market for the media converter products. A deeper penetration of these competitors poses a potential threat to sales and profit margins. Competition also exists from substitutes such as lower cost fiber switches. The Fast Ethernet and Gigabit Ethernet switch market is filled with a large number of domestic and Asian competitors.

          Order Book

Outstanding customer orders for Transition Networks products were approximately $1,977,000 at March 1, 2007 and $3,119,000 at March 1, 2006. Transition Networks orders are fulfilled on a relatively short-term basis and therefore the order book is not considered a significant indicator of future results.

5

(iii) JDL Technologies, Inc.

JDL Technologies, Inc., located in Eden Prairie Minnesota (“JDL”), provides telecommunications network design, specification, and training services to K-12 educational institutions. JDL focuses on providing services to the top 100 school districts in the United States, including all hardware, software, training, communications and services required to meet the business and educational learning requirements of the individual schools. Sales by JDL for 2006 were $12,929,000 (11% of consolidated sales) compared to 2005 sales of $15,433,000 (13% of consolidated sales). Sales of hardware, software and related equipment totaled $8,630,000 in 2006 or 67% of JDL sales compared to $10,964,000 in 2005 or 71% of JDL sales. Training, support, consulting and connectivity revenue were $4,299,000 and $4,449,000 in 2006 and 2005, respectively.

          U.S. Virgin Islands’ Department of Education (“VIDOE”)

Since 2001, JDL has owned and operated a network providing interconnection, internet and other telecommunications services to the schools and administration facilities of the VIDOE. JDL’s revenues from the VIDOE were $626,000 and $2,607,000 in 2006 and 2005 respectively. JDL’s net investment in plant and facilities used to provide service to the VIDOE totaled $2,212,000 and $1,392,000 at December 31, 2006 and 2005 respectively.

The Federal Communications Commission (“FCC”) provides funding each year through it E-RATE program to schools throughout the U.S. to enable them to purchase services like those provided by JDL to the VIDOE. E-RATE funding eligibility is determined annually by the Schools and Libraries Division (“SLD”) of the Universal Service Administration Company. Funding awards are based on the costs to provide eligible services and the economic circumstances of the residents of the respective school districts; since inception of the E-RATE program the U.S. Virgin Islands public schools have always qualified for funding. It is not unusual for companies in the telecommunications industry to provide services to schools for E-RATE covered services under contracts for which the SLD approval process is incomplete. At December 31, 2005 JDL was providing service to and recognizing revenues from the VIDOE for the 2005 – 2006 school year under a contract that had not been approved by the SLD as it was determined at that time to be remote that funding would not be approved. VIDOE is dependent on E-RATE funding for up to 90% of the cost of many of the services provided by JDL.

Since April 2006 JDL has been the subject of a civil investigation by the U.S. Department of Justice (“DOJ”) regarding allegations that JDL (and other parties) made false claims for E-RATE funding involving the VIDOE. In addition to cooperating with DOJ investigators since April 2006 the Company has conducted its own internal investigation of its VIDOE business.

On July 1, 2006, JDL began providing services to the VIDOE under a new contract for the 2006 – 2007 school year. Neither the 2005 – 2006 contract, nor the 2006 – 2007 contract had been approved by the SLD as of the start of the 2006 -2007 contract year.

As a result of its internal investigation the Company believes that JDL has acted ethically and legally in its dealings with the VIDOE and the E-RATE program. Moreover, to date the Company has not been notified by the DOJ or any other agency of any program violation or the basis of any other claim and the Company believes that DOJ’s investigation of JDL will be resolved without material cost to the Company. However, the possibility exists that the DOJ may assert claims against JDL that, if proved, could result in materially adverse financial consequences to the Company.

6

During 2006, as a result of its experience with the E-RATE funding process, it became apparent that JDL’s ability to receive E-RATE funds was affected by actions that might have been taken by other individuals or companies involved with the VIDOE and E-RATE programs. This gave rise to the possibility that if the VIDOE were to be sanctioned by the E-RATE program due to the actions of others, JDL might be unable to collect for provided services even though JDL’s conduct was compliant with the E-RATE program. It also became apparent in 2006 that JDL’s contracts with the VIDOE would not be approved for payment by the SLD until the SLD was satisfied that the VIDOE was operating within the E-RATE program’s legal guidelines. Accordingly, after considering the uncertainties created by the DOJ investigation of VIDOE, SLD’s review of VIDOE’s compliance with the E-RATE program and JDL’s inability to collect for services provided without SLD approval, the Company determined it could not recognize revenue on JDL’s VIDOE contracts in 2006, until it received a Funding Commitment Decision Letter (“FCDL”) from the SLD approving the contracts. The Company will maintain this approach into 2007 and beyond, until it becomes convinced that such approvals are routine and that it is remote funding will not be approved and that financial reports including such revenues can be relied upon as accurate. (A further discussion of JDL’s revenue recognition policies can be found in Note 1 to the consolidated financial statements.) Billings for services in 2006 to the VIDOE that went unrecognized in 2006 totaled $2,555,000. Accounts receivable at December 31, 2006 and 2005 from the VIDOE for services provided and recognized in 2005 revenues under contracts not yet approved by the SLD totaled $1,175,000.

In April 2007 and May 2007, the SLD approved the contracts between JDL and the VIDOE for the 2005 – 2006 and 2006 – 2007 school years and issued the appropriate FCDLs. As a result of the approvals, JDL expects to recognize $2,555,000 of VIDOE services revenue in the second quarter of 2007. The Company also concluded that accounts receivable amounts on the books related to 2005 revenues were collectible and did not need to be reserved. The Company and the VIDOE are now pursuing SLD approval on new contracts for the 2007 – 2008 school year.

          Order Book

Outstanding customer orders and contracts for JDL products and services were approximately $7,853,000 at March 1, 2007 and $10,115,000 at March 1, 2006. JDL’s contracts with certain customers are subject to approval by the SLD. Approved amounts could vary from the original contracts.

(iv) Austin Taylor

Austin Taylor Communications, Ltd. located at Bethesda, North Wales, United Kingdom. Austin Taylor is a provider of telephony and data networking products to leading telecommunications companies, distributors and installers throughout the U.K., Europe and the Middle East. Austin Taylor sales were $6,958,000 (6% of consolidated revenues) in 2006 and $5,674,000 (5% of consolidated revenues) in 2005.

Austin Taylor has a strong supply chain product development relationship with its Chinese supplier which has been established over a number of years. At the plant in Bethesda the company designs and manufactures external metal cabinets and internal metal boxes to industry standards and to customer specifications. All manufacturing and supply line products are supported to ISO: 9001:2000 approved standards to guarantee customer quality, consistency and reliability. Approximately 57% and 50% of Austin Taylor sales were to U.K. customers in 2006 and 2005.

Outstanding customer orders for Austin Taylor products were approximately $171,000 at March 1, 2007 compared to $190,000 at March 1, 2006. Because Austin Taylor fills new orders on a relatively short timetable, the Company does not believe its order book is a significant indicator of future results.

(2) Employment Levels

As of March 1, 2007 the Company employed 505 people. Of this number, 297 were employed by Suttle (including 121 in Hector, Minnesota and 176 in Costa Rica), 122 by Transition Networks, Inc., 37 by JDL Technologies, Inc., 37 by Austin Taylor Communications, Ltd and 14 corporate general and administrative positions. None of the Company’s employees are represented under collective bargaining agreements. The Company considers its employee relations to be good.

7

(3) Executive Officers of Registrant

The executive officers of the Company and their ages at March 1, 2007 were as follows:

Financial information about domestic and foreign operations and export sales may be obtained by reference to Note 10 of the “Notes to Consolidated Financial Statements” under Item 8 herein.

8

The risks described below are material in relation to on our business, financial condition and results of operations and could adversely impact the achievement of forward looking statements. Accordingly, the following risk factors should be considered when reviewing other information set forth in this report:

9

10

The administrative and manufacturing functions of CSI are conducted at the following facilities:

CSI believes these facilities will be adequate to accommodate its administrative, manufacturing and distribution needs for the foreseeable future.

Since April 2006 the Company’s JDL Technologies, Inc. subsidiary (along with other parties) has been the subject of a civil investigation by the U.S. Department of Justice (“DOJ”) into whether false claims under the federal government’s E-RATE program were made in connection with work performed for the Virgin Islands Department of Education (VIDOE). In addition to cooperating with DOJ investigators over the past 12 months, the Company has conducted its own internal investigation of its business dealings with VIDOE and its compliance with the E-RATE program. While the DOJ investigation is continuing, no legal action has been initiated against the Company by the DOJ or any other agency as of the date of this report. In addition, as a result of its own internal investigation, the Company believes it has acted ethically and legally in its business dealings VIDOE and in its compliance with E-RATE program requirements and believes the DOJ investigation will be resolved without material additional cost to the Company. Nevertheless, the possibility exists that the DOJ may exert claims against JDL that, if proved, could result in materially adverse financial consequences to the Company.

A former officer of one of the Company’s subsidiaries is claiming that he is entitled to a substantially greater retirement benefit than he is currently receiving. The former officer has asserted that, in addition to what he is currently receiving, the Company should also provide a supplemental retirement benefit of approximately $100,000 per year based on the former officer’s interpretation of the meaning of certain terms in the former officer’s employment contract with the subsidiary and in a side letter delivered by the Company concurrently with the signing of the employment agreement. The Company has denied the former officer’s claim for a supplemental retirement benefit. While the former officer has, since 2004, threatened to present his claim in both judicial and administrative forums, as of the date of this report, the Company has not received any notice from a court or public official regarding the commencement of legal proceedings related to the former officers’ claim. If the former officer initiates legal action, the Company will vigorously defend against the claims that have been asserted and believes the former officer’s claims will be resolved without material cost to the Company.

The Company is not aware of any other material litigation or other claims presently pending against the Company.

Not applicable.

11

PART II

The Company’s common stock trades on the American Stock Exchange (“AMEX”) under the trading symbol JCS.

The table below presents the price range of high and low trades of the Company’s common stock for each quarterly period indicated as reported by AMEX for 2006 and 2005.

At March 31, 2007 there were approximately 700 holders of record of Communications Systems, Inc. common stock.

Communications Systems, Inc. paid regular quarterly dividends to its shareholders at the rates indicated below:

The payment of future dividends will be determined at the discretion of the Board of Directors.

12

The following table presents information about the Company’s equity compensation plans, under which equity securities of the Company are authorized for issuance, as of December 31, 2006:

Securities Authorized for Issuance Under Equity Compensation Plans

Equity compensation plans not approved by security holders:

None

13

The following graph presents, at the end of each of the Company’s last five fiscal years, the cumulative total return on the common stock of the Company as compared to the cumulative total return reported for the AMEX Total Return Index (U.S. and Foreign), the AMEX Technology (IT) Index, the AMEX Consumer Manufacturing Index and the AMEX Industrial Manufacturing Index. Company information and each index assume the investment of $100 on the last business day before January 1, 2001 and the reinvestment of all dividends.

Comparison of Five-Year Cumulative Total Return

Not applicable.

The registrant repurchased 455 shares of its common stock totaling $4,097 during the fourth quarter of 2006. At December 31, 2006, the Company was authorized to purchase in accordance with Rule 10b-18 202,197 shares of its common stock pursuant to Board authorizations granted in November 2002.

14

COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES
SELECTED FINANCIAL INFORMATION
(in thousands except per share amounts)

15

Communications Systems, Inc. (herein collectively called “CSI”, “our” or the “Company”) is a Minnesota corporation organized in 1969 which operates directly and through its subsidiaries located in the United States, Costa Rica and the United Kingdom. CSI is principally engaged in the manufacture and sale of modular connecting and wiring devices for voice and data communications, digital subscriber line filters, structured wiring systems and the manufacture of media and rate conversion products for telecommunications networks. CSI also provides network design, training services, general contracting of computer infrastructure installations, provisioning of high-speed internet access and maintenance support of network operation centers for K-12 schools.

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, there may be “forward looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. The Company may make forward-looking statements 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 such 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 such forward looking statements are subject to risks and uncertainties which could cause actual performance, activities, anticipated results, outcomes or plans to differ significantly from those indicated in the forward-looking statements. Such risks and uncertainties include, but are not limited to: lower sales to major telephone companies and other major customers; the introduction of competitive products and technologies; our ability to successfully reduce operating expenses at certain business units; the general health of the telecom sector, successful integration and profitability of acquisitions; delays in new product introductions; higher than expected expense related to new sales and marketing initiatives; unfavorable resolution of claims and litigation, availability of adequate supplies of raw materials and components; fuel prices; government funding of education technology spending; and other factors discussed from time to time in the Company’s filings with the Securities and Exchange Commission.

Critical Accounting Policies

Allowance for Doubtful Accounts: The Company records a provision for doubtful accounts receivable based on an individual analysis and specific identification problem accounts. This involves a degree of judgment based on discussions with our internal sales and marketing groups and examinations of the financial stability of our customers. There can be no assurance that our estimates will match actual amounts ultimately collected. During periods of downturn in the market for our products or economic recession, a greater degree of risk exists concerning the ultimate collectability of our accounts receivable due to the impact that these conditions might have on our customer base.

Sales Returns: An allowance is established for possible return of products, rebates and advertising allowances. The amount of the allowance is an estimate, which is based on historical ratios of returns to sales, the historical average length of time between the sale and the return and other factors. Though management considers these allowances adequate and proper, changes in customers’ behavior versus historical experience or changes in the Company’s return policies are among the factors that could affect the adequacy of this allowance.

Inventory Valuation: The Company’s inventories are valued at the lower of cost or market. Reserves for overstock and obsolescence are estimated and recorded to reduce the carrying value to estimated net realizable value. The amount of the reserve is determined based on projected sales information, plans for discontinued products and other factors. Though management considers these reserves adequate and proper, changes in sales volumes due to unexpected economic or competitive conditions are among the factors that could materially affect the adequacy of this reserve.

16

Income Taxes: We account for income taxes in accordance with the provisions of Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. In the preparation of the Company’s consolidated financial statements, management calculates income taxes. This includes estimating the Company’s 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 realized from future taxable income. The valuation allowance for deferred income tax benefits is determined based upon the expectation of whether the benefits are more likely than not to be realized.

Warranty: The Company’s warranty programs vary by business groups and by product lines. Reserves for the estimated cost of product warranties are established at the time revenue is recognized. The costs of our warranty obligations are estimated based on warranty policy and the applicable contractual warranty, our historical experience of known product failure rates, our vendors’ experience and material and service delivery costs incurred in correcting product failures. Management reviews the estimated warranty liability on a quarterly basis to determine its adequacy. Though management considers these balances adequate and proper, changes in the Company’s warranty policy or a significant change in product defects versus historical experience are among the factors that could affect the adequacy of this reserve.

Goodwill Impairment: Goodwill is required to be evaluated for impairment on an annual basis and between annual tests upon the occurrence of certain events or circumstances, according to SFAS No. 142, Goodwill and Other Intangible Assets. The standard requires a two-step process be performed to analyze whether or not goodwill has been impaired. Step one is to test for potential impairment, and requires that the fair value of the reporting unit be compared to its book value including goodwill. If the fair value is higher than the book value, no impairment is recognized. If the fair value is lower than the book value, a second step must be performed. The second step is to measure the amount of impairment loss, if any, and requires that a hypothetical purchase price allocation be done to determine the implied fair value of goodwill. This fair value is then compared to the carrying value of goodwill. If the implied fair value is lower than the carrying value, an impairment adjustment must be recorded. The Company had net goodwill of $5,264,000 in each of the years ended December 31, 2006, 2005 and 2004. Carrying amounts of goodwill by segment as of December 31, 2006 are as follows: Suttle $1,272,000; Transition Networks $3,288,000; JDL Technologies $704,000.

Due to several factors, the JDL Technologies segment experienced lower than expected margins and return on capital invested in fiscal 2006 and 2005. Current projections are for margins and return on capital to increase to more acceptable levels. If this does not occur according to projections, the reductions in anticipated cash flow in relation the net assets of this segment may indicate that the fair value of this segment is less than book value resulting in impairment charges against earnings. At December 31, 2006 the Company assessment of the JDL segment indicated that its goodwill was not impaired. Management will continue to evaluate for any potential impairment.

The Company believes that accounting estimates related to goodwill impairment are critical because the underlying assumptions used for the discounted cash flow can change from period to period and could potentially cause a material impact to the income statement. Management’s assumptions about inflation rates and other internal and external economic conditions, such as earnings growth rate, require significant judgment based on fluctuating rates and expected revenues.

Revenue Recognition: The Company recognizes revenue when the earnings process is complete, evidenced by persuasive evidence of an agreement, delivery has occurred or services have been rendered, the price is fixed or determinable, and collectability is reasonably assured. In the Suttle, Transition Networks and Austin Taylor segments, the earning process completion is evidenced through the shipment of goods, as the sales terms of these segments are FOB shipping point, the risk of loss is transferred upon shipment and there are no significant obligations subsequent to that point. Other than the sales returns as discussed above, there are not significant estimates related to revenue recognition for these segments.

JDL Technologies records revenue on hardware, software and related equipment sales and installation contracts when the products are installed and accepted by the customer. In 2005, JDL entered into a fixed-price contract with a large school district to install and upgrade its network equipment and infrastructure. Revenue under this contract was recognized on a percentage-of-completion basis. The method used to determine the progress of completion was based on the ratio of costs incurred to total estimated costs.

17

JDL records revenue on service contracts on a straight-line basis over the contract period. Each contract is individually reviewed to determine when the earnings process is complete. Contracts with the Virgin Islands Department of Education (VIDOE) are funded by the federal government’s E-RATE program and must be approved by the Schools and Libraries Division (SLD) of the Universal Service Administration Company (USAC) before payment can be received. Due to our experience with the funding process, our history of being approved for funding for covered services and our direct involvement in the application process we have enacted a policy to recognize revenue prior to funding approval being received from the SLD so long as we can conclude that it is remote that funding will not be approved.

In order to make the “remote” conclusion quarterly we made an assessment that included consideration of the following:

During the years ended December 31, 2005 and 2004 we recognized revenue in advance of the funding approval by SLD because we had sufficient evidence to conclude that it was remote that funding would not be approved.

In early April 2006, we had not received funding approval for the June 30, 2005-June 30, 2006 school year. During our quarterly revenue recognition review process we received a letter from the Department of Justice (DOJ) informing us that we were the subject of an investigation regarding false claims to the E-RATE program involving the VIDOE. This investigation involved other parties as well. An internal investigation was started immediately by compiling and safeguarding relevant records.

We concluded that even if JDL was cleared of any wrongdoing, it was possible that the VIDOE might attract sanctions including debarment from the E-RATE program, which would preclude the approval of our contract with VIDOE. Based on this analysis we ceased recognizing revenue on this contract effective January 1, 2006. We continue to monitor this situation and will recognize the revenue in accordance with our policy if and when it is appropriate. During the year ended December 31, 2006 unrecognized revenue related to services provided to the VIDOE was $2,555,000.

Foreign Currency Translation: Assets and liabilities of the foreign subsidiary are translated to U.S. dollars at year-end rates, and the statements of operations are translated at average exchange rates during the year. Translation adjustments arising from the translation of the foreign affiliates’ net assets into U.S dollars are recorded in other comprehensive income.

Results of Operations

2006 Compared to 2005

Sales from continuing operations were $115,440,000 in 2006, which was consistent with sales of $115,382,000 in 2005. Operating income from continuing operations declined 14% to $5,025,000 from $5,870,000 in 2005. Income from continuing operations before income taxes declined 9% to $5,723,000 from $6,318,000 in 2005. Income from continuing operations declined 2% to $4,495,000 in 2006 compared to $4,590,000 in 2005. 2006 results were affected by the adoption of a new accounting pronouncement which required recognition of an expense for stock options of $157,000. The Company sold the operations of Image Systems, Inc. in October 2005. Those operations had a net of income tax loss of $343,000 in 2005. The Company recorded an after-tax gain on the sale of the operations of $222,000.

18

Suttle sales declined 10% to $42,690,000 in 2006 compared to $47,324,000 in 2005. Sales to the major telephone companies declined 31% to $17,893,000 in 2006 compared to $26,094,000 in 2005. Sales to these customers accounted for 42% of Suttle’s sales in 2006 compared to 55% of sales in 2005. The principal reason for the decline was the loss of contracts to provide DSL products to Suttle’s largest customer. Sales under the contracts declined $7,788,000 in 2006 compared to 2005. Suttle expects to recover a portion of this business in 2007. Sales to distributors, original equipment manufacturers (OEMs), and electrical contractors increased 22% to $16,443,000 in 2006 compared to $13,491,000 in 2005. This customer segment accounted for 39% of sales in 2006 compared to 29% in 2005. International sales increased 10% to $2,683,000 and accounted for 6% of Suttle’s 2006 sales. Sales to other customers increased 7% to $5,671,000.

The following table summarizes Suttle’s 2006 and 2005 sales by product group:

Suttle’s gross margins declined to $12,441,000 in 2006 compared to $12,998,000 in 2005. The gross margin percentage was 29% in 2006 compared to 27% in 2005. The increase in gross margin as a percentage of sales was due to the change in product mix and customer mix. Suttle realizes its highest selling margins on modular connecting products. DSL products are the least profitable. The loss of the DSL contracts for Suttle’s largest customer reduced gross margins by approximately $1,600,000 in 2006. Suttle also earns better margins on sales to distributor and OEM customers where pricing is usually based on Company list prices than from major telephone customers where pricing is usually based on negotiated contracts. Competition for business with major telephone companies is intense. Suttle gave up its contract to provide DSL products to a major telephone customer in 2006 because it could not sell the products profitably at the price offered by the customer. Imports from Asia were 31% lower in 2006 than in 2005. Suttle had outsourced its DSL product manufacturing to Asian suppliers. Selling, general and administrative expenses increased 5% to $6,370,000 in 2006 from $6,089,000 in 2005. The increase was primarily due to increases in general and administrative salaries and benefits which increased $260,000 or 6%. Suttle’s operating income declined 12% to $6,071,000 in 2006 from $6,909,000 in 2005.

Transition Networks sales increased 13% $52,863,000 compared to $46,952,000 in 2005. Transition Networks organizes its sales force and segments its customers geographically. Sales by customer groups in 2006 and 2005 were:

Sales in North America increased 11% over 2005. International sales increased 17%. Sales are benefiting from the increasing reach and scope of communications networks throughout the world. Transition Networks received its largest single order ever in 2006, selling $1,700,000 of Ethernet switches that will be part of a fiber-to-the-home (FTTH) project in Slovenia. As FTTH becomes the communications standard worldwide, the Company believes the need for products that enable communications across different types of media will continue to increase.

The following table summarizes Transition Networks’ 2006 and 2005 sales by product group:

19

Gross margin increased to $23,261,000 in 2006 compared to $18,793,000 in 2005. Gross margin as a percentage of sales increased to 44% in 2006 compared to 40% in 2005. Gross margins in 2005 were negatively affected by a second quarter inventory write-down adjustment of approximately $1.1 million dollars. Selling, general and administrative expenses increased 8% to $18,501,000 in 2006 from $17,089,000 in 2005 due to increases in the sales force headcount and marketing program incentives and expenses. Compensation and benefits expenses increased $1,308,000 or 14%. Marketing, advertising and other selling costs increased $497,000 or 13%. On July 1, 2005, CSI consolidated the MiLAN and Transition Networks business units into one operating unit under the direction of Transition Networks management. Operating income for the combined units increased 179% to $4,760,000 in 2006 compared to $1,704,000 in 2005.

Sales by JDL Technologies, Inc. (the Company’s education consulting business unit) declined to $12,929,000 in 2006 compared to $15,433,000 in 2005. The following table summarizes JDL’s revenues by customer group in 2006 and 2005:

Beginning in April 2006 JDL has been the subject (along with others) of an investigation by the U.S. Department of Justice (“DOJ”) regarding false claims for E-RATE funding involving the VIDOE. In addition to cooperating with DOJ investigators since April 2006, the Company has conducted its own internal investigation of its VIDOE business. To date the Company has not been notified by the DOJ or any other agency of any program violation or the basis of any other claim. Moreover, as a result of its internal investigation the Company believes it has acted ethically and legally in its dealings with the VIDOE and the E-RATE program and that the DOJ’s investigation of JDL will be resolved without material cost to the Company. However, the possibility exists that the DOJ may assert claims against JDL that, if proved, could result in materially adverse financial consequences to the Company.

During 2006, as a result of its experience with the E-RATE funding process, it became apparent that the Company’s ability to receive E-RATE funds was affected by actions that might have been taken by other individuals or companies involved with the VIDOE and E-RATE programs. This gave rise to the possibility that if the VIDOE were to be sanctioned by the E-RATE program due to the actions of others, JDL might be unable to collect provided services even though JDL’s conduct was compliant with the E-RATE program. It also became apparent in 2006 that JDL’s contracts with the VIDOE would not be approved for payment by the SLD until the SLD was satisfied that the VIDOE was operating within the E-RATE program’s legal guidelines. Accordingly, after considering the uncertainties created by the DOJ investigation of VIDOE, SLD’s review of VIDOE’s compliance with the E-RATE program and JDL’s inability to collect for services provided without SLD approval, the Company ceased revenue recognition on JDL’s VIDOE contracts effective January 1, 2006. The Company will maintain this approach into 2007 and beyond, until it becomes convinced that government approvals of E-RATE funded projects are routine and that it is remote that such funding will not be approved. (A further discussion of revenue recognition policies can be found in Note 1 to the consolidated financial statements.) Billings for services in 2006 to the VIDOE that went unrecognized in 2006 totaled $2,555,000. In April and May 2007, JDL Technologies’ contracts to provide maintenance, interconnection and internet access services to the U.S. Virgin Islands Department of Education for the 2005 – 2006 and 2006 – 2007 school years were approved by the Schools and Libraries Division (SLD) of the Universal Service Administration Company. The Company will recognize the $2,555,000 of revenue from these contracts in its second quarter 2007 financial statements.

20

In the second quarter of 2005, JDL entered into a fixed-price contract with the Oakland, CA school district to install and upgrade its network equipment and infrastructure. The total value of this contract was $6,645,000. Revenues and earnings under this contract were recognized based on Company estimates using the percentage-of-completion method. Revenues recognized on the contract were $3,023,000 and $3,622,000 in 2006 and 2005, respectively. Margins recognized on the contract were $192,000 and $413,000 in 2006 and 2005, respectively. The contract was completed in 2006.

Revenues earned in Broward County FL declined $766,000 or 10% in 2006. The revenue decline was due to lower equipment sales to the school district, which has largely completed its communications infrastructure build-out. JDL does not anticipate future equipment sales to approach 2005 levels. The decline in equipment sales was offset in part by increased sales of network operations services. JDL also offers training and professional development services to school districts throughout the U.S. Revenues from these services increased 51% to $1,014,000 in 2006.

Gross margins earned by JDL in 2006 declined to $1,507,000 in 2006 compared to $5,079,000 in 2005. Gross margins in 2006 were negatively impacted by the absence of E-RATE revenues from JDL’s VIDOE contracts. Margins were also negatively affected by increased depreciation charges on plant investments in the U.S. Virgin Islands and higher than anticipated costs on the Oakland project and on lower margin equipment sales to Broward County. Selling, general and administrative expenses increased 5% to $4,708,000 from $4,489,000 in 2005. The increase was due to legal and professional fees incurred associated with the Department of Justice investigation of the E-RATE program. JDL had an operating loss of $3,202,000 in 2006 compared to operating income of $590,000 in 2005.

Austin Taylor’s revenues increased 23% in 2006 to $6,958,000. Gross margin increased to $1,378,000 in 2006 from $651,000 in 2005. Gross margin as a percentage of sales improved to 20% in 2006 from 11% in 2005. Operating income in 2006 was $385,000 compared to an operating loss of $935,000 in 2005. Austin Taylor restructured its business in 2006. Employee headcount was reduced, sales of unprofitable products were discontinued and manufacturing of other products was outsourced to Asian manufacturers. This process enabled Austin Taylor to compete more successfully for business and expand its profit margins.

Net investment and other income increased to $698,000 in 2006 compared to $448,000 in 2005 due to increased earnings on cash investments. The Company generally invested its excess cash in high quality, tax advantaged municipal bond funds in 2006. At December 31, 2005 Austin Taylor had a net operating loss (NOL) carryforward in the United Kingdom (U.K.) of $1,354,000, which was fully reserved by the Company because of uncertainty about the ability of Austin Taylor to utilize the tax benefits. The Company utilized a portion of the NOL carryforward to offset Austin Taylor’s 2006 tax expense. The combination of the NOL benefit, the tax free interest income and reduced reserves for exposures to state and foreign income taxes dropped the Company’s 2006 tax rate to 21% compared to a normal U.S. rate of 34%.

2005 Compared to 2004

Sales from continuing operations in 2005 increased 6% to $115,382,000 compared to $108,555,000 in 2004. Operating income from continuing operations in 2005 decreased to $5,870,000 compared to $7,629,000 in 2004. CSI’s continuing operations are now in four principal business units: Suttle, JDL Technologies and Transition Networks and Austin Taylor. In 2005, Image Systems was sold and MiLAN Technologies was merged into Transition Networks. The Company’s core business units providing broadband products and Digital Subscriber Line (DSL) products continued to show growth in 2005.

Suttle sales increased to $47,324,000 in 2005 compared to $40,114,000 in 2004 due to increased volumes with existing and new customers. Sales to the major telephone companies increased 17% to $26,094,000 in 2005 compared to $22,388,000 in 2004. Sales to these customers accounted for 55% of Suttle’s sales in 2005 and 56% of sales in 2004. Sales to distributors, original equipment manufacturers (OEMs), and electrical contractors increased to $13,491,000 in 2005 compared to $9,554,000 in 2004. Suttle discontinued contract manufacturing operations and sales in the fourth quarter of 2004. Contract manufacturing sales totaled $2,480,000 in the first nine months of 2004.

21

Suttle’s gross margins increased to $12,998,000 in 2005 compared to $9,961,000 in 2004. The gross margin percentage was 27% in 2005 compared to 25% in 2004. The gross margin percentage increase was due to cost reductions gained by shifting more manufacturing to a lower cost plant in Costa Rica, continuing to outsource more manufacturing of certain products to Asia and increased business volumes. Selling, general and administrative expenses increased to $6,089,000 in 2005 compared to $5,201,000 in 2004. The increase was primarily due to increases in sales incentives, more aggressive marketing and selling programs and higher general and administrative salaries. Suttle’s operating income was $6,909,000 in 2005 compared to operating income of $4,760,000 in 2004.

Transition Networks sales decreased to $46,952,000 in 2005 compared to $52,443,000 in 2004. The decrease in sales was due to softer demand for media conversion and switching products in 2005 compared to 2004. Gross margin decreased to $18,793,000 in 2005 from $21,174,000 in 2004. The business recorded an inventory write-down adjustment of approximately $1.1 million dollars in the second quarter of 2005 associated with the absorption of MiLAN Technology which negatively impacted gross margin dollars. However, gross margin as a percentage of sales remained at 40% in 2005 and 2004 due to sales of higher margin products. Selling, general and administrative expenses increased to $17,089,000 in 2005 compared to $16,640,000 in 2004 due to an increase in the sales force headcount and marketing program incentives and expenses. MiLAN also recorded severance costs of $170,000 in 2005 and $0 in 2004. Operating income for this segment decreased to $1,704,000 in 2005 compared to $4,533,000 in 2004. On July 1, 2005, CSI consolidated the MiLAN and Transition Networks business units into one operating unit under the direction of Transition Networks management. Operations subsequent to July 1, 2005 have proven to be successful and include a 30% staff reduction in the former MiLAN operations.

Sales by JDL Technologies, Inc. (the Company’s education consulting business unit) increased to $15,433,000 in 2005 compared to $7,969,000 in 2004. The increase was due to higher sales of network equipment and connectivity services in 2005 as compared to 2004 due to new contracts awarded with new and current client school districts. In the second quarter of 2005, JDL entered into a fixed-price contract with a large school district to install and upgrade its network equipment and infrastructure. The total value of this contract was $6,645,000. As of December 31, 2005, costs and estimated earnings under this contract recognized on a percentage-of-completion basis totaled $3,622,000. Total billings for this contract were $2,388,000. The method used to determine the progress of completion is based on the ratio of costs incurred to total estimated costs. Gross margin in 2005 increased to $5,079,000 compared to $4,199,000 in 2004. Gross margin as a percentage of sales decreased to 33% in 2005 from 53% in 2004 period due to an increase in lower margin sales of network equipment to client school districts, lower margin with a large wiring contract, increased expenses for a major network renovation that JDL owns and manages for a large customer and increased expenses from expanding JDL Florida operations. Selling, general and administrative expenses increased to $4,489,000 in 2005 compared to $3,015,000 in the same period of 2004 due to higher sales headcount and increased marketing and administrative salaries including costs of expanding JDL’s Florida operations. JDL’s operating income was $590,000 in 2005 compared to operating income of $1,184,000 in 2004.

Austin Taylor’s revenues decreased 29% to $5,674,000 in 2005 compared to $8,029,000 in 2004. Gross margin increased to $651,000 in 2005 from $275,000 in 2004. Gross margin as a percentage of sales improved to 11% in 2005 from 3% in 2004. Austin Taylor had operating losses of $935,000 and $450,000 in 2005 and 2004 respectively. Austin Taylor began a restructuring plan in 2005. Employee headcount was reduced, which resulted in severance expenses charged against earnings, sales of unprofitable products were discontinued and manufacturing of other products was outsourced to Asian manufacturers. The Company had entered into negotiations and had a plan to sell Austin Taylor. However, the Company could not obtain terms it regarded as beneficial to shareholders, and made the determination to keep and restructure the operations.

Consolidated net investment and other income increased to $448,000 in 2005 compared to $167,000 in 2004 due to increased earnings on invested cash and money market balances. Consolidated income from continuing operations before income taxes decreased to $6,318,000 in 2005 compared to $7,796,000 in 2004. Due to the closing of the Company’s Puerto Rico operations and completion of an examination by the Internal Revenue Service of the Company’s federal income tax returns for the year ended December 31, 2002 the Company (in 2005) reviewed and its estimated accrued tax liabilities. The review process led the Company to conclude that its tax liabilities were significantly overaccrued. Adjustments to correct the overaccruals gave the Company an effective tax rate of 27% in fiscal year 2005 compared to an effective rate of 37% in 2004. The Company expects that the effective income tax rate for fiscal 2006 will be approximately 37%. Consolidated net income including discontinued operations in 2005 decreased slightly to $4,470,000 compared to $4,763,000 in 2004.

22

Net income includes the discontinued operations of Image Systems, a medical and technical imaging business unit located in Eden Prairie, Minnesota. Effective October 1, 2005, the Company negotiated an agreement to sell the inventory, equipment and all intangibles (trade names, intellectual property, etc.) of Image Systems to Richardson Electronics, Ltd. for approximately $1.5 million. The Company recorded an after tax gain on the sale in the fourth quarter of 2005 of approximately $222,000.

Acquisitions and Dispositions

The Company is a growth-oriented manufacturer of telecommunications connecting and networking devices. The Company is continuing to search for acquisition candidates with products that will enable the Company to better serve its target markets.

Effects of Inflation

Inflation has not had a significant effect on operations. The Company does not have long-term production or procurement contracts and has historically been able to adjust pricing and purchasing decisions to respond to inflationary pressures.

Liquidity and Capital Resources

At December 31, 2006, the Company had approximately $28,751,000 of cash and cash equivalents compared to $26,661,000 of cash and cash equivalents at December 31, 2005. The Company had current assets of approximately $78,410,000 and current liabilities of $9,454,000 at December 31, 2006 compared to current assets of $78,748,000 and current liabilities of $11,700,000 at the end of 2005.

Cash flow provided by operating activities was approximately $6,641,000 in 2006 compared to $4,582,000 provided by operations in 2005. The increase was primarily due to slower growth of the Company’s inventory levels, and the completion and billing of JDL’s Oakland project, which had costs and estimated earnings in excess of billings of $1,233,000 at December 2005.

Investing activities used $1,429,000 of cash in 2006 compared to using $2,768,000 of cash in 2005. Purchases of new plant and equipment totaled $2,475,000 in 2006, of which $1,584,000 went to support JDL’s investment in the Virgin Island’s educational network. The Company expects to invest approximately $1,700,000 in plant and equipment additions in 2007. In 2006 the Company also collected its $1,103,000 receivable outstanding from the sale of Image Systems Corporation.

Net cash used by financing activities was $2,923,000 in 2006 compared to $1,173,000 in 2005. Cash dividends paid on common stock increased to $2,971,000 in 2006 from $2,307,000 in 2005. The Company’s quarterly dividend rate increased from $.08 per share at January 1, 2006 to $.10 per share at January 1, 2007. Proceeds from common stock issuances, principally exercises of employee stock options, totaled approximately $732,000 in 2006 and $1,164,000 in 2005. The Company purchased in open market transactions and retired 68,681 shares for $756,000 in 2006 and 12,154 shares for $133,000 in 2005. At December 31, 2006, Board of Director authorizations to purchase approximately 202,000 additional shares remained in effect. The Company may purchase and retire additional shares in 2007 if warranted by market conditions and the Company’s financial position.

The Company revoked its Section 936 election effective January 1, 2002 and has included all subsequent revenues and expenses related to Puerto Rico operations in its consolidated federal income tax group. 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 cumulative amount of prior earnings on which no tollgate tax has been paid was approximately $11,054,000 at December 31, 2006. The Company had accrued $1,572,000 to pay its tollgate tax obligations and associated interest and penalties. We expect to settle these obligations in 2007.

Due to the closing of the Company’s Puerto Rico operations and completion of an examination by the Internal Revenue Service of the Company’s federal income tax returns for the year ended December 31, 2002 the Company (in 2005) reviewed its estimated accrued tax liabilities. The review process led the Company to reduce its tax reserves by $950,000, resulting in an effective tax rate of 27% in fiscal year 2005. Due to the effects of the Company’s tax position in the United Kingdom and a reduced estimate of its exposure to other state and foreign

23

income taxes, its effective rate in 2006 was 21%. The Company expects that the effective income tax rate for fiscal 2007 will be approximately 36%.

In 2005, the Board of Directors of Suttle Costa Rica S. A. declared a dividend in the amount of $3,500,000 payable to the Company. The dividend and related dividend reinvestment plan qualify under IRC Sec. 965. which allows the Company to receive an 85% dividend received deduction provided the amount of the dividend is reinvested in the United States pursuant to a domestic reinvestment plan. Approximately, $3,100,000 of qualified capital expenditures were purchased in 2005 and the balance was acquired in 2006.

At December 31, 2006 approximately $654,000 of assets were invested in the Company’s assembly plant subsidiary in Costa Rica. The Company expects to maintain assets in Costa Rica as needed to support the continued operation of the Suttle subsidiary. The Company uses the U.S. dollar as its functional currency in Costa Rica. Accordingly, the Company believes its risk of material loss due to fluctuations in foreign currency markets to be small.

The Company had no outstanding obligations under its line of credit at December 31, 2006 and 2005. The Company’s entire credit line ($10,000,000 at March 1, 2007) is available for use. The current line of credit expires September 30, 2007. Management believes that we will be able to renew the line on terms acceptable to the Company; however this can not be assured. 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.

Contractual Obligation Summary

The Company leases land, buildings and equipment under operating leases with original terms from one to five years. Certain of these leases contain renewal and purchase options. Rent expense charged to continuing operations was $1,331,000, $1,114,000 and $1,232,000 in 2006, 2005 and 2004 respectively. In 2005 and 2004 the Company subleased a portion of one of its offices. Sublease income received was $66,000 and $71,000 in 2005 and 2004 respectively.

The following table summarizes our future payments on contractual obligations outstanding at December 31, 2006:

As of December 31, 2006, the Company had no other material commitments (either cancelable or non-cancelable) for capital expenditures, short or long term debt, capital leases or other purchase commitments related to ongoing operations.

Recently Issued Accounting Pronouncements

In July 2006 the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48 (FIN 48), “Accounting for Income Taxes – an interpretation of FASB Statement No. 109”, which clarifies accounting for uncertain tax positions. FIN 48 requires the Company to recognize the impact of a tax position in the Company’s financial statements if that position is likely to be sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective for the Company beginning January 1, 2007. The Company has not determined the impact of the adoption of FIN 48 will have on the Company’s consolidated financial statements.

In September 2006 the FASB issued SFAS No. 157, “Fair Value Measurements”. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands fair value disclosure requirements. SFAS No. 157 applies whenever another accounting standard requires (or permits) assets or liabilities to be measured at fair value, but does not expand the use of fair value to new circumstances. SFAS No. 157 is effective beginning in 2008. The Company has not yet determined the effect SFAS No. 157 will have on its financial statements.

24

The Company adopted SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Post Retirement Plans” on December 31, 2006. SFAS No. 158 requires the Company to recognize the funded status of its post retirement plans on the balance sheet and recognize as a component of accumulated other comprehensive income the gains and losses, prior service costs or credits that occur during the financial year but are not recognized as components of the Company’s pension costs. The adoption of SFAS No. 158 caused the Company to adjust its 2006 financial statements to include $200,000 of previously unrecognized actuarial gains in Austin Taylor’s pension plan funds.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115”. SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The amendment to SFAS No. 115 applies to all entities with investments in available-for-sale or trading securities. The statement is effective for fiscal years beginning after November 15, 2007. The Company has not yet determined the effect SFAS No. 159 will have on its financial statements.

The Company has no freestanding or embedded derivatives. 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 December 31, 2006 our bank line of credit carried a variable interest rate based on our bank’s average certificate of deposit rate plus 1.5%. 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, the Company is not exposed to material future losses due to market risk.

25

(a) FINANCIAL STATEMENTS

REPORT OF MANAGEMENT

The management of Communications Systems, Inc. and its subsidiary companies is responsible for the integrity and objectivity of the financial statements and other financial information contained in the annual report. The financial statements and related information were prepared in accordance with accounting principles generally accepted in the United States of America and include amounts that are based on management’s informed judgments and estimates.

In fulfilling its responsibilities for the integrity of financial information, management maintains accounting systems and related controls. These controls provide reasonable assurance, at appropriate costs, that assets are safeguarded against losses and that financial records are reliable for use in preparing financial statements. Management recognizes its responsibility for conducting the Company’s affairs according to the highest standards of personal and corporate conduct.

The Audit Committee of the Board of Directors, comprised solely of outside directors, meets with the independent auditors and management periodically to review accounting, auditing, financial reporting and internal control matters. The independent auditors have free access to this committee, without management present, to discuss the results of their audit work and their opinion on the adequacy of internal financial controls and the quality of financial reporting.

26

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Shareholders and Board of Directors of
Communications Systems, Inc.:

We have audited the accompanying consolidated balance sheets of Communications Systems, Inc. and subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of income and comprehensive income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also include the financial statement schedule listed in the Index at Item 15. The consolidated financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and the schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the financial statement schedule referred to above, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

27

COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS