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Nov. 12, 2020, 4:11 p.m. EST

10-Q: COMMUNICATIONS SYSTEMS INC

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(EDGAR Online via COMTEX) -- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

Communications Systems, Inc. provides network infrastructure and services for global deployments of enterprise and industrial broadband networks through the following business segments:

Electronics & Software

This segment is initially comprised of CSI's Transition Networks and Net2Edge businesses. With over 30 years of growth and expertise in hardware and software development in this segment, the Company offers customers network solutions that provide secure, reliable connectivity and power through PoE products and actionable intelligence to end devices in an IoT ecosystem through embedded and cloud-based management software. In addition, this segment continues to generate revenue from its traditional products consisting of, media converters, NICs, and Ethernet switches that offer the ability to affordably integrate the benefits of fiber optics into any data network, in any application, and in any environment. The product portfolio gives customers simple, secure, and intelligent solutions for the network edge by offering support for multiple interface speeds, PoE options, and a broad array of protocols.

As data networks continue to change and evolve, the Company' solutions enable customers to easily deploy, provision, and proactively manage their networks with actionable insights about their edge devices and connected end points, thereby minimizing the administrative burden of the operator. The Company distributes hardware-based connectivity solutions through a network of resellers in over 50 countries.

Services & Support

This segment is initially comprised of CSI's JDL Technologies and Ecessa Corporation businesses. With over 30 years of growth and expertise in managed services and SD-WAN solutions in this segment, the Company offers customers:

? Technology services and infrastructure in the commercial, healthcare, financial, and education market segments. The Company's portfolio of technology solutions includes IT managed services supporting client infrastructures from the data center to the desktop, security products and services, cloud migrations, network virtualization and resiliency, wired and wireless network design and implementation, and converged infrastructure configuration and deployment. We provide many of these technology services to the education space, including having provided services to one of the largest school districts in the US for more than 30 years. We also provide these services to a number of commercial and healthcare clients.

? SD-WAN Never Down(R) networks, sold as a product or as a recurring service, enable organizations of all sizes to reliably run Internet and cloud-based applications, connect offices worldwide and distribute traffic among a fabric of multiple, diverse ISP links, ensuring business continuity by removing bottlenecks and eliminating network downtime. These capabilities optimize Never Down performance of business-critical applications, aid in lowering IT costs, and make it easier to provision, maintain and support business networks and the applications that run over them.

Except as otherwise expressly discussed, all operating results for 2019 and 2020 only reflect the Company's continuing operations and exclude the discontinued operations of the Company's former Suttle business. Operating results for 2019 have been reclassified to reflect the Company's new segment reporting.

Third Quarter 2020 Summary

? Consolidated sales were $12.1 million in Q3 2020 compared to $13.6 million in Q3 2019.

? The Company incurred operating income from continuing operations of $306,000 in Q3 2020 compared to operating income from continuing operations of $772,000 in Q3 2019.

? Net income from continuing operations was $554,000, or $0.06 per diluted share in Q3 2020, compared to net income from continuing operations of $887,000, or $0.10 per diluted share, in Q3 2019.

Forward-looking statements

In this report and, from time to time, in reports filed with the Securities and Exchange Commission ("SEC"), in press releases, and in other communications to shareholders or the investing public, the Company may make "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. We may make these 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 these 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 these forward-looking statements are subject to risks and uncertainties that could cause actual performance, activities, anticipated results, outcomes or plans to differ significantly from those indicated in the forward-looking statements. These risks and uncertainties include, but are not limited to:

General Risks and Uncertainties:

? The ability of the Company's two operating segments, Electronics & Software and Services & Support, to each function in an efficient, cost-effective manner and profitable manner, under the oversight of the CSI parent;

? Any short-term or long-term effect that the COVID-19 Pandemic may have on the American and world economies generally, or us as a manufacturing entity, including our ability to manufacture, market, and sell our products while complying with applicable or otherwise appropriate social distancing policies, as discussed throughout the "Forward-looking statements" section and more thoroughly below in the section "Impact of COVID-19 Pandemic";

? Our ability to successfully and profitably integrate our new Ecessa subsidiary into our existing operations, particularly in the Services & Support segment;

? Our ability to manage corporate costs incurred as a public company in an effective manner given our lower revenues and smaller scale as a result of the sale of Suttle operations;

? The ability of our Board of Directors and our management leadership team to identify business development options for the Company and the Company's ability to implement these plans;

? The impact of changing government expenditures in our markets; and

? The fact that our information technology systems may be exposed to various cybersecurity risks and other disruptions that could impair our ability to operate.

Electronics & Software Segment Risks and Uncertainties:

? The ability of this segment to develop and sell new products, including intelligent edge solutions, for new and existing markets at a level adequate to counter the decline in sales of its traditional products;

? The ability to develop, field test, manufacture and sell new products in sufficient quantities to achieve profitability;

? The ability to sustain meaningful product differentiation and achieve substantial gross margins;

? Reliance on contract manufacturers and OEMs to supply it with components and products in a timely manner as we develop and introduce new products;

? The fact that as this segment has more success in selling its products, including PoE products, as part of major infrastructure projects, it may experience significant fluctuations in quarter-to-quarter and year-to-year revenue and profitability; and

? Our ability to manage an inventory of components and finished products that is complex and complicated by our need to maintain a significant inventory of components (i) that may be or become in short supply or discontinued by the component manufacturer, (ii) that must be purchased in bulk to obtain favorable pricing, or (iii) that require long lead times. These factors may result in this business segment purchasing and maintaining significant amounts of inventory, that if not used or expected to be used based on anticipated production requirements, (i) may become excess or obsolete and (ii) could result in sales price reductions or inventory write-downs that could adversely affect this business and results of operations.

Services & Support Segment Risks and Uncertainties:

? Our ability to continue to obtain and manage the historically fluctuating business from its traditional South Florida school district customer;

? Our ability to expand to other educational prospects;

? Our ability to profitably increase our business serving small and medium-sized ("SMB") commercial businesses as well as any decreased spending by our existing SMB customers due to uncertainty or lower customer demand due to the COVID-19 pandemic;

? Our ability to successfully and profitably manage a large number of small accounts;

? Our ability to establish and maintain a productive and efficient workforce;

? Our ability to compete in a fast growing and large field of SD-WAN competitors, some whom have more features than our current product offering; and

? Our ability to integrate the recently acquired Ecessa SD-WAN business and the IVDesk private cloud services into the Services & Support operating segment.

The Company discusses these and other risk factors from time to time in its filings with the SEC, including risk factors presented under Item 1A of the Company's most recently filed Annual Report on Form 10-K and Quarterly Reports on Form 10-Q.

Impact of COVID-19 Pandemic

We are subject to risks and uncertainties as a result of the COVID-19 pandemic. In response to the pandemic, we instituted temporary office closures, implemented shelter-in-place orders and restrictions and instituted a mandatory work from home policy for substantially all office employees, and instituted social distancing work rules for operations personnel that continued to work in our facilities to satisfy customer orders. We experienced supply chain and demand disruptions during the first nine months of 2020 and expect the disruption to our supply to continue throughout 2020, as well as higher logistics and operational costs due to the COVID-19 pandemic. At the same time, we have seen an increase in demand for our fiber and high-speed products as customers are looking to upgrade their networks. As noted below, we are also seeing delays in orders as some projects are pushed out due to the inability to access locations due to the shutdowns. We may also see a slowdown in our business if one or more of our major customer or suppliers delays its purchase or supplies due to uncertainty in its business operations, encounters difficulties in its production due to employee safety or workforce concerns, is unable to obtain materials or labor from third parties that it needs to complete its projects, and may see a slowdown in our collection of receivables if our customers encounter cash flow difficulties or delay payments to preserve their cash resources. We are continuing to actively monitor the effects and potential impacts of the COVID-19 pandemic on all aspects of our business, liquidity and capital resources. The extent to which the COVID-19 pandemic may materially impact our financial condition, liquidity or results of operations is uncertain at this time.

Three Months Ended September 30, 2020 Compared to

Three Months Ended September 30, 2019

Consolidated sales declined 11.1% in the third quarter of 2020 to $12,110,000 compared to $13,622,000 in the same period of 2019. Consolidated operating income from continuing operations in the third quarter of 2020 decreased to $306,000 from operating income from continuing operations of $772,000 in the third quarter of 2019. Net income from continuing operations in the third quarter of 2020 was $554,000 or $0.06 per share compared to net income from continuing operations of $887,000 or $0.10 per share in the third quarter of 2019.

Electronics & Software

Electronics & Software sales decreased 33% to $8,755,000 in the third quarter of 2020 compared to $13,035,000 in 2019. The Electronics & Software segment organizes its sales force by vertical markets and segments its customers geographically. Third quarter sales by region are presented in the following table:

Electronics & Software Sales by Region







                               2020                      2019
        North America   $        7,672,000       $         11,479,000
        International            1,083,000                  1,556,000
                        $        8,755,000       $         13,035,000
        


The following table summarizes the 2020 and 2019 third quarter sales by its major product groups:







                                        Electronics & Software Sales by Product Group
                                               2020                         2019
        Intelligent edge solutions   $           2,990,000       $             5,791,000
        Traditional products                     5,765,000                     7,244,000
                                     $           8,755,000       $            13,035,000
        


Sales in North America decreased $3,807,000, or 33%, primarily due to delayed project spending by customers due to the COVID-19 pandemic in addition to $2,820,000 of sales for a major metropolitan smart city IoT project recorded in the prior year, that did not reoccur in the current year and delayed spending from a major Canadian telecommunications provider. International sales decreased $473,000, or 30%, primarily due to an overall drop in demand for traditional products and delayed project spending by customers due to the economic effects of the COVID-19 pandemic. Sales of Intelligent edge solutions ("IES") products decreased 48% or $2,801,000 due to the $2,820,000 of deliveries in the prior year related to the major metropolitan smart city IoT projects that did not reoccur. Traditional product sales decreased 20% or $1,479,000 due mainly to a decline in media converter and optical device orders from one major telecommunications customer.

Gross profit on third quarter sales decreased to $4,009,000 in 2020 from $6,282,000 in 2019. Gross margin decreased to 45.8% in the third quarter of 2020 from 48.2% in 2019 primarily due to the volume and favorable margin impacts from the prior year major metropolitan smart city IoT project that did not reoccur this year. Selling, general and administrative expenses decreased 26% to $3,281,000, or 37.5% of sales, in the third quarter of 2020 compared to $4,419,000, or 33.9% of sales, in 2019 due to reduced travel, marketing and personnel expenses, in part due to steps taken by management in response to the COVID-19 pandemic.

Electronics & Software incurred operating income of $728,000 in the third quarter of 2020 compared to operating income of $1,863,000 in 2019, primarily due to lower sales and gross margin.

Services & Support

Services & Support sales increased 351% to $3,530,000 in the third quarter of 2020 compared to $783,000 in 2019.

Revenues by customer group were as follows:







                                                                      Services & Support Revenue by
                                                                             Customer Group
                                                                         2020                  2019
        Education                                                  $   2,312,000         $      63,000
        Healthcare                                                       244,000               175,000
        Financial and other commercial clients                           799,000               353,000
        CSI IT operations                                                175,000               192,000
                                                                   $   3,530,000         $     783,000
        


Revenues by revenue type were as follows:







                                        Services & Support Revenue by Type
                                              2020                    2019
        Project & product revenue    $         2,611,000       $       130,000
        Services & support revenue               919,000               653,000
                                     $         3,530,000       $       783,000
                                                       -                     -
        


Revenues from the education sector increased $2,249,000 or 3570% in the third quarter of 2020 as compared to the 2019 third quarter due primarily to the commencement of projects that had been previously delayed due to funding issues where the same quarter of the prior year had very little project revenue in this sector. Revenue from sales to SMBs, which are primarily healthcare and financial clients increased $515,000 or 98% in the third quarter of 2020 as compared to 2019 due to the acquisition of Ecessa effective May 14, 2020. Project and product revenue increased $2,481,000 or 1908% in the third quarter of 2020 as compared to the third quarter of 2019 due primarily to the increase in the education sector. Services and support revenue increased $266,000 or 41% as compared to the same quarter of the prior year due to new client acquisition within managed services and the Company's acquisition of Ecessa, which has service and support revenue on its SD-WAN products. Overall, Ecessa contributed $535,000 in revenue during the quarter.

Gross profit increased 644% to $1,340,000 in the third quarter of 2020 compared to $180,000 in the same period in 2019. Gross margin increased to 38.0% in the third quarter of 2020 compared to 23.0% in 2019 due to the increase in projects in the education sector during the third quarter of 2020, while there was limited project revenue in the prior year, resulting in lower 2019 gross margins. Selling, general and administrative expenses increased 160% in the third quarter of 2020 to $909,000, or 25.8% of sales, compared to $349,000, or 44.6% of sales, in 2019 due the May 14, 2020 acquisition of Ecessa and the inclusion of its general and administrative costs that are not included in the prior year.

Services & Support reported operating income of $431,000 in the third quarter of 2020 compared to an operating loss of $169,000 in the same period of 2019, primarily due to increased education revenue.

Other

As a result of our treatment of Suttle as discontinued operations, "Other" includes non-allocated corporate overhead costs as well as costs allocated to Suttle that are not considered discontinued operations. In the past, the Company would estimate annual revenue and headcount for each principal business unit and then allocate a portion of shared service corporate overhead costs based on these metrics. Because Suttle is now treated as discontinued operations, these costs are now included within "Other." The Company is currently examining how to allocate these costs in the future given its sale of Suttle, acquisition of Ecessa and realignment of its operation into its Electronics & Software and Services & Support segments.

Income Taxes

The Company's income from continuing operations before income taxes was $563,000 in the third quarter of 2020 compared to income from continuing operations before income taxes of $860,000 in the third quarter of 2019. The Company's effective income tax rate was 1.6% in the third quarter of 2020 and (3.1%) in 2019. This effective tax rate for 2020 differs from the federal tax rate of 21% due to state income taxes, foreign tax rate differences, foreign losses not deductible for U.S. income tax purposes, the effect of uncertain income tax positions, stock compensation windfalls and changes in valuation allowances related to deferred tax assets. As of December 31, 2019, the Company had a federal net operating loss carryforward from 2015 through 2019 activity of approximately $7,687,000 that is available to offset future taxable income and begins to expire in 2035. The Company also has a federal capital loss carryforward from 2018 of approximately $1,930,000 that is available to offset future capital gains and expires in 2023.

Nine Months Ended September 30, 2020 Compared to

Nine Months Ended September 30, 2019

Consolidated sales decreased 13% in the first nine months of 2020 to $30,900,000 compared to $35,543,000 in the same period of 2019. Consolidated operating loss from continuing operations in the first nine months of 2020 was $2,564,000 compared to an operating loss from continuing operations of $1,179,000 in the same period of 2019. Net loss from continuing operations in the first nine months of 2020 was $1,622,000 or $ (0.17) per share compared to net loss from continuing operations of $955,000 or $ (0.11) per share in the first nine months of 2019.

Electronics & Software

Electronics & Software sales decreased 21% to $25,579,000 in the first nine months of 2020 compared to $32,262,000 in 2019. The Electronics & Software segment organizes its sales force by vertical markets and segments its customers geographically. First nine-month sales by region are presented in the following table:

Electronics & Software Sales by Region







                                 2020                      2019
        North America   $        22,019,000       $        26,448,000
        International             3,560,000                 5,814,000
                        $        25,579,000       $        32,262,000
        


The following table summarizes the segment's 2020 and 2019 first nine-month sales by its major product groups:







                                        Electronics & Software Sales by Product Group
                                               2020                         2019
        Intelligent edge solutions   $            9,368,000       $           10,846,000
        Traditional products                     16,211,000                   21,416,000
                                     $           25,579,000       $           32,262,000
        


Sales in North America decreased $4,429,000, or 17%, primarily due to delayed project spending by customers due to the effect of the COVID-19 pandemic, $2,820,000 of sales for a major metropolitan smart city IoT project recorded in the prior year, that did not reoccur in the current year, and a decline in sales to major Canadian telecommunications customer, partially offset by strong sales to Federal agencies. International sales decreased $2,254,000, or 39%, primarily due to an overall drop in demand for traditional products and the economic effects of the COVID-19 pandemic. Sales of Intelligent edge solutions ("IES") products decreased 14% or $1,478,000 due to $2,820,000 of deliveries in the prior year for a major metropolitan smart city IoT project that did not reoccur this year, partially offset by higher sales of security and surveillance products and sales to Federal agencies. Traditional product sales decreased 24% or $5,205,000 due mainly to a decline in media converter orders from major telecommunications customers.

Gross profit on first nine-month sales decreased to $10,834,000 in 2020 as compared to $14,370,000 in 2019. Gross margin decreased to 42.4% in the first nine months of 2020 from 44.5% in 2019 primarily due to the volume and favorable margin impacts from the prior year major metropolitan smart city IoT project that did not reoccur this year, increased sales of some IES products to Federal agencies at lower margins, partially offset by lower inventory write-downs year over year. Selling, general and administrative expenses decreased 18% to $10,816,000, or 42.3% of sales, in the first nine months of 2020 compared to $13,116,000, or 40.7% of sales, in 2019 due to reduced travel, marketing and personnel expenses, in part due to steps taken by management in response to the COVID-19 pandemic.

Electronics & Software had operating income of $18,000 in the first nine months of 2020 compared to operating income of $1,254,000 in the same period of 2019, primarily due to lower sales and gross margin.

Services & Support

Services & Support sales increased 49% to $5,882,000 in the first nine months of 2020 compared to $3,942,000 in 2019.

Revenues by customer group were as follows:







                                                                      Services & Support Revenue by
                                                                             Customer Group
                                                                         2020                  2019
        Education                                                  $   3,031,000         $   1,831,000
        Healthcare                                                       674,000               551,000
        Financial and other commercial clients                         1,616,000               902,000
        CSI IT operations                                                561,000               658,000
                                                                   $   5,882,000         $   3,942,000
        


Revenues by revenue type were as follows:







                                        Services & Support Revenue by Type
                                             2020                    2019
        Project & product revenue    $       3,498,000       $       2,124,000
        Services & support revenue           2,384,000               1,818,000
                                     $       5,882,000       $       3,942,000
        


Revenues from the education sector increased $1,200,000, or 66%, in the first nine months of 2020 as compared to the same period in 2019 due primarily to the commencement of projects that had been previously delayed due to funding issues where the same quarter of the prior year had very little project revenue in this sector. Projects for this customer commenced at the end of the second quarter of 2020. Revenue from sales to SMBs, which are primarily healthcare, financial and commercial clients increased $837,000, or 58%, in the first nine months of 2020 as compared to 2019 due to new client acquisition and rate increases in our commercial services division as well as the acquisition of Ecessa on May 14, 2020. The decrease in the CSI IT operations revenue as compared to the first nine months of 2019 is related to hardware refresh revenue in the prior year that was not repeated in the current year. Project and product revenue increased $1,374,000 or 65% in the first nine months of 2020 as compared to the first nine months of 2019 due primarily to the increase in the education sector. Services and support revenue increased $566,000 or 31% as compared to the same quarter of the prior year due to new client acquisition within managed services and the Company's acquisition of Ecessa, which has service and support revenue on its SD-WAN products. Overall, Ecessa contributed $798,000 in revenue during the year.

Gross profit increased 61% to $2,090,000 in the first nine months of 2020 compared to $1,299,000 in the same period in 2019. Gross margin increased to 35.5% in the first nine months of 2020 compared to 33.0% in 2019 due to the increase in project revenue in the education sector, primarily within the third quarter. Selling, general and administrative expenses increased 63% in the first nine months of 2020 to $1,720,000, or 29.2% of sales, compared to $1,056,000, or 26.8% of sales, in 2019 due to the May 2020 acquisition of Ecessa and the inclusion of its general and administrative costs that are not included in the prior year.

The operating income was of $370,000 in the first nine months of 2020 compared to operating income of $243,000 in the same period of 2019, primarily due to increased education revenue.

Other

As a result of our treatment of Suttle as discontinued operations, "Other" includes non-allocated corporate overhead costs as well as costs allocated to Suttle that are not considered discontinued operations. In the past, the Company would estimate annual revenue and headcount for each principal business unit and . . .

Nov 12, 2020

COMTEX_374366007/2041/2020-11-12T16:10:38

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