(EDGAR Online via COMTEX) -- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Recent Developments: Proposed Merger with Pineapple Energy and Proposed Sale of E&S Segment Businesses
As previously disclosed, on March 1, 2021, CSI entered into an Agreement and Plan of Merger (the "Merger Agreement") with Helios Merger Co., a Delaware corporation and a wholly-owned subsidiary of CSI (the "Merger Sub"), Pineapple Energy LLC, a Delaware limited liability company ("Pineapple"), Lake Street Solar LLC, a Delaware limited liability company (the "Members' Representative"), and Randall D. Sampson, as the Shareholders' Representative (the "Shareholders' Representative," and together with CSI, the Merger Sub, Pineapple and the Members' Representative, the "Parties"), pursuant to which Merger Sub will merge with and into Pineapple with Pineapple surviving the merger as a wholly owned subsidiary of CSI (the "Pineapple Merger").
Simultaneously with the execution of the Merger Agreement, Pineapple entered into a Voting Agreement, dated March 1, 2021 (the "Voting Agreement") with officers and director of CSI (the "CSI Holders"). The CSI Holders hold in the aggregate approximately 13.8% of CSI's outstanding shares. Pursuant to the Voting Agreement, each CSI Holder has agreed, with respect to all of the voting securities of CSI that such CSI Holder beneficially owns as of the date thereof or thereafter, to vote in favor of the Merger. The Voting Agreement will terminate on the Effective Time (as defined therein) or upon termination of the Merger Agreement in accordance with its terms.
Pursuant to the Merger Agreement, at the closing of the Merger, CSI will enter into a Contingent Value Rights Agreement (the "CVR Agreement") with a person designated by CSI as the Holders' Representative (as defined therein), and the Rights Agent (as defined therein). Pursuant to the CVR Agreement, each shareholder of CSI as of immediately prior to the closing of the Merger will receive one non-transferable Contingent Value Right ("CVR") for each outstanding share of common stock of CSI held as of the close of business on the day immediately before the Effective Time of the Merger, which will represent the right to receive pro-rata distributions of proceeds from Dispositions that occur following the Effective Time.
A detailed description of the Pineapple Merger, the Voting Agreement and the CVR Agreement is contained in the Form 8-K dated March 1, 2021, and the Form 10-K for the year ended December 31, 2020, which was filed with the SEC on March 31, 2021.
In addition, a full description of the terms of the Pineapple Merger will be provided in a proxy statement for the shareholders of Communications Systems, Inc. (the "Pineapple Merger Proxy Statement") to be filed with the SEC. CSI urges investors, shareholders and other interested persons to read, when available, the preliminary proxy statement as well as other documents filed with the SEC because these documents will contain important information about CSI, Pineapple, and the proposed transaction. The definitive proxy statement will be mailed to CSI shareholders as of a record date to be established for voting on the proposed transaction. Shareholders will also be able to obtain a copy of the definitive proxy statement (when available), without charge, by directing a request to: Communications Systems, Inc., 10900 Red Circle Drive, Minnetonka, MN 55343. The preliminary and definitive proxy statement, once available, can also be obtained, without charge, at the SEC's website ( www.sec.gov ).
Proposed Sale of E&S Segment Businesses
As previously disclosed, on April 28, 2021 the Company entered into a definitive securities purchase agreement with Lantronix, Inc., under which CSI agreed to sell to Lantronix CSI's Transition Networks and Net2Edge businesses ("E&S Segment Sale") for an aggregate purchase price of up to $32,027,566, consisting of (i) $25,027,566 in cash payable at closing, subject to a working capital adjustment following closing, plus (ii) earnout payments of up to $7,000,000, payable following two successive 180-day intervals after the closing of the transaction based on revenue targets for these companies. The sale requires CSI shareholder approval and is expected to close in June 2021. Concurrently with the closing of the transaction, CSI and Lantronix will enter into a Transition Services Agreement under which CSI will perform administrative and IT services, and lease office, warehouse and production space to Lantronix at CSI's Minnetonka, Minnesota facility for a period of up to twelve months.
A detailed description of the E&S Segment Sale is contained in the Form 8-K dated April 28, 2021.
In addition, a full description of the terms of the E&S Segment Sale will be provided in a proxy statement for the shareholders of Communications Systems, Inc. (the "E&S Segment Sale Proxy Statement") to be filed with the SEC. CSI urges investors, shareholders and other interested persons to read, when available, the preliminary proxy statement as well as other documents filed with the SEC because these documents will contain important information about the proposed transaction. The definitive proxy statement will be mailed to CSI shareholders as of a record date to be established for voting on the proposed transaction. Shareholders will also be able to obtain a copy of the definitive proxy statement (when available), without charge, by directing a request to:
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 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 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 2020 and 2021 only reflect the Company's continuing operations and exclude the discontinued operations of the Company's former Suttle business.
First Quarter 2021 Summary
? Consolidated sales were $10.2 million in Q1 2021 compared to $9.2 million in Q1 2020.
? The Company incurred an operating loss from continuing operations of $2.1 million in Q1 2021 compared to an operating loss from continuing operations of $1.2 million in Q1 2020.
? Net loss from continuing operations was $2.2 million, or ($0.23) per diluted share in Q1 2021, compared to net loss from continuing operations of $809,000, or ($0.09) per diluted share, in Q1 2020.
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:
In addition to these factors and the specific factors related to the Company's two business segments listed below, there are factors related to the Company's pending sale of its E&S segment subsidiaries to Lantronix, including:
? The Company's ability to obtain shareholder approval for the sale to Lantronix;
? Conditions to the closing of the sale to Lantronix may not be satisfied or the sale may involve unexpected costs, liabilities or delays;
? Up to $7 million of the purchase price is structured in the form of an earnout based on revenues generated by Lantronix in the 360 days following closing, and there is no guaranty that sufficient revenues will be recognized for the earnout to be paid to the Company;
? How the restrictions placed on the Company's ability to actively solicit competing bids, and the obligation for the Company to pay a termination fee of $875,000 under certain circumstances, might deter other potential acquirers of the Electronics and Software segment;
? Conditions to the closing of the previously announced CSI-Pineapple merger may not be satisfied or the merger may involve unexpected costs, liabilities or delays;
? Related to the CSI-Pineapple announced merger, the Company's ability to successfully sell its other existing operating business assets and its real estate assets at a value close to their current fair market value and distribute these proceeds to its existing shareholder base;
? The fact that the continuing CSI-Pineapple entity will be entitled to retain ten percent of the net proceeds of CSI legacy assets that are sold pursuant to agreements entered into after the effective date of the CSI-Pineapple closing;
? The occurrence of any other risks to consummation of the sale to Lantronix or the CSI-Pineapple merger, including the risk that the sale to Lantronix or CSI-Pineapple merger will not be consummated within the expected time period or any event, change or other circumstances that could give rise to the termination of the sale to Lantronix or the CSI-Pineapple merger;
? Risks that the Lantronix transaction and the CSI-Pineapple merger will disrupt current CSI plans and operations or that the business or stock price of CSI may suffer as a result of uncertainty surrounding the Lantronix transaction and the CSI-Pineapple merger;
? The outcome of any legal proceedings related to the sale to Lantronix or the CSI-Pineapple merger;
? The fact that CSI cannot yet determine the exact amount and timing of any pre-CSI-Pineapple merger cash dividends or the value of the Contingent Value Rights that CSI intends to distribute to its shareholders immediately prior to the effective date of the CSI-Pineapple merger;
? 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";
? 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 to maintain customer and supplier relationships and key employees during the period between signing the definitive agreement to sell this segment to Lantronix and closing on the transaction;
? 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 an aftermath of the COVID-19 Pandemic, the Company has faced some slowdown and uncertainty with respect the future delivery of components of some of its products, including publicized computer chip shortages and longer supplier lead times for components;
? 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, particularly because the Company was not selected as the primary vendor on the next multi-year project for this school district customer, but has been selected as the secondary vendor for structured cabling and enterprise networking;
? Our ability to expand to other educational customers;
? 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 continue 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 2020 and the first quarter of 2021, 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. In addition, as noted above, we have faced some slowdown and uncertainty with respect to the future delivery of components of some of our products, including publicized chip shortages and longer supplier lead time for other components. 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 March 31, 2021 Compared to
Three Months Ended March 31, 2020
Consolidated sales increased 10.9% in the first quarter of 2021 to $10,159,000 compared to $9,163,000 in the same period of 2020. Consolidated operating loss from continuing operations in the first quarter of 2021 increased to $2,147,000 from an operating loss from continuing operations of $1,224,000 in the first quarter of 2020. Net loss from continuing operations in the first quarter of 2021 was $2,161,000 or $ (0.23) per share compared to net loss from continuing operations of $809,000 or $ (0.09) per share in the first quarter of 2020.
Electronics & Software
Electronics & Software sales decreased 2% to $8,365,000 in the first quarter of 2021 compared to $8,536,000 in 2020. The Electronics & Software segment organizes its sales force by vertical markets and segments its customers geographically. First quarter sales by region are presented in the following table:
Electronics & Software Sales by Region
2021 2020 North America $ 7,201,000 $ 7,448,000 International 1,164,000 1,088,000 $ 8,365,000 $ 8,536,000
The following table summarizes the 2021 and 2020 first quarter sales by its major product groups:
Electronics & Software Sales by Product Group 2021 2020 Intelligent edge solutions $ 3,713,000 $ 3,354,000 Traditional products 4,652,000 5,182,000 $ 8,365,000 $ 8,536,000
Sales in North America decreased $247,000, or 3%, primarily due to supply chain constraints in addition to delayed project spending by customers due to the COVID-19 pandemic. International sales increased $76,000, or 7%, primarily due to growth in the Asia Pacific region of sales of our traditional products. Sales of Intelligent edge solutions ("IES") products increased 11% or $359,000 due to an uptick in our core IES media converter products by Federal agencies and an uptick in our Switch products used in security and surveillance applications. Traditional product sales decreased 10% or $530,000 due to supply chain constraints in addition to delayed project spending by customers due to the COVID-19 pandemic.
Gross profit on first quarter sales decreased to $3,584,000 in 2021 from $3,729,000 in 2020. Gross margin decreased to 42.8% in the first quarter of 2021 from 43.7% in 2020 primarily due to an unfavorable product mix including some lower margin sales on IES products sold to Federal agencies due to competitive bidding. Selling, general and administrative expenses decreased 7% to $3,608,000, or 43.1% of sales, in the first quarter of 2021 compared to $3,897,000, or 45.7% of sales, in the first quarter of 2020 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 an operating loss of $24,000 in the first quarter of 2021 compared to an operating loss of $168,000 in the first quarter of 2020, primarily due to lower sales and gross margin.
Services & Support
Services & Support sales increased 134% to $1,938,000 in the first quarter of 2021 compared to $827,000 in 2020.
Revenues by customer group were as follows:
Services & Support Revenue by Customer Group 2021 2020 Financial $ 424,000 $ 94,000 Healthcare 253,000 190,000 Education 63,000 93,000 Other commercial clients 1,054,000 250,000 CSI IT operations 144,000 200,000 $ 1,938,000 $ 827,000
Revenues by revenue type were as follows:
Services & Support Revenue by Type 2021 2020 Project & product revenue $ 385,000 $ 141,000 Services & support revenue 1,553,000 686,000 $ 1,938,000 $ 827,000
Revenues from the education sector decreased $30,000 or 32% in the first quarter of 2021 as compared to the 2020 first quarter due to the substantial completion of projects from the Company's Florida school district customer. The Company was not selected as the primary vendor on the next multi-year project for this school district, but has been selected as the secondary vendor for structured cabling and enterprise networking.
Revenue from sales to SMBs, which are primarily financial, healthcare and commercial clients increased $1,197,000 or 224% in the first quarter of 2021 as compared to the first quarter of 2020 due to the acquisition of Ecessa on May 14, 2020 and the acquisition of the assets of IVDesk on November 3, 2020. Project and product revenue increased $244,000 or 173% in the first quarter of 2021 as compared to the first quarter of 2020 due primarily to the acquisition of Ecessa and its SD-WAN products. Services and support revenue increased $867,000 or 126% as compared to the same quarter of the prior year due to the Company's acquisition of Ecessa and its service and support revenue on its SD-WAN products as well as the acquisition of IVDesk, which contributed $597,000 in revenue during the quarter. Overall, Ecessa contributed $653,000 in revenue during the quarter.
Gross profit increased 275% to $776,000 in the first quarter of 2021 compared to $207,000 in the same period in 2020. Gross margin increased to 40.0% in the first quarter of 2021 compared to 25.0% in 2020 due to the increase in services & support revenue, which has higher margins. Selling, general and administrative expenses increased 198% in the first quarter of 2021 to $979,000, or 50.5% of sales, compared to $328,000, or 39.7% of sales, in the first quarter of 2020 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.
Services & Support reported an operating loss of $203,000 in the first quarter of 2021 compared to an operating loss of $121,000 in the same period of 2020, primarily due to increased selling, general and administrative expenses, including amortization expense.
"Other" includes non-allocated corporate overhead costs that are not considered discontinued operations. Prior to 2019, the Company would estimate annual revenue and headcount for each reporting segment and then allocate a portion of shared service corporate overhead costs based on these metrics. Because the Company began presenting its former Suttle segment as discontinued operations in 2019, allocated costs associated with Suttle were included within "Other."
Other corporate costs increased by $985,000 due to outside legal and financial consulting costs related to the previously announced Pineapple Energy merger and the April 29, 2021 announced sale of Transition Networks and Net2Edge (the Company's Electronics & Software operating segment).
The Company's loss from continuing operations before income taxes was $2,160,000 in the first quarter of 2021 compared to a loss from continuing operations before income taxes of $813,000 in the first quarter of 2020. The Company's effective income tax rate was (0.1%) in the first quarter of 2021 and 0.5% in 2020. This effective tax rate for 2021 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, 2020, the Company had a federal net operating loss carryforward from 2015 through 2020 activity of approximately $10,940,000 that is available to offset future taxable income and begins to expire in 2035. The Company also has a federal capital loss . . .
May 07, 2021
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