Back to GetFilings.com



- --------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended SEPTEMBER 30, 2004

OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR
15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to
..................... ........................

Commission File Number: 001-31588

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

MINNESOTA 41-0957999
.................................................................................
(State or other jurisdiction of (Federal Employer
incorporation or organization) Identification No.)

213 South Main Street, Hector, MN 55342
.................................................................................
(Address of principal executive offices) (Zip Code)

(320) 848-6231
.................................................................................
Registrant's telephone number, including area code

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES [X] NO [ ]

Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). YES [ ] NO [X]

APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.

CLASS Outstanding at October 29, 2004
- -------------------------------------- -------------------------------
Common Stock, par value $.05 per share 8,269,443

Total Pages (17)
- --------------------------------------------------------------------------------


COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

INDEX

Page No.
Part I. Financial Information

Item 1. Financial Statements

Consolidated Balance Sheets 3

Consolidated Statements of Income and 4
Comprehensive (Loss) Income

Consolidated Statements of Changes in
Stockholders' Equity 5

Consolidated Statements of Cash Flows 6

Notes to Consolidated Financial Statements 7

Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 12

Part II. Other Information 17









2


PART I. FINANCIAL INFORMATION
Item 1. Financial Statements

COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(unaudited)

September 30 December 31
Assets: 2004 2003
------------ ------------
Current assets:
Cash $ 23,491,505 $ 14,941,254
Trade receivables, net 22,367,762 22,647,129
Related party receivables 248,694 387,411
Inventories 22,215,272 24,354,041
Deferred income taxes 3,163,869 2,682,869
Other current assets 1,681,800 1,197,027
------------ ------------
Total current assets 73,168,90 66,209,731

Property, plant and equipment 34,044,366 32,331,619
less accumulated depreciation (27,305,836) (26,499,908)
------------ ------------
Net property, plant and equipment 6,738,530 5,831,711

Other assets:
Goodwill 5,253,793 5,253,793
Deferred income taxes 1,252,757 1,252,757
Other assets 253,866 547,966
------------ ------------
Total other assets 6,760,416 7,054,516
------------ ------------
Total Assets $ 86,667,848 $ 79,095,958
============ ============

Liabilities and Stockholders' Equity:

Current liabilities:
Accounts payable $ 4,574,552 $ 2,194,560
Accrued compensation and benefits 3,358,716 3,013,533
Other accrued liabilities 2,211,165 1,885,000
Dividends payable 412,842 327,397
Income taxes payable 2,507,340 837,703
------------ ------------
Total current liabilities 13,064,615 8,258,193

Stockholders' Equity 73,603,233 70,837,765
------------ ------------
Total Liabilities and Stockholders' Equity $ 86,667,848 $ 79,095,958
============ ============

See notes to consolidated financial statements.

3




COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE (LOSS) INCOME
(unaudited)

Three Months Ended September 30 Nine Months Ended September 30
----------------------------- ------------------------------
2004 2003 2004 2003
------------ ------------ ------------ ------------

Sales $ 29,261,887 $ 24,666,206 $ 81,644,191 $ 76,110,039

Costs and expenses:
Cost of sales 19,285,153 18,114,844 54,660,083 54,738,237
Selling, general and
administrative expenses 7,475,145 5,989,064 21,759,886 18,879,561
------------ ------------ ------------ ------------
Total costs and expenses 26,760,298 24,103,908 76,419,969 73,617,798
------------ ------------ ------------ ------------

Operating income 2,501,589 562,298 5,224,222 2,492,241

Other income and (expenses):
Investment and other income 20,504 39,687 96,257 332,697
Interest expense (19,788) (34,161) (71,468)
------------ ------------ ------------ ------------
Other income (expense), net 20,504 19,899 62,096 261,229

Income before income taxes 2,522,093 582,197 5,286,318 2,753,470

Income taxes 985,000 135,000 2,035,000 955,000
------------ ------------ ------------ ------------

Net income 1,537,093 447,197 3,251,318 1,798,470
------------ ------------ ------------ ------------

Other comprehensive (loss) income:
Foreign currency
translation adjustment (9,042) 24,626 29,331 113,182
------------ ------------ ------------ ------------
Comprehensive income $ 1,528,051 $ 471,823 $ 3,280,649 $ 1,911,652
============ ============ ============ =============

Basic net income per share $ .19 $ .05 $ .40 $ .22
Diluted net income per share $ .19 $ .05 $ .39 $ .22


Average Basic Shares Outstanding 8,243,242 8,168,870 8,229,121 8,163,414
Average Dilutive Shares Outstanding 8,266,056 8,196,638 8,265,772 8,181,784


See notes to consolidated financial statements.


4


COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(unaudited)



Cumulative
Common Stock Additional Other
---------------------- Paid-in Retained Comprehensive
Shares Amount Capital Earnings Income (Loss) Total
--------- ---------- ------------ ------------ ------------ ------------

BALANCE AT DECEMBER 31, 2002 8,142,716 $ 407,135 $ 27,613,163 $ 40,920,358 $ (69,378) $ 68,871,278
Net income 2,717,481 2,717,481
Issuance of common stock under
Employee Stock Purchase Plan 23,172 1,159 122,503 123,662
Issuance of common stock to
Employee Stock Ownership Plan 32,000 1,600 253,440 255,040
Issuance of common stock under
Employee Stock Option Plan 1,700 85 11,645 11,730
Purchase of common stock (14,217) (711) (46,115) (51,122) (97,948)
Shareholder dividends (1,308,233) (1,308,233)
Other comprehensive income 264,755 264,755
--------- ---------- ------------ ------------ ------------ ------------
BALANCE AT DECEMBER 31, 2003 8,185,371 409,268 27,954,636 42,278,484 195,377 70,837,765
Net income 3,251,318 3,251,318
Issuance of common stock under
Employee Stock Purchase Plan 22,193 1,110 160,489 161,599
Issuance of common stock to
Employee Stock Ownership Plan 33,000 1,650 262,724 264,374
Issuance of common stock under
Employee Stock Option Plan 19,685 984 137,209 138,193
Purchase of common stock (986) (49) (3,389) (4,502) (7,940)
Shareholder dividends (1,071,407) (1,071,407)
Other comprehensive income 29,331 29,331
--------- ---------- ------------ ------------ ------------ ------------
BALANCE AT SEPTEMBER 30, 2004 8,259,263 $ 412,963 $ 28,511,669 $ 44,453,893 $ 224,708 $ 73,603,233
========= ========== ============ ============ ============ ============


See notes to consolidated financial statements.



5


COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)


Nine Months Ended September 30
----------------------------------
2004 2003
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:

Net income $ 3,251,318 $ 1,798,470
Adjustments to reconcile net income
to net cash provided by operating activities:
Depreciation and amortization 1,712,014 1,868,935
Changes in assets and liabilities net of effects of the
purchase of Image Systems Corporation in 2004:
Trade and related party receivables, net 1,013,826 (177,024)
Inventories 2,878,342 (173,996)
Other current assets (456,664) 355,092
Accounts payable 2,191,861 (1,972,435)
Accrued expenses 874,702 496,193
Income taxes payable 1,669,637 (1,327,655)
------------ ------------
Net cash provided by operating activities 13,135,036 867,580

CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures (1,138,023) (622,955)
Other assets 259,968 (175,372)
Payment for purchase of Image Systems Corporation (2,801,683)
------------ ------------
Net cash used in investing activities (3,679,738) (798,327)

CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of notes payable (7,000,000)
Dividends paid (984,272) (979,110)
Proceeds from issuance of common stock 138,193
Purchase of common stock (7,940) (679)
------------ ------------
Net cash used in financing activities (854,019) (7,979,789)
------------ ------------

EFFECT OF FOREIGN EXCHANGE RATE CHANGES ON CASH (51,028) 41,382
------------ ------------

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 8,550,251 (7,869,154)

CASH AT BEGINNING OF PERIOD 14,941,254 19,816,328
------------ ------------
CASH AT END OF PERIOD $ 23,491,505 $ 11,947,174
============ ============

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Income taxes paid $ 368,363 $ 2,275,318
Interest paid 34,083 91,255
Dividends declared not paid 412,842 327,440

See notes to consolidated financial statements.


6


COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - CONSOLIDATED FINANCIAL STATEMENTS
The consolidated balance sheet as of September 30, 2004 and the related
consolidated statements of income and comprehensive (loss) income for the three
and nine-month periods ended September 30, 2004 and the consolidated statements
of changes in stockholders' equity and the consolidated statements of cash flows
for the nine-month periods ended September 30, 2004 and 2003 have been prepared
by Communications Systems, Inc. and Subsidiaries (the Company or we) without
audit. In the opinion of management, all adjustments (which include only normal
recurring adjustments) necessary to present fairly the financial position,
results of operations, and cash flows at September 30, 2004 and 2003 and for the
nine months then ended have been made.

Certain information and footnote disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted. It is suggested these condensed financial
statements be read in conjunction with the financial statements and notes
thereto included in the Company's December 31, 2003 Annual Report to
Shareholders. The results of operations for the periods ended September 30 are
not necessarily indicative of the operating results for the entire year.

In February 2004 the Company issued 33,000 shares of the Company's common stock
to the Employee Stock Ownership Plan in payment of its 2003 obligation. In a
noncash transaction, the Company recorded additional stockholders' equity of
$262,724 (reflecting the market value of the stock at the time of the
contribution) and reduced accrued expenses by the same amount. In September
2004, the Company issued 22,193 shares of the Company's common stock to
employees participating in the Employee Stock Purchase Plan for the plan year
ended August 31, 2004. Under the terms of the plan, in a non-cash transaction,
the Company recorded additional stockholders equity of $160,489 (reflecting 85%
of the fair market value of the stock at August 31, 2004) and reduced accrued
expenses by the same amount.

STOCK BASED COMPENSATION PLANS

The Company has adopted the disclosure provisions of SFAS No. 123, "Accounting
for Stock-Based Compensation," but applies APB Opinion No. 25, "Accounting for
Stock Issued to Employees" for measurement and recognition of stock-based
transactions with its employees and accordingly no stock-based employee
compensation cost is reflected in net income. If the Company had elected to
recognize compensation cost for its stock based transactions using the method
prescribed by SFAS No. 123, pro forma net income and net income per share would
have been as follows:
Three Months Ended September 30
-------------------------------
2004 2003
------------ ------------
Net Income
As reported $ 1,537,000 $ 447,000
Compensation expense, net of tax $ 101,000 $ 106,000
Pro forma $ 1,436,000 $ 341,000

Earnings Per Share-Basic
As reported $ . 19 $ .05
Pro forma $ . 17 $ .04
Earnings Per Share-Diluted
As reported $ . 19 $ .05
Pro forma $ . 17 $ .04


7

COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

Nine Months Ended September 30
-------------------------------
2004 2003
------------ ------------
Net Income
As reported $ 3,251,000 $ 1,798,000
Compensation expense, net of tax $ 291,000 $ 283,000
Pro forma $ 2,960,000 $ 1,515,000

Earnings Per Share-Basic
As reported $ . 40 $ .22
Pro forma $ . 36 $ .19

Earnings Per Share-Diluted
As reported $ . 39 $ .22
Pro forma $ . 36 $ .19


NOTE 2 - ACQUISITIONS

Effective March 24, 2004, the Company acquired substantially all the outstanding
shares of Image Systems Corporation (Pinksheets: IMSG) for a cash purchase price
per share of $0.643 or approximately $2.8 million in total consideration. Image
Systems Corporation (Image Systems), located in Minnetonka, Minnesota designs,
manufactures and markets high-resolution display solutions and accessories for
customers in the medical imaging market or for other customers who have
stringent and or unique display requirements. In addition, Image Systems has
been a premier developer of video graphics products since 1988. The proforma
effects of the Image Systems Corporation acquisition on our consolidated
financial statements were not material to the Company's consolidated financial
statements. The acquisition and operations of Image Systems are included in the
Company's consolidated financial results from the purchase date March 24, 2004.
The sum of amounts assigned to assets acquired and liabilities assumed exceeded
the cost of the acquired entity. To account for this excess, the amounts
assigned to property, plant and equipment were reduced on a pro-rata basis. In
the acquisition, the estimated fair value of the following assets were acquired
and liabilities assumed:

Property, plant and equipment $ 1,434,000
Accounts receivable 576,297
Inventory 716,999
Cash 103,625
Other assets 508,770
Accounts payable (180,162)
Accrued expenses (254,221)
-------------
Total purchase price 2,905,308
Less cash acquired (103,625)
-------------
Payment for purchase of Image Systems Corp.,
net of cash acquired $ 2,801,683
=============

8

COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

NOTE 3 - INVENTORIES

Inventories summarized below are priced at the lower of first-in, first-out cost
or market:
September 30 December 31
2004 2003
------------ -------------
Finished Goods $ 13,113,241 $ 14,531,725
Raw Materials 9,102,031 9,822,316
------------ -------------
Total $ 22,215,272 $ 24,354,041
============ =============

NOTE 4 - GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill represents the amount by which the purchase price and transaction costs
of business the Company has acquired exceed the estimated fair value of the net
tangible assets and separately identifiable assets of these businesses. The
Company adopted Statement of Financial Accounting Standards (SFAS) No. 142
"Goodwill and Other Intangible Assets" on January 1, 2002. Under SFAS No. 142,
goodwill and intangible assets with indefinite useful lives are not amortized,
but are tested at least annually for impairment. We reassess the value of our
business units and related goodwill balances at the beginning of the first
quarter of each fiscal year and at other times if events have occurred or
circumstances exist that indicate the carrying amount of goodwill may not be
recoverable. Accordingly, we have determined that there was no impairment as of
January 1, 2003 and no events occurred during the nine months ended September
30, 2004 that indicated our remaining goodwill was not recoverable. As of
September 30, 2004 the Company had net goodwill of $5,254,000. Intangible assets
with definite useful lives (consisting of a royalty agreement) will continue to
be amortized over its remaining life of five years. Amortization included in
costs and expenses was $34,000 and $52,000 for the nine months ended September
30, 2004 and 2003, respectively.

NOTE 5 - WARRANTY

We provide reserves for the estimated cost of product warranties at the time
revenue is recognized. We estimate the costs of our warranty obligations based
on our warranty policy or applicable contractual warranty, historical experience
of known product failure rates, and use of materials and service delivery costs
incurred in correcting product failures. Management reviews the estimated
warranty liability on a quarterly basis to determine its adequacy.

The following table presents the changes in the Company's warranty liability for
the nine months ended September 30, 2004, the majority of which relates to a
five-year obligation to provide for potential future liabilities for network
equipment sales.

2004 2003
------------ -------------
Beginning Balance $ 659,684 $ 662,672
Actual warranty costs paid (164,153) (80,124)
Amounts charged to expense 162,602 118,920
------------ -------------
Ending balance $ 658,133 $ 701,468
============ =============

9

COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

NOTE 6 - SEGMENT INFORMATION
The Company classifies its businesses into five segments: Suttle, which
manufactures U.S. standard modular connecting and wiring devices for voice and
data communications; Austin Taylor, which manufactures British standard line
jacks, patch panels, wiring harness assemblies, metal boxes, distribution
cabinets and distribution and central office frames; Transition Networks and
MiLAN Technology, which designs and markets data transmission, computer network
and media conversion products and print servers; and JDL Technologies, (JDL),
which provides telecommunications network design, specification and training
services to educational institutions; Other includes Image Systems Corporation,
(substantially all assets purchased March 24, 2004) which designs, manufactures
and markets high-resolution display solutions and accessories for customers in
the medical imaging market and non-allocated corporate general and
administrative expenses. Information concerning the Company's continuing
operations in the various segments for the nine-month periods ended September
30, 2004 and 2003 is as follows:


Austin Transition JDL
Suttle Taylor Networks/Milan Technologies Other Consolidated
------------ ----------- -------------- ------------ ------------ ------------

Nine Months Ended September 30, 2004:

Sales $ 29,028,596 $ 6,432,841 $ 38,634,203 $ 5,955,630 $ 1,592,921 $ 81,644,191
Cost of sales 21,974,415 5,730,726 22,896,378 3,019,252 1,039,312 54,660,083
------------ ----------- ------------ ----------- ------------ ------------
Gross profit 7,054,181 702,115 15,737,825 2,936,378 553,609 26,984,108
Selling, general and
administrative expenses 3,798,847 992,667 12,244,635 2,224,526 2,499,211 21,759,886
------------ ----------- ------------ ----------- ------------ ------------
Operating income (loss) $ 3,255,334 $ (290,552) $ 3,493,190 $ 711,852 $ (1,945,602) $ 5,224,222
============ =========== ============ =========== ============ ============

Depreciation and amortization $ 1,039,873 $ 241,507 $ 221,569 $ 90,000 $ 119,065 $ 1,712,014
============ =========== ============ =========== ============ ============

Capital expenditure $ 436,301 $ 10,747 $ 350,991 $ 251,962 $ 88,022 $ 1,138,023
============ =========== ============ =========== ============ ============

Total Assets $ 34,808,354 $ 5,595,865 $ 27,811,561 $ 5,640,038 $ 12,812,030 $ 86,667,848
============ =========== ============ =========== ============ ============

Nine Months Ended September 30, 2003:
Sales $ 24,090,756 $ 4,819,816 $ 37,157,838 $10,041,629 $ - $ 76,110,039
Cost of sales 19,427,142 4,734,324 23,910,190 6,666,581 - 54,738,237
------------ ----------- ------------ ----------- ------------ ------------
Gross profit 4,663,614 85,492 13,247,648 3,375,048 - 21,371,802
Selling, general and
administrative expenses 3,626,938 991,232 10,421,768 2,486,417 1,353,206 18,879,561
------------ ----------- ------------ ----------- ------------ ------------
Operating income (loss) $ 1,036,676 $ (905,740) $ 2,825,880 $ 888,631 $ (1,353,206) $ 2,492,241
============ =========== ============ =========== ============ ============

Depreciation and amortization $ 1,142,240 $ 235,365 $ 231,774 $ 135,540 $ 124,016 $ 1,868,935
============ =========== ============ =========== ============ ============

Capital expenditures $ 219,235 $ 95,496 $ 112,002 $ 173,494 $ 22,728 $ 622,955
============ =========== ============ =========== ============ ============

Total Assets $ 30,441,931 $ 6,045,815 $ 30,781,433 $ 6,741,469 $ 6,217,659 $ 80,228,307
============ =========== ============ =========== ============ ============


10

COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

Information concerning the Company's operations in the various segments for the
three-month periods ended September 30, 2004 and 2003 is as follows:


Austin Transition JDL
Suttle Taylor Networks/Milan Technologies Other Consolidated
------------ ----------- -------------- ------------ ------------ ------------
Three Months Ended September 30, 2004:

Sales $ 10,301,463 $ 1,860,199 $ 13,438,216 $ 2,937,286 $ 724,723 $ 29,261,887
Cost of sales 7,503,676 1,692,821 7,926,917 1,698,790 462,949 19,285,153
------------ ----------- ------------ ----------- ------------ ------------
Gross profit 2,797,787 167,378 5,511,299 1,238,496 261,774 9,976,734
Selling, general and
administrative expenses 1,311,788 328,961 3,978,355 737,934 1,118,107 7,475,145
------------ ----------- ------------ ----------- ------------ ------------
Operating income (loss) $ 1,485,999 $ (161,583) $ 1,532,944 $ 500,562 $ (856,333) $ 2,501,589
============ =========== ============ =========== ============ ============

Depreciation and amortization $ 334,088 $ 75,205 $ 74,403 $ 30,000 $ 41,003 $ 554,699
============ =========== ============ =========== ============ ============

Capital expenditures $ 131,110 $ - $ 130,020 $ 151,345 $ 25,294 $ 437,769
============ =========== ============ =========== ============ ============

Three Months Ended September 30, 2003:
Sales $ 8,648,471 $ 1,532,870 $ 12,440,587 $ 2,044,278 $ - $ 24,666,206
Cost of sales 6,889,177 1,454,640 8,182,967 1,588,060 - 18,114,844
------------ ----------- ------------ ----------- ------------ ------------
Gross profit 1,759,294 78,230 4,257,620 456,218 - 6,551,362
Selling, general and
administrative expenses 1,208,159 303,634 3,428,894 631,882 416,495 5,989,064
------------ ----------- ------------ ----------- ------------ ------------
Operating income (loss) $ 551,135 $ (225,404) $ 828,726 $ (175,664) $ (416,495) $ 562,298
============ =========== ============ =========== ============ ============

Depreciation and amortization $ 379,381 $ 80,973 $ 41,367 $ 45,180 $ 76,016 $ 622,917
============ =========== ============ =========== ============ ============

Capital expenditures $ 56,858 $ 95,496 $ 52,120 $ 27,500 $ - $ 231,974
============ =========== ============ =========== ============ ============


NOTE 7 - INCOME TAXES

In the preparation of the Company's consolidated financial statements,
management calculates income taxes based upon the estimated effective rate
applicable to operating results for the full fiscal year. This includes
estimating the current tax liability as well as assessing temporary differences
resulting from different treatment of items for tax and book accounting
purposes. These differences result in deferred tax assets and liabilities, which
are recorded on the balance sheet. These assets and liabilities are analyzed
regularly and management assesses the likelihood that deferred tax assets will
be recovered from future taxable income. The Company's effective income tax rate
was 38% and 35% as of September 30, 2004 and 2003, respectively, which
approximates the estimated annual effective tax rate. The increase in effective
tax rate is primarily due to higher income in the U.S., which is taxed at a
higher rate. In addition, the Company has lower foreign sales in 2004, which
reduces the utilization of the income tax reduction from the "Extraterritorial
Income Exclusion" on foreign sales.

NOTE 8 - NET INCOME PER SHARE

Basic net income per common share is based on the weighted average number of
common shares outstanding during each year. Diluted net income per common share
takes into effect the dilutive effect of potential common shares outstanding.
The Company's only potential common shares outstanding are stock options, which
resulted in a dilutive effect of 36,651 shares and 18,370 shares for the periods
ended September 30, 2004 and 2003, respectively. The Company calculates the
dilutive effect of outstanding options using the treasury stock method. The
total number of non-dilutive stock options was 1,111,024 at September 30, 2004
and 1,293,664 at September 30, 2003.

11


COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
- --------------------------------------------------------------------------------

Nine Months Ended September 30, 2004 Compared to
Nine Months Ended September 30, 2003
------------------------------------

Consolidated sales in 2004 increased 7% to $81,644,000 compared to $76,110,000
in 2003. The 2004 nine-month revenues include $1,593,000 in sales contributed
from the Image Systems business unit, which was acquired in March 2004.
Consolidated operating income in 2004 increased to $5,224,000 compared to
operating income of $2,492,000 in the first nine months of 2003. The Company's
core business units providing broadband products, Digital Subscriber Line (DSL)
products and media conversion and network switching products continue to show
revenue and earnings growth in the first nine months of 2004 compared to 2003.

Suttle sales increased to $29,029,000 in the first nine months of 2004 compared
to $24,091,000 in the same period of 2003 due to increased volumes with existing
and new customers. Sales to the major telephone companies increased 14% to
$15,519,000 in 2004 compared to $13,609,000 in 2003. Sales to these customers
accounted for 53% and 56% of Suttle's U.S. customer sales in 2004 and 2003,
respectively. Sales to distributors, original equipment manufacturers (OEMs),
and electrical contractors increased to $6,966,000 in 2004 compared to
$5,729,000 in 2003. Contract manufacturing sales totaled $2,480,000 in the first
nine months of 2004 compared to $2,274,000 in 2003.

Suttle's gross margins increased to $7,054,000 in the first nine months of 2004
compared to $4,664,000 in the same period in 2003. The gross margin percentage
was 24% in 2004 compared to 19% in 2003. The gross margin percentage increase
was due to cost reductions gained by shifting more manufacturing to the lower
cost plant in Costa Rica and from outsourcing the manufacturing of certain
products to Asia. Selling, general and administrative expenses increased
slightly to $3,799,000 in the first nine months of 2004 compared to $3,627,000
in the same period in 2003. Suttle's operating income was $3,255,000 in the
first nine months of 2004 compared to operating income of $1,037,000 in the same
period of 2003.

Austin Taylor's sales increased to $6,433,000 in the first nine months of 2004
compared to $4,820,000 in the same period of 2003 due to increased business
volumes with existing customers. Austin Taylor's gross margin increased to
$702,000 in the first nine months of 2004 compared to $85,000 in 2003. The
increase in gross margin was principally due to increased business volumes and
lower manufacturing and overhead costs. Selling, general and administrative
expenses was $993,000 in the first nine months of 2004 compared to $991,000 in
the same period in 2003. Austin Taylor's operating loss in the first nine months
of 2004 was $291,000 compared to an operating loss of $906,000 in the first nine
months in 2003. Total severance costs incurred in the first nine months of 2003
were $290,000.

Transition Networks / MiLAN Technology segment sales increased to $38,634,000 in
the first nine months of 2004 compared to $37,158,000 in the same period in
2003. Gross margin increased to $15,738,000 in the first nine months of 2004
from $13,248,000 in 2003. Gross margin as a percentage of sales was 41% in 2004
compared to 36% in 2003. The gross margin increase was due primarily to higher
business volumes and reductions in material and product component cost
reductions. Selling, general and administrative expenses increased to
$12,245,000 in the first nine months of 2004 compared to $10,422,000 in 2003 due
to an increase in the sales force headcount and marketing program expenses.
Operating income for this segment increased to $3,493,000 in the first nine
months of 2004 compared to $2,826,000 in the same period in 2003.

12

COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

Sales by JDL Technologies, Inc. (the Company's education consulting business
unit) was $5,956,000 in the first nine months of 2004 compared to $10,042,000 in
the same period in 2003. The decrease was due to lower sales of equipment in
2004 as compared to 2003. Gross margin in the first nine months of 2004
decreased to $2,936,000 compared to $3,375,000 in the same period of 2003. Gross
margin as a percentage of sales increased to 49% in 2004 from 34% in the 2003
period due to an increase in higher margin sales of connectivity and consulting
services to client school districts. Selling, general and administrative
expenses decreased $262,000 in the first nine months of 2004 compared to the
same period of 2003. JDL's operating income was $712,000 in the first nine
months of 2004 compared to operating income of $889,000 in the same period in
2003.

Consolidated investment and other income decreased $236,000 in the first nine
months in 2004 compared to 2003. The Company realized a net gain on disposal of
non-operating assets relative to the closing of the final building in Puerto
Rico in the second quarter of 2003 of approximately $280,000 which was recorded
as other income. Interest expense decreased by $37,000 in the first nine months
of 2004 compared to the same period in 2003 due to a decrease in borrowings on
the line of credit and a lower interest rate. Income before income taxes
increased to $5,286,000 in the nine-month period in 2004 compared to $2,754,000
in the same period in 2003. The Company's annualized effective income tax rate
is 38% in 2004 compared to 35% in 2003. The increase is due to higher income in
the U.S., which is taxed at a higher rate. In addition, the Company has lower
foreign sales in 2004, which reduces the utilization of the income tax savings
from the "Extraterritorial Income Exclusion" on foreign sales. Net income
through the first nine months of 2004 increased to $3,251,000 compared to
$1,799,000 in the same period in 2003.

Three Months Ended September 30, 2004 Compared to
Three Months Ended September 30, 2003
-------------------------------------

Consolidated sales increased 19% to $29,262,000 in the three-month period ended
September 30, 2004 compared to $24,666,000 in the same period in 2003.
Consolidated operating income increased to $2,502,000 in the three months ended
September 30, 2004 compared to $562,000 in the same period in 2003.

Suttle sales increased to $10,301,000 in 2004 compared to $8,648,000 in 2003 due
to increased volumes in traditional products and DSL filters. Suttle's gross
margins increased to $2,798,000 in 2004 compared to $1,759,000 in 2003. Selling,
general and administrative expenses increased slightly to $1,312,000 in the
third quarter of 2004 compared to $1,208,000 incurred in the same period of
2003. The increase was primarily due to increases in sales incentives and
expenses. Suttle had operating income of $1,486,000 in the third quarter in 2004
compared to operating income of $551,000 in the same period in 2003.

Austin Taylor's sales increased to $1,860,000 in the 2004 three-month period
compared to $1,533,000 in the same period in 2003. Austin Taylor's gross margin
also increased to $167,000 in 2004 compared to $78,000 in 2003 due to increased
volume and lower overhead costs. Selling, general and administrative expenses
increased slightly to $329,000 in the third quarter of 2004 compared to $304,000
in 2003. The operating loss was $162,000 in the third quarter of 2004 compared
to an operating loss of $225,000 in the third quarter of 2003.

13

COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

Transition Networks / MiLAN Technology segment sales increased to $13,438,000 in
the third quarter of 2004 compared to $12,441,000 in the same period in 2003.
Gross margin increased to $5,511,000 in 2004 from $4,258,000 in 2003. Gross
margin as a percentage of sales was 41% in 2004 compared to 34% in 2003. The
gross margin increase was due primarily to higher business volumes and
reductions in material and product component costs. Selling, general and
administrative expenses increased to $3,978,000 in 2004 compared to $3,429,000
in 2003 due to increased sales and marketing expenses. Operating income
increased to $1,533,000 in the third quarter of 2004 compared to $828,000 in the
same period of 2003.

Sales by JDL Technologies, Inc. (the Company's education consulting business
unit) increased to $2,937,000 in the third quarter of 2004 compared to
$2,044,000 in the same period in 2003. JDL's gross margin increased to
$1,238,000 in the third quarter of 2004 compared to $456,000 in the third
quarter of 2003. Gross margin as a percentage of sales in the third quarter of
2004 increased to 42% from 22% in the 2003 period due to increased sales of
higher margin connectivity and consulting services and decreased sales of
equipment and hardware products which generate lower margins. Selling, general
and administrative expenses increased to $738,000 in the third quarter of 2004
compared to $632,000 in the same period of 2003. JDL's operating income was
$501,000 in the third quarter of 2004 compared to an operating loss of $176,000
in the 2003 third quarter.

Investment and other income in the third quarter of 2004 decreased by $19,100 in
2004 compared to 2003. Interest expense decreased by $20,000 in the third
quarter of 2004 compared to the same period in 2003 due to a decrease in
borrowings on the line of credit and a lower interest rate. Income before income
taxes increased to $2,522,000 compared to $582,000 in the third quarter of 2003.
Net income for the third quarter of 2004 was $1,537,000 compared to net income
of $447,000 in the third quarter of 2003.

Liquidity and Capital Resources
-------------------------------

At September 30, 2004, the Company had $23,492,000 of cash and cash equivalents
compared to $14,941,000 of cash and cash equivalents at December 31, 2003. The
Company had working capital of approximately $60,104,000 and a current ratio of
5.6 to 1 compared to working capital of $57,952,000 and a current ratio of 8.0
to 1 at the end of 2003.

Net cash provided by operating activities was $13,135,000 in the first nine
months of 2004 compared to net cash provided by operating activities of $868,000
in the same period in 2003. The cash flow increase was due primarily to
increased net income, a reduction in trade receivables and inventories and an
increase in the level of trade accounts payable, income taxes payable and
accrued expenses.

Net cash used in investing activities was $3,680,000 in the first nine months in
2004 compared to $798,000 in the same period in 2003. In March 2004, the Company
acquired substantially all of the outstanding shares of Image Systems
Corporation (Pinksheets:IMSG) for a cash purchase price per share of $0.643 or
approximately $2.8 million in total consideration net of cash acquired. In the
first nine months in 2004 cash investments in new plant and equipment totaled
$1,138,000 compared to $623,000 in 2003. Plant and equipment purchases in both
years were financed by internal cash flows. The Company expects to spend
$1,400,000 in total on capital additions in 2004.

14

COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

Net cash used in financing activities was $854,000 in the first nine months of
2004 compared to net cash used in financing activities in 2003 of $7,980,000. In
2003, the Company paid off the line of credit, which totaled $7,000,000 at
December 31, 2002. At September 30, 2004 Board authorizations are outstanding to
purchase an additional 283,200 shares. Cash dividends paid in the first nine
months of 2004 was approximately $985,000.

In the opinion of management, based on the Company's current financial and
operating position and projected future expenditures, sufficient funds are
available to meet the Company's anticipated operating and capital expenditure
needs.

Critical Accounting Policies
----------------------------

Our critical accounting policies, including the assumptions and judgements
underlying them, are discussed in our 2003 Form 10-K in Note 1 Summary of
Significant Accounting Policies included in our Consolidated Financial
Statements. There were no significant changes to our critical accounting
policies during the nine months ended September 30, 2004. These policies have
been consistently applied in all material respects and disclose such matters as
allowance for doubtful accounts, sales returns, inventory valuation, warranty
expense, income taxes, revenue recognition, asset impairment recognition and
foreign currency translation. On an ongoing basis, we evaluate our estimates
based on historical experience and on various other assumptions that are
believed to be reasonable under the circumstances, the result of which form the
basis for making judgements about the carrying value of assets and liabilities
that are not readily apparent from other sources. Results may differ from these
estimates due to actual outcomes being different from those on which we based
our assumptions. Management on an ongoing basis reviews these estimates and
judgements.

Recently Issued Accounting Pronouncements
-----------------------------------------

In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities" (VIE), an Interpretation of ARB No. 51, which
requires all VIEs to be consolidated by the primary beneficiary. The primary
beneficiary is the entity that holds the majority of the beneficial interests in
the VIE. In addition, the interpretation expands disclosure requirements for
both VIEs that are consolidated as well as VIEs from which the entity is the
holder of a significant amount of the beneficial interests, but not the
majority. In October 2003, the FASB agreed to defer the effective date so that a
public company would not need to apply the provisions of the interpretation to
VIE interests acquired before February 1, 2003, until the end of the first
interim or annual period ending after December 15, 2003. Because we have no
variable interest entities, the adoption of this new standard did not have a
material effect on our consolidated financial position or results of operations.



15

COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

Item 3. Quantitative and Qualitative Disclosures about Market Risk.
- --------------------------------------------------------------------

The Company has no freestanding or embedded derivatives. All contracts that
contain provisions meeting the definition of a derivative also meet the
requirements of, and have been designated as normal purchases or sales. The
Company's policy is to not use freestanding derivatives and to not enter into
contracts with terms that cannot be designated as normal purchases or sales.

The vast majority of our transactions are denominated in U.S. dollars; as such,
fluctuations in foreign currency exchange rates have historically not been
material to the Company. At September 30, 2004 our bank line of credit carried a
variable interest rate based on the London Interbank Offered Rate (Libor) plus
2%. The Company's investments are money market type of investments that earn
interest at prevailing market rates and as such do not have material risk
exposure.

Based on the Company's operations, in the opinion of management, no material
future losses or exposure exist relative to market risk.

Item 4. Controls and Procedures
- --------------------------------

Under the supervision and with the participation of our management, including
our Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"), we
evaluated the effectiveness of the design and operation of our disclosure
controls and procedures (as defined in Rule 13a-15(e) under the Securities
Exchange Act of 1934 (the "Exchange Act")). Based on that evaluation, our CEO
and CFO have concluded that, as of the end of the period covered by this report,
our disclosure controls and procedures are operating effectively and are
adequately designed to ensure that information required to be disclosed by us in
the reports we file or submit under the Exchange Act is recorded, processed,
summarized and reported, within the time periods specified in the applicable
rules and forms and is accumulated and communicated to our management, including
the CEO and CFO, as appropriate to allow timely decisions regarding required
disclosure. During the period covered by this Report there was no change in our
internal control over financial reporting (as defined in Rule 13a-15(f) under
the Exchange Act) that materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.

16

COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

PART II. OTHER INFORMATION

Items 1 - 4. Not Applicable

Item 5. Other Information

On November 2, 2004 the Company issued a news release which announced that
Curtis A. Sampson, the Company's Founder, Chairman of the Board and Chief
Executive Officer, has entered into a pre-arranged, systematic trading plan to
sell CSI shares in accordance with the guidelines specified by Rule 10b5-1 under
the Securities Exchange Act of 1934 and CSI's policies with respect to insider
sales. Mr. Sampson's 10b5-1 Plan provides for the sale of approximately 110,000
CSI shares of common stock, beginning November 3, 2004. As of November 3, 2004,
Mr. Sampson beneficially owned approximately 1,608,000 shares. Mr. Sampson has
designated a target price for the sale shares covered by the 10b5-1 Plan. If the
CSI stock is not trading at or above the target price, the shares may not be
sold.

Item 6. Exhibits and Reports on Form 8-K.

(a) The following exhibits are included herein:

31.1 Certification of Chief Executive Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002 (Rules 13a-14 and 15d-14 of the Exchange Act).

31.2 Certification of Chief Financial Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002 (Rules 13a-14 and 15d-14 of the Exchange Act).

32. Certifications pursuant Section 906 of the Sarbanes-Oxley Act of 2002
(18 U.S.C. ss.1350).

(b) Reports on Form 8-K.

On August 5, 2004, the Company filed a Current Report on Form 8-K with the
Securities and Exchange Commission, reporting under Item 9 its second quarter
2004 earnings release to shareholders.

Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereto duly authorized.

Communications Systems, Inc.

By /s/ Curtis A. Sampson
-----------------------
Curtis A. Sampson
Chairman and
Date: November 15, 2004 Chief Executive Officer

/s/ Paul N. Hanson
-----------------------
Paul N. Hanson
Vice President and
Date: November 15, 2004 Chief Financial Officer

17