COMMUNICATIONS SYSTEMS INC
10-Q, 1999-08-13
TELEPHONE & TELEGRAPH APPARATUS
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- --------------------------------------------------------------------------------
                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

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

For the quarterly period ended            JUNE 30, 1999
                               -------------------------------------------------

                                       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:   0-10355

                          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

 ................................................................................
  (Former name, address, and former fiscal year, if changed since last report)

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
                                          ---    ---

                      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
Common Stock, par value                             Outstanding at July 31, 1999
    $.05 per share                                            8,625,477

                 Total Pages (14) Exhibit Index at (NO EXHIBITS)
- --------------------------------------------------------------------------------


<PAGE>


                  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 Comprehensive Income      4

        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               10

Part II.  Other Information                                            14










                                       2
<PAGE>
<TABLE>
<CAPTION>

                                  PART I. FINANCIAL INFORMATION

                          COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

Item 1.  Financial Statements

                                   CONSOLIDATED BALANCE SHEETS
                                           (unaudited)

                                                                       June 30        December 31
Assets:                                                                   1999               1998
                                                                  ------------       ------------
Current assets:
<S>                                                               <C>                <C>
   Cash                                                           $ 13,598,920       $ 20,405,363
   Receivables, net                                                 20,197,190         14,624,123
   Inventories (Note 4)                                             17,901,924         20,837,508
   Deferred income taxes                                             1,348,000          1,348,000
   Other current assets                                                833,049            499,549
                                                                  ------------       ------------
      Total current assets                                          53,879,083         57,714,543

Property, plant and equipment                                       31,578,765         30,654,182
   less accumulated depreciation                                   (20,592,522)       (19,275,422)
                                                                  ------------       ------------
   Net property, plant and equipment                                10,986,243         11,378,760

Other assets:
  Excess of cost over net assets acquired                           10,955,787          8,392,261
  Investments in mortgage backed and other securities                6,775,887          1,316,912
  Deferred income taxes                                                553,158            548,047
  Notes receivable from sale of assets of
    discontinued operations                                          3,565,390          3,765,390
  Other assets                                                         968,243            783,799
                                                                  ------------       ------------
      Total other assets                                            22,818,465         14,806,409
                                                                  ------------       ------------

Total Assets                                                      $ 87,683,791       $ 83,899,712
                                                                  ============       ============

Liabilities and Stockholders' Equity:

Current liabilities:
   Notes payable                                                  $  9,907,706       $  9,077,598
   Accounts payable                                                  6,357,219          4,589,078
   Accrued expenses                                                  4,637,213          3,823,596
   Dividends payable                                                   860,944            879,130
   Income taxes payable                                              1,993,193          2,076,658
                                                                  ------------       ------------
      Total current liabilities                                     23,756,275         20,446,060

Stockholders' Equity                                                63,927,516         63,453,652
                                                                  ------------       ------------

Total Liabilities and Stockholders' Equity                        $ 87,683,791       $ 83,899,712
                                                                  ============       ============

                         See notes to consolidated financial statements.
</TABLE>

                                       3
<PAGE>
<TABLE>
<CAPTION>

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

                                                    Three Months Ended June 30         Six Months Ended June 30
                                                   ----------------------------     -----------------------------
                                                          1999            1998             1999             1998
                                                   ------------    ------------     ------------     ------------
<S>                                                <C>             <C>              <C>              <C>
Sales                                              $ 29,807,344    $ 16,969,774     $ 56,404,236     $ 34,455,837

Costs and expenses:
  Cost of sales                                      19,906,281      11,619,503       37,467,395       23,861,597
  Selling, general and
    administrative expenses                           7,822,663       2,635,334       13,597,274        5,593,711
                                                   ------------    ------------     ------------     ------------
      Total costs and expenses                       27,728,944      14,254,837       51,064,669       29,455,308
                                                   ------------    ------------     ------------     ------------

Operating income                                      2,078,400       2,714,937        5,339,567        5,000,529

Other income and (expenses):
  Investment income                                     218,125         328,342          421,760          788,234
  Interest expense                                     (168,835)         (1,264)        (321,178)          (2,525)
                                                   ------------    ------------     ------------     ------------
    Other income, net                                    49,290         327,078          100,582          785,709

Income before income taxes                            2,127,690       3,042,015        5,440,149        5,786,238

Income taxes (Note 5)                                   380,000         600,000        1,220,000        1,150,000
                                                   ------------    ------------     ------------     ------------

Net income                                            1,747,690       2,442,015        4,220,149        4,636,238
                                                   ------------    ------------     ------------     ------------

Other comprehensive income -
  Foreign currency translation adjustment               (94,154)        (12,185)        (325,657)          71,075
                                                   ------------    ------------     ------------     ------------
Comprehensive income                               $  1,653,536    $  2,429,830     $  3,894,492     $  4,707,313
                                                   ============    ============     ============     ============

Basic net income per share                         $        .20    $        .27     $        .48     $        .50
Diluted net income per share                       $        .20    $        .27     $        .48     $        .50


Average Basic Shares Outstanding                      8,623,804       9,111,450        8,712,894        9,215,611
Average Dilutive Shares Outstanding                   8,716,487       9,214,932        8,775,711        9,314,022

                                  See notes to consolidated financial statements.

</TABLE>
                                                         4
<PAGE>
<TABLE>
<CAPTION>

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



                                        Common Stock         Additional                 Stock Option       Other
                                   ---------------------       Paid-in        Retaine          Notes   Comprehensive
                                      Shares      Amount       Capital        Earnings    Receivable       Income           Total
                                   ---------   ---------    -----------    -----------   -----------    -----------   ------------
<S>                                <C>         <C>         <C>            <C>            <C>            <C>           <C>
BALANCE AT DECEMBER 31, 1997       9,326,652   $ 466,333   $ 24,132,771   $ 44,552,855   $        -     $   111,737   $ 69,263,696
  Net income                                                                 7,867,425                                   7,867,425
  Issuance of stock to acquire
    JDL Technologies, Inc.           158,005       7,900      2,204,170                                                  2,212,070
  Issuance of common stock under
    Employee Stock Purchase Plan      12,210         610        112,259                                                    112,869
  Issuance of stock under
    Employee Stock Option Plan        84,834       4,242        938,102                                                    942,344
  Tax benefit from non qualified
    employee stock options                                       37,017                                                     37,017
  Issuance of notes receivable
     for stock options, net                                                                (288,225)                      (288,225)
  Purchase of stock                 (790,400)    (39,520)    (2,173,405)   (11,052,325)                                (13,265,250)
  Shareholder dividends                                                     (3,505,492)                                 (3,505,492)
  Foreign currency translation
   adjustment                                                                                                77,198         77,198
                                   ---------   ---------    -----------    -----------   -----------    -----------   ------------
BALANCE AT DECEMBER 31, 1998       8,791,301     439,565     25,250,914     37,862,463     (288,225)        188,935     63,453,652
  Net income                                                                 4,220,149                                   4,220,149
  Issuance of common stock to
    Employee Stock Ownership Plan     19,893         995        234,005                                                    235,000
  Issuance of common stock under
    Employee Stock Option Plan         5,300         265         53,069                                                     53,334
  Purchase of stock                 (203,400)    (10,170)      (589,075)    (1,367,658)                                 (1,966,903)
  Shareholder dividends                                                     (1,742,059)                                 (1,742,059)
  Foreign currency translation
    adjustment                                                                                             (325,657)      (325,657)
                                   ---------   ---------    -----------    -----------   -----------    -----------   ------------
BALANCE AT JUNE 30, 1999           8,613,094   $ 430,655   $ 24,948,913   $ 38,972,895   $  (288,225)   $  (136,722)  $ 63,927,516
                                   =========   =========    ===========    ===========   ===========    ===========   ============

                                            See notes to consolidated financial statements.
</TABLE>

                                                                  5
<PAGE>
<TABLE>
<CAPTION>

                                  COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES
                                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                                   (unaudited)
                                                                                    Six Months Ended June 30
                                                                               ---------------------------------
                                                                                       1999                1998
                                                                                ------------        ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
<S>                                                                             <C>                 <C>
     Net income                                                                 $  4,220,149        $  4,636,238
     Adjustments to reconcile net income
       to net cash provided by operating activities:
         Depreciation and amortization                                             2,448,596           1,355,908
         Changes in assets and liabilities net of effects from
         acquisition of LANart Corporation:
           Decrease (increase) in accounts receivable                             (3,864,667)            192,239
           Decrease (increase) in inventory                                        4,056,044          (2,030,678)
           Decrease (increase) in other current assets                              (358,705)          1,245,259
           Increase in accounts payable                                              557,046             253,009
           Increase (decrease) in accrued expenses                                  (533,887)            933,581
           Increase (decrease) in income taxes payable                               (78,664)            107,093
                                                                                ------------        ------------
             Net cash provided by operating activities                             6,445,912           6,692,649

CASH FLOWS FROM INVESTING ACTIVITIES:
     Capital expenditures                                                           (926,280)         (2,131,338)
     Maturities of mortgage-backed and other investment securities                   166,025             825,167
     Purchases of mortgaged-backed and other securities                           (5,625,000)
     Increase in other assets                                                       (196,766)           (481,478)
     Collection of notes receivable                                                  200,000             200,000
     Proceeds from maturities of U.S. Treasury securities                                              5,249,314
     Payment for purchase of LANart Corporation, net of cash acquired             (3,983,703)
                                                                                ------------        ------------
           Net cash (used in) provided by investing activities                   (10,365,724)          3,661,665

CASH FLOWS FROM FINANCING ACTIVITIES:
     Repayment of notes payable                                                     (266,813)
     Proceeds from issuance of notes payable                                       1,096,921
     Dividends paid                                                               (1,760,245)         (1,676,818)
     Proceeds from issuance of common stock                                           53,334             626,869
     Purchase of stock                                                            (1,966,903)         (7,597,249)
                                                                                ------------        ------------
           Net cash used in financing activities                                  (2,843,706)         (8,647,198)
                                                                                ------------        ------------

EFFECT OF FOREIGN EXCHANGE RATE CHANGES ON CASH                                      (42,925)             31,242
                                                                                ------------        ------------

NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS                              (6,806,443)          1,738,358

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                                  20,405,363          17,942,315
                                                                                ------------        ------------

CASH AND CASH EQUIVALENTS AT END OF PERIOD                                      $ 13,598,920        $ 19,680,673
                                                                                ============        ============

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
     Income taxes paid                                                          $  1,303,136        $  1,040,711
     Interest paid                                                                   325,983               2,525

                                 See notes to consolidated financial statements.
</TABLE>

                                                        6
<PAGE>


                  COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - CONSOLIDATED FINANCIAL STATEMENTS

The balance  sheet and statement of changes in  stockholders'  equity as of June
30, 1999,  the statements of income and  comprehensive  income for the three and
six month periods ended June 30, 1999 and 1998 and the  statements of cash flows
for the six-month periods ended June 30, 1999 and 1998 have been prepared by the
Company  without audit.  In the opinion of management,  all  adjustments  (which
include  only normal  recurring  adjustments)  necessary  to present  fairly the
financial position,  results of operations,  and cash flows at June 30, 1999 and
1998 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,  1998  Annual  Report  to
Shareholders.  The results of  operations  for the periods ended June 30 are not
necessarily indicative of the operating results for the entire year.

Effective  December 1, 1998,  the  Company  acquired  all the  capital  stock of
Transition  Networks,  Inc. for $8,507,000 (cash payments net of cash acquired).
The  transaction  is being  accounted for as a purchase,  and the  operations of
Transition  Networks,  Inc. are included in  consolidated  operations  as of the
effective  date.  Excess cost over net assets  acquired in the  transaction  was
$4,047,000, which is being amortized on a straight-line basis over 5 years.

Effective  August 7, 1998, in a noncash  transaction,  the Company  acquired JDL
Technologies,  Inc. in  exchange  for 158,005  shares of its common  stock.  The
acquisition was accounted for as a purchase.  The excess of cost over net assets
acquired  in the  transaction  was  $2,223,000,  which is being  amortized  on a
straight-line basis over 5 years. The results of operations of JDL Technologies,
Inc. have been included in the Company's operations effective August 7, 1998.

Unaudited  consolidated  results of  operations  on a pro forma  basis as though
these acquisitions were effective January 1, 1998 are as follows:

                                   Three Months Ended      Six Months Ended
                                       June 30, 1998         June 30, 1998
                                      --------------       ---------------
   Revenues                           $   24,657,533       $    48,519,350
   Net income                              2,292,955             3,978,923
   Basic net income per share         $          .25        $          .42
   Diluted net income per share       $          .24        $          .42

In February 1999 the Company issued 19,893 shares of the Company's  common stock
to the Employee  Stock  Ownership Plan in payment of its 1998  obligation.  In a
noncash  transaction,  the Company recorded additional  stockholders'  equity of
$235,000  (reflecting  the  market  value  of  the  stock  at  the  time  of the
contribution) and reduced accrued expenses by the same amount.

Effective  April 8, 1999,  the Company  acquired all the capital stock of LANart
Corporation for $3,984,000 (cash payments net of cash acquired). The transaction
is being  accounted for as a purchase.  Excess cost over net assets  acquired in
the  transaction  was  $3,550,000,  which is being  amortized on a straight-line
basis over 5 years. The operations of LANart Corporation, which are not material
to the Company's financial statements,  are included in consolidated  operations
as of the effective  date.  Subsequent to the  acquisition,  the Company  merged
LANart's operations into Transition Networks, Inc.

                                       7
<PAGE>

NOTE 2 - 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.  The
Company calculates the dilutive effect of outstanding options using the treasury
stock method.

NOTE 3 - SEGMENT INFORMATION

The  Company  classifies  its  businesses  into three  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, which
designs and markets data transmission and computer network  products;  and other
operations.  Information  concerning the Company's continuing  operations in the
various  segments for the  six-month  periods ended June 30, 1999 and 1998 is as
follows: <TABLE> <CAPTION>
                                              Austin    Transition
                                 Suttle       Taylor      Networks      Other   Consolidated
                             ---------------------------------------------------------------

Six Months Ended June 30, 1999:
<S>                           <C>          <C>         <C>          <C>          <C>
Revenues                      $29,977,460  $5,708,793  $16,729,834  $ 3,988,149  $56,404,236
Cost of sales                  19,369,544   4,615,993   10,683,321    2,798,537   37,467,395
                             ---------------------------------------------------------------
Gross profit                   10,607,916   1,092,800    6,046,513    1,189,612   18,936,841
Selling, general and
  administrative expenses       4,085,366     680,594    6,653,141    2,178,173   13,597,274
                             ---------------------------------------------------------------
Operating income (loss)       $ 6,522,550  $  412,206  $  (606,628) $  (988,561) $ 5,339,567
                             ===============================================================

Depreciation and amortization $ 1,059,262  $  319,923  $   751,134  $   318,277  $ 2,448,596
                             ===============================================================

Assets                        $49,090,211  $6,849,903  $19,610,095  $12,133,582  $87,683,791
                             ===============================================================

Capital expenditures          $   516,764  $  258,750  $    96,638  $    54,128  $   926,280
                             ===============================================================

Six Months Ended June 30, 1998:
Revenues                      $28,195,697  $6,260,140                            $34,455,837
Cost of sales                  18,852,059   5,009,538                             23,861,597
                             ---------------------------------------------------------------
Gross profit                    9,343,638   1,250,602                             10,594,240
Selling, general and
  administrative expenses       4,173,543     682,856               $  737,312     5,593,711
                             ---------------------------------------------------------------
Operating income (loss)       $ 5,170,095  $  567,746               $ (737,312)  $ 5,000,529
                             ===============================================================

Depreciation and amortization $ 1,015,051  $  277,329               $   63,528   $ 1,355,908
                             ===============================================================

Assets                        $55,752,796  $9,830,885               $9,310,837   $74,894,518
                             ===============================================================

Capital expenditures          $ 1,654,323  $  452,976               $   24,039   $ 2,131,338
                             ===============================================================
</TABLE>


Information  concerning  the  Company's  continuing  operations  in the  various
segments for the three-month periods ended June 30, 1999 and 1998 is as follows:

                                       8
<PAGE>

<TABLE>
<CAPTION>

                                              Austin    Transition
                                 Suttle       Taylor      Networks     Other    Consolidated
                             ---------------------------------------------------------------

Three Months Ended June 30, 1999:
<S>                           <C>          <C>         <C>          <C>          <C>
Revenues                      $14,007,252  $2,901,298  $ 9,964,452  $2,934,342   $29,807,344
Cost of sales                   9,123,663   2,364,131    6,340,492   2,077,995    19,906,281
                             ---------------------------------------------------------------
Gross profit                    4,883,589     537,167    3,623,960     856,347     9,901,063
Selling, general and
  administrative expenses       2,137,522     340,786    4,138,177   1,206,178     7,822,663
                             ---------------------------------------------------------------
Operating income (loss)       $ 2,746,067  $  196,381  $  (514,217) $ (349,831)  $ 2,078,400
                             ===============================================================

Depreciation and amortization $   529,630  $  158,649  $   488,891  $  159,139   $ 1,336,309
                             ===============================================================

Capital expenditures          $   236,671  $  141,045  $    36,493  $   33,850   $   448,059
                             ===============================================================

Three Months Ended June 30, 1998:
Revenues                      $14,047,383  $2,922,391                            $16,969,774
Cost of sales                   9,251,029   2,368,474                             11,619,503
                             ---------------------------------------------------------------
Gross profit                    4,796,354     553,917                              5,350,271
Selling, general and
  administrative expenses       1,938,154     359,535               $  337,645     2,635,334
                             ---------------------------------------------------------------
Operating income (loss)       $ 2,858,200  $  194,382               $ (337,645)  $ 2,714,937
                             ===============================================================

Depreciation and amortization $   507,524  $  138,808               $   31,764   $   678,096
                             ===============================================================

Capital expenditures          $   719,294  $  403,203               $    2,966   $ 1,125,463
                             ===============================================================
</TABLE>



NOTE 4 - INVENTORIES

Inventories summarized below are priced at the lower of first-in, first-out cost
or market:

                                            June 30       December 31
                                              1999              1998
     Finished Goods                    $  6,763,423      $  8,450,447
     Raw Materials                       11,138,501        12,387,061
                                       ------------      ------------
       Total                           $ 17,901,924      $ 20,837,508
                                       ============      ============

NOTE 5 - INCOME TAXES

Income taxes are computed based upon the estimated  effective rate applicable to
operating  results for the full fiscal year. For the periods ended June 30, 1999
and 1998 income taxes do not bear a normal  relationship to income before income
taxes,  primarily  because income from Puerto Rico  operations is taxed at rates
lower than the U.S. rate.

- --------------------------------------------------------------------------------
Statements regarding the Company's anticipated performance in future periods are
forward looking and involve risks and  uncertainties,  including but not limited
to:  buying  patterns of its Regional  Bell  Operating  Customers,  competitor's
products,  the  success  of  its  recent  acquisitions,  changes  in  tax  laws,
particularly  in regard to taxation of its subsidiary in Puerto Rico,  Year 2000
exposures and other risks involving the telecommunications industry generally.
- --------------------------------------------------------------------------------


                                       9
<PAGE>



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

                   Six Months Ended June 30, 1999 Compared to
                         Six Months Ended June 30, 1998

Consolidated sales increased 64% to $56,404,000.  Consolidated  operating income
increased 7% to $5,340,000.

Suttle  sales  increased  6% to  $29,977,000.  Sales to  customers in the United
States  (U.S.)  increased  7% to  $28,745,000.  Sales  to  the  Big 6  telephone
companies (the five Regional Bell Operating Companies (RBOCs) and GTE) increased
16% to  $18,785,000.  Sales to these  customers  accounted  for 63% of  Suttle's
sales.  Sales to distributors,  original  equipment  manufacturers  (OEMs),  and
electrical  contractors  increased  $211,000,  or 3%. Sales to retail  customers
decreased  $670,000  or 29% due to  decreased  sales  to Radio  Shack,  which is
Suttle's  principal retail customer.  Suttle's export sales,  including sales to
Canada decreased 6% to $1,232,000.

The sales  increases  were mainly of  Suttle's  CorroShield  and data  products.
CorroShield  product  sales  increased  40%,  reflecting a return to more normal
buying  patterns  by  the  RBOCs,  which  are  CorroShield's   major  customers.
CorroShield  products are continuing to displace  conventional  voice connecting
products.  Sales of conventional  products declined 20% in the 1999 period.  The
Company's  sales of  conventional  voice  products  are also being hurt by price
competition from foreign manufacturers. Sales of data products increased 28%.
Sales of fiber-optic connector products decreased 27%.

Suttle's gross margins  increased 14% to  $10,608,000.  Gross margin  percentage
improved to 35.4% in 1999 from 33.1% in 1998.  The  improvement  in gross margin
was due to product mix. The fastest selling  products in 1999  (CorroShield  and
data  products)  tended to be the products  with the highest  margins.  Selling,
general and  administrative  expenses declined $89,000 or 2%. 1998 expenses were
higher than normal due to a campaign to increase  export sales and sales of data
products. Suttle's operating income increased $1,352,000 or 26%.

Austin  Taylor's  sales  decreased  9% to  $5,709,000.  The  decrease was due to
reduced sales of CATV products  caused by major  reductions of cable  television
construction  activity in the U.K. and below plan sales to Pacific Rim telephone
companies. Austin Taylor's gross margin declined 13% to $1,093,000. Gross margin
as a percentage  of sales was 19% compared to 20% in 1998.  The decline in gross
margin was  principally  due to lower  business  volume.  Selling,  general  and
administrative expenses decreased $2,000. Operating income decreased $156,000 or
27%.

The Company acquired Transition Networks,  Inc. in December 1998. In April 1999,
the Company acquired LANart  Corporation,  which has been merged into Transition
Networks.  The combined  entities had sales of $16,730,000 and an operating loss
of $607,000 in the 1999 period.  Expenses associated with closing LANart's sales
and marketing operations in Europe and transferring  inventory and manufacturing
processes  from  Massachusetts  to  Minnesota  were a  significant  cause of the
operating loss.



                                       10
<PAGE>

The Company  acquired JDL  Technologies,  Inc. in August 1998.  JDL had sales of
$3,988,000  in the 1999  period,  an increase of 8% (on a pro forma  basis) from
sales in the first six months of 1998.  JDL had an operating loss of $136,000 in
1999 compared to a pro forma loss of $211,000 in 1998. Government funding delays
for new  telecommunications  infrastructure  in the  public  schools  negatively
affected  JDL's  performance in the first part of 1999. JDL earned a significant
portion of its  revenues in the 1999 period from  contracts  to provide  network
services and equipment to the U.S. Virgin Islands Department of Education and to
the Gary,  Indiana  public  schools.  CSI's  corporate  operating  expenses were
$853,000 compared to $737,000 in the 1998 period.

Consolidated investment income, net of interest expense,  decreased $685,000 due
to decreased  levels of funds  available for investment and interest  expense on
notes payable associated with acquisitions. Income before income taxes decreased
$346,000 or 6%. The Company's  effective  income tax rate was 22.4%  compared to
19.9% in 1998.  The  increase  in the tax rate was  because  the Company did not
generate sufficient tax credits in Puerto Rico to shelter all of its Puerto Rico
earnings. Net income decreased $416,000 or 9%.

                  Three Months Ended June 30, 1999 Compared to
                        Three Months Ended June 30, 1998

Consolidated sales increased 76% to $29,807,000.  Consolidated  operating income
decreased 23% to $2,078,000.

Suttle sales decreased $40,000 to $14,007,000.  Sales to customers in the United
States (U.S.)  decreased  $16,000 to  $13,361,000.  Sales to the Big 6 telephone
companies (the five Regional Bell Operating Companies (RBOCs) and GTE) increased
5% to $8,776,000.  Sales to these customers accounted for 63% of Suttle's sales.
Sales to distributors,  original equipment  manufacturers (OEMs), and electrical
contractors  decreased  $215,000,  or 6%.  Sales to retail  customers  decreased
$119,000  or 13% due to  decreased  sales to  Radio  Shack,  which  is  Suttle's
principal retail customer. Suttle's export sales decreased 4% to $670,000.

Suttle's  CorroShield  and data product  lines had solid sales  increases in the
1999 three  month  period.  Sales of data  products  increased  35%,  reflecting
increased  customer demand for high-speed data  connections to internet  service
providers.  CorroShield product sales increased 47%, reflecting a return to more
normal buying patterns by the RBOCs,  which are  CorroShield's  major customers.
CorroShield  product sales are displacing sales of conventional voice connecting
products with RBOC customers.  Sales of conventional voice products declined 36%
in the 1999 period.  The Company's sales of conventional voice products are also
being hurt by price competition from foreign manufacturers. Sales of fiber-optic
connector products decreased 27%.

Suttle's  gross  margins  increased 2% to  $4,884,000.  Gross margin  percentage
improved to 34.9% in 1999 from 34.1% in 1998.  The  improvement  in gross margin
was due to product mix. The fastest selling  products in 1999  (CorroShield  and
data  products)  tended to be the products  with the highest  margins.  Selling,
general  and  administrative   expenses  increased  $199,000  or  10%.  Suttle's
operating income decreased $112,000 or 4%.

                                       11
<PAGE>

Austin  Taylor's  sales  decreased  1% to  $2,901,000.  The  decrease was due to
reduced sales of CATV products  caused by major  reductions of cable  television
construction  activity in the U.K.  Austin  Taylor's gross margin declined 3% to
$537,000.  Gross margin as a percentage of sales was 18.5%  compared to 18.9% in
1998.  The  decline in gross  margin was  principally  due to higher  prices for
certain purchased parts. Selling,  general and administrative expenses decreased
$19,000 or 5%. Operating income increased $2,000 or 1%.

The Company acquired Transition Networks,  Inc. in December 1998. In April 1999,
the Company acquired LANart  Corporation,  which has been merged into Transition
Networks. The combined entities had sales of $9,964,000 and an operating loss of
$514,000 in the 1999 period. Expenses associated with closing LANart's sales and
marketing  operations in Europe and  transferring  inventory  and  manufacturing
processes  from  Massachusetts  to  Minnesota  were a  significant  cause of the
operating loss.

JDL Technologies, Inc had sales of $2,934,000 in the 1999 period, an increase of
$910,000  (on a pro forma basis) from sales in the second  quarter of 1998.  JDL
had operating income of $107,000 in 1999 compared to a pro forma loss of $37,000
in 1998.  JDL earned a  significant  portion of its  revenues in the 1999 period
from  contracts to provide  network  services and  equipment to the U.S.  Virgin
Islands Department of Education and to the Gary,  Indiana public schools.  CSI's
corporate  operating  expenses in the second  quarter were $457,000  compared to
$338,000 in the 1998 period.

Consolidated investment income, net of interest expense,  decreased $278,000 due
to decreased  levels of funds  available for investment and interest  expense on
notes payable associated with acquisitions. Income before income taxes decreased
$914,000 or 30%. The Company's  effective  income tax rate was 17.8% compared to
19.7% in 1998. Net income decreased $694,000 or 28%.

                         Liquidity and Capital Resources

At June 30, 1999,  the Company had  approximately  $13,599,000  of cash and cash
equivalents compared to $20,405,000 of cash and cash equivalents at December 31,
1998. The Company had working capital of approximately $30,123,000 and a current
ratio of 2.3 to 1 compared to working capital of $37,268,000 and a current ratio
of 2.8 to 1 at the end of 1998.

Cash flow provided by operations was  approximately  $6,446,000 in the first six
months of 1999 compared to  $6,693,000 in the same period in 1998.  The decrease
was due to the need to finance  increased  accounts  receivable levels caused by
the Company's  increased  sales volume.  Cash flow  benefited in the 1999 period
from decreased  inventory levels, as the Company was able to satisfy some of the
increased customer demand out of existing stocks.  Depreciation and amortization
charges, which are noncash expenses, increased $1,093,000 due to amortization of
excess costs associated with the Company's acquisitions.

Investing  activities  utilized  $10,366,000  of cash in the 1999  period.  Cash
investments in new plant and equipment totaled  $926,000,  which was financed by
internal  cash  flows.  The  Company  expects  to spend  $3,500,000  on  capital
additions  in 1999.  The  Company  paid  $3,984,000  (net of cash  acquired)  to
purchase  LANart  Corporation.  The Company  financed that  acquisition  using a
combination  of  internal  funds  and  short-term   borrowing  from  U.S.  Bank.
Subsequent to the acquisition,  the Company invested an additional $1,457,000 of
cash  in  LANart  to pay  acquired  liabilities  and  provide  working  capital.
Short-term notes payable  outstanding  increased to $9,908,000 at June 30, 1999.
The Company  expects to repay or refinance  this debt in 1999.  The Company also
invested   $5,625,000  of  cash  held  by  its  subsidiary  in  Puerto  Rico  in
intermediate term bank notes.

                                       12
<PAGE>

Net  cash  used  in  financing  activities  was  $2,844,000.  The  Company  paid
$1,967,000  to purchase  and retire  203,400  shares of its stock in open market
transactions during the 1999 period. Dividends paid on common stock increased to
$1,760,000. Proceeds from borrowings, net of repayments, were $830,000.

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.

                                Year 2000 Issues

Most old computer software was originally designed to use references to calendar
dates on an  abbreviated  basis.  Under this system,  references to the calendar
year  are  abbreviated  to the  last  two  digits  of the  year,  i.e.  1999  is
abbreviated  as "99".  Software  using this system often fails to recognize that
the year 2000,  abbreviated as "00",  follows 1999. This "Y2K" problem can cause
computing errors in date sensitive processes.  In 1998, the Company surveyed its
operations  to locate  computer  systems that could be subject to this error and
initiated a program of corrective action.

The Company's  accounting  and management  control  systems at Suttle and Austin
Taylor utilize a company-wide computer network centered in the Company's Hector,
MN corporate office. The hardware and software used in operating the network are
all purchased from third party suppliers.  The Company has contracted with these
suppliers  and  obtained  the  necessary  hardware  and  software to upgrade its
computer  systems.   The  Company  believes  these  systems  are  currently  Y2K
compliant. Cost of hardware and software purchased as part of the Y2K compliance
program was $150,000. The Company did not separately track internal costs of Y2K
compliance.

In 1998, the Company acquired JDL  Technologies,  Inc. and Transition  Networks,
Inc. These  operations are not presently part of the Company's  central computer
network. Both operations utilize personal computer based computing networks that
were materially Y2K compliant prior to their acquisition by the Company.

At the present time,  none of the Company's  subsidiaries  manufacture  products
containing  embedded  controllers or microprocessors  that are date sensitive or
subject to the Y2K  problem.  The Company  does not believe it has any  warranty
exposure to customers due to potential Y2K problems.

The Company has also been in contact with its major  customers  and suppliers to
estimate  the  extent  to which it may be  vulnerable  to their  respective  Y2K
problems.  The  Company is  reliant on third  parties  for  critical  functions,
including   raw   materials   and   supplies,   transportation,   utilities  and
communications  services.  Multiple  sources of supply are available for most of
these products and services.  The Company has not received any  indication  from
these parties that they will not be Y2K compliant.  The Company's worst probable
Y2K related  problem is the failure of third  parties to provide  necessary  raw
material,  manufacturing supplies, utilities or communications services. Failure
to receive needed materials or services could disrupt  manufacturing systems and
delay shipments to customers. The Company expects to utilize multiple sources of
supply to meet any problems that arise.  The Company does not expect  production
to be materially affected by Y2K related production problems.

At the present  time,  the Company  expects to handle Y2K problems that occur as
part of the ordinary course of business.  No special contingency plans have been
developed.  The Company  will  continue to monitor  its Y2K  situation  and will
respond appropriately if any problem arises.

                                       13
<PAGE>

                           PART II. OTHER INFORMATION

Items 1 - 3.  Not Applicable

Item 4. Submission of Matters to a Vote of Securities Holders The Annual Meeting
of the  Shareholders  of the Registrant was held on May 18, 1999 in Minneapolis,
MN. The total number of shares  outstanding  and entitled to vote at the meeting
was  8,811,144 of which  8,181,525  were  present  either in person or by proxy.
Shareholders  re-elected  board members Edwin C. Freeman,  Luella Gross Goldberg
and Edward E. Strickland to three-year terms expiring at the 2002 Annual Meeting
of Shareholders. The vote for these board members was as follows:

                                            In Favor        Abstaining
         Edwin C. Freeman                  8,149,950           31,575
         Luella Gross Goldberg             8,147,845           33,680
         Edward E. Strickland              8,149,625           31,900

John C.  Ortman  has  retired  and did not  seek  re-election  to the  board  of
directors.

Board members  continuing in office are Paul J.  Anderson,  Wayne E. Sampson and
Frederick  M.  Green  (whose  terms  expire  at  the  2000  Annual   Meeting  of
Shareholders) and Curtis A. Sampson,  Joseph W. Parris and Gerald D. Pint (whose
terms expire at the 2001 Annual Meeting of Shareholders).

Shareholders  also  approved   amendments  to  increase  the  number  of  shares
authorized to be issued under the Company's 1992 Stock Plan by 500,000 shares to
1,900,000  shares;  and to  amend  the  Company's  1990  Stock  Option  Plan for
Nonemployee  Directors to increase the stock options  automatically granted each
year to  non-employee  directors  from 2,000 to 3,000 shares.  The vote on these
amendments was as follows:

                                     In Favor    Opposed  Abstaining  Not Voting
1992 Stock Plan Amendment           5,885,184  1,240,610     168,889     886,842
Nonemployee Director Stock Options  7,585,335    411,293     184,897

Items 5 - 6.  Not Applicable

Signatures

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

                                           Communications Systems, Inc.

                                           By  /s/ Paul N. Hanson
                                           ------------------------------
                                           Paul N. Hanson
                                           Vice President and
                                           Chief Financial Officer
Date:  August 13, 1999

                                       14
<PAGE>

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<NAME>                       COMMUNICATIONS SYSTEMS, INC.
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