Pineapple Energy Inc. - Quarter Report: 2018 March (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One) 

For the quarterly period ended March 31, 2018

OR

For the transition period from ________ to ________ 

Commission File Number: 001-31588

COMMUNICATIONS SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

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 ☒  NO ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES ☒  NO ☐

Indicate by a check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or emerging growth company (as defined by Rule 12b-2 of the Exchange Act).

Large Accelerated Filer ☐ Accelerated Filer ☐ Non-Accelerated Filer ☐ Smaller Reporting Company ☒  Emerging growth company ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act. YES ☐ 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.

COMMUNICATIONS SYSTEMS, INC. AND SUBSIDIARIES

INDEX 

The accompanying notes are an integral part of the condensed consolidated financial statements.

The accompanying notes are an integral part of the condensed consolidated financial statements.

The accompanying notes are an integral part of the condensed consolidated financial statements.

The accompanying notes are an integral part of the condensed consolidated financial statements.

COMMUNICATIONS SYSTEMS, INC. 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 

(Unaudited) 

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Description of Business

Communications Systems, Inc. (herein collectively referred to as “CSI,” “our,” “we” or the “Company”) is a Minnesota corporation organized in 1969 that operates directly and through its subsidiaries located in the United States (U.S.) and the United Kingdom (U.K.). CSI is principally engaged through its Suttle, Inc. (“Suttle”) subsidiary and business unit in the manufacture and sale of connectivity infrastructure products for broadband and voice communications, and through its Transition Networks, Inc. (“Transition Networks” or “Transition”) subsidiary and business unit in the manufacture and sale of core media conversion products, Ethernet switches, and other connectivity and data transmission products. Through its JDL Technologies, Inc. (“JDL Technologies” or “JDL”) business unit, CSI provides technology solutions including virtualization, managed services, wired and wireless network design and implementation, and hybrid cloud infrastructure and deployment. Through its Net2Edge Limited (“Net2Edge”) U.K.-based business unit, the Company develops, manufactures and sells products that enable telecommunications carriers to connect legacy networks to high-speed services.

The Company classifies its businesses into four segments corresponding to the Suttle, Transition Networks, JDL Technologies and Net2Edge business units. Non-allocated general and administrative expenses are separately accounted for as “Other” in the Company’s segment reporting. Intersegment revenues are eliminated upon consolidation.

Financial Statement Presentation

The condensed consolidated balance sheets and condensed consolidated statement of changes in stockholders’ equity as of March 31, 2018 and the related condensed consolidated statements of loss and comprehensive loss, and the condensed consolidated statements of cash flows for the periods ended March 31, 2018 and 2017 have been prepared by Company management. In the opinion of management, all adjustments (which include only normal recurring adjustments, except where noted) necessary to present fairly the financial position, results of operations, and cash flows at March 31, 2018 and 2017 and for the periods then ended have been made.

Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with generally accepted accounting principles in the United States of America have been condensed or omitted. We recommend these condensed consolidated financial statements be read in conjunction with the financial statements and notes thereto included in the Company’s December 31, 2017 Annual Report to Shareholders on Form 10-K. The results of operations for the period ended March 31, 2018 are not necessarily indicative of operating results for the entire year.

The presentation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities at the balance sheet date, and the reported amounts of revenues and expenses during the reporting period. The estimates and assumptions used in the accompanying condensed consolidated financial statements are based upon management’s evaluation of the relevant facts and circumstances as of the time of the financial statements. Actual results could differ from those estimates.

Except to the extent updated or described below, the significant accounting policies set forth in Note 1 to the consolidated financial statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, appropriately represent, in all material respects, the current status of accounting policies, and are incorporated herein by reference.

Accumulated Other Comprehensive Loss

The components of accumulated other comprehensive loss, net of tax, are as follows: 

NOTE 2 – REVENUE RECOGNITION

The Company adopted ASC 606 on January 1, 2018 using the modified retrospective method for all contracts not completed as of the date of adoption. The reported results for 2018 reflect the application of ASC 606 guidance while the reported results for 2017 were prepared under the guidance of ASC 605, Revenue Recognition (ASC 605), which is also referred to herein as “legacy GAAP” or the “previous guidance”. The adoption of ASC 606 represents a change in accounting principle that will more closely align revenue recognition with the delivery of the Company’s goods and services and will provide financial statement readers with enhanced disclosures. In accordance with ASC 606, revenue is recognized when a customer obtains control of promised goods or services. The amount of revenue recognized reflects the consideration to which the Company expects to be entitled to receive in exchange for these goods or services.

Suttle, Inc. & Transition Networks

The Company’s Suttle business unit manufactures and markets a broad range of products that support broadband and telephone service under the Suttle brand name in the United States and internationally. Suttle markets its outside plant and premise distribution products globally to telecommunications companies, service providers, residential builders, and low-voltage installers through distributors and the Company’s sales staff. Suttle’s customers include telephone, CATV, internet service providers, distributors, and enterprise networks.

The Company’s Transition Networks business unit sells media converter devices, NIDs, Ethernet switches and other connectivity products that make it possible to transmit telecommunications signals across networks and between systems using various types of media. Transition sells its products through distributors, resellers, integrators, and OEMs.

The Company has determined that the performance obligation for its Suttle and Transition Networks divisions is the Company’s connectivity infrastructure and data transmission products. To determine when revenue should be recognized, it is important to determine when the transfer of control has occurred. The Company has determined that control transfers for these products upon shipment or delivery to the customer, in accordance with the agreed upon shipping terms. As such, the timing of revenue recognition occurs at a specific point in time.

JDL Technologies, Inc.

The Company’s JDL Technologies, Inc. division is a managed service provider and a value-added reseller supplying IT solutions focused on IT service and support management; network design, deployment and integration; cloud, hosted and virtualized services; and network operations center management. Major technology solutions include networking, virtualization, cloud and infrastructure services, most of which are available under JDL managed service contracts.

The Company has determined that the following performance obligations identified in its JDL Technologies, Inc. division are transferred over time: managed services and professional services (time and materials (“T&M”) & fixed price). The division’s managed services performance obligation is a bundled solution, a series of distinct services that are substantially the same and that have the same pattern of transfer to the customer and are recognized evenly over the term of the contract. T&M professional services arrangements are measured over time with an input method based on hours expended towards satisfying this performance obligation. Fixed price professional service arrangements under a relatively longer-term service will also be measured over time with an input method based on hours expended.

The Company has also identified the following performance obligations within its JDL Technologies division that are recognized at a point in time which include resale of third-party hardware and software, installation, arranging for another party to transfer services to the customer, and certain professional services. The resale of third-party hardware and software is recognized at a point in time, when the goods are shipped or delivered to the customer’s location, in accordance with the shipping terms. Installation services are recognized at a point in time when the services are completed. The service the Company provides to arrange for another party to transfer services to the customer is satisfied at a point in time as the Company has transferred control upon the service first being made available to the customer by the third party vendor, which are required to be presented on a net basis. Depending on the nature of the service, certain professional services transfer control at a point in time. The Company evaluates these circumstances on a case by case basis to determine if revenue should be recognized over time or at a point in time.

Net2Edge Limited

The Company’s Net2Edge Limited division manufactures and markets Ethernet based network access devices. The Company principally sells its products through approved partners and integrators outside the United States. The Company has determined that the performance obligation in the Net2Edge division is its connectivity infrastructure and data transmission products that are recognized at a point in time.

Significant Judgments

In order to determine the transaction price, the Company estimates the amount of variable consideration at the outset of the contract, depending on the facts and circumstances relative to the contract. The Company may provide credits or incentives to its customers, which are accounted for as either variable consideration or consideration payable to the customer. The Company estimates product returns based on historical return rates. The Company constrains (reduces) the estimates of variable consideration such that it is probable that a significant revenue reversal of previously recognized revenue will not occur throughout the life of the contract. When determining if variable consideration should be constrained, management considers whether there are factors outside the Company’s control that could result in a significant reversal of revenue. In making these assessments, the Company considers the likelihood and magnitude of a potential reversal of revenue. The Company will assess if any incentives it offers to its customer is a consideration payable. The Company accounts for consideration payable to a customer as a reduction of the transaction price, and therefore, of revenue. For contracts with more than one performance obligation, the consideration is allocated between separate products and services based on their stand-alone selling prices. Judgment is required to determine standalone selling prices for each distinct performance obligation. The Company generally determines standalone selling prices based on the actual prices charged to customers and has an established range of amounts that fall within stand-alone selling price for its distinct performance obligations. The Company evaluates this range quarterly.

Costs to Obtain or Fulfill a Contract

In addition to the new revenue recognition guidance, ASC 340-40 was added to provide guidance on the accounting for certain costs to obtain and fulfill contracts (or, in some cases, an anticipated contract) with a customer. ASC 340-40 is applicable only to incremental contract costs, those that an entity would not have incurred if the contract had not been obtained, and requires the capitalization of such costs as well as provides guidance on the amortization and impairment considerations. The Company elects the practical expedient and expenses certain costs to obtain contracts when applicable. There were no material costs to obtain a contract in the quarter ended March 31, 2018.

Financial Statement Impact of Adopting ASC 606

The Company adopted ASC 606 using the modified retrospective method. The cumulative effect of applying the new guidance to all contracts with customers that were not completed as of January 1, 2018 would require an adjustment to the opening balance of retained earnings as of the adoption date. As a result of applying the modified retrospective method to adopt the new revenue guidance, the Company determined that there were no significant adjustments to be made to its consolidated balance sheet as of January 1, 2018.

Impact of New Revenue Guidance on Financial Statement Line Items

The following table compares the reported condensed consolidated balance sheet, statement of loss and comprehensive loss and cash flows, as of and for the three months ended March 31, 2018, to the pro-forma amounts had the previous guidance been in effect:

Transaction Price Allocated to Future Performance Obligations

In order to determine the allocation of the transaction price and amounts allocated to the performance obligations, the Company first determined the standalone selling price for each distinct performance obligations in the contract in order to determine the allocations of the transaction price in proportion to the standalone selling price for each performance obligation in the contract in accordance with ASC 606-10-32-31 and 32-33. Judgment is required to determine standalone selling price for each distinct performance obligation. The Company generally determines standalone selling prices based on the actual prices charged to customers and has an established range of amounts that fall within stand-alone selling price for its distinct performance obligations. The Company will evaluate this range quarterly.

Practical Expedients and Exemptions

The Company adopted various practical expedients and policy elections related to the accounting for significant finance components, sales taxes, shipping and handling, costs to obtain a contract and immaterial promised goods or services, which will mitigate certain impacts of adopting this new standard. The practical expedient to disclose the unfulfilled performance obligations was not made as they are expected to be fulfilled within one year.

Disaggregation of revenue

Revenues are recognized when control of the promised goods or services is transferred to our customers, in an amount that best reflects the consideration we expect to be entitled to in exchange for those goods or services. In accordance with ASC 606-10-50-5, the following tables present how we disaggregate our revenues, which is different for each segment.

For Suttle, we analyze revenues by product and customer group, which is as follows for the three months ended March 31, 2018 and 2017:

For Transition Networks, we analyze revenue by region and product group, which is as follows for the three months ended March 31, 2018 and 2017:

For JDL, we analyze revenue by customer group, which is as follows for the three months ended March 31, 2018 and 2017:

The Company does not currently analyze revenue for Net2Edge on a disaggregated basis. Revenues from Net2Edge were $165,000 and $357,000 for the three months ended March 31, 2018 and 2017, respectively.

Contract Balances

The Company does not have material costs to obtain a contract or material contract liabilities.

NOTE 3 – CASH EQUIVALENTS AND INVESTMENTS

The following tables show the Company’s cash equivalents and available-for-sale securities’ amortized cost, gross unrealized gains, gross unrealized losses and fair value by significant investment category recorded as cash and cash equivalents or short and long term investments as of March 31, 2018 and December 31, 2017: 

March 31, 2018

The Company tests for other than temporary losses on a quarterly basis and has considered the unrealized losses indicated above to be temporary in nature. The Company intends to hold the investments until it can recover the full principal amount and has the ability to do so based on other sources of liquidity. The Company expects such recoveries to occur prior to the contractual maturities. All unrealized losses as of March 31, 2018 were in a continuous unrealized loss position for less than twelve months and are not deemed to be other than temporarily impaired as of March 31, 2018.

The following table summarizes the estimated fair value of our investments, designated as available-for-sale and classified by the contractual maturity date of the securities as of March 31, 2018:

The Company did not recognize any gross realized gains or losses during the three months ending March 31, 2018 and 2017, respectively. If the Company had realized gains or losses, they would be included within investment and other income in the accompanying condensed consolidated statement of loss and comprehensive loss.

NOTE 4 - STOCK-BASED COMPENSATION

Employee Stock Purchase Plan

Under the Company’s Employee Stock Purchase Plan (“ESPP”), employees are able to acquire shares of common stock at 85% of the price at the end of each current quarterly plan term. The most recent term ended March 31, 2018. The ESPP is considered compensatory under current Internal Revenue Service rules. At March 31, 2018, after giving effect to the shares issued as of that date, 45,250 shares remain available for purchase under the ESPP.

2011 Executive Incentive Compensation Plan

On March 28, 2011 the Board adopted and on May 19, 2011 the Company’s shareholders approved the Company’s 2011 Executive Incentive Compensation Plan (“2011 Incentive Plan”). The 2011 Incentive Plan authorizes incentive awards to officers, key employees and non-employee directors in the form of options (incentive and non-qualified), stock appreciation rights, restricted stock, restricted stock units, performance stock units (“deferred stock”), performance cash units, and other awards in stock, cash, or a combination of stock and cash. The 2011 Incentive Plan, as amended, allows the issuance of up to 2,000,000 shares of common stock.

During 2018, stock options covering 178,665 shares have been awarded to key executive employees and directors. These options expire seven years from the date of award and generally vest 25% each year beginning one year after the date of award. The Company also conditionally granted deferred stock awards of 163,002 shares to key employees during the first quarter of 2018 under the Company’s long-term incentive plan for performance over the 2018 to 2020 period. The actual number of shares of deferred stock, if any, that are ultimately earned by the respective employees will be determined based on achievement against performance goals at the end of the three-year period ending December 31, 2020 and any shares earned will be issued in the first quarter of 2021 to those key employees still with the Company at that time.

At March 31, 2018, 194,762 shares have been issued under the 2011 Incentive Plan, 1,609,007 shares are subject to currently outstanding options, deferred stock awards, and unvested restricted stock units, and 196,231 shares are eligible for grant under future awards.

Stock Option Plan for Directors

Shares of common stock are reserved for issuance to non-employee directors under options granted by the Company prior to 2011 under its Stock Option Plan for Non-Employee Directors (the “Director Plan”). Under the Director Plan nonqualified stock options to acquire shares of common stock were automatically granted to each non-employee director concurrent with annual meetings of shareholders in 2010 and earlier years, with the exercise price of options granted being the fair market value of the common stock on the date of the respective shareholder meetings. Options granted under the Director Plan expire 10 years from date of grant. No options have been granted under the Director Plan since 2011 when the Company amended the Director Plan to prohibit future option grants. As of March 31, 2018, there were 51,000 shares subject to outstanding options under the Director Plan.

Changes in Stock Options Outstanding

The following table summarizes changes in the number of outstanding stock options under the 2011 Incentive Plan and the Director Plan over the period December 31, 2017 to March 31, 2018:

The aggregate intrinsic value of all options (the amount by which the market price of the stock on the last day of the period exceeded the market price of the stock on the date of grant) outstanding at March 31, 2018 was $0. The intrinsic value of all options exercised during the three months ended March 31, 2018 was $0. Net cash proceeds from the exercise of all stock options were $0 in each of the three month periods ended March 31, 2018 and 2017.

Changes in Deferred Stock Outstanding

The following table summarizes the changes in the number of deferred stock shares under the 2011 Incentive Plan over the period December 31, 2017 to March 31, 2018:  

Changes in Restricted Stock Units Outstanding

The following table summarizes the changes in the number of restricted stock units under the 2011 Incentive Plan over the period December 31, 2017 to March 31, 2018:

Compensation Expense

Share-based compensation expense recognized for the three months ended March 31, 2018 was $85,000 before income taxes and $67,000 after income taxes. Share-based compensation expense recognized for the three months ended March 31, 2017 was $93,000 before income taxes and $60,000 after income taxes. Unrecognized compensation expense for the Company’s plans was $583,000 at March 31, 2018 and is expected to be recognized over a weighted-average period of 2.7 years. Share-based compensation expense is recorded as a part of selling, general and administrative expenses.

NOTE 5 - INVENTORIES

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

NOTE 6 –INTANGIBLE ASSETS

The Company’s identifiable intangible assets with finite lives, included in other assets, net on the condensed consolidated balance sheets, are being amortized over their estimated useful lives and were as follows: 

Amortization expense on these identifiable intangible assets was $3,000 and $12,000 during 2018 and 2017, respectively. The amortization expense is included in selling, general and administrative expenses. At March 31, 2018, the estimated future amortization expense for definite-lived intangible assets for the remainder of 2018 and all of the following four fiscal years is as follows:

NOTE 7 – 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 actual warranty expense could differ from the estimates made by the Company based on product performance. The warranty liability is included in other accrued liabilities on the condensed consolidated balance sheet.

The following table presents the changes in the Company’s warranty liability for the three month periods ended March 31, 2018 and 2017, respectively, the majority of which relates to a five-year obligation to provide for potential future liabilities for network equipment sales.

NOTE 8 – CONTINGENCIES

In the ordinary course of business, the Company is exposed to legal actions and claims and incurs costs to defend against these actions and claims. Company management is not aware of any outstanding or pending legal actions or claims that could materially affect the Company’s financial position or results of operations.

NOTE 9 – DEBT

Line of Credit

The Company has a $15,000,000 line of credit from Wells Fargo Bank.  The Company had no outstanding borrowings against the line of credit at March 31, 2018 and December 31, 2017. Due to the revolving nature of loans under our credit facility, additional borrowings and periodic repayments and re-borrowings may be made until the maturity date. The total amount available for borrowings under our credit facility at March 31, 2018 was $8,689,000, based on the borrowing base calculation. Interest on borrowings on the credit line is at LIBOR plus 2.0% (3.9% at March 31, 2018). The credit agreement expires August 12, 2021 and is secured by assets of the Company.  Our credit agreement contains financial covenants including a minimum liquidity balance of $10,000,000. Liquidity is calculated as the sum of unrestricted cash, marketable securities and the availability on the line of credit. The Company was in compliance with its financial covenants at March 31, 2018.

NOTE 10 – 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 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. Management analyzes these assets and liabilities regularly and assesses the likelihood that deferred tax assets will be recovered from future taxable income.  

At March 31, 2018 there was $45,000 of net uncertain tax benefit positions that would reduce the effective income tax rate if recognized. The Company records interest and penalties related to income taxes as income tax expense in the condensed consolidated statements of loss and comprehensive loss.

The Company is subject to U.S. federal income tax as well as income tax of multiple state and foreign jurisdictions. The tax years 2014-2017 remain open to examination by the Internal Revenue Service and the years 2013-2017 remain open to examination by various state tax departments. The tax years from 2014-2017 remain open in Costa Rica.

The Company’s effective income tax rate was (0.4%) for the first three months of 2018. The effective tax rate differs from the federal tax rate of 21% due to state income taxes, foreign tax rate differences, foreign losses not deductible for U.S. income tax purposes, provisions for interest charges for uncertain income tax positions, stock compensation shortfalls and changes in valuation allowances related to deferred tax assets. The foreign operating losses may ultimately be deductible in the countries in which they occurred; however the Company has not recorded a deferred tax asset for these losses due to uncertainty regarding the eventual realization of the benefit. The effect of the foreign operations was an overall rate decrease of approximately (12.0%) for the three months ended March 31, 2018. There were no additional uncertain tax positions identified in the first three months of 2018. The Company’s effective income tax rate for the three months ended March 31, 2017 was (4.8%), and differed from the federal tax rate due to state income taxes, foreign tax rate differences, foreign losses not deductible for U.S. income tax purposes, provisions for interest charges for uncertain income tax positions, stock compensation shortfalls and changes in valuation allowances related to deferred tax assets.

NOTE 11 – SEGMENT INFORMATION

The Company classifies its businesses into the four segments as follows:

Management has chosen to organize the enterprise and disclose reportable segments based on our products and services. Intersegment revenues are eliminated upon consolidation.

Information concerning the Company’s continuing operations in the various segments for the three month periods ended March 31, 2018 and 2017 is as follows: 

NOTE 12 – NET LOSS PER SHARE

Basic net income per common share is based on the weighted average number of common shares outstanding during each period and 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 and shares associated with the long-term incentive compensation plans, which resulted in no dilutive effect for the three month periods ended March 31, 2018 and 2017. The Company calculates the dilutive effect of outstanding options using the treasury stock method. Due to the net losses in the first three months of 2018 and 2017, there was no dilutive impact from stock options or unvested shares. Options totaling 1,332,272 and 903,148 were excluded from the calculation of diluted earnings per share for the three months ended March 31, 2018 and 2017 because the exercise price was greater than the average market price of common stock during the period and deferred stock awards totaling 309,819 and 190,812 shares would not have been included for the three months ended March 31, 2018 and 2017 because of unmet performance conditions.

NOTE 13 – FAIR VALUE MEASUREMENTS

The accounting guidance establishes a valuation hierarchy for disclosure of the inputs to valuation used to measure fair value. This hierarchy prioritizes the inputs into three broad levels as follows:

Level 1 – Observable inputs that reflect unadjusted quoted prices for identical assets or liabilities in active markets that the Company has the ability to access at the measurement date.

Level 2 – Observable inputs such as quoted prices for similar instruments and quoted prices in markets that are not active, and inputs that are directly observable or can be corroborated by observable market data. The types of assets and liabilities included in Level 2 are typically either comparable to actively traded securities or contracts, such as treasury securities with pricing interpolated from recent trades of similar securities, or priced with models using highly observable inputs, such as commodity options priced using observable forward prices and volatilities.

Level 3 – Significant inputs to pricing that have little or no observability as of the reporting date. The types of assets and liabilities included in Level 3 are those with inputs requiring significant management judgment or estimation, such as the complex and subjective models and forecasts used to determine the fair value of financial instruments.

Financial assets and liabilities measured at fair value on a recurring basis as of March 31, 2018 and December 31, 2017, are summarized below: 

We record transfers between levels of the fair value hierarchy, if necessary, at the end of the reporting period. There were no transfers between levels during the three months ended March 31, 2018.

NOTE 14 – RESTRUCTURING

During the three months ended March 31, 2017, the Company recorded $388,000 in restructuring expense. This consisted of severance and related benefits costs due to the restructuring within the Suttle business segment, including ongoing costs related to the closure of the Costa Rica facility. The facility was completely closed during 2017. The Company had no restructuring expenses for the three-month period ended March 31, 2108.

NOTE 15 – RECENT ACCOUNTING PRONOUNCEMENTS

In May 2014, the Financial Accounting Standards Board (FASB) issued a new accounting standard update on revenue recognition from contracts with customers. The new guidance will replace all current U.S. GAAP guidance on this topic and eliminate all industry-specific guidance. According to the new guidance, revenue is recognized when promised goods or services are transferred to customers in an amount that reflects the consideration the Company expects to receive in exchange for those goods or services. As a result of the FASB’s July 2015 deferral of the standard’s required implementation date, the guidance is effective for interim and annual reporting periods beginning after December 15, 2017. The Company adopted the accounting standard effective January 1, 2018 using the modified retrospective transition approach. Please see Note 2 for the required disclosures related to the impact of adopting this standard and a discussion of the Company’s updated policies related to revenue recognition and accounting for costs to obtain and fulfill a customer contract.

In February 2016, the FASB issued new accounting requirements regarding accounting for leases, which requires an entity to recognize both assets and liabilities arising from financing and operating leases, along with additional qualitative and quantitative disclosures. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within that reporting period, and early adoption is permitted. We have not yet determined the potential effects on our financial condition or results of operations.

In August 2016, the FASB issued new accounting guidance regarding the classification of cash receipts and payments in the Statement of Cash Flows. This guidance is intended to reduce diversity in practice in how certain cash receipts and cash payments are presented and classified in the Consolidated Statement of Cash Flows by providing guidance on eight specific cash flow issues. The Company adopted this standard as of January 1, 2018 with no material impact to the Consolidated Statement of Cash Flows.

NOTE 16 – SUBSEQUENT EVENTS

The Company has evaluated subsequent events through the date of this filing. We do not believe there are any material subsequent events that would require further disclosure.

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

Overview

Communications Systems, Inc. provides physical connectivity infrastructure and services for global deployments of broadband networks through the following business units:

First Quarter 2018 Summary

Forward-looking statements

In this report and, from time to time, in reports filed with the Securities and Exchange Commission (“SEC”), in press releases, and in other communications to shareholders or the investing public, the Company may make “forward looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. We may make these forward looking statements concerning possible or anticipated future financial performance, business activities, plans, pending claims, investigations or litigation, which are typically preceded by the words “believes,” “expects,” “anticipates,” “intends” or similar expressions. For these forward-looking statements, the Company claims the protection of the safe harbor for forward-looking statements contained in federal securities laws. Shareholders and the investing public should understand that these forward-looking statements are subject to risks and uncertainties that could cause actual performance, activities, anticipated results, outcomes or plans to differ significantly from those indicated in the forward-looking statements. These risks and uncertainties include, but are not limited to:

General Risks and Uncertainties:

Suttle Risks and Uncertainties:

Transition Networks Risks and Uncertainties:

JDL Technologies Risks and Uncertainties:

Net2Edge’s Risks and Uncertainties:

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

Company Results

Three Months Ended March 31, 2018 Compared to 

Three Months Ended March 31, 2017

Consolidated sales declined 19% in the first quarter of 2018 to $16,774,000 compared to $20,800,000 in the same period of 2017. Consolidated operating loss in the first quarter of 2018 was $1,974,000 compared to an operating loss of $1,460,000 in the first quarter of 2017. The Company incurred $388,000 in restructuring expense in the first quarter of 2017 related to the closure of its Costa Rica facility in 2017. Net loss in the first quarter of 2018 was $1,860,000 or $ (0.21) per share compared to net loss of $1,516,000 or $ (0.17) per share in the first quarter of 2017.

Suttle Results

Suttle sales decreased 21% in the first quarter of 2018 to $6,973,000 compared to $8,772,000 in the same period of 2017 due to continuing pricing pressures from major telecommunications customers, volume declines in legacy products, and a shift in purchasing decisions from Tier 1 telecommunications suppliers to installers.

Sales by customer groups in the first quarters of 2018 and 2017 were: 

Suttle’s sales by product groups in first quarter of 2018 and 2017 were: 

Sales to the major communication service providers decreased 26% in the first quarter of 2018 due to volume declines in legacy products. Sales to major communication service providers accounted for 85% of Suttle’s sales in the first quarter of 2018 compared to 91% of sales in 2017. Sales to distributors decreased 30% in the first quarter of 2018 due to the continued decline in DSL product sales and the impact from the discontinuation of certain legacy products, and accounted for 6% and 7% of sales in the first quarters of 2018 and 2017, respectively. International sales increased 368% in the first quarter of 2018 due to an increase in legacy product sales in Latin America, and accounted for 8% of Suttle’s first quarter 2018 sales.

Sales of structured cabling and connecting system products decreased 15% in the first quarter of 2018 due to a shift in purchasing decisions from Tier 1 telecommunications suppliers to installers.

Suttle’s gross margin increased 30% in the first quarter of 2018 to $1,375,000 compared to $1,058,000 in the same period of 2017. Gross margin as a percentage of sales increased to 19.7% from 12.1% in the same period of 2017 due to establishing a new pricing strategy for distributors and the discontinuation of certain lower margin legacy products. Selling, general and administrative expenses increased 2% to $2,256,000, or 32.4% of sales, in the first quarter of 2018 compared to $2,210,000, or 25.2% of sales, in the same period in 2017 due to expanded sales and marketing programs to reach the installer market. Suttle incurred $54,000 and $263,000 in research and development expenses in the respective 2018 and 2017 first quarters. Suttle incurred $388,000 in restructuring expense in the first quarter of 2017 related to the closure of its Costa Rica facility in 2017, but no expense in the first quarter of 2018.

Suttle incurred an operating loss of $881,000 in the first quarter of 2018 compared to an operating loss of $1,540,000 in 2017.

Transition Networks Results

Transition Networks sales increased 2% to $9,153,000 in the first quarter of 2018 compared to $9,004,000 in 2017. Transition Networks organizes its sales force by vertical markets and segments its customers geographically. First quarter sales by region are presented in the following table: 

The following table summarizes Transition Networks’ 2018 and 2017 first quarter sales by its major product groups: 

Sales in North America increased $570,000, or 8%, primarily due to an increase in federal projects. International sales decreased $421,000, or 22%, primarily due to the decline in Rest of World sales, offset slightly by an increase in EMEA sales. Media converter sales decreased 5% or $300,000 due to the timing of purchases by a carrier customer. Sales of ethernet switches and adapters increased 35% or $581,000 due to the success of new product introductions. All other product sales decreased 7% or $132,000 due to project timing.

Gross margin on first quarter sales increased to $3,927,000 in 2018 as compared to $3,885,000 in 2017. Gross margin as a percentage of sales decreased slightly to 42.9% in the first quarter of 2018 from 43.1% in 2017. Selling, general and administrative expenses remained fairly flat at $3,715,000, or 40.6% of sales, in the first quarter of 2018 compared to $3,739,000, or 41.5% of sales, in 2017.

Transition Networks had operating income of $212,000 in the first quarter of 2018 compared to income of $146,000 in 2017.

JDL Technologies Results

JDL Technologies sales decreased 75% to $710,000 in the first quarter of 2018 compared to $2,864,000 in 2017.

JDL’s revenues by customer group were as follows: