CoreCard Corp - Quarter Report: 2002 September (Form 10-Q)

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FORM 10-Q

Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934

FOR THE QUARTER ENDED SEPTEMBER 30, 2002

Commission file number 1-9330

Registrant’s telephone number, including area code: (770) 381-2900

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

Indicate by a check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).   Yes  [   ]  No  [X]

As of September 30, 2002, 4,495,530 shares of Common Stock were outstanding.

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Part I. FINANCIAL INFORMATION

Item 1. Financial Statements

Intelligent Systems Corporation
CONSOLIDATED BALANCE SHEETS
(in thousands except share amounts)

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The accompanying notes are an integral part of these consolidated balance sheets.

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Intelligent Systems Corporation
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited, in thousands except share amounts)

The accompanying notes are an integral part of these consolidated statements.

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Intelligent Systems Corporation
CONSOLIDATED STATEMENTS OF CASH FLOW
(unaudited, in thousands)

The accompanying notes are an integral part of these consolidated statements.

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Notes to Consolidated Financial Statements

Consolidated Statements of Comprehensive Income (Loss)
(unaudited, in thousands)

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The table following contains unaudited segment information for the three and nine month periods ended September 30, 2002 and 2001:

A reconciliation of consolidated segment data above to consolidated income (loss) and assets follows:

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Marketing expenses were up 17 percent and 63 percent in the three and nine month periods ended September 30, 2002, respectively, compared to 2001, reflecting mainly the inclusion of VISaer and CoreCard expenses in 2002 for the full periods in 2002 and an increase in personnel and promotion expense at QS Technologies. In addition, the ChemFree subsidiary added personnel to support a new sales initiative in California which caused an increase in its marketing expenses in the third quarter of 2002 compared to the prior year period. Consolidated general and administrative expenses were $1,199,000 and $3,545,000 in the three and nine month periods ended September 30, 2002, a decline compared to the respective periods last year. This difference reflects the net effect of a non-recurring charge in the third quarter of 2001 of $6,003,000 for impairment of goodwill associated with VISaer, offset by the inclusion of expenses at VISaer and CoreCard for the full periods in 2002, higher depreciation and amortization expense in 2002 (reflecting amortization of intangible assets acquired in the VISaer and CoreCard transactions) and increased legal expenses at ChemFree in 2002 related to a long-standing lawsuit to protect its intellectual property. Research and development expense increased by $737,000 and $5,634,000 in the three and nine month periods ended September 30, 2002, respectively, compared to the same periods last year. The significant increases in both periods in 2002 are related to the inclusion of R&D expenses of VISaer and CoreCard, mainly for new software development initiatives. We expect this level of expense to continue for most of 2003 at VISaer with a reduction in expense at CoreCard by the end of 2002. In the three and nine month periods ended September 30, 2001, R&D expense includes a non-recurring charge of $425,000 for purchased research and development projects of VISaer that had not reached technological feasibility and that did not have an alternative future use.

Interest Income - In the three and nine months periods ended September 30, 2002, we recorded $30,000 and $107,000 in interest income compared to interest income of $167,000 and $891,000 in the same periods in 2001. The change compared to 2001 is mainly because we earned significant interest through April 2001 on a short-term, high-interest $3,500,000 note receivable of our PaySys affiliate, prior to the sale of PaySys in April 2001. In 2002, we earned less interest income due to lower bank interest rates and cash balances, we had a lower principal amount of and interest rate on notes receivable and we included interest expense related to a loan from a minority shareholder of CoreCard (which was converted to equity at the end of June 2002).

Investment Income - In the third quarter and year-to-date periods ended September 30, 2002, we reported net investment losses of $360,000 and $902,000, respectively. This compares with investment income of $305,000 and $19,948,000 earned in the respective periods last year. The significant difference in the nine month period reflects a gain in the second quarter of last year of $17,770,000 on the PaySys sale transaction, as explained in more detail in the Overview section at the beginning of this Item 2. In the third quarter this year, we wrote off the remaining $250,000 carrying value of our minority investment in Lumenor, Inc., a start-up software company. In the first quarter this year, we recorded a reserve of $250,000 to write down the carrying value of our original investment in Lumenor based on a pending third party financing which subsequently failed to close resulting in the additional charge in our third quarter. We have included in the three and nine month periods in 2002 a write-down of $444,000 related to our minority interest in Nutec Sciences based on a pending sale (which closed early in the fourth quarter of 2002) of our interest following Nutec’s failure to raise new capital. In addition, in the nine months ended September 30, 2002, we wrote-off $1,246,000 related to our holdings in Daw Technologies, Inc. as explained in more detail in Note 7 to these financial statements and reserved $187,000 to reflect a reduction in value in our shares of Novient, Inc., a privately held software company, based on the valuation of its merger with another company. Offset against these losses were gains of $334,000 and $1,000,000 in the three and nine month periods ended September 30, 2002, respectively, on sales of shares of Atherogenics stock and $474,000 on the sale of our remaining interest in a former affiliate company, Risk Labs, in the first quarter of this year. In 2001, in addition to the PaySys gain, we recorded gains of $1,029,000 and $1,922,000 in the three and nine month periods, respectively, on two sales of part of our interest in Risk Labs.

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Equity Losses of Affiliates - On a quarterly basis, we recognize our pro rata share of the earnings or losses of affiliate companies based on the equity method of accounting. Affiliate companies are those companies in which we own 20 to 50 percent of the capital stock, which are organized as limited liability companies or in which we exert significant influence. We recorded $23,000 in net equity income and $103,000 of net equity losses in the three and nine month periods ended September 30, 2002, respectively, compared to net equity losses of $69,000 and $558,000 in the same periods last year. The difference between periods reflects the fact that one of our affiliate companies generated income in the third quarter of 2002 and the consolidation of VISaer in July 2001.

Other Income - Other income/expense in the three and nine month periods ended September 30, 2002 includes $133,000 and $1,035,000, respectively, mainly reflecting recognition of deferred gain from the sale of a VISaer product line in an earlier period.

Taxes - In the three and nine month periods ended September 30, 2002, as a result of a change in the tax code, we recorded an income tax benefit of $362,000 representing a refund for income tax recorded in 2001 for alternative minimum tax liability on the PaySys sale.

Common Shares– The basic weighted average number of shares outstanding in the three and nine month periods ended September 30, 2002 is lower than in the same periods of 2001 because we repurchased shares of our common stock in 2001, including 1,000,000 shares repurchased in our self-tender offer completed in July 2001. No shares have been repurchased in the nine months ended September 30, 2002 although we expect to repurchase a limited number of our common shares under an ongoing share repurchase program at the currently prevailing market prices.

Liquidity and Capital Resources

During the first nine months of 2002, cash decreased by $6,780,000. Our principal sources of cash were $2,013,000 from the sale of shares of Atherogenics stock and $474,000 from the sale of our remaining Risk Labs interest. During the nine month period ended September 30, 2002, our principal uses of cash in addition to regularly recurring corporate expenses were $3,205,000 to fund CoreCard product development, $4,800,000 to fund operating losses at VISaer due mainly to new product development, a $1,250,000 investment and $250,000 secured loan to Horizon Software International, Inc., a privately held software company, and a $243,000 follow-on investment in Medizeus, Inc., a health care software company. In the second quarter of 2002, we made a short-term $3,000,000 secured loan to a third party that was repaid in full on the maturity date in August 2002.

Since year-end 2001, property, plant and equipment increased by $225,000 mainly due to the consolidation of CoreCard. Intangibles increased by $900,000 in the first nine months of 2002, as a result of intangible assets recorded in the consolidation of CoreCard. Of the intangibles acquired, $642,000 was allocated to our pro rata share of acquired software which is being amortized over a five-year period and $289,000 was recorded as goodwill. Inventory increased to support ChemFree’s trial sales program in California which required an initial level of demonstration inventory to support sales efforts. Accounts payable increased by $216,000 since December 31, 2001 mainly due to increased purchases to build ChemFree inventory to support increased product sales, evaluations and leases coupled with longer payment cycles. Notes payable increased to $133,000 at September 30, 2002 compared to zero at year-end December 31, 2001 as a result of consolidating a loan to CoreCard from a minority shareholder of CoreCard (for which Intelligent Systems does not have any corporate liability). Deferred gain is lower at September 30, 2002 compared to December 31, 2001 because we recognized the difference in deferred gain as other income during 2002. Long-term deferred revenue increased by $939,000 in the first nine months of 2002 due to milestone payments by a VISaer customer on a software license contract. Minority interest increased by $1,373,000 compared to year-end 2001 reflecting a minority shareholder’s investment in CoreCard software. Finally, unrealized loss of $359,000 at December 31, 2001 changed to an unrealized loss of $110,000 at September 30, 2002 mainly due to the net effect of two transactions: recognition of unrealized losses related to Daw Technology stock in the second quarter and recognition of unrealized gains on sales of Atherogenics shares in the first nine months of 2002.

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In the past year, our Information Technology segment, in particular VISaer has experienced delays in contract awards and implementations which have had a negative impact on results of operations and increased VISaer’s cash requirements. VISaer has built a substantial prospect pipeline and has recently been awarded new contracts and additions to existing contracts which we believe provide a strong endorsement of VISaer’s product offering. Contracts typically have a cash deposit and milestone payments but VISaer has needed additional cash to finish the new software product that will be sold and installed under its new contracts. Current projections show that VISaer will be able to fund operations from cash flow in 2003. CoreCard has ongoing cash requirements as well. However, with the completion of the initial product offering and installation of the first customer, we expect to be able to reduce the cash outlay for product development expenses at CoreCard. We believe we have adequate cash to meet corporate and subsidiary needs in the foreseeable future.

In connection with the investment and loan to Horizon Software discussed above, subsequent to the third quarter ended September 30, 2002, we invested an additional $1,000,000 cash in Horizon Software and converted our $250,000 loan to additional equity based on Horizon’s achievement of certain milestones during 2002. We do not have other off-balance sheet arrangements, relationships, transactions or guarantees with third parties or related parties that would affect our liquidity or results of operations.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of assets, liabilities, revenues and expenses. We consider certain accounting policies related to revenue recognition, valuation of acquired intangibles and impairment of long-lived assets, and valuation of investments to be critical policies due to the estimation processes involved in each. For a detailed description on the application of these and other accounting policies, see Note 1 to the Consolidated Financial Statements contained in our annual report on Form 10-K for 2001.

Revenue Recognition - Our product revenue consists of fees from software licenses and sales or leases of industrial products. Our service revenue consists of fees for implementation, consulting, training, maintenance and support for software products. A portion of our revenue is derived from software contracts that contain significant production, modification and/or customization requirements and license fees for such contracts are recognized using contract accounting. In these cases, we recognize revenue on a percentage of completion basis that involves estimating our progress on the contract based on input measures. We recognize revenue and the related costs in the same proportion that the amount of labor hours incurred to date bears to the total estimated hours required for contract completion. If reliable estimates cannot be determined or if there is an acceptance clause in the contract, all revenue is deferred until the customer has accepted the software and any refund rights have expired. If we do not accurately estimate the resources required or the scope of work to be performed, or we do not manage the contract properly, in future periods we may need to restate revenues or to incur additional cost which would impact our margins and reported results.

Valuation of Intangibles - Purchase accounting for an acquisition requires use of accounting estimates and judgments to allocate the purchase price to the fair market value of the assets and liabilities purchased. Our business acquisitions typically result in goodwill and other intangible assets. The determination of the value of such intangible assets requires management to make estimates and assumptions that affect the amount of future period amortization expenses and possible impairment expense that we will incur. Periodically we review the values assigned to long-lived assets using an estimate of the undiscounted cash flows of the entity over the remaining life of the asset. Any resulting impairment could require a write-down that would have a material adverse impact on our financial condition or results of operations.

Valuation of Investments - We hold minority interests in non-publicly traded companies whose values are difficult to determine and are based on management’s estimate of realizability of the carrying value of the investment. Future adverse changes in market conditions, poor operating results or lack of progress of

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the underlying investment could result in losses or an inability to recover the current carrying value of the investment. Our policy is to record an impairment charge when we believe an investment has experienced a decline in value that is other than temporary. In the first nine months of 2002, we wrote down the value of several of our investments, as explained in more detail in Notes 7, 8, 9, and 10 to the financial statements in this Form 10-Q. Other such charges in future periods could have a material adverse impact on our financial condition or results of operations. We also hold minority interests in several publicly-traded companies whose shares experience price volatility and are thinly traded. The carrying value of these investments reflects the market value of the shares at the balance sheet date. Future values could increase or decrease and we may not be able to realize the current carrying value due to changes in the market price of the stock or limited liquidity of the stock.

Factors That May Affect Future Operations

Future operations in both the Information Technology and Industrial Products segments are subject to risks and uncertainties that may negatively impact our results or projected cash requirements. In addition, the value of our investments are impacted by a number of factors beyond our control. Among the factors that may affect our consolidated results of operations are delays in product development, undetected software errors, competitive pressures, technical difficulties, market acceptance of our products, availability of technical personnel, changes in customer requirements, delays in customer orders and payments, changes in financial markets, performance and financial condition of affiliate companies or our investments, and general economic conditions.

As explained in Note 4 to the financial statements in this Form 10-Q, in early January 2002, we acquired the right to elect a majority of CoreCard’s board of directors as a result of a default under a secured loan. We provided additional advances under the loan and in June 2002, along with another shareholder lender, we converted $3,173,000 of principal and interest owed to us into Series B Preferred stock of CoreCard. As a result, our ownership increased to approximately 65 percent. CoreCard will incur operating losses that are included in our consolidated statements of operations and it will require cash to operate in 2002 and into 2003. While we have no contractual requirement to provide additional funding, we are using part of our available cash balances to support the CoreCard operations in the near-term. If CoreCard is unsuccessful or if we decide to suspend funding, we may not recover all of these funds.

Furthermore, CoreCard is subject to a number of risks that may impact negatively its future performance, including significant non-competition restrictions entered into at the time of the sale of PaySys in April 2001 that limit who CoreCard can sell its products to for varying time periods through 2006, risks associated with completing and installing the initial software application, lack of a proven business model and installed base of customers, a limited operating history, an extended sales cycle and unproven market acceptance of the software offering and company profile.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We do not have any material market risk because we have no long-term borrowings.

Item 4. Controls and Procedures.

Within 90 days prior to the filing date of this report on Form 10-Q, management of ISC conducted an evaluation, under the supervision and with the participation of ISC’s management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that ISC’s disclosure controls and procedures are effective in ensuring that information required to be disclosed by ISC in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission’s rules and forms. In addition, ISC management, including our Chief Executive Officer and Chief Financial Officer, reviewed our internal controls, and there have been no significant changes in our internal controls or in other factors that could significantly affect those controls subsequent to the date of our last evaluation.

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Item 5. Other Information.

Certifications Under Section 906 of the Sarbanes-Oxley Act of 2002

The certifications of our Chief Executive Officer and Chief Financial Officer, as required by Section 906 of the Sarbanes-Oxley Act of 2002, have been submitted to the SEC as additional correspondence accompanying this report.

Part II. OTHER INFORMATION

Item 1. Legal Proceedings

On October 30, 2002, the Ninth Judicial Circuit Court of Orange County, Florida ruled in our favor with respect to a lawsuit filed in 2001, in which we were named as defendant. The lawsuit had been filed by former employees of PaySys claiming rights to acquire certain shares of PaySys stock that we acquired in 1993 from a PaySys founder.

Item 6. Exhibits and Reports on Form 8-K

There are no exhibits filed with this report and we have not filed a Form 8-K during the period covered by this report.

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CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

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CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

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