CoreCard Corp - Quarter Report: 2003 September (Form 10-Q)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission file number 1-9330

INTELLIGENT SYSTEMS CORPORATION

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  þ   No  o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2)   Yes  o   No  þ

As of November 10, 2003, 4,478,971 shares of Common Stock were outstanding.

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Item 1.  Financial Statements

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

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

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

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

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

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

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Intelligent Systems Corporation
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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      A reconciliation of consolidated segment data above to consolidated loss follows:

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

Results of Operations

The following discussion should be read in conjunction with the consolidated financial statements and the notes to the consolidated financial statements presented in this Form 10-Q.

Overview —  consolidated subsidiaries operate in two industry segments: Information Technology and Industrial Products. Included in the Information Technology sector are QS Technologies, Inc. (software for health and human services), VISaer, Inc. (software for maintenance, repair and overhaul operations in the aviation industry) and CoreCard Software, Inc. (software for the card processing market). The Industrial Products segment includes ChemFree Corporation (bio-remediating parts washers).

Revenues in the three and nine month periods ended September 30, 2003 decreased by 8 percent and increased by 18 percent, respectively, compared to the same periods in 2002. The net loss from operations in the three and nine month periods of 2003 was lower by 12 percent and 23 percent, respectively, than in the comparable periods in 2002. The reduced operating loss for the third quarter of 2003 is mainly the result of lower overall expense levels whereas the reduction in the year-to-date loss in 2003 is a combination of increased revenues and lower expense levels, most significantly in the area of software research and development. In the year-to-date period in 2003, our results include $4,464,000 in non-recurring gains (included in the investment income category) due to settlement of the escrow fund that had been established in April 2001 at the time of the sale of our affiliate company, PaySys International, Inc. to First Data Corporation.

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Revenue — Total revenues in the three month period ended September 2003 were $2,748,000, an 8 percent decline compared to the third quarter of 2002. Year-to-date total revenues in 2003 were $8,739,000, an 18 percent increase compared to the same period in 2002. Revenue from products, which includes sales of equipment in our Industrial Products segment as well as software license fees related to the Information Technology segment, decreased 7 percent and increased 15 percent in the three and nine month periods, respectively, of 2003 compared to the same periods in 2002. The increase in product revenue in the year-to-date period is due to an increase of $736,000 in revenue of Industrial Products, offset in part by a net decline of $40,000 in license revenue at the Information Technology subsidiaries. Of the Industrial Products increase, approximately 68 percent was due to a higher volume of products sold or leased due to increased demand for ChemFree products, particularly during the first half of the year, and approximately 32 percent of the increase was due to increases ranging from five to ten percent on product prices. The year-to-date increase in regards to the service revenue is due primarily to a 21 percent increase in VISaer’s service revenue reflecting a greater number of hours billed for professional services (mostly for international customers) in the first half of 2003 and a 22 percent increase in QS Technologies’ service revenue, the majority of which is related to annual maintenance contract revenue for domestic customers. The decrease in service revenue for the three month period ended September 30, 2003 compared to the same period in 2002 reflects completion of a VISaer professional services contract in the second quarter of 2003 that had begun in the third quarter of 2002. In 2003, the quarter and year-to-date product and service revenue includes a small contribution from CoreCard Software as the subsidiary began its initial customer installations.

Cost of Revenue — In both the three and nine month periods ended September 30, 2003, total cost of revenue was 59 percent of consolidated revenue compared to 55 percent in both the three and nine month periods of 2002. Cost of product revenue was virtually unchanged in both the three and nine month periods in 2003 and 2002, averaging between 48 percent and 50 percent in each period. The slight variations reflect principally ChemFree’s product mix in each period. Cost of service revenue (which relates to the Information Technology subsidiaries) was 74 percent in the three and nine month periods of 2003 compared to 68 percent and 65 percent, respectively, in the same periods last year. Of the $720,000 increase in total dollars spent for services year-to-date in 2003 compared to 2002, approximately 31 percent is related to QS Technologies and the balance is related mainly to VISaer. In both the three and nine month periods of 2003, QS Technologies’ cost of service revenue increased as a percentage of revenue because QS Technologies allocated more technical personnel to the customer support function this year than in 2002. In addition, VISaer’s cost of service revenue increased as a percentage of service revenue compared to the prior year in both the three and nine month periods of 2003 because VISaer utilized more expensive third party contractors for certain specialized development services in the first six months of 2003 and experienced some underutilization of professional services employees in the third quarter due to completion of a major contract in the second quarter of 2003.

Operating Expenses — In the three and nine month periods ended September 30, 2003, total consolidated operating expenses decreased by 13 percent and 15 percent, respectively, from the comparable periods last year. Consolidated marketing expenses were approximately the same in each of the comparable quarter and year-to-date periods in 2003 and 2002. Consolidated general and administrative expenses declined by 26 percent and 18 percent in the three and nine month periods, respectively, of 2003 compared to the same periods last year. On a year-to-date basis, this reduction reflects mainly the elimination of duplicate administrative and management personnel expenses totaling approximately $588,000 at CoreCard following the acquisition of CoreCard in the first quarter of 2002 as well as lower net facility costs due to reduced lease rates at the Norcross, Georgia offices. Consolidated research and development expenses in the three and nine month period ended September 30, 2003 were lower by 9 percent and 19 percent, respectively, than in the same periods in 2002. The significant decline is due mainly to reduced expenses at both VISaer and CoreCard. At VISaer, significant activities involving third party services related to the initial conversion and development of the Web-based VISaer software were completed in early 2003 and, at CoreCard, fewer employees are required now to complete the application product development than were needed in the same periods in 2002.

Interest Income — In the three and nine months ended September 30, 2003, we recorded $9,000 and $4,000, respectively, in interest income compared to interest income of $30,000 and $107,000 in the three and nine-month periods, respectively, in 2002. In 2002, we earned interest on higher cash and notes receivable balances than in 2003 because in 2002 we had a $1.2 million note receivable outstanding for five months and a $3.0 million note receivable outstanding for four months. Both notes were repaid or converted to equity investments in 2002.

Investment Income — In the third quarter of 2003, we recorded a net investment loss of $24,000 compared to a net investment loss of $360,000 in the same period of 2002. For the nine month period ended September 30, 2003, we earned net investment income of $3,645,000 compared to a net investment loss of $902,000 in the same period last year. Investment income in the first nine months of 2003 includes $4,464,000 earned in the first half of the year related to the PaySys escrow settlement, offset in part by write-downs of $600,000 in the first quarter and $76,000 in the second quarter to

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reduce the carrying value of our investments in RF Solutions, Inc. and Silverpop Inc., respectively, a first quarter charge of $119,000 to reduce the carrying value of a note receivable from RF Solutions, Inc. and a third quarter loss of $24,000 on the sale of our shares of Matria Healthcare, Inc. common stock. See Notes 3, 4 and 5 to the unaudited condensed financial statements included in Item 1 of this filing for a detailed description of certain of these transactions. Included in the investment losses in the first nine months of 2002 were write-downs in the carrying value of Daw Technologies, Inc., Novient, Inc. and Lumenor, Inc., offset in part by gains on the sales of the company’s holdings in Atherogenics, Inc. stock and Risk Laboratories, LLC. See Note 3 to the Consolidated Financial Statements in the Report on Form 10-K for 2002 for details of these transactions.

Equity Earnings (Losses) of Affiliate Companies — On a quarterly basis, we recognize our pro rata share of the earnings or losses of affiliate companies that we record on the equity method. We recorded $80,000 and $47,000 in net equity in earnings of affiliate companies in the three and nine months ended September 30, 2003, respectively. By comparison, we recorded net equity in earnings of $23,000 for the three month period ended September 30, 2002 and net equity in losses of $103,000 for the year-to-date period in 2002. These results include our pro rata share of the net earnings or losses reported by four affiliate companies (CoreXpand, MediZeus, Riverside Software and Horizon Software) in 2003 and three affiliate companies (CoreXpand, MediZeus and Horizon Software) in 2002.

Other Income, Net — Other income includes $74,000 and $288,000 in the third quarter and first nine months, respectively, of 2003. Such amounts include recognition of deferred gain of $33,000 and $99,000 in the three and nine month periods, respectively, related to a VISaer product line sale in July 2000, $42,000 and $118,000 in foreign currency exchange gains in the quarter and year-to-date periods, respectively, and other non-recurring miscellaneous income. In 2002, other income reflects mainly recognition of deferred gain related to the VISaer product line sale.

Income Taxes — In the first quarter of 2003, we recorded an income tax benefit of $104,000 that reflects a refund of alternative minimum taxes paid by the VISaer subsidiary in a prior year. We did not accrue for any income tax liability in year-to-date 2003 because we currently estimate the company will not incur income tax liability in 2003 and we believe that the deferred tax assets should be fully reserved given their character and our recent losses. The income tax benefit recorded in 2002 represents a refund for income taxes related to alternative minimum taxes paid in 2001 on the PaySys sale.

Common Shares — The basic and diluted weighted average number of basic shares outstanding in the three and nine month periods ended September 30, 2003 declined slightly from the three and nine month periods ended September 30, 2002 due to the repurchase and retirement of a small number of shares of our common stock.

Liquidity and Capital Resources

Our cash balance at September 30, 2003 was $2,320,000 compared to $2,644,000 at December 31, 2002. For the year-to-date period ended September 30, 2003, our principal source of cash was $4,540,000 in investment income, of which $4,464,000 was proceeds of the PaySys escrow settlement. During the nine month period, we used $4,295,000 for operations, principally to support CoreCard ($2,246,000 in total) and VISaer ($3,300,000 in total), offset in part by cash generated by the QS Technologies subsidiary. Cash used for operations also included a decrease of $238,000 in accounts payable and an increase in inventory of $80,000 (to support higher sales levels at ChemFree).

On October 1, 2003, we established a secured, revolving line of credit with a banking institution pursuant to which we may borrow up to $1,500,000 calculated on a borrowing base determined by the level of domestic accounts receivable and inventory of our consolidated subsidiary companies. The term of the revolving line of credit is one year and the line bears interest at the rate of prime plus one and one-half percent of the outstanding balance. As of this filing, no amounts have been borrowed under the line of credit.

We estimate that our cash requirements for the balance of 2003 will be lower and more predictable than in 2002 and the first nine months of this year due to new and pending software license contracts at our Information Technology segment subsidiaries, revised customer payment schedules resulting in earlier and more regular payments, and lower product development costs at VISaer and CoreCard Software. It is unclear what further impact, if any, will result from the ongoing uncertainty in the Middle East, potential further terrorist attacks or threats thereof either in the United States or abroad, the sudden acute respiratory syndrome (“SARS”) epidemics and other general economic factors, particularly with respect to our VISaer subsidiary’s customers. In the nine month period ended September 30, 2003, approximately 88 percent of VISaer’s revenue was from international customers involved in the commercial aviation industry and a significant number of its prospective customers are located in the Asian and Pacific markets. VISaer has won a number of new contracts in 2003, has delivered a major version release of its new web-based software product and believes there is demand for its new product,

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pending successful installations at customer sites. External factors contributed to weakness in the commercial aviation market in 2003 and resulted in delays in contract awards and implementations and, combined with some internal software development delays, increased VISaer’s cash requirements in the first nine months of 2003. Based on revised payment schedules with major customers and new contracts signed, VISaer believes its cash requirements will be substantially lower in the fourth quarter of 2003 and early 2004. As of this date, we do not intend to provide significant additional funding, if any, to VISaer. Refer to Factors That May Affect Future Operations below. From time to time, we have relied on sales of assets to generate cash to support our early stage companies and we may do so in the future if it is deemed desirable or necessary, although we have no specific plans to do so at this time. We believe that our cash balances and access to bank borrowings will be adequate to support our consolidated operations and plans for the foreseeable future. We do not have off-balance sheet arrangements, relationships, transactions or guarantees with third parties or related parties that would have a material affect on our financial condition, 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. Management discusses its estimates and judgments with the Audit Committee of the Board of Directors. 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 2002.

Revenue Recognition - Our product revenue consists of fees from software licenses and sales of equipment and supplies. 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 some situations, 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 may result in the allocation of a portion of the purchase price to 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. On at least an annual basis, 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, lack of progress of the underlying investment, or inability to raise capital to support the business plan at favorable valuations, or at all, could result in losses or an inability to recover the current carrying value of the investment. Our policy with respect to minority interests is to record an impairment charge when we believe an investment has experienced a decline in value that is other than temporary. Such charges could have a material adverse impact on our financial condition or results of operations and are generally not predictable or quantifiable in advance.

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 or financial condition are delays in software product development, undetected software errors, competitive pressures (including

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pricing), inability to establish referenceable customers for new product offerings by CoreCard or VISaer, failure of our product specifications and features to achieve market acceptance, changes in customer requirements and preferences, delays in anticipated customer payments, declines in performance, financial condition or valuation of minority-owned companies, terrorist activities or threat thereof, the aftermath of the war against Iraq, other geopolitical or military actions, the spread of communicable diseases, such as SARS and the impact of these factors on the commercial aviation industry, particularly in the developing Asian-Pacific markets, and other general economic conditions, particularly those which may cause commercial and government customers to delay or cancel software purchase decisions.

Both VISaer and CoreCard will incur operating losses in 2003 although their cash requirements are expected to be less than their reported losses because of customer payments based on milestone achievements in advance of being able to recognize license revenue. CoreCard and VISaer have required cash to operate in 2003, although at lower levels than in 2002 due to lower expense levels and customer payments. We anticipate that our other subsidiaries and our corporate operations will be slightly positive in 2003 in the aggregate. If either CoreCard or VISaer is unsuccessful or if we decide to suspend funding and the subsidiary’s internally generated cash flow is insufficient to support its operations, we may not recover our investment. Furthermore, if VISaer or CoreCard customers fail to make scheduled payments or if CoreCard or VISaer are unsuccessful in completing their software and implementing initial reference customers for their new software products, anticipated cash inflows may be delayed, resulting in increased cash requirements.

To minimize the effects of further potential declines in an already weak aviation market, VISaer is taking steps to focus its resources on meeting current contract requirements, maximizing professional services revenue and reducing expenses related to new sales and marketing efforts. VISaer has renegotiated payment schedules with several customers to provide more predictable, regular payments on contracts. However, these efforts may not produce the expected results and VISaer’s cash requirements and financial results could differ from our current forecasts. As of this date, we do not intend to continue to provide significant funding to VISaer. While we believe VISaer’s current forecast is reasonable, if customers do not fulfill their commitments for periodic payments, then its cash flow may be insufficient to support its current operations and VISaer would need to reduce its personnel and operating expenses or significantly cut back the scope of its operations.

CoreCard’s challenge is to establish a growing base of referenceable, satisfied customers and to overcome customer reluctance to implement a business critical system based on a new product offering with limited installations. CoreCard successfully installed its first significant customer in the third quarter of 2003 and is expanding its marketing efforts to identify several other reference customers although it does not have further contracts as of this filing. Furthermore, the fourth quarter of the year is typically the busiest for CoreCard’s target market and therefore it is unlikely that new customers would be committed until 2004. Depending on the number, payment terms and timing of any new software contracts, CoreCard’s cash requirements and budgeted results may differ from our current forecasts.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We do not have any material market risk because we have no long-term borrowings and our exposure to foreign currency valuation is minimal, since we sell our products denominated in US dollars.

Item 4. Controls and Procedures

ISC’s Chief Executive Officer and Chief Financial Officer have reviewed and evaluated the effectiveness of ISC’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of September 30, 2003. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that ISC’s current disclosure controls and procedures are effective in timely notifying them of material information related to ISC (including its consolidated subsidiaries) required to be disclosed in the reports ISC files or submits under the Exchange Act.

There have been no significant changes in ISC’s internal control over financial reporting that occurred during the quarter ended September 30, 2003 that have materially affected, or are reasonably likely to materially affect, ISC’s internal control over financial reporting.

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Part II. OTHER INFORMATION

Item 6. Exhibits and Reports on Form 8-K

We filed a Form 8-K on August 6, 2003 disclosing that we issued a press release on August 6, 2003 announcing our financial results for the quarter ended June 30, 2003.

The following exhibits are filed or furnished with this report:

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, hereunto duly authorized.

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