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

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

     (Mark One)

For the quarterly period ended June 30, 2003

OR

For the transition period from      to      

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 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 August 1, 2003, 4,479,881 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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Item 2. Management’s Discussion and Analysis of Results of Operations and Financial Condition

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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 - Our consolidated subsidiaries during 2003 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 six month periods ended June 3003 increased 27 percent and 36 percent, respectively, compared to the same periods in 2002. Our net loss from operations in the three and six month periods of 2003 lower by 26 percent and 27 percent, respectively, than in the comparable periods in 2002. The reduction in operating loss is a result of improved performance at each of our subsidiaries reflecting higher levels of sales at ChemFree, VISaer and QS Technologies and lower overall expense levels, most significantly in the area of software research and development. In the year-to-date period in 2003, our results include a total of $4,464,000 in non-recurring investment gains 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.

Revenue - Total revenues in the three and six month periods ended June 2003 were $2,821,000 and $5,991,000, respectively, an increase of 27 percent and 36 percent compared to the same periods 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, increased 35 percent and 30 percent in the three and six month periods, respectively, of 2003 compared to the same periods in 2002. The increase in product revenue is due mainly to a 28 percent and 33 percent increase in the three and six month periods, respectively, of 2003 in sales of ChemFree products, due to a greater number of machines sold or leased as well as a modest price increase and more unit sales of fluid and filters due to increased demand for ChemFree products, particularly in the European marketplace. The company does not expect the same rate of growth in succeeding periods, particularly during the summer months. Revenue from services billed by the Information Technology segment increased 16 percent and 45 percent in the three and six-month periods ended June 30, 2003, respectively, compared to the same periods in 2002. The year-to-date increase is due primarily to a 64 percent increase in VISaer’s service revenue reflecting a greater number of hours billed for professional services (mostly for international customers) and a 20 percent increase in QS Technologies’ service revenue, the majority of which is related to annual maintenance contract revenue for domestic customers. The increase in service revenue for the three month period ended June 30, 2003 compared to the same period in 2002 reflects growth at VISaer and QS Technologies, although at a somewhat slower rate than in the first quarter of 2003.

Cost of Revenue - In the three-month period ended June 30, 2003, total cost of revenue was 60 percent of consolidated revenue, compared to 54 percent in the same period last year. In the six month period ended June 30, 2003, total cost of revenue was 59 percent of consolidated revenue compared to 54 percent in the six month period of 2002. Cost of product revenue was virtually unchanged in both the three and six 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 77 percent and 74 percent in the three and six month periods of 2003 compared to 61 percent and 63 percent in the same periods last year, reflecting changes at both QS Technologies and VISaer. VISaer’s cost of service revenue increased in absolute dollars to support a higher level of professional service and maintenance contracts in both the three and six-month periods of 2003 compared to 2002. Cost as a percentage of service revenue increased in the three month period ended June 30, 2003 compared to prior year and the first quarter of 2003 because VISaer experienced some underutilization of professional services employees due to deferral of certain professional services engagements to the third quarter of 2003, rather than commencing in the second quarter as

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expected. QS Technologies’ cost of service revenue increased in absolute amounts and as a percentage of revenue because QS Technologies allocated more technical personnel to the customer support function this year than in 2002.

Operating Expenses - In the three and six month periods ended June 30, 2003, total consolidated operating expenses decreased by 18 percent and 16 percent, respectively, from the comparable periods last year. Consolidated marketing expenses were down by 16 percent in the three months ended June 30, 2003 compared to the second quarter last year mainly because last year ChemFree incurred up-front expenses for a new marketing initiative that did not require the same level of expenditure in 2003. Consolidated marketing expenses increased by 4 percent in the first six months of 2003 due to increased marketing expenditures at the Information Technologies subsidiaries mainly to support a higher level of sales activity for new product introductions. Consolidated general and administrative expenses declined by 14 percent and 13 percent in the three and six month periods, respectively, of 2003 compared to the same periods last year. This reduction reflects mainly the elimination of duplicate administrative and management personnel expenses at CoreCard following the acquisition of CoreCard in the first quarter of 2002. Consolidated research and development expenses in the three and six month period ended June 30, 2003 were lower by 19 percent and 22 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 related to the initial conversion and development of the Web-based VISaer software have been completed and, at CoreCard, fewer employees are required now than were needed in the early stages to create the technology platform and develop the initial software code.

Interest Income - In the first six months of 2003, we recorded $5,000 in interest expense compared to interest income of $53,000 and $77,000 in the three and six-month periods, respectively, in 2002. In 2003, interest expense relates to interest payable on equipment leases. In 2002, we earned interest on higher cash balances than in 2003.

Investment Income - In the second quarter and year-to-date periods in 2003, we earned net investment income of $205,000 and $3,669,000, respectively. Investment income in 2003 includes $4,183,000 and $281,000 in the first and second quarters, respectively, earned on 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 reduce the carrying value of our investments in RF Solutions, Inc. and Silverpop Inc., respectively, and a first quarter 2003 charge of $119,000 to reduce the carrying value of a note receivable from RF Solutions, Inc. See Notes 3, 4 and 5 to these condensed financial statements elsewhere in this filing for a detailed description of these transactions. By comparison, in the second quarter and year-to-date periods of 2002, we reported net investment losses of $1,339,000 and $542,000, respectively. Included in the investment losses in the first six months of 2002 were write-downs in the carrying value of Daw Technologies, Inc., Novient, Inc. and Lumenor totaling $1,929,000. 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. These companies are typically early stage companies that incur losses during their development and early revenue stages. We recorded $34,000 net equity in earnings of affiliate companies in the quarter ended June 30, 2003 and $33,000 of net equity losses in the first six months of 2003. For the same periods in 2002, we recorded net equity losses of $60,000 and $126,000, respectively. 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 one affiliate company (CoreXpand) in 2002.

Other Income, Net - Other income includes $187,000 and $214,000 in the second quarter and first six months, respectively, of 2003. Such amounts include recognition of deferred gain related to a VISaer product line sale in July 2000 as well as approximately $64,000 in non-recurring miscellaneous income and $75,000 in foreign currency exchange gain. In 2002, other income reflects mainly recognition of deferred gain related to the VISaer product line sale.

Taxes - In the first quarter of 2003, we recorded a 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 a tax liability for the full year 2003 and we believe that the deferred tax assets should be fully reserved given their character and our recent losses. Taxes in 2002 represent a subsidiary’s state tax liability.

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

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Liquidity and Capital Resources

Our cash balance at June 30, 2003 was $3,111,000 compared to $2,644,000 at December 31, 2002. For the year-to-date period ended June 30, 2003, our principal source of cash was $4,464,000 from the proceeds of the PaySys escrow settlement. During the six month period, our principal use of cash was $3,666,000 to support operations at CoreCard Software and VISaer. Cash used for operations also included a decrease of $206,000 in accounts payable and an increase in inventory of $113,000 (to support higher sales levels at ChemFree) offset by an increase in deferred revenue.

We estimate that our cash requirements for 2003 will be lower than in 2002 based on new and pending software license contracts at our Information Technology segment subsidiaries, anticipated customer payments based on milestone achievements, 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 six months period ended June 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 were 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 increasing demand for its new product, pending successful installations at customer sites. External factors contributed to weakness in the commercial aviation market in the first half of 2003 and resulted in delays in contract awards and implementations, thereby increasing VISaer’s cash requirements in the first half of 2003. We are also exploring the possibility of obtaining a new bank line of credit. However, there can be no assurance that a line of credit will be available on satisfactory terms, if at all. 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. Based on scheduled payments and new contracts signed, we believe VISaer’s cash requirements will be lower in the second half of 2003 and that our cash balances are 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

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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 not 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 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 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 scheduled customer payments based on milestone achievements in advance of being able to recognize license revenue. CoreCard and VISaer will require cash to operate in 2003, although we believe cash requirements will be at lower levels than in 2002. We anticipate that our other subsidiaries and our corporate operations will be cash neutral to slightly positive in 2003 in the aggregate. If either CoreCard or VISaer is unsuccessful or if we decide to suspend funding, we may not recover our investment. Furthermore, if VISaer fails to meet product development milestones or if CoreCard or VISaer are unsuccessful in implementing initial reference customers for their new software products, anticipated payments from customers 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 proactive steps to focus its resources on meeting current contract requirements, maximizing professional services revenue and reducing expenses related to new sales and marketing efforts. However, these efforts may not produce the expected results and VISaer’s cash requirements and financial results could differ from our current forecasts. CoreCard’s challenge is to establish a growing base of referable, satisfied customers and to overcome customer reluctance to implement a business critical system based on a new product offering with limited installations. CoreCard signed its first significant customer contract in the second quarter of 2003 and expects to expand its marketing efforts in the second half of the year to identify several other reference customers. Depending on the number and payment terms of 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.

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 June 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.

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

Part II. OTHER INFORMATION

Item 4. Vote of Security Holders

At the Annual Meeting of Shareholders held on May 30, 2003, the shareholders of ISC re-elected James V. Napier and J. Leland Strange as directors of the company to serve until the 2006 Annual Meeting. Mr. Napier was elected by a vote of 4,223,889 FOR and 83,769 WITHHELD while Mr. Strange was elected by a vote of 4,223,849 FOR and 83,769 WITHHELD. At the Annual Meeting, the shareholders also approved the adoption of the Intelligent Systems Corporation 2003 Stock Incentive Plan (the “Plan”). The Plan was approved by a vote of 1,559,368 FOR, 500,506 AGAINST, 97,888 ABSTENTIONS and 2,149,706 BROKER NON-VOTES.

Item 6. Exhibits and Reports on Form 8-K

We filed a Form 8-K on May 7, 2003 disclosing that we issued a press release on May 7, 2003 announcing our financial results for the quarter ended March 31, 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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