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

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

OR

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 x   No o

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

As of March 31, 2003, 4,489,321 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 consolidated balance sheets.

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

     The accompanying notes are an integral part of these 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 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 income (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 - 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).

Revenue in the first quarter of 2003 was $3,170,000, an increase of 45 percent compared to the same period in 2002. Our net loss from operations in the first quarter of 2003 was $2,574,000 compared to a net loss of $3,617,000 in the first quarter of 2002. The reduction in operating loss is a result of improved performance at each of the controlled subsidiaries resulting from higher sales levels at VISaer, QS Technologies and ChemFree and lower expense levels, principally in the area of research and development. In the current quarter, we recognized a total of $3,523,000 in other income that offset the loss

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from operations, resulting in consolidated net income for the quarter of $949,000 compared to a net loss of $2,122,000 in the first quarter of 2002. The income in the first quarter of 2003 reflects a gain of $4,183,000 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 revenue in the first quarter of 2003 was $3,170,000, an increase of 45 percent compared to revenue of $2,187,000 in the same period last year. 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 26 percent period-to-period whereas revenue from services billed by the Information Technology segment increased 80 percent period-to-period. The increase in product revenue is due mainly to a 39 percent increase period-to-period in sales of ChemFree products, reflecting a greater number of machines sold or leased as well as more units sales of fluid and filters due to increased demand for the ChemFree products. Compared to the same period last year, ChemFree’s revenue increased by 24 percent in domestic markets and 123 percent internationally, although the company does not expect the same level of increase in each succeeding quarter of 2003, particularly in the European markets or during the summer months. With respect to revenue from services, the period-to-period increase is due primarily to a 112 percent increase in VISaer’s service revenue reflecting a greater number of hours billed for professional services and a 29 percent increase in QS Technologies’ service revenue, the majority of which is related to annual maintenance contract revenue.

Cost of Revenue - In the three months ended March 31, 2003, cost of revenue was 57 percent of consolidated revenue, compared to 55 percent in the same period last year. Cost of product revenue was 45 percent of product revenue in the first quarter of 2003 compared to 48 percent in the comparable period in 2002. The decrease between periods reflects a more favorable product mix in the current quarter as proportionately more of ChemFree’s revenue was derived from higher margin fluid and filter sales (as compared to lower margin parts washer machines). Cost of service revenue (all of which relates to the VISaer and QS Technologies subsidiaries) increased by 92 percent from period to period and by 7 percent as a percentage of service revenue, reflecting changes at both QS Technologies and VISaer. While VISaer’s cost of service revenue increased in absolute dollars to support a higher level of service revenue, the cost as a percentage of service revenue declined because the utilization rate for billable VISaer personnel was higher in the first quarter this year than last year. 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 in the first quarter of this year than in the first quarter last year.

Operating Expenses - In the first quarter of 2003, total consolidated operating expenses decreased by 15 percent from the comparable period last year. Consolidated marketing expenses were up 31 percent period-to-period, reflecting mainly higher expenses in the Information Technology segment to support a higher sales volume offset in part by a reduction in marketing expenses in the Industrial Products segment. This reduction occurred because last year ChemFree incurred significant up-front expenses for a new marketing initiative in 2002 that did not require the same level of expenditure in 2003. Consolidated general and administrative expenses declined by 12 percent in the first period of 2003 compared to the first period 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 expense in the first period of 2003 was $2,081,000 which is $705,000 (or 25 percent) less than for the first period last year. The significant decline is due mainly to reduced expenses at both VISaer and CoreCard. At VISaer, significant activities and subcontractor expense 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 initial specifications and software code.

Interest Income - In the first quarter this year, we recorded $5,000 in interest expense compared to interest income of $24,000 in the first quarter of 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 first quarter of 2003, we earned net investment income of $3,464,000, representing investment income of $4,183,000 earned on the PaySys escrow settlement offset in part by a write-down of $600,000 to reduce the carrying value of our investment in RF Solutions, Inc. and a charge of $119,000 to reduce the carrying value of a note receivable from RF Solutions, Inc. (see Notes 3 and 4 to these financial statements for a detailed description of these transactions). By comparison, in the first quarter of 2002, we earned $797,000 in net investment income representing gains of $573,000 on the sale of shares of Atherogenics stock and $474,000 on the private sale of our remaining interest in a former affiliate company, Risk Labs, off set by a reserve of $250,000 to write down the carrying value of our minority interest in a privately held early stage software company.

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Equity 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 $67,000 and $66,000 of net equity losses in the first quarter of 2003 and 2002, respectively, which included our pro rata share of the net earnings or losses reported by three affiliate companies (CoreXpand, MediZeus and Horizon Software) in 2003 and one affiliate company (CoreXpand) in 2002.

Other Income, Net - Other income includes $27,000 and $752,000 in the first quarter of 2003 and 2002, respectively, most of which reflects recognition of deferred gain related to a VISaer product line sale in July 2000.

Taxes - In the first quarter of 2003, we recorded a tax benefit of $104,000 which 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 the first quarter of 2003 because we currently estimate the company will not incur a tax liability for the full year 2003. In the first quarter of 2002, we recorded income tax expense of $11,000 representing a subsidiary’s state tax liability.

Common Shares - The basic and diluted weighted average number of basic shares outstanding in the first quarter of 2002 declined slightly due to our repurchase and retirement of a small number of shares of our common stock.

Liquidity and Capital Resources

Our cash balance at March 31, 2003 was $5,108,000 compared to $2,644,000 at December 31, 2002. For the first quarter ended March 31, 2003, our principal source of cash was $4,183,000 from the proceeds of the PaySys escrow settlement. During the three month period, our principal uses of cash were to support operations at CoreCard Software and VISaer, through advances totaling $1,578,000. Cash used for operations included a decrease of $217,000 in accounts payable and cash provided by operations included $686,000 generated from collections of accounts receivable.

In the first quarter of 2003, all of the preferred shareholders of VISaer permanently waived their rights to redemption by VISaer of their preferred shares. Consequently, VISaer reclassed the amounts that it had accrued in prior periods related to the redemption provision and, on our consolidated balance sheet at March 31, 2003, we reclassed the amounts shown as “redeemable preferred stock of subsidiary” at December 31, 2002, against goodwill. There was no income statement impact on this entry.

Our budgeted cash requirements for 2003 are substantially lower than for 2002 based on new and pending software license contracts at our Information Technology segment subsidiaries, anticipated software customer payments based on milestone achievements, and lower product development costs at VISaer and CoreCard Software. It is unclear what impact, if any, will result from the war against Iraq, potential further terrorist attacks either in the United States or abroad, the sudden acute respiratory syndrome (SARS) epidemic and other general economic factors, particularly with respect to VISaer’s and ChemFree’s international business, which represented $1,346,000 (42 percent) of consolidated revenue for the first quarter of 2003. We expect the impact may be more severe at VISaer since approximately 90 percent of its current year revenue is from international customers involved in the commercial aviation industry and a significant number of its prospective customers are in the Asian and Pacific markets. Unanticipated delays in contract awards, implementations or customer payments may increase our cash requirements during 2003. We believe our cash balances are adequate to support our 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 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. 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

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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 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 by CoreCard, 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, the aftermath of the war against Iraq, other geopolitical or military actions, the SARS epidemic 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 at significantly lower levels than in 2002. We anticipate that our other subsidiaries and our corporate operations will be cash neutral 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 is unsuccessful in implementing its initial reference customers, anticipated payments from customers may be delayed, resulting in increased cash requirements. To minimize the effects of a potential slowdown in new business booked by VISaer due to further potential declines in an already weak aviation market, VISaer is taking proactive steps to focus its resources on meeting current contract requirements and deferring expenses related to new sales and marketing efforts. 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 from an early stage company with limited installations. One such customer contract is in negotiation at this time and others will be needed to overcome this reluctance. Depending on the number and payment terms of new software contracts, CoreCard’s cash requirements and budgeted results may differ from our current forecasts.

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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

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.

Part II. OTHER INFORMATION

Item 5.     Other Information

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

In accordance with guidance recently issued by the SEC, we have submitted the certifications of our Chief Executive Officer and our Chief Financial Officer required by section 906 of the Sarbanes-Oxley Act of 2002 as Exhibits 99.1 and 99.2, respectively, accompanying this report. Pursuant to this SEC guidance, such exhibits shall not be deemed to be “filed” as part of this report.

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 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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CERTIFICATION

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

I, J. Leland Strange, the Chief Executive Officer of Intelligent Systems Corporation, certify that:

Date: May 15, 2003

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

I, Bonnie L. Herron, the Chief Financial Officer of Intelligent Systems Corporation, certify that:

Date: May 15, 2003

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