CoreCard Corp - Quarter Report: 2017 September (Form 10-Q)

United States

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

 (Mark One)

For the quarterly period ended September 30, 2017

OR

For the transition period from _________ to ____________

Commission file number 1-9330

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

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer”, “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☑

As of October 31, 2017, 8,777,988 shares of Common Stock of the issuer were outstanding.

Intelligent Systems Corporation

Index

Form 10-Q

Page

Part I      Financial Information

Item 1. Financial Statements

Intelligent Systems Corporation

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share amounts)

The accompanying notes are an integral part of these Consolidated Financial Statements.

Intelligent Systems Corporation

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited, in thousands, except share and per share amounts)

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(unaudited, in thousands)

The accompanying notes are an integral part of these Consolidated Financial Statements.

Intelligent Systems Corporation

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited, in thousands)

The accompanying notes are an integral part of these Consolidated Financial Statements.

Intelligent Systems Corporation

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

In the quarter ended June 30, 2017, we recorded an impairment charge of $90,000 to reduce the carrying value of our minority equity ownership in an investee company, a privately-held technology company in the FinTech industry. During the quarter ended June 30, 2017, the investee closed on a Series A preferred stock financing with higher preference to our Series Seed preferred stock which resulted in substantial dilution to our investment. As such, we felt a ninety percent write-down was warranted. CoreCard remains in an ongoing business relationship with the company pursuant to a Processing Agreement and has recognized more than our investment in processing services revenue.

In the quarter ended September 30, 2017, the remaining cash held in escrow from the sale of one of our investee companies to Cisco, Inc. in the fourth quarter of 2015, was released. Since we had no reasonable way to estimate the amount of escrow, if any, to be released to us at the initial time of the sale, no provision was previously recorded in the financial statements. We received cash of $372,000, which was recognized as a gain in the third quarter of 2017.

In the quarter ended September 30, 2017, we sold shares in a tender offer for stock of one of our investee companies, a privately-held technology company in the FinTech industry. We sold approximately ninety-one percent of our shares. We recognized a gain of $1,466,000 over our carrying value of $98,000. We retained a small equity stake in the investee and CoreCard remains in an ongoing business relationship with the company pursuant to a Processing Agreement previously entered into by the parties.

As of September 30, 2017, there is $90,000 of unrecognized compensation cost related to stock options. During the quarter ended September 30, 2017, an aggregate of 5,000 options were granted to a new independent member of our board of directors pursuant to the 2011 Non-Employee Director Option Plan (Director Plan). Pursuant to the terms of the Director Plan, the options were granted at fair value on the date of the grant. During the three and nine months ended September 30, 2017, 6,000 options and 18,000 options, respectively, expired unexercised, net of cancellation. During the nine months ended September 30, 2017, 60,000 options were exercised. The following table summarizes options as of September 30, 2017:

The estimated fair value of options granted is calculated using the Black-Scholes option pricing model with assumptions as previously disclosed in our 2016 Form 10-K.

The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the company’s closing stock price on the last trading day of the third quarter of 2017 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on September 30, 2017. The amount of aggregate intrinsic value will change based on the market value of the company’s stock.

Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash, marketable securities and trade accounts. Our available cash is held in accounts managed by third-party financial institutions. Cash may exceed the Federal Deposit Insurance Corporation, or FDIC, insurance limits. While we monitor cash balances on a regular basis and adjust the balances as appropriate, these balances could be impacted if the underlying financial institutions fail. To date, we have experienced no loss or lack of access to our cash; however, we can provide no assurances that access to our cash will not be impacted by adverse conditions in the financial markets.

GAAP establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable input be used when available.  Observable inputs are based on data obtained from sources independent of the company that market participants would use in pricing the asset or liability.  Unobservable inputs are inputs that reflect the company’s assumptions about the estimates market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. 

The hierarchy is measured in three levels based on the reliability of inputs:

• Level 1

Valuations based on quoted prices in active markets for identical assets or liabilities that we have the ability to access. Valuation adjustments and block discounts are not applied to Level 1 instruments.

• Level 2

Valuations based on quoted prices in less active, dealer or broker markets.  Fair values are primarily obtained from third party pricing services for identical or comparable assets or liabilities.

• Level 3

Valuations derived from other valuation methodologies, including pricing models, discounted cash flow models and similar techniques, and not based on market, exchange, dealer, or broker-traded transactions.  Level 3 valuations incorporate certain assumptions and projections that are not observable in the market and significant professional judgment is needed in determining the fair value assigned to such assets or liabilities.

In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety.

Our available-for-sale investments are classified within Level 1 of the valuation hierarchy.

The fair value of equity method and cost method investments has not been determined as it was impracticable to do so due to the fact that the investee companies are relatively small, early stage private companies for which there is no comparable valuation data available without unreasonable time and expense.

As a result of the recapitalization of CoreCard, we recorded the following adjustments to our shareholders’ equity to eliminate the minority interest component. There was no impact on the statement of operations for the three and nine months ended September 30, 2017.

There were no unrecognized tax benefits at September 30, 2017 and December 31, 2016. Our policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. There were no accrued interest or penalties associated with any unrecognized tax benefits, nor was any interest expense recognized during the periods presented. We have determined we have no uncertain tax positions.

We file a consolidated U.S. federal income tax return for all subsidiaries in which our ownership equals or exceeds 80%, as well as individual subsidiary returns in various states and foreign jurisdictions. With few exceptions we are no longer subject to U.S. federal, state and local or foreign income tax examinations by taxing authorities for years before 2013.

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

In addition to historical information, this Form 10-Q may contain forward-looking statements relating to ISC. All statements, trend analyses and other information relative to markets for our products and trends in revenue, gross margins and anticipated expense levels, as well as other statements including words such as “anticipate”, “believe”, “plan”, “estimate”, “expect”, and “intend”, and other similar expressions, constitute forward-looking statements. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties including those factors described below under “Factors That May Affect Future Operations”, and that actual results may differ materially from those contemplated by such forward-looking statements. ISC undertakes no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes in future operating results.

For purposes of this discussion and analysis, we are assuming and relying upon the reader’s familiarity with the information contained in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, in the Form 10-K for the year ended December 31, 2016 as filed with the Securities and Exchange Commission.

Overview 

Our consolidated operations consist of our CoreCard Software subsidiary and its affiliate companies in Romania and India, as well as the corporate office which provides significant administrative, human resources and executive management support to CoreCard.  

We provide technology solutions and processing services to the financial services market, commonly referred to as the FinTech industry. We offer processing services as an alternative for customers who prefer to outsource this function instead of licensing our software and running the application in-house. We derive our product revenue from licensing our comprehensive suite of financial transaction management software to accounts receivable businesses, financial institutions, retailers and processors to manage their credit and debit cards, prepaid cards, private label cards, fleet cards, loyalty programs, and accounts receivable and small loan transactions. Our service revenue consists of fees for software maintenance and support for licensed software products, fees for processing services that we provide to companies that outsource their financial transaction processing functions to us, and professional services primarily for software customizations provided to both license and processing customers.

We have frequently recognized consolidated operating losses on a quarterly and annual basis and are likely to do so in the foreseeable future. We may report operating profits on an irregular basis and our results vary in part depending on the size and number of software licenses recognized in a particular period and the level of expenses incurred to support existing customers and development and sales activities. A significant portion of our expense is related to personnel, including approximately 280 employees located in India and Romania. We are likely to incur losses in the near future because revenue for processing services is spread out over multi-year contracts while we are currently investing in the infrastructure, resources, processes and software features to support this developing business. In addition, we have certain corporate office expenses associated with being a public company that impact our operating results.   

Our revenue fluctuates from period to period and our results are not necessarily indicative of the results to be expected in future periods. It is difficult to predict the level of consolidated revenue on a quarterly or annual basis for a number of reasons, including the following:

Results of Operations

The following discussion should be read in conjunction with the Consolidated Financial Statements and the notes to Consolidated Financial Statements presented in this quarterly report.

Revenue – Total revenue from continuing operations in the three and nine month periods ended September 30, 2017 was $1,868,000 and $6,756,000, respectively, which represents a decrease of 29 percent for the quarter and an increase of 16 percent on a year-to-date basis compared to the respective periods in 2016.

Cost of Revenue – Total cost of revenue was 43 percent and 45 percent of total revenue, respectively, in the three month and nine month periods ended September 30, 2017 compared to 54 percent and 50 percent of total revenue in the corresponding periods in 2016.

Operating Expenses – In the three and nine month periods ended September 30, 2017, total operating expenses from continuing operations were 41 percent and 26 percent greater than in the comparable period in 2016 primarily as the result of increased research and development expenses. Research and development expenses were $495,000 (78 percent) greater in the third quarter of 2017 and $1,068,000 (56 percent) greater year-to-date 2017 compared to the same periods last year, primarily due to payroll and related expenses for additional offshore technical personnel, as well as an increase in contractor fees for certain development efforts. The increase in R&D technical staff is a direct result of the revenue increase experienced throughout 2016 into 2017, resulting in a greater need for more customized development efforts along with planned enhancements to our base product offerings. Marketing expenses decreased by $16,000 and $62,000, respectively, for the three and nine month periods ended September 30, 2017 compared to the corresponding periods in 2016, primarily due to less marketing initiatives in 2017. General and administrative expenses decreased $33,000 and $94,000, respectively for the three and nine month periods ended September 30, 2017 compared to the corresponding periods in 2016. The quarterly and year-to-date decrease is mainly due to lower professional fees as well as fewer personnel at the corporate office.

Other Income (Loss) – In the three and nine months ended September 30, 2017, we recorded income of $1,868,000 and $1,842,000, respectively, compared to income of $37,000 and a loss of $606,000 for the comparable 2016 periods. Both 2017 periods are primarily comprised of the gain of $1,466,000 on the sale of our investment in a privately-held technology company in the third quarter 2017, and the gain of $372,000 from funds held in escrow on an investment sale from 2015, both of which are described in more detail in Note 2 to the Consolidated Financial Statements. The year-to-date 2016 loss is primarily attributable to the write-down of $750,000 on an investment, as described in more detail in Note 2 to the Consolidated Financial Statements, offset in part by income earned on our cash balances.

Noncontrolling Interest – As disclosed in Note 9 to the financial statements, effective January 1, 2017 we no longer allocate any net income (loss) to the minority interest held by former shareholders of CoreCard Software.

Liquidity and Capital Resources

Our cash balance at September 30, 2017 was $16,458,000 compared to $17,724,000 at December 31, 2016. The principal source of cash during the period was the sale of our investment in a privately-held technology company which generated cash proceeds of $1,564,000, as described in more detail in Note 2 to the Consolidated Financial Statements. In addition, we received $372,000 of cash held in escrow from the sale of one of our investee companies, as described in more detail in Note 2 to the Consolidated Financial Statements. The principal use of cash during the period was funding a loan of $750,000 to a privately-held identity company, as described in more detail in Note 3 to the Consolidated Financial Statements, and funding our investment of $1,000,000 in a privately-held technology company on January 4, 2017; the liability for the investment funding was included in “Other Current Liabilities” at December 31, 2016.

During the nine months ended September 30, 2017, continuing operations used $1,005,000 cash for operations of the FinTech business and corporate office. The most significant working capital changes since December 31, 2016 include a decrease in deferred revenue of $337,000 primarily due to the recognition of professional services contracts associated with customizations for a global license customer and accounts receivable increased by $404,000 as we generated milestone billings related to the same customizations along with a one-time minimum contractual guarantee billing. In addition, work-in-process (included in other current assets) decreased $177,000 as development costs associated with the aforementioned customization contracts was recognized.

We used $432,000 cash to acquire computer equipment primarily to upgrade our U.S. based processing environment and for the technical resources added in our India office.

We expect to have sufficient liquidity from cash on hand as well as projected customer payments to support our operations and capital equipment purchases in the foreseeable future. Currently we expect to use cash in excess of what is required for our current operations for opportunities we believe will expand our CoreCard and FinTech business, although there can be no assurance that appropriate opportunities will arise.

Off-Balance Sheet Arrangements

We do not currently have any off-balance sheet arrangements that are reasonably likely to have a current or future material effect 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 is 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 investments and accrued costs and expenses 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 the fiscal year ended December 31, 2016. Reference is also made to the discussion of the application of these critical accounting policies and estimates contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for 2016. During the nine month period ended September 30, 2017, there were no significant or material changes in the application of critical accounting policies that would require an update to the information provided in the Form 10-K for 2016.

Factors That May Affect Future Operations

Future operations are subject to risks and uncertainties that may negatively impact our future results of operations or projected cash requirements. It is difficult to predict future quarterly and annual results with certainty.

Among the numerous factors that may affect our consolidated results of operations or financial condition are the following:

Item 4. Controls and Procedures

As of the end of the period covered by this report, the company carried out an evaluation, under the supervision and with the participation of the company’s management, including the company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the company’s disclosure controls and procedures pursuant to Rule 13a-15(b) under the Exchange Act. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the company’s disclosure controls and procedures are effective. There were no significant changes in the company’s internal control over financial reporting or in other factors identified in connection with this evaluation that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the company’s internal control over financial reporting.

Part II. OTHER INFORMATION

Item 6. Exhibits

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.

Exhibit Index

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