Intelligent Systems Corporation

Index

Form 10-Q

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)amounts)

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

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

Intelligent Systems Corporation

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands, except share amounts)

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)

Foreign revenues are based on the location of the customer. Revenues from customers by geographic areas for the three and ninesix months ended SeptemberJune 30, 20192020 and 20182019 are as follows:

Concentration of Revenue

The following table indicates the percentage of consolidated revenue represented by each customer that represented more than 10 percent of consolidated revenue in the three and ninesix month periods ended SeptemberJune 30, 20192020 and 2018.2019. Most of our customers have multi-year contracts with recurring revenue as well as professional services fees that vary by period depending on their business needs.

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, 20182019 as filed with the Securities and Exchange Commission.

Overview 

Our consolidated operations consist of our CoreCard Software subsidiary and its affiliate companies in IndiaRomania and Romania,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 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 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 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 results vary in part depending on the size and number of software licenses recognized as well as the value and number of professional services contracts recognized in a particular period. As we continue to grow our Processing Services business, we continue to gain economies of scale on the investment we have made in the infrastructure, resources, processes and software features developed over the past number of years to support this growing side of our business. We are adding new processing customers at a faster pace than we are adding new license customers, resulting in steady growth in the processing revenue stream. However, we are also experiencing growth in our license revenue and associated professional services revenue due to the addition of a large new customer in 2018. In total, this customer represented 58 percent65% and 50% of our consolidated revenues forin the first ninesix months of 2019.2020 and 2019, respectively. We expect future professional services, maintenance, and license revenue from this customer in 20192020 and future years; however, the amount and timing will be dependent on various factors not in our control such as the number of accounts on file and the level of customization needed by the customer. License revenue from this customer, similar to other license arrangements, is tiered based on the number of active accounts on the system. Once the customer achieves each tier level they receive a perpetual license up to that number of accounts; inactive accounts do not count toward the license tier. The customer receives an unlimited perpetual license at a maximum tier level that allows them to utilize the software for any number of active accounts. They currently use the software for a single institution and additional license fees apply if multiple institutions are added. Support and maintenance fees are charged based on the tier level achieved and increase at new tier levels.

While we typically receive revenue based on the number of active accounts on file rather than transaction volume, the recently declared pandemic related to the coronavirus could adversely impact our future results if the ability of our customers to continue to add new accounts is negatively impacted by the decrease in economic activity caused by the virus. As noted above, we receive license revenue when our customers achieve new active account tiers. The impact of slower growth or declines in active accounts would result in lower than expected license revenue which would then result in lower than expected maintenance revenue. Similarly, we typically receive processing revenue based on the number of active accounts our customers have on our system. If our customers fail to add new accounts or experience declines in active accounts due to inactivity, we could experience lower than expected growth in processing revenue or lower processing revenue. We could also experience delays or declines in professional services revenue and new customer sign-ups and implementations if customers or potential customers delay or cancel their plans due to the virus related economic slowdown. Thus far, we have experienced some slowdowns in customer account growth and some customers have stopped adding new accounts resulting in flat or declining active accounts. The impact on first and second quarter results was limited and, for the second quarter, was mitigated primarily by new program offerings by a large customer related to government stimulus efforts. These programs are limited in duration and may not continue beyond the initial statutory term of one year. We could therefore experience more significant negative impacts on full year results which we are not currently able to quantify.

Additionally, our operations could be impacted, and we could experience higher costs if, despite our mitigation and prevention efforts, the virus spread prevents affected employees from performing key duties. Our employees in India have been required to work remotely since mid-March. We have maintained key functions; however, the continuance of remote work will likely negatively impact productivity which could impact operations and revenues.

The infrastructure of our multi customer environment is scalable for the future. A significant portion of our expense is related to personnel, including approximately 480530 employees located in India and 10 employees located in Romania. Our ability to hire and train employees on our processes and software impacts our ability to onboard new customers and deliver professional services for software customizations. 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:

We continue to maintain a strong cash position. We intend to use cash balances to support the domestic and international operations associated with our CoreCard business and to expand our operations in the FinTech industry through financing the growth of CoreCard and, if appropriate opportunities become available, through acquisitions of businesses in this industry. In November 2018, our Board of Directors authorized a share repurchase program of $5 million. We did not make any share repurchases in 20182020 or 2019.

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 in the three and ninesix month periods ended SeptemberJune 30, 20192020 was $9,522,000$8,053,000 and $24,000,000,$15,946,000, respectively, which represents increases of 767 percent and 7110 percent compared to the respective periods in 2018.2019.

Cost of Revenue – Total cost of revenue was 3246 percent and 3545 percent of total revenue in the three and ninesix month periods ended SeptemberJune 30, 2019,2020, respectively, compared to 4339 percent and 38 percent of total revenue in the corresponding periods of 2018.2019. The decreaseincrease in cost of revenue as a percentage of revenue is primarily driven by increaseddecreased product sales with low associated costs. Cost of revenue includes costs to provide annual maintenance and support services to our installed base of licensed customers, costs to provide professional services, and costs to provide our financial transaction processing services. The cost and gross margins on such revenues can vary considerably from period to period depending on the customer mix, customer requirements and project complexity as well as the mix of our U.S. and offshore employees working on the various aspects of services provided. In addition, we continue to devote the resources necessary to support our growing processing business, including direct costs for regulatory compliance, infrastructure, network certifications, and customer support. However, we are continuing to experience economies of scale in our processing environment and did experience a decrease year over year for our cost of financial transaction processing services as a percentage of transaction processing services revenue. This may be subject to change in the future if new regulations or processing standards are implemented causing us to incur additional costs to comply.

Operating Expenses – In the three and nine month periodsperiod ended SeptemberJune 30, 2019,2020, total operating expenses from consolidated operations were greaterlower than in the corresponding period in 20182019 primarily asdue to lower general and administrative expenses. In the result of increasedsix month period ended June 30, 2020, total operating expenses from consolidated operations were lower than in the corresponding period in 2019 primarily due to lower research and development expenses as well as higher general and administrative expenses.expense. Research and development expenses were 967 percent higher and 4711 percent higherlower in three and ninesix month periods in 2019,2020, respectively, as compared to the same periods in 2018,2019. In the three month period ended June 30, 2020, research and development expenses were higher mainly due to payroll and related expense for additional offshore technical personnelpersonnel. In the six month period ended June 30, 2020, research and a recognition baseddevelopment expenses were lower mainly due to lower recognition-based bonus accrual.accruals, partially offset by payroll and related expense for additional offshore technical personnel. General and administrative expenses were higher36 percent lower in 2019 than in 2018,the three month period ended June 30, 2020 due to higher legal and advisory expenses related to continuing2019 contract negotiations and strategic initiatives of the Board as well asthat did not recur in the comparable 2020 period. General and administrative expenses were 4 percent higher personnel-related expense at CoreCard andin the corporate offices in 2019.six month period ended June 30, 2020. Marketing expenses decreased 39 percent and 29 percent for the three and ninesix month periods in 20192020, respectively, as compared to the respectivesame periods in 20182019 as we continued to place less focus on marketing initiatives for CoreCard in 2019.CoreCard. Our client base continues to increase with minimal marketing efforts as we continue to have prospects contact us via online searches; however, we will continue to re-evaluate our marketing expenditures as needed to competitively position the Processing Services business.   

Investment Income (Loss) – In the three and six months ended June 30, 2020, we recorded $95,000 and $1,145,000 of investment losses, respectively, compared to investment losses of $21,000 for the three months ended June 30, 2019 and investment income of $4,000 for the six months ended June 30, 2019. The investment losses for the six months ended June 30, 2020 primarily relate to impairment charges on investments resulting from the economic downturn caused by the recent pandemic and losses on equity method investments.

Other Income (Loss) – In the three and ninesix months ended SeptemberJune 30, 2019,2020, we recorded a loss of $5,000 and income of $248,000,$117,000 and $253,000, respectively, compared to income of $245,000$146,000 and $128,000$249,000 for the comparable 20182019 periods. The decrease in the third quarter of 2019 is primarily due to losses on equity method investments related to a 40% equity interest acquired in the second quarter of 2019, partially offset by higher income earned on our cash balances. The increase for the ninethree month period is primarily due to 2018 investment activity that did not recurlower interest rates in 2019 as well as higher income earned on our cash balances. The nine month period in 2018 included the write-down of $250,000 on an investment, as described in more detail in Note 3 to the Consolidated Financial Statements, offset in part by income earned on our cash balances.2020 period.

Income Taxes – Our effective tax raterates for the three and ninesix months ended SeptemberJune 30, 2019 was 26.32020 were 19.3 percent and 24.722.5 percent respectively, compared to 5.8effective tax rates of 22.7 percent and 4.623.4 percent for the respective periods in 2018. The increase is due to utilization of net operating loss carryforwards in 2018.2019.

Liquidity and Capital Resources

Our cash balance at SeptemberJune 30, 2019,2020, was $23,676,000$32,316,000 compared to $18,919,000$26,415,000 at December 31, 2018.2019. During the ninesix months ended SeptemberJune 30, 2019,2020, cash provided by operations was $7,679,000$9,714,000 compared to cash provided by operations of $4,986,000$5,954,000 for the ninesix months ended SeptemberJune 30, 2018.2019. The increase is primarily due to higher deferred revenue and lower accounts receivable balances and a non-cash impairment charge, partially offset by lower net income and an increase in other current liabilities, primarily income taxes payable.lower accrued payroll. In addition, we advanced $1,500,000$1,000,000 on a Promissory Note and a Loan Agreement which is described in more detail in Note 43 to the Consolidated Financial Statements.

During the nine months ended September 30, 2019, we We used $1,553,000$2,767,000 of cash to acquire computer equipment primarily for enhancements to our processing environment in the U.S. and the technical resources added in our India offices.office and to upgrade our existing processing environment in the U.S.

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 and valuation of investments to be critical policies due to the estimation processes involved in each. To the extent deemed material, managementManagement 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, 2018.2019. 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 2018.2019. During the ninesix month period ended SeptemberJune 30, 2019,2020, there were no significant or material changes in the application of critical accounting policies, other than the adoption of ASU 2016-02, Leases (Topic 842) as described further in Note 1 and 8 to the Consolidated Financial Statements, that would require an update to the information provided in the Form 10-K for 2018.policies.

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.

In addition toAmong the factors discussed above in Overview to Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations, numerous factors that may affect our consolidated results of operations or financial condition including but not limited to: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 1.3. Legal Proceedings

On or about July 9, 2019, a securities class action complaint was filed in the United States District Court for the Eastern District of New York (Case No. 1:19-cv-03949) by Michael Skrzeczkoski, individually and on behalf of all others similarly situated, against the company, our executive officers, and each member of the Board of Directors.certain current and former directors and officers. The complaint alleges, among other things, that certain of our press releases and SEC filings were misleading as a result of the failure to disclose alleged related party transactions affecting revenue recognition and the absence of disclosure regarding certain allegations against former director Parker H. Petit in connection with his former position with MiMedx, Inc. The complaint seeks to recover attorney’s fees and costs and unspecified damages on behalf of purchasers who acquired our stock during the period from January 23, 2019, through May 29, 2019, and purportedly suffered financial harm as a result of the alleged misleading statements. On September 26, 2019, the Court appointed Edgardo Canez as lead plaintiff (“Lead Plaintiff”) on behalf of the putative class. On November 18, 2019, Lead Plaintiff, individually and on behalf of a putative class of persons or entities who purchased or otherwise acquired publicly traded company securities from May 23, 2014 through May 29, 2019, filed an amended class action complaint against the company, and certain current and former directors and officers (the “Amended Complaint”). The Amended Complaint alleges similar allegations in violation of Sections 10(b) and 20(a) of the Securities Exchange Act as the previously filed complaint. The Amended Complaint seeks to recover attorney’s fees and costs and unspecified damages. On January 2, 2020, Defendants submitted a motion to dismiss, and on March 3, 2020, briefing on the motion to dismiss was completed. The motion to dismiss is currently pending. We dispute these claims and intend to defend the matter vigorously.

On or about February 14, 2020, two purported shareholders, derivatively and on behalf of the Company, filed substantially similar shareholder derivative actions in the Eastern District of New York against certain current and former directors and officers (the “Individual Defendants”), and the Company as a nominal defendant (together with the Individual Defendants, the “Defendants”). The complaints assert a claim against Messrs. Strange, Moise, Petit, Fuzzell and Chandler for a violation of Section 14(a) of the Securities Exchange Act by issuing purportedly misleading statements in the Company’s 2017 and 2018 Proxies.  The complaints also assert claims against the Individual Defendants for breaches of fiduciary duty, waste of corporate assets, and unjust enrichment arising out of, among other things, purportedly undisclosed related party transactions, other relationships, and certain allegations against former director Parker H. Petit in connection with his former position with MiMedx, Inc. and other companies. The relief sought in the complaints includes changes to the Company’s corporate governance procedures, unspecified damages, equitable relief, restitution, and attorney’s fees and costs.  On April 20, 2020, the two derivative actions were consolidated and captioned, In re Intelligent Systems Corporation Stockholder Derivative Litigation, Lead Case No. 1:20-cv-00832, in the Eastern District of New York.  On June 19, 2020, Defendants filed their motion to dismiss. Plaintiffs’ opposition to Defendants’ motion to dismiss is currently due by August 18, 2020, and Defendants’ reply brief in further support of the motion to dismiss is due by September 28, 2020.

For information regarding our accounting for legal contingencies, see Note 8 of the Notes to Consolidated Financial Statements in this Form 10-Q.

Item 4. Controls and Procedures

Evaluation of Disclosure Control Over Financial Reporting

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.

Changes in Internal Control Over Financial Reporting

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