Current assets:

Cash

Accounts receivable, net

Notes and interest receivable, current portion

Inventories

Other current assets

 

Total current assets

 

Long-term investments

Notes and interest receivable, net of current portion

Property and equipment, at cost less accumulated depreciation

Goodwill, net

Other intangibles, net

Other assets, net

 

Total assets

 

 

Current liabilities:

Note payable

Accounts payable

Deferred revenue

Accrued payroll

Accrued expenses and other current liabilities

 

Total current liabilities

 

Long-term liabilities

 

Commitments and contingencies (Note 9)

Minority interest

 

Stockholders’ equity:

Common stock, $0.01 par value, 20,000,000 shares authorized, 4,478,971 shares issued and outstanding at June 30, 2007 and December 31, 2006

Additional paid-in capital

Accumulated other comprehensive loss

Accumulated deficit

 

Total stockholders’ equity

 

Total liabilities and stockholders’ equity

 

Revenue

Products

Services

 

Total revenue

 

Cost of revenue

Products

Services

 

Total cost of revenue

 

Expenses

Marketing

General & administrative

Research & development

 

Loss from operations

 

Other income (expense)

Interest income (expense), net

Investment income, net

Equity in income of affiliate companies

Other income (loss), net

 

Loss before income taxes

 

Income from discontinued operations, no tax effect

Gain on sale of discontinued operations, no tax effect

 

Net loss

 

 

Loss per share from continuing operations:
                           Basic & diluted

Income per share from discontinued operations:
                           Basic & diluted

 

Net loss per share: Basic & diluted

 

Basic weighted average common shares outstanding

Diluted weighted average common shares outstanding

 

Net loss

Adjustments to reconcile net loss to net cash used for operating activities:

Depreciation and amortization

Stock-based compensation expense

Gain on sale of QS business

Investment income

Equity in earnings of affiliate companies

Changes in operating assets and liabilities:

Accounts receivable

Inventories

Other current assets

Accounts payable

Accrued payroll

Deferred revenue

Accrued expenses and other current liabilities

Other liabilities

 

Cash used for operating activities

 

 

Proceeds related to sales of investments or marketable securities

Proceeds from notes and interest receivable

Distributions from long-term investments

Payments on notes payable

Purchases of property and equipment

 

Cash provided by investing activities

 

 

Borrowings under short-term borrowing arrangements

 

Cash provided by financing activities

 

 

Effects of exchange rate changes on cash

 

Net increase in cash

Cash at beginning of period

 

Cash at end of period

 

 

Cash paid during the period for interest

 

Throughout this report, the terms “we”, “us”, “ours”, “ISC” and “company” refer to Intelligent Systems Corporation, including its majority-owned subsidiaries.

The unaudited consolidated financial statements presented in this Form 10-QSB have been prepared in accordance with accounting principles generally accepted in the United States applicable to interim financial statements. Accordingly, they do not include all of the information and notes required for complete financial statements. In the opinion of ISC management, these consolidated financial statements contain all adjustments (which comprise only normal and recurring accruals) necessary to present fairly the financial position and results of operations as of and for the three and six month periods ended June 30, 2007 and 2006. The interim results for the three and six months ended June 30, 2007 are not necessarily indicative of the results to be expected for the full year. These statements should be read in conjunction with our consolidated financial statements and notes thereto for the fiscal year ended December 31, 2006, as filed in our Annual Report on Form 10-KSB.

Discontinued Operations – As explained in more detail in Note 2 to the Consolidated Financial Statements included in our 2006 Form 10-KSB, effective July 31, 2006, we completed the sale of the business and certain assets of our QS Technologies, Inc. (“QS”) subsidiary to Netsmart Public Health, Inc. and its parent company, Netsmart Technologies, Inc., referred to collectively as “Netsmart”. In accordance with Financial Accounting Standards Board Statement No.144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, the QS business is presented as discontinued operations for the three and six months ended June 30, 2007 and 2006.

The following condensed financial information is provided for the QS Discontinued Operations for the periods shown.

Net sales

Operating Income

Net income before tax

Income tax

 

Net income from discontinued operations

 

Contract Settlement – In February 2007, our CoreCard subsidiary reached a mutual agreement with one of its customers to terminate a Software License Agreement between them. The Settlement Agreement assigns no fault to either party and reflects a change in priorities and available funding at the customer. The customer paid $380,000 on the effective date of the Settlement Agreement, including a $100,000 termination fee, resulting in aggregate non-refundable payments to CoreCard of $1.1 million under the Software License Agreement (including amounts paid in 2006 and included in deferred revenue as of December 31, 2006). In the quarter ended March 31, 2007, the company recognized license revenue of $1.1 million related to this contract. In the quarter ended June 30, 2007, CoreCard proposed a termination to a foreign customer contract due to a change in the customer’s technical management team and software requirements which CoreCard deemed not to be in its best interest. The customer agreed to the termination, with no refund of payments. Accordingly, in the quarter ended June 30, 2007, CoreCard recognized $131,000 in revenue for services rendered and paid for prior to the termination.

Comprehensive Income (Loss) – In accordance with Financial Accounting Standards Board Statement No. 130, “Reporting Comprehensive Income”, comprehensive income (loss) is the total of net income (loss) and all other non-owner changes in equity in a period. A summary follows:

Net loss

Other comprehensive income (loss):

Foreign currency translation adjustment

 

Comprehensive loss

 

Stock based Compensation – At June 30, 2007, we have two stock-based compensation plans in effect. In December 2004, the FASB issued FASB Statement No. 123R, “Share-Based Payment” (SFAS 123R) which replaced APB No. 25 and SFAS 123. We adopted SFAS 123R effective January 1, 2006 using the modified prospective application method of adoption which requires us to record compensation cost related to unvested stock awards as of December 31, 2005 by recognizing the unamortized grant date fair value in accordance with provisions of SFAS 123R on a straight line basis over the service periods of each award. We have estimated forfeiture rates based on our historical experience. Stock option compensation expense is recognized as a component of general and administrative expenses in the accompanying Consolidated Financial Statements.

The estimated fair value of the options granted during prior years was calculated using the Black Scholes option pricing model with assumptions as previously disclosed in our Form 10-KSB.

As a result of the adoption of SFAS 123(R), we recorded $4,000 and $3,000 of stock-based compensation expense for the three months ended June 30, 2007 and 2006, respectively, and $4,000 and $6,000 of stock-based compensation expense for the six months ended June 30, 2007 and 2006, respectively, related to our stock option plans. Had we continued to account for these options under APB 25, we would have recorded no such expense in any period.

As of June 30, 2007, there is $21,000 of unrecognized compensation cost related to stock options. In the quarter ended June 30, 2007, an aggregate of 12,000 options were granted to independent directors at fair market value on the date of the annual shareholder’s meeting, as provided in the Directors Stock Option Plan. No options were exercised or forfeited during the three or six month periods ended June 30, 2007. The following table summarizes options as of June 30, 2007:

Outstanding at June 30, 2007

Vested and exercisable at June 30, 2007

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 second quarter of 2007 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 June 30, 2007. The amount of aggregate intrinsic value will change based on the fair market value of the company’s stock.

Concentration of Revenue – The following table indicates the percentage of consolidated revenue represented by each customer for any period in which such customer represented more than 10% of consolidated revenue.

VISaer Customer A

VISaer Customer B

ChemFree Customer C

ChemFree Customer D

CoreCard Customer E

 

Notes Receivable – As explained in Note 2 to the Consolidated Financial Statements included in our 2006 Form 10-KSB, in connection with the sale of our QS Technologies business, we received a promissory note from the buyer in the amount of $1,435,000. The principal amount of the note was subject to adjustment based on revenue and earnings of the QS business for the period from August 1, 2006 through January 31, 2007. In the quarter ended March 31, 2007, the buyer informed the company that it was not proposing any adjustment to the note. Accordingly, in the three months ended March 31, 2007, the company reversed the balance of its transaction related contingency accrual and recognized additional gain of $97,000 on the sale of the QS discontinued operations. Such amount is recorded in Gain on Sale of Discontinued Operations in the results for the six months ended June 30, 2007.

On August 31, 2006, as explained in Note 3 to the Consolidated Financial Statements included in our 2006 Form 10-KSB, we received a promissory note from the buyer of our Horizon Software investment in the principal amount of $2,850,000. On January 4, 2007, the note and accrued interest were paid in full.

Commitments and Contingencies – Please refer to Note 9 to our Consolidated Financial Statements included in our 2006 Form 10-KSB for a description of our commitments and contingencies. There has been no material change since December 31, 2006 in the commitments described in such note.

Legal Matters – As explained in Note 9 to our Consolidated Financial Statements included in our 2006 Form 10-KSB, our ChemFree subsidiary is involved in two legal matters. In December 2004, ChemFree filed a patent infringement action against J. Walter Co. Ltd. and J. Walter, Inc. (collectively the “Defendant”) in the United States Court for the Northern District of Georgia. The complaint alleges that certain of the Defendant’s products infringe various U.S. patents held by ChemFree and seeks a ruling to compel Defendant to cease its infringing activities. The Defendant has asserted various defenses and a counterclaim. The court issued a ruling in July 2007 with respect to the parties’ Markman submissions, a preliminary procedure for defining certain patent-related terms, which ruling generally confirmed ChemFree’s definitions. The parties are in the discovery phase of the case and no trial date has been set. In a separate matter, an arbitrator issued a ruling in February 2007 in an arbitration proceeding involving ChemFree versus Zymo International, Inc. (“Zymo”). The arbitrator found in ChemFree’s favor on all substantive issues. Among other items, the arbitrator ruled that ChemFree was not in breach of the co-ownership agreement and that Zymo must pay an aggregate of $156,000 to ChemFree for its share of legal expenses and damages for lack of cooperation in patent matters covered by the co-ownership agreement. The arbitrator also ruled that, if Zymo participates in a certain J. Walter patent infringement action after June 30, 2007, it must pay an additional $27,500 to ChemFree. Since the ruling, Zymo paid to ChemFree $156,000, less $5,000 in expenses allocable to ChemFree for amounts previously paid by Zymo for co-owned patent matters. Zymo also received court approval to withdraw from the J. Walter infringement action described above.

ISC Guarantees – In conjunction with a Software License Agreement entered into on June 12, 2003 between our majority owned subsidiary, CoreCard Software, Inc. and a CoreCard customer, ISC entered into a letter of guarantee with the CoreCard customer. Under the guarantee, in the event that the Software License is terminated due to CoreCard discontinuing operations, ISC has guaranteed to make available at its expense up to four employees to provide technical assistance to the customer during a transition period of up to one year. The guarantee phases out upon the achievement of certain operational milestones by CoreCard or after five years, whichever occurs sooner. As of June 30, 2007, it does not appear probable that the guarantee will be paid; thus no amounts have been accrued with respect to this guarantee.

Industry Segments – Segment information is presented consistently with the basis described in the 2006 Form 10-KSB. The table following contains segment information for continuing operations for the three and six month periods ended June 30, 2007 and 2006.

Revenue

Operating Loss

Revenue

Operating income (loss)

 

Revenue

Operating loss

Corporate expenses

 

Consolidated operating loss from continuing operations

 

 

Information Technology

Industrial Products

 

Consolidated segments

Corporate

 

Consolidated depreciation and amortization

 

 

Information Technology

Industrial Products

 

Consolidated segments

Corporate

 

Consolidated capital expenditures

 

Information Technology

Industrial Products

 

Consolidated segments

Corporate

 

Consolidated assets

 

New Accounting Pronouncements– On July 13, 2006, the FASB issued FASB Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes”. FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return. FIN 48 is applicable to all uncertain positions for taxes accounted for under FASB Statement 109, “Accounting for Income Taxes” and requires that a company record any change in net assets that results from the application of the interpretation as an adjustment to retained earnings. The interpretation is effective for fiscal years that start after December 15, 2006 and, accordingly we adopted FIN 48 effective January 1, 2007. See discussion in Note 12 below.

In September 2006, the FASB issued FASB Statement No. 157, “Fair Value Measurements” (SFAS 157) to increase consistency and comparability in fair value measurements. SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements of certain assets, liabilities and items in stockholders’ equity that are measured at fair value. SFAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007, although early adoption is encouraged. We have not yet determined the impact that the adoption of the standard will have on our financial statements.

On February 15, 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities: Including an amendment of FASB Statement No. 115” (SFAS 159). SFAS 159, which builds on other Statements related to fair value such as SFAS 157 above, permits entities to elect to measure many financial instruments and certain other items at fair value with changes in value reported in earnings. It is designed to mitigate earnings volatility that arises when assets and liabilities are measured differently. SFAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. We have not yet determined the impact that the adoption of the standard will have on our financial statements.

Adoption of FIN 48 – Effective January 1, 2007, we adopted the provisions of Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 prescribes a recognition threshold that a tax position is required to meet before being recognized in the financial statements and provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition issues. We have recognized tax benefits from all tax positions we have taken, and there has been no adjustment to any carry forwards (net operating loss or research and development credits) as a result of the implementation of FIN 48. The adoption of FIN 48 did not have a material effect on our consolidated financial position or results of operations. As of June 30, 2007, we do not have any unrecognized tax benefits and we do not anticipate any significant changes in the balance of unrecognized tax benefits during the next twelve months.

Our policy is to recognize accrued interest related to uncertain tax positions in interest expense and related penalties, if applicable, in general and administrative expense. No interest expense or penalties were recognized during the three and six months ended June 30, 2007.

We file a consolidated U.S. federal income tax return for all subsidiaries in which our ownership exceeds 80 percent, as well as individual subsidiary returns in various states and foreign jurisdictions. Our VISaer subsidiary files a separate U.S. federal income tax return. 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 2003.

A change in revenue level at one of our subsidiaries may impact consolidated revenue or be offset by an opposing change at another subsidiary.

Economic and marketplace trends may impact our subsidiaries differently or not at all and our software subsidiaries have limited experience in their marketplaces which makes it difficult to identify and evaluate trends that may impact their business.

Our software subsidiaries, CoreCard Software and VISaer, have been involved in major new product development initiatives for the past six years and have limited experience delivering and installing their new products at customer sites, making it difficult to predict with certainty when they will recognize revenue on individual software contracts.

Our subsidiaries are relatively small in revenue size and, in the Information Technology sector, license revenue at a subsidiary in a given period may consist of a relatively small number of contracts. Consequently, even small delays in a subsidiary’s delivery under a software contract (which may be out of its control) could have a significant and unpredictable impact on consolidated revenue that we can recognize in a given quarterly or annual period.

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, was $2.6 million in the three month period ended June 30, 2007, a 10 percent increase compared to $2.3 million in the three months ended June 30, 2006. In the six month period ended June 30, 2007, product revenue increased 35 percent to $5.7 million, compared to $4.2 million in the year-to-date period in 2006. Product revenue associated with the Industrial Products segment grew by 13 percent in both the three and six month periods ended June 30, 2007, compared to the respective periods in 2006. Industrial products sales represented 94 percent and 77 percent of product revenue in the three and six month periods ended June 30, 2007. By comparison, Industrial Product sales represented 91 percent and 92 percent of product revenue in the three and six month periods ended June 30, 2006. The increase in product revenue in the three and six months ended June 30, 2007 is attributed mainly to a higher volume of ChemFree SmartWasher products sold to domestic corporate customers in the second quarter, as well as an increase in international sales in the first quarter of the year. Product revenue associated with the Information Technology segment increased by $965,000 in the six months ended June 30, 2007 compared to the same period last year, reflecting primarily a large software license contract recognized by our CoreCard Software subsidiary in the first quarter of 2007.

Service revenue increased by 6 percent in the three month period ended June 30, 2007 but declined by 47 percent in the first half of 2007 compared to the same period last year. The decline in year-to-date service revenue is attributed mainly to a single multi-year contract at the VISaer subsidiary that was completed and recognized in the first quarter of 2006, contributing $1.8 million in service revenue. There was no such comparable single contract in the first six months of 2007.

Cost of product revenue was 58 percent of product revenue in the second quarter of 2007 compared to 52 percent of product revenue in the same period in 2006. The principal reason for the increase in product cost as a percent of product revenue is due to the fact that ChemFree sold a higher volume of parts washers at an average lower price in the second quarter of 2007 during the rollout of a new program with a large domestic corporate customer, as well as an increase in the cost of plastic components. ChemFree expects that margins will improve as the installed base of machines generates higher margin sales of consumable fluid and filters in future periods. Demand for ChemFree products exceeded supply during the latter part of the second quarter of 2007, in part due to a change in suppliers for plastic components and the downtime associated with re-tooling and qualifying new suppliers. ChemFree does not expect that the interruption of these components will be repeated but if it is revenue could be negatively impacted in the short-term. In the six month period ended June 30, 2007, cost of product sales was 45 percent of product revenue compared to 53 percent in the same period last year. The change is due to the net effect of the second quarter 2007 decline in ChemFree product margins offset by that the fact that software license revenue, which has a very low cost of revenue compared to the cost associated with industrial products, represented 23 percent of product revenue in the six months ended June 30, 2007 but only eight percent of product revenue in the six month period in 2006.

Cost of service revenue (which relates to the software subsidiaries only) was 61 percent and 44 percent of service revenue in the three months ended June 30, 2007 and 2006, respectively. Cost of service revenue was 60 percent and 46 percent of service revenue in the six-month periods ended June 30, 2007 and 2006, respectively. The change between periods reflects primarily the fact that the number of hours and the average standard cost allocated to CoreCard’s customer support and professional services activities were higher than in the same periods in 2006. In addition, VISaer had a single multi-year contract that contributed $1.8 million in service revenue in year-to-date 2006 which had a proportionately lower cost of service revenue than is typical for their professional services contracts and maintenance revenue.

Delays in securing certain component plastic parts for the ChemFree parts washers due to a recent change in suppliers and the potential need to acquire additional molds from which certain parts are produced, which could result in a higher backlog, lower revenue and higher costs in the near-term.

In the Industrial Products market, failure by ChemFree to protect its intellectual property assets, which could increase competition in the marketplace and result in greater price pressure and lower margins, thus impacting sales, profits and projected cash flow.

Increased operating expenses and diversion of resources related to compliance with the internal control over financial reporting requirements of Section 404 of the Sarbanes-Oxley Act of 2002.

Delays in software development projects which could cause our customers to delay implementations, delay payments or cancel contracts, which would increase our costs and reduce our revenue.

Undetected software errors or poor quality control which may delay product releases, increase our costs, result in non-acceptance of our software by customers or delay revenue recognition.

Competitive pressures (including pricing, changes in customer requirements and preferences, and competitor product offerings) which may cause prospective customers to choose an alternative product solution, resulting in lower revenue and profits (or increased losses).

The inability of our CoreCard or VISaer subsidiaries to establish a base of referenceable customers for their new product offerings, resulting in lower revenue and profits (or increased losses), increased cash needs and possibly leading to restructuring or cutting back of the subsidiary’s operations.

Failure of our products’ specifications and features to achieve market acceptance.

The inability of our software subsidiaries to retain key software developers and managers who have accumulated years of know-how in our target markets and company products, or failure to attract and train a sufficient number of new software developers and testers to support our product development plans and customer requirements at projected cost levels.

Further increases in the price of oil, which could increase ChemFree’s product costs and which could affect VISaer’s results if potential aviation customers delay or cancel purchases of software or services in the face of declining industry trends or poor financial condition.

Delays in anticipated customer payments for any reason which would increase our cash requirements and possibly our losses.

Declines in performance, financial condition or valuation of minority-owned companies which could cause us to write-down the carrying value of our investment or postpone an anticipated liquidity event, which could negatively impact our earnings and cash.

Negative trends affecting the commercial aviation industry worldwide which could impact VISaer’s short-term customer purchases, thus increasing its losses and need for cash.

An insufficient number of potential CoreCard customers decide to purchase and run an in-house software system and instead choose to outsource their account transaction processing which could result in lower revenue and greater cash requirements.

Other general economic and political conditions that cause customers to delay or cancel software purchases.

 

3(i)

Amended and Restated Articles of Incorporation of the Registrant dated November 14, 1991, as amended November 25, 1997. (Incorporated by reference to Exhibit 3.1 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 1991 and to Exhibit 3.1 to the Registrant’s Report on Form 8-K dated November 25, 1997.)

 

3(ii)

 

4.1

Rights Agreement dated as of November 25, 1997 between the Registrant and American Stock Transfer & Trust Company as Rights Agent. (Incorporated by reference to Exhibit 4.1 of the Registrant’s Report on Form 8-K dated November 25, 1997 and filed on December 16, 1997.)

 

4.2

 

31.1

 

31.2

 

32.1

 

3(i)

 

3(ii)

 

4.1

 

4.2

 

31.1

 

31.2

 

32.1