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

Other intangibles, net

Other assets

 

Total assets

 

Current liabilities:

Line of credit

Note payable, current portion

Accounts payable

Deferred revenue

Accrued payroll

Accrued expenses and other current liabilities

 

Total current liabilities

Long-term liabilities

 

Commitments and contingencies (Note 8)

Minority interest

 

Stockholders’ equity:

Common stock, $0.01 par value, 20,000,000 shares authorized, 4,478,971 shares issued and outstanding at September 30, 2008 and December 31, 2007

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

Equity in income of affiliate companies

Other expense

 

Loss from continuing operations before income taxes

Income taxes

 

Loss from continuing operations

Income (loss) from discontinued operations

Gain on sale of discontinued operations, no tax effect

 

Net loss

 

Loss per share from continuing operations:

Basic

Diluted

Income (loss) per share from discontinued operations:

Basic

Diluted

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 discontinued operations

Non-cash interest expense (income), net

Investment income

Equity in income of affiliate companies

Changes in operating assets and liabilities

Accounts receivable

Accrued interest 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 from sale of discontinued operations

Investment in subsidiary

Proceeds from sale of investment or marketable securities

Proceeds from notes and interest receivable

Payments on notes payable

Purchases of property and equipment

 

Cash provided by investing activities

 

 

Borrowings under line of credit

Repayments made under line of credit

Borrowings under other short-term 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

Cash paid during the period for income taxes

Proceeds from sale:

Cash

Note receivable, net of discount

Liabilities assumed by (assets transferred to) buyer:

Other current assets

Property, plant and equipment, net

Intangible assets

Other assets

Accrued payroll

Accounts payable

Deferred revenue

Other liability

Accrued transaction related expenses

 

Gain on sale of VISaer business

 

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

The unaudited Consolidated Financial Statements presented in this Form 10-Q 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 nine month periods ended September 30, 2008 and 2007. The interim results for the three and nine months ended September 30, 2008 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, 2007, as filed in our Annual Report on Form 10-KSB.

Discontinued Operations - Effective April 16, 2008, the company and two subsidiaries, VISaer, Inc. and VISaer (U.K.) Limited (collectively, “VISaer”) completed the sale of substantially all the assets related to VISaer’s business pursuant to the terms of an asset purchase agreement (the “Asset Purchase Agreement”) between IBS Technics, Inc. (“IBS Technics”) and VISaer. IBS Technics is a subsidiary of IBS Software Services, Inc., a software services company that had previously provided certain software development services to VISaer as an independent third party contractor.

The purchase price consisted of $3,025,000 paid in cash at closing plus future earn-out and contingent payments to be paid over four years based on certain performance metrics of the VISaer business following the sale, with guaranteed minimum payments aggregating $1.5 million in cash (discounted to a net present value of $1,261,000), payable in three equal installments in 2010, 2011 and 2012. In addition, IBS Technics assumed approximately $258,000 in liabilities of VISaer related to employee vacation benefits and $437,000 payable to IBS Technics for prior services. IBS hired the VISaer employees as of the effective date of the transaction. IBS Technics acquired assets, net of liabilities, of $48,000 related to customer contracts and assumed the ongoing liabilities and obligations associated with such contracts. We retained the remainder of the liabilities of the VISaer business along with cash and accounts receivable aggregating approximately $465,000 as of the closing date. Based on the carrying value of the assets and liabilities transferred to IBS Technics and the estimated costs and expenses incurred in connection with the sale, the company reported a gain on the sale transaction of $2,884,000 in the quarter ended June 30, 2008.

The transaction also provides for contingent payments which may be earned based on the attainment by the acquired VISaer business of certain levels of revenue in each of the calendar years 2008 through 2011. As the amount, if any, of such payments is not quantifiable at this time, no amount has been recorded for such contingency payments.

The following condensed financial information is provided for the VISaer discontinued operations for the periods shown.

Net sales

Operating loss

Income (loss) from discontinued operations

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 September 30, 2008, we have two stock-based compensation plans in effect. In December 2004, the FASB issued FASB Statement No. 123R, “Share-Based Payment” (SFAS No. 123R) which replaced APB No. 25 and SFAS No. 123. We adopted SFAS No.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 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. As a result of adopting SFAS No. 123R, we recorded $6,000 and $4,000 of stock based compensation expense for the three months ended September 30, 2008 and 2007, respectively, and $15,000 and $8,000 of stock-based compensation expense for the nine months ended September 30, 2008 and 2007, respectively.

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

As of September 30, 2008, there is $18,000 of unrecognized compensation cost related to stock options. During the quarter ended June 30, 2008, a total of 12,000 options were granted to the three independent members of the board of directors pursuant to the Non-employee Director Stock Option Plan (“Director Plan”). Pursuant to the terms of the Director Plan, the options were granted at fair market value on the date of the Annual Shareholders meeting. No options were exercised or forfeited during the three and nine months ended September 30, 2008. The following table summarizes options as of September 30, 2008:

Outstanding at September 30, 2008

Vested and exercisable at September 30, 2008

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 2008 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, 2008. 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.

ChemFree Customer A

ChemFree Customer B

ChemFree Customer C

ChemFree Customer D

Industry Segments - Segment information is presented consistently with the basis described in the 2007 Form 10-KSB. The following table contains segment information for continuing operations for the three and nine months ended September 30, 2008 and 2007.

Revenue

Operating loss

Revenue

Operating income

 

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

 

Commitments and Contingencies - Please refer to Note 9 to our Consolidated Financial Statements included in our 2007 Form 10-KSB for a description of our commitments and contingencies. As a result of the sale of the VISaer business as described in Note 3, the VISaer property lease was assumed by the buyer. Accordingly, our future minimum lease payments for 2008, 2009 and 2010 will be lower than previously reported by $108,000, $145,000 and $85,000, respectively.

Legal Matters - In December 2004, ChemFree filed a patent infringement action against J. Walter Co. Ltd. and J. Walter, Inc. 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 the defendant to cease its infringing activities. The defendant has asserted various defenses. The parties have completed the discovery phase of the case and no trial date has been set. While the resolution and timing of any legal action is not predictable, ChemFree believes it has sufficient grounds to prevail in these actions, although there can be no assurance that the disputes will be resolved in its favor. During the second and third quarter of 2008, several pre-trial rulings were made by the judge assigned to the case with respect to various motions submitted by ChemFree and J. Walter Co. Ltd. and J. Walter, Inc. One of the rulings awarded ChemFree legal expenses related to a certain matter in an amount to be determined. Since the amount of the award has not been determined at this time, no amount for awarded legal expenses has been accrued in the accompanying Consolidated Financial Statements included in this filing.

VISaer Stock Purchase Transaction - On April 3, 2008, the company acquired additional shares of common stock of VISaer, Inc. from a minority shareholder. The purchase price for the stock was $125,000 paid in cash plus an additional amount to be paid in the future, contingent upon the net amount of cash realized by Intelligent Systems (calculated in accordance with a formula agreed between the parties) resulting from the VISaer sale transaction. Presently, the company estimates that the additional amount that would be payable to the minority shareholder in 2010, 2011 and 2012 (based on the guaranteed minimum payments of the VISaer buyer as explained in Note 3) aggregates approximately $126,000 ($150,000 undiscounted); accordingly, the company has accrued $126,000 as a long-term liability in the Consolidated Financial Statements. The total purchase price for the additional VISaer stock, consisting of the initial payment of $125,000 and the accrued liability for future payments of $126,000, was recorded as additional goodwill of VISaer at the time of the transaction and included in the calculation of the gain on sale for the VISaer transaction.

Income Taxes - 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 No. 48”). FIN No. 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 No. 48. The adoption of FIN No. 48 did not have a material effect on our consolidated financial position or results of operations. As of September 30, 2008, 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 such interest expense or penalties were recognized during the three or nine months ended September 30, 2008 and 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. Through April 15, 2008, our VISaer subsidiary filed a separate U.S. federal income tax return. For periods after April 15, 2008, we will include VISaer in our consolidated 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 2005.

New Accounting Pronouncements - In September 2006, the FASB issued FASB Statement No. 157, “Fair Value Measurements” (“FASB No.157”) to increase consistency and comparability in fair value measurements. FASB No. 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. FASB No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. Accordingly, we adopted FASB No. 157 effective January 1, 2008. The adoption of the standard did not have a material impact on our Consolidated 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” (“FASB No.159”). FASB No. 159, which builds on other statements related to fair value such as FASB No. 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. FASB No. 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. Accordingly, we adopted FASB 159 effective January 1, 2008. The adoption of the standard did not have a material impact on our Consolidated Financial Statements.

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 subsidiary has limited experience in its marketplace which may affect its ability to identify and evaluate trends that may impact its business.

CoreCard Software has been involved in major new product development initiatives for a number of years and has limited experience delivering and installing products at customer sites, making it difficult to predict with certainty when it may recognize revenue on individual software contracts.

Our subsidiaries are relatively small in revenue size and, in the Information Technology sector, revenue in a given period may consist of a relatively small number of contracts. Consequently, even small delays in a delivery under a software contract (which may be out of our 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 $2.9 million in the three month period ended September 30, 2008, a 38 percent decline compared to $4.7 million in the three months ended September 30, 2007. For the nine month period ended September 30, 2008, revenue from products was $10.3 million, essentially flat compared to the same period in 2007. The decline in product revenue in the third quarter of 2008 compared to the prior year is primarily associated with a change in domestic sales of ChemFree products (our Industrial Products segment) due to the fact that in the third quarter of last year, a new customer began a national program to sell ChemFree products to its installed customer base, resulting in a high initial volume of sales. With the initial rollout complete, the number of new machines sold to this customer in the third quarter of 2008 was lower than during the peak period last year. ChemFree experienced an increase of 14 percent in revenue in the nine month period ended September 30, 2008 as compared to the nine month period in 2007, reflecting a 12 percent increase in domestic sales and a 26 percent increase in international sales. Sales of ChemFree’s fluid and filter consumables increased significantly in both the three and nine month periods of 2008 compared to 2007, reflecting the increasing base of users of its SmartWasher part washers. Due to general economic conditions and uncertainty about the impact of a slowing economy on the automotive repair and supplies industry, the company is planning for relatively flat or perhaps slightly lower volume of machine sales than in the third quarter of 2008 and is carefully managing its costs and inventory levels accordingly. ChemFree’s installed base of lease customers as well as the need for customers to purchase replacement consumable supplies provide an ongoing base of business that we believe will be relatively unaffected by fluctuations in general economic conditions. Software license revenue associated with the Information Technology segment was minimal in the three and nine month periods ended September 30, 2008 compared to approximately $1.3 million in license revenue in the nine months ended September 30, 2007 (which reflected primarily a single software license contract recognized by our CoreCard Software subsidiary in the first quarter of 2007). The company recognizes software license revenue only upon completion of each contract and acceptance by customers. At September 30, 2008, CoreCard Software had approximately $1.6 million in deferred revenue associated with in-process customer contracts that it expects to recognize upon contract completion within the next three to six months, depending to a large extend on customer go-live schedules.

Service revenue associated with the Information Technology segment was nine percent higher and seven percent lower, respectively, in the three and nine month periods ended September 30, 2008 compared to the same periods last year. The change is attributed mainly to changes in the amount and timing of professional services projects that are requested and delivered to CoreCard customers. Revenue from professional services can vary considerably from period to period based mainly on the timing of customer projects.

Turmoil in the global financial markets could impact CoreCard’s revenue and prospects in the foreseeable future if customers or prospects postpone software purchases or implementations. We are carefully monitoring the evolving dynamics in the marketplace and have proactively taken steps to lower expenses through reduction in payroll and discretionary marketing spending. We expect to support existing customers and contracts and to continue to add new prospects and customers as opportunities arise in these uncertain times.

Cost of product revenue was 55 percent and 54 percent of product revenue in the three and nine month periods, respectively, in 2008 compared to 57 percent and 51 percent of product revenue in the respective periods in 2007. The principal reason for the slight decline in product cost as a percent of product revenue in the third quarter of 2008 is due mainly to a favorable mix of higher margin consumable supplies to machine sales. In the nine month period of 2008, cost of product revenue as a percent of product revenue was slightly higher than in the same period last year because in the nine month period in 2007, product revenue included $1.1 million in software licenses which have a low cost of revenue. Excluding the software revenue, cost of product revenue in the nine month period ended September 30, 2007 would have been 58 percent of product revenue compared to 54 percent in the same period in 2008 due to a favorable mix of higher margin consumable supplies to machine sale in the current year.

Cost of service revenue (which relates to our software business only) was 60 percent and 86 percent of service revenue in the three and nine month periods ended September 30, 2008 compared to 114 percent and 82 percent of service revenue in the respective periods in 2007. Services include maintenance and customer support activities as well as professional services for software projects. The mix of service revenue in a given period, as well as the number of customers and new products being supported, impacts the gross margin on service revenue. CoreCard is providing a high level of support to its initial customers to ensure it builds a solid base of reference customers and puts in place an infrastructure for future growth. Cost of providing routine maintenance and support services as a percentage of service revenue is expected to decrease as CoreCard’s installed base of customers increases whereas the cost of professional services as a percent of revenue is expected to have a relatively stable gross margin percentage from period to period.

Turmoil in the global financial markets could have a serious negative impact on CoreCard due to potential customers (most of whom are financial institutions) delaying purchase or implementation decisions.

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

Our CoreCard subsidiary could fail to deliver software products which meet the business and technology requirements of its target markets within a reasonable time frame and at a price point that supports a profitable, sustainable business model.

One of ChemFree’s customers represented approximately 45 percent of consolidated revenue in the first nine months of 2008; any unforeseen changes in the volume of orders or timeliness of payments from such customer could have a negative impact on inventory levels and cash, at least in the near-term.

Failure by our ChemFree subsidiary to protect its intellectual property assets could increase competition in the marketplace and result in greater price pressure and lower margins, thus potentially impacting sales, profits and projected cash flows.

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

Compliance with the internal controls over financial reporting requirements of Section 404 of the Sarbanes-Oxley Act of 2002 could increase operating expenses and divert management and staff resources.

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

CoreCard could fail to establish a base of reference customers for its product offerings, resulting in lower revenue and profits (or increased losses) and increased cash needs.

In certain limited situations, ChemFree’s lease customers are permitted to terminate the lease covering a SmartWasher^® machine, requiring the unamortized balance of the original machine cost to be written off which could reduce profits in that reporting period and result in lower revenue in future periods.

CoreCard could fail to retain key software developers and managers who have accumulated years of know-how in our target markets and company products, or fail 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.

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

Declines in performance, financial condition or valuation of minority-owned companies 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.

Failure to meet the continued listing standards of NYSE Alternext US (formerly The American Stock Exchange) could result in delisting of our common stock, with a potentially negative impact on market price and liquidity of our common stock.

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

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.)

 

Bylaws of the Registrant dated December 7, 2007. (Incorporated by reference to Exhibit 3.2 of the Registrant’s Form 8-K dated December 7, 2007).

 

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.)

 

Form of Rights Certificate. (Incorporated by reference to Exhibit 4.2 of the Registrant’s Report on Form 8-K dated November 25, 1997 and filed on December 16, 1997.)

 

Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

Certification of Chief Executive Officer and Chief Financial Officer furnished as required by Section 906 of the Sarbanes-Oxley Act of 2002.

 

Date: November 14, 2008

 

 

 

Date: November 14, 2008

 

 

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.)

 

Bylaws of the Registrant dated December 7, 2007. (Incorporated by reference to Exhibit 3.2 of the Registrant’s Form 8-K dated December 7, 2007).

 

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.)

 

Form of Rights Certificate. (Incorporated by reference to Exhibit 4.2 of the Registrant’s Report on Form 8-K dated November 25, 1997 and filed on December 16, 1997.)

 

Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

Certification of Chief Executive Officer and Chief Financial Officer furnished as required by Section 906 of the Sarbanes-Oxley Act of 2002.