Current assets:

Cash

Accounts receivable, net

Notes and interest receivable, current portion

Inventories, net

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

Patents, net

 

Total assets

 

Current liabilities:

Accounts payable

Deferred revenue

Accrued payroll

Accrued expenses

Other current liabilities

 

Total current liabilities

 

Long-term liabilities

 

Commitments and contingencies (Note 8)

Intelligent Systems Corporation stockholders’ equity:

Common stock, $0.01 par value, 20,000,000 shares authorized, 8,958,028 shares issued and outstanding at June 30, 2010 and December 31, 2009

Additional paid-in capital

Accumulated other comprehensive loss

Accumulated deficit

 

Total Intelligent Systems Corporation stockholders’ equity

Non-controlling interest

 

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

 

Income (loss) from operations

 

Other income (expense)

Interest income, net

Equity in income (loss) of affiliate company

Other income

 

Income (loss) before income taxes

Income taxes

 

Net income (loss)

 

Income (loss) per share:

Basic

Diluted

 

Basic weighted average common shares outstanding

Diluted weighted average common shares outstanding

 

 

Net income (loss)

Adjustments to reconcile net income (loss) to net cash used for operating activities:

Depreciation and amortization

Stock-based compensation expense

Non-cash interest income, net

Equity in (income) loss of affiliate company

Changes in operating assets and liabilities

Accounts receivable

Inventories

Other current assets

Accounts payable

Deferred revenue

Accrued payroll

Accrued expenses and other current liabilities

 

Net cash used for operating activities

 

 

Proceeds from notes and interest receivable

Purchases of property and equipment

 

Net cash provided by (used for) investing activities

 

 

Borrowings under line of credit

Repayments made under line of credit

Payments on notes payable

 

Net cash provided by (used for) financing activities

 

 

Effects of exchange rate changes on cash

 

Net decrease 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

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 six month periods ended June 30, 2010 and 2009. The interim results for the three and six months ended June 30, 2010 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, 2009, as filed in our Annual Report on Form 10-K.

Comprehensive Income (Loss) — 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 income (loss)

Other comprehensive income:

Foreign currency translation adjustment

 

Comprehensive income (loss)

 

Stock-based Compensation — At June 30, 2010, we have two stock-based compensation plans in effect. We record compensation cost related to unvested stock awards by recognizing the unamortized grant date fair value 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. We recorded $2,000 and $3,000 of stock-based compensation expense in the three months ended June 30, 2010 and 2009, respectively and $5,000 and $6,000 for the six month periods ended June 30, 2010 and 2009, 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-K.

As of June 30, 2010, there is $12,000 of unrecognized compensation cost related to stock options. During the quarter ended June 30, 2010, an aggregate of 12,000 options were granted to the three independent members of our 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 during the three and six month periods ended June 30, 2010. During the quarter ended June 30, 2010, 11,000 employee options expired unexercised. The following table summarizes options as of June 30, 2010:

Outstanding at June 30, 2010

Vested and exercisable at June 30, 2010

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 2010 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, 2010. The amount of aggregate intrinsic value will change based on the fair market value of the company’s stock.

Fair Value of Financial Instruments — The carrying value of cash, accounts receivable, accounts payable and certain other financial instruments (such as short-term borrowings, accrued expenses, and other current liabilities) included in the accompanying consolidated balance sheets approximates their fair value principally due to the short-term maturity of these instruments. The carrying value of non-interest bearing notes receivable beyond one year have been discounted at a rate of 6% which approximates rates offered in the market for notes receivable with similar terms and conditions. The fair value of equity method and cost method investments has not been determined as it was impracticable to do so.

Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash, trade accounts and notes receivable. 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.

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

CoreCard Customer D

Short-term Borrowings — On June 28, 2010, we renewed our working capital line of credit with our bank. The revolving line of credit bears interest at the higher of the prime rate plus one and one half percent and 6.5% (6.5% at June 30, 2010), is secured by all assets of the company and our principal subsidiaries, is guaranteed by our subsidiaries, and expires June 30, 2011. We may borrow an aggregate of 80 percent of qualified accounts receivable of our consolidated subsidiaries plus 50 percent of inventory, up to a maximum of $1,250,000. At June 30, 2010, our borrowing base calculation resulted in availability of $1,250,000, of which we had drawn down $0. The terms of the loan contain typical covenants not to sell or transfer material assets, to create liens against assets, to merge with another entity, to change corporate structure or the nature of our business, to declare or pay dividends, or to redeem shares of common stock. The loan agreement also contains covenants not to change the chief executive and chief financial officers of the company or to make loans to or invest in new minority-owned companies, without first obtaining the consent of our bank in each case. Furthermore, the terms of the loan include a covenant requiring the company to maintain a minimum tangible net worth as defined in the loan agreement at the end of each calendar quarter during the loan term.

Commitments and Contingencies — Please refer to Note 7 in the Consolidated Financial Statements included in our 2009 Form 10-K for a description of our commitments and contingencies in addition to those disclosed here.

Legal Matters — In December 2004, our ChemFree subsidiary filed a patent infringement action against J. Walter Co. Ltd. and J. Walter, Inc. (“J. Walter”) in the United States Court for the Northern District of Georgia. The complaint alleged that certain of the defendants’ products infringed four U.S. patents held by ChemFree and sought a ruling to compel the defendants to cease their infringing activities. The defendants asserted various defenses. The trial took place during the week of July 13, 2009. On June 18, 2010, the judge issued his Findings of Fact and Conclusions of Law which found (i) that certain of J. Walter’s products did infringe on ChemFree’s four patents-in-suit; (ii) in ChemFree’s favor on the issue of the patents’ named co-inventors and (iii) in J. Walter’s favor on the issue of invalidity of the four patents-in-suit for “obviousness”. In his ruling on invalidity of four of ChemFree’s patents due to obviousness, the judge relied heavily on a 2007 U.S. Supreme Court ruling (issued more than three years after ChemFree’s lawsuit was filed) which modified the manner for determining obviousness of a patent by replacing the long-standing rigid application of the “teaching, suggestion or motivation test” for determining obviousness with an “expansive and flexible approach”. On July 6, 2010, ChemFree filed a Motion for Reconsideration of the judge’s findings and conclusions followed on July 23, 2010, by the filing of a Second Motion for Additional Findings and Conclusions. Depending upon the outcome of these additional filings and the judge’s final order in the case, ChemFree will have a number of options to consider which could include but are not limited to an appeal. The timing of the final outcome of this matter is not predictable with any degree of certainty.

As previously disclosed, IBS Technics, the company that acquired certain assets and the operations of our VISaer subsidiary in April 2008, has alleged a breach of certain representations and warranties in the Asset Purchase Agreement (“APA”). On April 15, 2010, we received a claim from IBS Technics seeking indemnification under the APA in the amount of approximately $2.6 million. We replied to their notice, disputing their allegations. On June 17, 2010, we notified IBS Technics that they had failed to make a guaranteed earnout payment of $500,000 due on June 15, 2010 in accordance with the terms of the APA. If we cannot agree on a mutually acceptable resolution to these matters, it is possible that it will proceed to binding arbitration as required under the APA. Given the status of the matter and our belief that we have reasonable grounds to refute IBS Technics’ allegations and prevail in any litigation, presently we have not taken a reserve against the amount receivable from IBS Technics. If the matter is taken to arbitration or other legal proceedings, it is at least reasonably possible that the amount of the receivable could be reduced.

Except as noted above, other commitments and contingencies described in Note 7 to our Consolidated Financial Statements included in our 2009 Form 10-K are unchanged.

Industry Segments — Segment information is presented consistently with the basis described in our 2009 Form 10-K. The following table contains segment information for continuing operations for the three and six months ended June 30, 2010 and 2009.

Revenue

Operating loss

Revenue

Operating income

 

Revenue

Operating income

Corporate expenses

 

Consolidated operating income ( loss)

 

 

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

 

Income Taxes — As of June 30, 2010, the company has recorded a liability of $65,000 in connection with unrecognized tax benefits related to uncertain tax positions. The liability includes $8,622 of interest and penalties. As of June 30, 2010, management expects some incremental but not significant changes in the balance of unrecognized tax benefits over 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. During the three and six months ended June 30, 2010, we recognized $4,113 in interest expense and $4,509 in penalties related to the uncertain tax positions. No interest or penalties were recognized in 2009.

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. For periods prior to April 15, 2008, our VISaer subsidiary filed 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 2005.

On July 17, 2009, we completed a rights offering of common stock to our shareholders. Under the terms of the rights offering, we distributed at no charge to the holders of our common stock non-transferable rights to purchase shares of our common stock. We distributed one right for each share of common stock owned by such holder on the record date of June 17, 2009. The company sold 4,479,014 new shares of common stock and received gross proceeds of $3,135,310, less expenses related to the transaction of $149,000, from the rights offering. Giving effect to the rights offering, we have 8,958,028 shares of common stock outstanding as of June 30, 2010.

Recent Accounting Pronouncements — In October 2009, the Financial Accounting Standards Board (“FASB”) issued accounting guidance which amends the criteria for allocating a contract’s consideration to individual services or products in multiple-deliverable arrangements. The guidance establishes a selling price hierarchy for determining the selling price of a deliverable, which includes: (1) vendor-specific objective evidence if available, (2) third-party evidence if vendor-specific evidence is not available, and (3) estimated selling price if neither vendor-specific nor third-party evidence is available. This guidance is effective for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 (January 1, 2011 for us), and we are currently evaluating the potential impact, if any, on our Consolidated Financial Statements.

We have considered all other recently issued accounting pronouncements and do not believe the adoption of such pronouncements will have a material impact on our Consolidated Financial Statements.

Subsequent Events — We evaluated subsequent events through August 13, 2010 when these financial statements were issued. Except as otherwise disclosed in this report, we are not aware of any significant events that occurred subsequent to the balance sheet date but prior to the filing of this report that would have a material impact on our Consolidated Financial Statements.

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

Customers may decide to postpone or cancel a planned implementation of our software for any number of reasons, which may be unrelated to our software features or contract performance, but which may affect the amount, timing and characterization of our deferred and/or recognized revenue.

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 an unpredictable impact on consolidated revenue that is recognized in a given quarterly or annual period.

Revenue from products, which includes sales and leases of equipment and supplies in our Industrial Products segment as well as software license fees related to the Information Technology segment, was $3.8 million in the three month period ended June 30, 2010, a 46 percent increase compared to the three month period ended June 30, 2009. Product revenue increased by 40 percent to $7.1 million in the six month period ended June 30, 2010 compared to the first six months of 2009. The period to period increases reflect stronger sales of ChemFree’s SmartWasher^® parts washer in both the domestic and international markets due to increased demand as the economy recovers as well as new sales programs. Fluid and filter consumables in both domestic and international markets increased in the three and six month periods ended June 30, 2010 compared to the same periods in 2009. The increase reflects in part an increasing base of new and existing users of the SmartWasher^® part washers and, in part, increased availability in 2010 of fluid for the European market following a transition to a new fluid processing facility that took place during the second quarter of 2009 (during which time fluid supplies were limited). Software license revenue associated with the Information Technology segment increased significantly in both the three and six month periods ended June 30, 2010 compared to the respective periods in 2009 and represented over ten percent of product sales in each period in 2010. We recognize software license revenue generally upon completion of each contract and acceptance by customers. Second quarter and year-to-date software revenue in 2010 was bolstered by the completion and recognition of a software contract that contributed almost $500,000 in revenue.

Service revenue associated with the Information Technology segment was $844,000 and $1,194,000 in the three and six months ended June 30, 2010, representing increases of 56 percent and 42 percent compared to the respective periods in 2009. The change is attributed to increased professional services projects that were completed for CoreCard customers as well as an increase in the installed base of customers that pay for maintenance and technical support.

Cost of product revenue was 57 percent and 54 percent of product revenue in the three and six months ended June 30, 2010, respectively compared to costs of 52 percent and 53 percent of product revenue in the respective periods in 2009. In 2010, sales of ChemFree’s SmartWasher^® machines, which have a higher cost of sales compared to higher margin fluid and filters, increased and represented a larger percentage of product revenue in both the quarter and year-to-date periods of 2010 than in the comparable periods in 2009. As a result, while both sales and gross profit dollars increased in 2010, the gross margin percentage declined slightly due to the change in ChemFree product mix. In addition, the increase in license revenue at CoreCard in both the three and six month periods ended June 30, 2010 was accompanied by an increase in cost associated with bringing new software implementations successfully to completion (which included CoreCard’s first international customer and first major conversion customer).

Cost of service revenue (which relates to our CoreCard business only) was 46 percent and 47 percent of service revenue in the three and six month periods ended June 30, 2010 as compared to 46 percent and 64 percent of service revenue in the respective periods last year. 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. The cost to provide annual maintenance and support services as a percentage of service revenue has declined as CoreCard’s installed base of customers with maintenance contracts has increased, since certain costs are spread across a larger maintenance revenue base. The cost and gross margins on professional services revenue are tied to specific projects and will vary depending on the specific project requirements and complexity as well as the mix of our U.S. and offshore employees working on the project. CoreCard is providing a high level of support to its customers for both maintenance and professional services activities to ensure it builds a solid base of reference customers and puts in place an infrastructure for future growth.

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

Stricter regulations and reluctance by financial institutions to act as sponsor banks for prospective customers (such as issuers and processors of credit and prepaid cards) could increase CoreCard’s losses and cash requirements.

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

It is unclear whether the recent activity in the legal action described in Note 8 to the Consolidated Financial Statements will have any impact on our ChemFree subsidiary in the foreseeable future but there is at least a reasonable possibility that a finding of invalidity of certain of ChemFree’s patents could increase competition in the marketplace and result in greater price pressure and lower margins, thus potentially impacting sales, profits and projected cash flows.

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.

As an alternative to licensing its software, CoreCard is now offering outsourced processing services running on the CoreCard software system. There are numerous risks associated with entering any new line of business and if CoreCard fails to manage the risks associated with its processing operations, it could have a negative impact on our business.

One of ChemFree’s customers represented 31 percent of our consolidated revenue in the first half of 2010 and any unplanned 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.

Delays in production or shortages of certain sole-sourced parts for our ChemFree products could impact revenue and orders. The company has experienced some ongoing difficulty securing acceptable quality of one plastic part that impacts one of its specialty product models and expects it will take a number of months to improve the situation.

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.

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).

Increasing government regulation in the United States and foreign countries related to such issues as data privacy, financial and credit transactions could require changes to our products and services and could affect our existing customer relationships or prevent us from getting new customers.

CoreCard could fail to expand its base of customers as quickly as anticipated, resulting in lower revenue and profits (or increased losses) and increased cash needs.

In certain 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 Amex could result in delisting of our common stock, with a potentially negative impact on the 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 March 18, 2010. (Incorporated by reference to Exhibit 3.(1) to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2009.)

 

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.)

 

Ninth Modification to Loan Documents by and among Intelligent Systems Corporation and Fidelity Bank dated June 28, 2010.

 

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.

Amended and Restated Articles of Incorporation of the Registrant dated March 18, 2010. (Incorporated by reference to Exhibit 3.(1) to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2009.)

 

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.)

 

Ninth Modification to Loan Documents by and among Intelligent Systems Corporation and Fidelity Bank dated June 28, 2010.

 

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.