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INTELLIGENT SYSTEMS CORPORATION

(INS)
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INTELLIGENT : Management's Discussion and Analysis of Financial Condition and Results of Operations (form 10-Q)

08/05/2021 | 07:33am EST

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, 2020 as filed with the Securities and Exchange Commission.



Overview


Our consolidated operations consist of our CoreCard Software subsidiary and its affiliate companies in Romania, India and the United Arab Emirates 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, buy now pay later programs, 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.

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 also receive license revenue and are experiencing growth in our professional services revenue due to the addition of Goldman Sachs Group, Inc. as a customer in 2018, referred to as "Customer A" in the Notes to Consolidated Financial Statements. In total, this customer represented 71% and 65% of our consolidated revenues in the first six months of 2021 and 2020, respectively. We expect future professional services, maintenance, and license revenue from this customer in 2021 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, which we expect to occur in the second half of 2021. Support and maintenance fees are charged based on the tier level achieved and increase at new tier levels.

In 2020, we experienced the loss of a large customer due to insolvency. In October 2020, we opened offices in Dubai and Chennai and hired some of the insolvent customer's employees. In April 2021, we completed an agreement to purchase computer hardware and customer intangible assets and collected previously unrecognized accounts receivable resulting in revenue of $0.6 million for the quarter ended June 30, 2021. We have collected and settled all outstanding receivables from this customer, and we do not anticipate receiving additional revenue from them in the future. In the second quarter of 2021, we converted one of their customers to our processing platform. We expect revenue for the remainder of 2021 and future years from servicing this new customer and adding other new customers in the region.




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We typically receive revenue based on the number of active accounts on file rather than transaction volume and therefore the COVID-19 pandemic and related economic slowdown has had a muted impact on our results. Most of our employees in India have been working remotely throughout the pandemic which has primarily impacted our ability to hire and train new employees. We have been able to maintain key functions and business continuity while delivering growth in our professional services revenue; however, the hiring and training constraints could impact future growth in our professional services revenue. Additionally, with the recent increase in severity of the pandemic in India, we could experience operational disruptions or service delays which could impact the amount and timing of revenues for the remainder of the year.

The infrastructure of our multi customer environment is scalable for the future. A significant portion of our expense is related to personnel, including approximately 610 employees located in India, Romania and Dubai. In October 2020, we added new locations in Dubai, United Arab Emirates and Chennai, India to expand our international capabilities. 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:

? Software license revenue in a given period may consist of a relatively small

number of contracts and contract values can vary considerably depending on the

software product and scope of the license sold. Consequently, even minor delays

in delivery under a software contract (which may be out of our control) could

have a significant and unpredictable impact on the consolidated revenue that we

recognize in a given quarterly or annual period.

? 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 or

contract performance, but which may affect the amount, timing and

characterization of our deferred and/or recognized revenue.

? Customers typically require our professional services to modify or enhance

their CoreCard software implementation based on their specific business

strategy and operational requirements, which vary from customer to customer and

  period to period.



? The timing of new processing customer implementations is often dependent on

third party approvals or processes which are typically not under our direct

  control.



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, all of which has been utilized. In April 2021, the Board authorized an additional $10 million for our share repurchase program, of which $4.4 million has been utilized. We made share repurchases of $7.8 million for the six months ended 2021, and no share repurchases in the six month period ended June 30, 2020. We have $5.6 million of authorized share repurchases remaining at June 30, 2021.




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 six month periods ended June 30, 2021 was $13,355,000 and $22,267,000, respectively, which represents increases of 66 percent and 40 percent compared to the respective periods in 2020.

? Revenue from services was $11,055,000 and $19,967,000 in the three and six

month periods ended June 30, 2021, respectively, which represents increases of

37 percent and 25 percent compared to the respective periods in 2020. Revenue

from transaction processing services, software maintenance and support

services, and professional services were greater in the second quarter and

first six months of 2021 as compared to the second quarter and first six months

of 2020 due to an increase in the number of customers and accounts on file and

an increase in the number and value of professional services contracts

completed during the second quarter and first six months of 2021. We expect

that processing services will continue to grow as our customer base increases;

however, the time required to implement new customer programs could be delayed

due to third party integration and approval processes or due to disruptions in

India caused by the recent pandemic. It is difficult to predict with accuracy

the number and value of professional services contracts that our customers will

require in a given period. Customers typically request our professional

services to modify or enhance their CoreCard software implementation based on

their specific business strategy and operational requirements, which vary from

customer to customer and period to period.





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? Revenue from products, which is primarily software license fees, was $2,300,000

in both the three and six month periods, ended June 30, 2021, compared to $0 in

both the respective comparable periods of 2020. The increase results from our

largest customer achieving a new license tier in the second quarter of 2021.

Cost of Revenue - Total cost of revenue was 42 percent and 45 percent of total revenue in the three and six month periods ended June 30, 2021, respectively, compared to 46 percent and 45 percent in the corresponding periods of 2020. 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. Investments in our infrastructure in 2020 and 2021 are in anticipation of adding customers in future periods. As such, we will not experience economies of scale unless we add additional customers, as anticipated. 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 six month periods ended June 30, 2021, total operating expenses from consolidated operations were higher than in the corresponding period in 2020 primarily due to higher research and development costs and higher general and administrative expenses. Research and development expenses were 188 percent and 159 percent higher in three and six month periods in 2021, respectively, as compared to the same periods in 2020. In the three and six month periods ended June 30, 2021, research and development expenses were higher mainly due to payroll for additional offshore technical personnel and hardship bonus payments related to the pandemic's impact on our offshore employees. Additionally, we hired onshore technical personnel to work on the development of an updated platform. General and administrative expenses were 76 percent and 20 percent higher in the three and six month periods ended June 30, 2021, respectively, due to bonus accruals in the current period as well as a stock grant to the board in the second quarter of 2021 that was similarly granted in the third quarter in 2020. Marketing expenses increased 48 percent and 32 percent for the three and six month periods in 2021, respectively, as compared to the same periods in 2020. 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, 2021, we recorded $134,000 and $267,000 of investment losses, respectively, compared to investment losses of $95,000 and $1,145,000 for the three and six months ended June 30, 2020, respectively. The 2020 investment losses primarily relate to first quarter 2020 impairment charges on investments resulting from the economic downturn caused by the recent pandemic and losses on equity method investments. We did not record any impairments in 2021.

Other Income (Loss) - In the three and six months ended June 30, 2021, we recorded income of $81,000 and $156,000, respectively, compared to income of $117,000 and $253,000 for the comparable 2020 periods. The decrease results from lower interest rates and lower cash balances in the 2021 period.

Income Taxes - Our effective tax rates for the three and six months ended June 30, 2021 were 26.3 percent and 26.2 percent compared to effective tax rates of 19.3 percent and 22.5 percent for the respective periods in 2020.

Liquidity and Capital Resources

Our cash balance at June 30, 2021, was $26,210,000 compared to $37,956,000 at December 31, 2020. During the six months ended June 30, 2021, cash provided by operations was $405,000 compared to cash provided by operations of $9,714,000 for the six months ended June 30, 2020. The decrease is primarily due to lower deferred revenue balances, higher accounts receivable balances and a decrease in cash held for program management funding, partially offset by higher net income and higher depreciation. In addition, during the second quarter of 2021, we invested $1,000,000 in a privately held supply chain financing company which is described in more detail in Note 4 to the Consolidated Financial Statements. We used $2,612,000 of cash to acquire computer equipment primarily for continued investments in our existing processing environment in the U.S and technical resources added in our India office.




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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 share repurchases and opportunities we believe will expand our FinTech business, as exemplified in transactions described in Notes 3 and 4, although there can be no assurance that appropriate opportunities will arise. In November 2018, our Board of Directors authorized a share repurchase program of $5 million, all of which has been utilized. In April 2021, the Board authorized an additional $10 million for our share repurchase program, of which $4.4 million has been utilized. We made share repurchases of $7.8 million for the six months ended 2021, and no share repurchases in the six month period ended June 30, 2020. We have $5.6 million of authorized share repurchases remaining at June 30, 2021.

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. Management discusses its estimates and judgments with the Audit Committee of the Board of Directors. For a detailed description on the application of these and other accounting policies, see Note 1 to the Consolidated Financial Statements contained in our Annual Report on Form 10-K for the fiscal year ended December 31, 2020. 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 2020. During the six month period ended June 30, 2021, there were no significant or material changes in the application of critical accounting 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.

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



  ? Weakness or instability in the global financial markets could have a negative
    impact due to potential customers (most of whom perform some type of financial
    services) delaying decisions to purchase software or initiate processing
    services.


  ? Increased federal and state regulations and reluctance by financial
    institutions to act as sponsor banks for prospective customers could result in
    losses and additional cash requirements.


  ? Our largest customer represented 71% of our consolidated revenues for the six
    months ended June 30, 2021. In the event of material failures to meet contract
    obligations related to the services provided, there is risk of breach of
    contract and loss of the customer and related future revenues. Additionally,
    loss of the customer and related future revenues could result if they choose
    an alternative service provider or decide to exit the business or service line
    that falls under the services that we provide for them.


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


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


  ? Our processing business is impacted, directly or indirectly, by more
    regulations than our licensed software business. If we fail to provide
    services that comply with (or allow our customers to comply with) applicable
    regulations or processing standards, we could be subject to financial or other
    penalties that could negatively impact our business.


  ? A security breach in our platform could expose confidential information of our
    customers' account holders, hackers could seize our digital infrastructure and
    hold it for ransom or other cyber risk events could occur and create material
    losses in excess of our insurance coverage.


  ? 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.


  ? We could fail to expand our base of customers as quickly as anticipated,
    resulting in lower revenue and profits and increased cash needs.


  ? We 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.




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  ? Increasing and changing government regulations 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 which could
    increase our costs and could affect our existing customer relationships or
    prevent us from getting new customers.


  ? Delays in anticipated customer payments for any reason would increase our cash
    requirements and could adversely impact our profits.


  ? 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 losses).


  ? Our future capital needs are uncertain and depend on a number of factors;
    additional capital may not be available on acceptable terms, if at all.


  ? Volatility in the markets, including as a result of political instability,
    civil unrest, war or terrorism, or pandemics or other natural disasters, such
    as the recent outbreak of coronavirus, could adversely affect future results
    of operations and could negatively impact the valuation of our investments.


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

© Edgar Online, source Glimpses

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