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INTELLIGENT SYSTEMS CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 14, 2014

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. Except to the extent required by law, 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 6. Management's Discussion and Analysis of Financial Condition and Results of Operations, in the Form 10-K for the year ended December 31, 2013 as filed with the Securities and Exchange Commission.

We derive our product revenue from sales and leases of equipment and supplies in our Industrial Products sector and from sales of software licenses in our Information Technology Products and Services sector. Our service revenue consists of fees for software customization, processing services, maintenance and support for software products in our Information Technology Products and Services sector. Our revenue fluctuates from period to period and our results are not necessarily indicative of the results to be expected in future periods. Period-to-period comparisons may not be meaningful and it is difficult to predict the level of consolidated revenue on a quarterly or annual basis for a number of reasons, including the following:

? A change in revenue level at one of our subsidiaries may impact consolidated

revenue or be offset by an opposing change at another subsidiary.

? 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 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.

We have frequently recognized consolidated operating losses on a quarterly and annual basis and are likely to do so in the future from time to time. Our ChemFree subsidiary typically generates a profit and positive cash flow from operations on a quarterly and annual basis. CoreCard may report operating profits on an irregular basis and its results vary in part depending on the size and number of software licenses recognized in a particular period and the level of expenses incurred to support existing customers and development and sales activities. A significant portion of CoreCard's expense is related to personnel, including approximately 200 employees located in India and Romania. In addition, CoreCard is now offering processing services as an alternative for customers who prefer to outsource this function instead of licensing our software and running the application in-house. There are a number of uncertainties related to a new line of business. We are likely to incur losses in the near future for the processing business because contract revenue is spread out over multi-year contracts while we are currently investing in the infrastructure, resources and processes to support this new processing business. For these and other reasons, our operating results are likely to vary from quarter to quarter and at the present time are generally not predictable with a reasonable degree of certainty.

From time to time, we derive income from sales of holdings in affiliate and other minority-owned companies or we may record a charge if we believe the value of a non-consolidated company is impaired. We also recognize on a quarterly basis our pro rata share of the income or losses of an affiliate company accounted for by the equity method. The timing and amount of the gain or loss recognized as a result of a sale or the amount of equity in the income or losses of the affiliate generally are not under our control and are not necessarily indicative of future results, either on a quarterly or annual basis.

In recent years, most of our cash has been generated by our ChemFree operations and, on an irregular basis, from sales of our investments or subsidiaries. We have used a significant amount of the cash received from these transactions and operations to support the domestic and international operations associated with our CoreCard subsidiary and the corporate office.

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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 month period ended June 30, 2014 was $3,695,000, a decrease of 11 percent compared to $4,166,000 in the second quarter of 2013. For the six month period ended June 30, 2014, total revenue was $7,365,000, a decline of 11 percent compared to $8,252,000 in the same period in 2013.

? 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 Products and Services segment, was $2,879,000, a decline of 9 percent compared to the three month period ended June 30, 2013. Product revenue was $5,556,000 in the six month period ended June 30, 2014, a decline of 15 percent compared to the six month period ended June 30, 2013. In both the three and six month periods ended June 30, 2014, the decline is primarily related to the ChemFree subsidiary and reflects the expiration of an equipment lease contract in mid-2013 when one of ChemFree's largest lease customers opted to purchase the leased equipment and not renew the lease. The total number of SmartWasher machines sold in the second quarter and year-to-date periods of 2014 showed improvement compared to the same periods in 2013. ? Service revenue associated with the Information Technology Products and Services segment was $816,000 in the three month period ended June 30, 2014 compared to $1,007,000 in the same period last year. In the six months ended June 30, 2014, service revenue was $1,809,000, a 5 percent increase compared to the same period in 2013. Service revenue includes three components: revenue from annual maintenance and support contracts for our installed customer base, revenue from professional services (such as software customizations or modifications) and revenue from our processing services. In both the three and six month periods of 2014, revenue generated from CoreCard's transaction processing services increased significantly period-to-period due to an increase in the number of customers and accounts on file. However, this increase was offset by lower levels of revenue generated from professional services due to a decrease in the number and value of contracts completed in 2014 as well as lower maintenance revenue from customers that pay for maintenance and technical support. We expect that processing services will continue to grow as CoreCard's customer base increases and that maintenance revenue will increase slightly from the current level. However, it is not possible to predict with any accuracy the number and value of professional services contracts that CoreCard's customers will require in a given period. Customers typically require our professional services to modify or enhance their CoreCard software implementation based on their specific business strategy and operational requirements, which can vary considerably from customer to customer and period to period.



Cost of Revenue - Total cost of revenue was 56 percent and 54 percent of total revenue in the three and six month periods ended June 30, 2014, respectively, compared to 49 percent and 52 percent of total revenue in the three and six month periods ended June 30, 2013, respectively.

? Cost of product revenue was 56 percent in both the three and six months ended June 30, 2014 respectively, compared to 46 percent and 47 percent of product revenue in the respective periods in 2013. The reduction in cost of revenue is related mainly to revenue mix during the periods. The relatively higher cost of product in 2014 reflects primarily the decline in ChemFree's more profitable lease revenue in both the second quarter and year-to-date periods of 2014, thus reducing the gross margin contribution in those periods. ? Cost of service revenue (which relates to our CoreCard business only) was lower as a percentage of service revenue in both the three and six month periods ended June 30, 2014, as compared to the respective periods last year. Cost of service revenue includes three components: 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 card processing services. Costs associated with delivering professional services vary considerably from period to period depending on the project complexity and mix of domestic vs. international employees delivering such services. 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. We have become more efficient and reduced the costs required to deliver maintenance and customer support to our installed base of license customers. In addition, although our actual costs to provide card processing services are higher in the second quarter and year-to-date periods of 2014 than in the comparable period in 2013 (because we continue to devote the resources necessary to support this new service initiative, including additional direct costs for regulatory compliance, infrastructure and customer support), the costs increased at a lower rate than did processing revenue resulting in an improvement in gross margin. However, we expect these costs to continue to outpace processing revenue for the foreseeable future. Page 11



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Operating Expenses - Consolidated marketing expenses were lower by 17 percent ($81,000) and 21 percent ($206,000) in the three and six month periods ended June 30, 2014 compared to the same periods in 2013 due mainly to a decrease in sales commission expense incurred by ChemFree. General and administrative expenses were 14 percent ($82,000) and 21 percent ($272,000) higher in the three and six month periods of 2014, respectively, compared to the same periods of 2013, reflecting higher management costs at CoreCard as well as higher legal expenses in the year-to-date period associated with the ChemFree legal settlement matter (refer to Note 7). Research and development expenses were 28 percent higher in the both the second quarter and year-to-date periods of 2014 compared to the same periods last year, mainly due to fewer technical personnel expenses being charged to cost of services for maintenance and professional services, in line with lower revenue reported for such services.

Accrued Legal Settlement Expense - As a result of the settlement of the ChemFree legal matter described under Legal Proceedings below, in the year-to-date period ended June 30, 2014, we accrued $387,000, reflecting the differences between the $706,000 settlement amount and amounts accrued in prior periods.

Investment Income - In the second quarter and year-to-date periods of 2014, we recorded investment income of $125,000. We recorded a gain of $146,500 on the sale of our minority interest in Silverpop, a privately-held company that was acquired by IBM in May 2014. Offset against this investment gain was a write-down of $21,500 to reduce the carrying value of a privately held company in which we owned a small interest to zero, our estimate of its net realizable value.

Equity in Income (Loss) of Affiliate Company - On a quarterly basis, we recognize our pro rata share of the earnings or losses of an affiliate company that we record on the equity method. The small change between periods reflects minor difference in profitability of the affiliate company in the periods presented.

Income Taxes - We recorded $0 and $12,000 in the three and six month periods ended June 30, 2014, respectively, for state income tax expense. In the comparable periods in 2013, the three and six month amounts shown for income taxes include $22,000 in connection with uncertain tax positions.

Liquidity and Capital Resources

Our cash balance at June 30, 2014 was $2,939,000 compared to $3,433,000 at December 31, 2013 and $2,923,000 at March 31, 2014. During the six month period ended June 30, 2014, we used $530,000 cash for operating activities, including a payment related to the ChemFree legal settlement matter described under Legal Proceedings below. The first payment of $236,000 was made in May 2014 and two additional payments of $235,000 each are due 90 days and 180 days after the settlement date. Although these payments were not in our original cash forecast for 2014, we currently project that we will have sufficient liquidity from cash on hand, continued cash positive operations at ChemFree, projected customer payments at CoreCard and, if needed, working capital borrowings or sale of marketable securities to support our operations in the foreseeable future.

During the six months ended June 30, 2014, we used $130,000 for capital purchases, primarily computer equipment. We also received cash proceeds of $169,000 from the sale to IBM of Silverpop, a privately held technology company in which we owned a small equity interest.

We renewed our line of credit in June 2014 with a maximum principal availability of $1.25 million based on qualified receivables and inventory levels which we will use as necessary to support short-term cash needs. We have not drawn down under the bank line of credit in the past four years. The line of credit expires on June 30, 2016, subject to the bank renewing the line for an additional period. Delays in meeting project milestones or software delivery commitments at CoreCard could cause customers to postpone payments and increase our need for cash. Presently, we do not believe there is a material risk that we will not perform successfully on any contracts but if customer payments are delayed for any reason, if we do not control costs or if we encounter unforeseen technical or quality problems, then we could require more cash than presently planned.

Long-term, we currently expect that liquidity will improve and consolidated operations will generate sufficient cash to fund their requirements with use of our credit facility to accommodate short-term needs. Other long-term sources of liquidity include potential sales of investments, subsidiaries or other assets. Furthermore, the timing and amount of any such transactions are uncertain and, to the extent they involve non-consolidated companies, generally not within our control.

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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, valuation of investments and accrued expenses 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, 2013. 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 2013. During the three and six month periods ended June 30, 2014, there were no significant or material changes in the application of critical accounting policies that would require an update to the information provided in the Form 10-K.

Factors That May Affect Future Operations

Future operations in both the Information Technology Products and Services and Industrial Products segments 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. Any trend or delay that affects even one of our subsidiaries could have a negative impact on the company's consolidated results of operations or cash requirements on a quarterly or annual basis. In addition, the carrying value of our investments is impacted by a number of factors which are generally beyond our control since we are typically a non-control shareholder in a private company with limited liquidity.

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

Information Technology Products and Services Industry

? As an alternative to licensing its software, CoreCard is now offering

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.

? 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 negatively impact the processing services business and

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.

? 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.

? CoreCard's processing business is impacted, directly or indirectly, by more

regulations than its licensed software business. If the company fails to

provide services that comply with (or allow its customers to comply with)

applicable regulations or processing standards, it could be subject to

financial or other penalties that could negatively impact its business.

? 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.

? 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.

? 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 would

increase our costs and could affect our existing customer relationships or

prevent us from getting new customers.

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Industrial Products Industry

? One of ChemFree's customers represented 22 percent and 21 percent of our

consolidated revenue in the three and six-month periods ended June 30, 2014,

respectively. Changes in the volume of orders or timeliness of payments from

such customer could potentially have a negative impact on revenue, inventory

levels and cash, at least in the near-term. For instance in the third quarter

of 2013, the customer decided to temporarily reduce new machine orders due to

some internal process changes which resulted in postponed shipments and

significantly reduced revenue and profits related to such customer in the

second half of 2013 and to a lesser extent in the first half of 2014.

? Delays in production or shortages of certain sole-sourced parts for our

ChemFree products could impact revenue and orders. For example, one of

ChemFree's suppliers of a sole-sourced component experienced an equipment

malfunction which created a backlog of certain of ChemFree's products in the

second quarter of 2013. Although the shortage and short-term impact of the

shortage was resolved, longer term the company is taking steps to reduce its

dependency on a single supplier where feasible.

? Increases in prices of raw materials and sub-assemblies could reduce ChemFree's

gross profit if it is not able to offset such increased costs with higher

selling prices for its products or other reductions in production costs.

? In certain situations, ChemFree's lease customers are permitted to terminate

the lease covering one or more SmartWasher® machines. Effective July 1, 2013,

one of ChemFree's lease customers opted to terminate its equipment lease and

purchase the machines instead. This termination significantly reduced equipment

lease revenue beginning in the third quarter of 2013 and lease revenue is

expected to be lower in future periods compared to prior periods, although the

customer continues to purchase fluid and filter supplies.

Other



? Delays in anticipated customer payments for any reason would increase our cash

requirements and possibly our losses.

? 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).

? 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.

? 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.

? Other general economic and political conditions could cause customers to delay

or cancel purchases.


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