Summary of INTELLIGENT SYSTEMS CORP

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

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, 2011 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 consulting, customization, training, 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 generates an operating profit and positive cash flow on a quarterly and annual basis. Our CoreCard subsidiary is not consistently profitable, due in part to significant research and development expense that is invested in its product offerings and the deferral of initial contract revenue recognition until licensed software and associated services are delivered to its customers. Depending upon 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, CoreCard may report operating profits on an irregular basis as it builds a larger customer base. A significant portion of CoreCard's expense is related to personnel, including a workforce of approximately 200 employees located in India. 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 may 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, and from a shareholder rights offering in mid-2009. 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, 2012 was $4,032,000 compared to $4,157,000 in the second quarter of 2011. For the six month period ended June 30, 2012, total revenue was $8,126,000, an increase of 6 percent compared to $7,701,000 in the same period in 2011.

· 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 $3,357,000, a decline of 8 percent compared to the three month period ended June 30, 2011. Product revenue was $6,775,000 in the six month period ended June 30, 2012, an increase of 1 percent compared to the six month period ended June 30, 2011. In both the three and six month periods ended June 30, 2012, our ChemFree subsidiary reported year-over-year growth in total product revenue, led by increased domestic sales volume of its SmartWasher® parts washer machines. However, software license revenue associated with our Information Technology segment declined in both the three and six month periods ended June 30, 2012 compared to the same periods in 2011 due to fewer new software license contracts completed in 2012 than in the corresponding periods last year.

· Service revenue associated with the Information Technology segment was $675,000 and $1,351,000 in the three and six months ended June 30, 2012, respectively, an increase of 32 percent compared to each of the respective periods in 2011. 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 card processing services. The change in the quarter and year-to-date periods in 2012 compared to the same periods in 2011 is attributed to an increase in 2012 in the installed base of customers that pay for maintenance and technical support as well as card processing services and more professional services projects that were completed for CoreCard customers. The number and timing of professional services contracts vary significantly from period to period based on customer requirements and priorities.

Cost of Revenue - Total cost of revenue was 57 percent and 56 percent of total revenue in the three and six month periods ended June 30, 2012, respectively, compared to 50 percent and 51 percent of total revenue in the three and six month periods ended June 30, 2011, respectively. The difference between periods reflects mainly changes in CoreCard's product and service revenue from period to period.

· Cost of product revenue was 52 percent and 51 percent of product revenue in the three and six months ended June 30, 2012, respectively, compared to 48 percent and 49 percent of product revenue in the respective periods in 2011. In 2012, the higher cost of sales as a percent of product revenue reflects the fact that CoreCard's software license revenue (which has a lower cost of sales than ChemFree's partswasher products) represented a smaller percentage of total product revenue in 2012 than in 2011. ChemFree's cost of sales as a percentage of its revenue was relatively consistent in 2012 and 2011 but the decline in software license revenue in the 2012 periods impacted the total product cost of sales percentage.

· Cost of service revenue (which relates to our CoreCard business only) was significantly higher as a percentage of service revenue in both the three and six month periods ended June 30, 2012, as compared to 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. Cost of service revenue includes three components: the 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. The cost and gross margins on professional services revenue are tied to specific projects and vary depending on the individual project requirements and complexity as well as the mix of our U.S. and offshore employees working on the project. Our initial costs to provide card processing services are high relative to the revenue earned because we are putting in place the systems and processes necessary to support this new service initiative. We had lower such costs in the second quarter and year-to-date periods in 2011 because we were offering limited processing services in 2011. CoreCard is providing a high level of support to its customers for maintenance, compliance and professional services activities to ensure it builds a solid base of reference customers and puts in place an infrastructure for future growth.

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Operating Expenses - In the three and six month periods ended June 30, 2012, total consolidated operating expenses were higher by 4 percent and 3 percent, respectively, than in the corresponding periods in 2011. Consolidated marketing expenses were higher by 5 percent ($28,000) and 9 percent ($94,000) in the three and six month periods ended June 30, 2012 compared to the same periods in 2011 due mainly to increases in personnel and consulting expenses. Consolidated general and administrative expenses were higher by 26 percent ($156,000) in the three month period ended June 30, 2012 reflecting mainly higher legal expenses than in the same period in 2011, as well as increases in several categories such as option expense, salaries and benefits, accounting and SEC reporting, none of which was individually significant. General and administrative expenses were 7 percent ($109,000) higher in the six month period ended June 30, 2012, compared to the same period of 2011, reflecting increases in a number of categories such as option expense, salaries and benefits and legal, none of which was individually significant. Consolidated research and development expenses were lower by 16 percent ($117,000) and 6 percent ($88,000) in the three and six month periods ended June 30, 2012, respectively, compared to the same periods in 2011, due to a higher percentage of technical personnel expenses being charged to cost of services revenue for maintenance, processing and professional services in 2012.

Interest Income, net - We recorded net interest income of $0 and $5,000, in the three and six month periods ended June 30, 2012, respectively, compared to net interest income of $6,000 and $17,000 in the three and six month periods ended June 30, 2011. The difference between periods reflects primarily the fact that the note receivable related to the sale of our former VISaer subsidiary was lower in 2012 than in 2011 due to principal payments made in 2011 and 2012.

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. We recorded net equity losses of our affiliate company in the three and six month periods ended June 30, 2012, compared to net equity income of our affiliate company in the three and six month periods ended June 30, 2011. The change between periods reflects a decline in profitability of the affiliate company in 2012.

Other Income - As previously explained, the second quarter and year-to-date results for 2011 include income of $450,000 earned by our ChemFree subsidiary upon the settlement of a legal matter.

Income Taxes - We recorded $35,000 and $48,000, in the three and six month periods ended June 30, 2012, respectively, for state income tax expense, which amounts include $13,000 in connection with uncertain tax positions. In the comparable periods in 2011, the three and six month amounts shown for income taxes include $26,000 in connection with uncertain tax positions.

Liquidity and Capital Resources

Our cash balance at June 30, 2012 was $2,505,000 as compared to $3,152,000 at December 31, 2011. During the six months ended June 30, 2012, a principal source of cash was receipt of a scheduled $250,000 payment from the purchaser of our former VISaer subsidiary (as explained in more detail in Note 2 to the Consolidated Financial Statements contained in our 2011 Annual Report on Form 10-K). We used $466,000 cash for operations. Major working capital changes included:
· an increase in accounts receivable of $379,000 reflecting mainly higher billings in May and June 2012 as compared to December 2011.

· an increase of $97,000 in inventory due mainly to building finished goods inventory to support ChemFree's sales growth and estimated near-term demand

· an increase in deferred revenue of $184,000 reflecting mainly milestone billings to CoreCard customers in advance of revenue recognition

· an increase in accrued expenses of $187,000, the majority of which is related to slower payment of commissions owed to third parties and, to a lesser extent, accruals for freight and state income taxes.

During the six months ended June 30, 2012, we used $112,000 of cash to purchase computer and facility equipment at our operating companies. We also used $300,000 to acquire a minority ownership interest in an early stage technology company.

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 periodic working capital borrowings or sale of marketable securities, if needed, to support our operations and capital equipment purchases in the foreseeable future. We renewed our line of credit in June 2012 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. The line of credit expires June 30, 2014, subject to the bank renewing the line for an additional period. We have not drawn down under the bank line of credit in more than two years. We presently project that we will have sufficient accounts receivable, inventory balances and tangible net worth for the foreseeable future to support the borrowing base and loan covenants for any required draws under our bank line of credit.. 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.

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Long-term, we currently expect that liquidity will continue to 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 although there are no current plans to do so. 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.

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 acquired intangibles and impairment of long-lived assets, 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, 2011. 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 2011. During the three and six month periods ended June 30, 2012, 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-controlling 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:

· Further weakness in the global financial markets could have a negative impact on CoreCard due to potential customers (most of whom perform some type of financial services) delaying purchase or software 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 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.

· 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.

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· One of ChemFree's customers represented 29 percent of our consolidated periods ended June 30, 2012 and any unplanned 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.

· Delays in production or shortages of certain sole-sourced parts for our ChemFree products could impact revenue and orders.

· Increased 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 2011, the company raised prices on certain of its SmartWasher® products to offset cost increases but may not be able to do so in the future due to competitive pressure.

· 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 or service solution, resulting in lower revenue and profits (or increased losses).

· 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 to meet applicable compliance requirements, which could increase our costs 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, which may require 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.

· 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 software purchases.