##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-QSB (Mark One) x
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended June 30, 2004 OR o
    
    TRANSITION REPORT PURSUANT TO
SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from  to Commission file number 1-9330 INTELLIGENT SYSTEMS CORPORATION  Georgia
    
    58-1964787(State or other jurisdiction of incorporation or organization)
    
    (I.R.S. Employer Identification No.)4355 Shackleford Road, Norcross, Georgia
    
    30093(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number, including area code: (770) 381-2900 Indicate by a check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes x No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes o No x As of July 31, 2004, 4,478,971 shares of Common Stock were outstanding. Transitional
Small Business Disclosure Format (check one): Yes
o  No x




---



TABLE OF CONTENTS  Part I. FINANCIAL INFORMATIONItem 1. Financial StatementsCONDENSED CONSOLIDATED BALANCE SHEETSCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONSCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSItem 2. Managements Discussion and Analysis or Plan of OperationsItem 3. Controls and ProceduresPart II. OTHER INFORMATIONItem 4. Submission of Matters to a Vote of Security HoldersItem 6. Exhibits and Reports on Form 8-KSIGNATURESEX-31.1 SECTION 302 CERTIFICATION OF THE CEOEX-31.2 SECTION 302 CERTIFICATION OF THE CFOEX-32.1 SECTION 906 CERTIFICATION OF THE CEO & CFO    Table of Contents  
 Part I. FINANCIAL INFORMATION 
 Item 1. Financial Statements 
 Intelligent Systems Corporation
CONDENSED CONSOLIDATED BALANCE SHEETS(in thousands, except share amounts) June 30,
    
    December 31,2004
    
    2003(unaudited)ASSETSCurrent assets:Cash
    
    $
    547
    
    
    $
    1,133Accounts receivable, net
    
    
    2,670
    
    
    
    1,543Notes and interest receivable
    
    
    
    
    
    
    142Inventories
    
    
    708
    
    
    
    766Other current assets
    
    
    227
    
    
    
    614Total current assets
    
    
    4,152
    
    
    
    4,198Long-term investments
    
    
    4,848
    
    
    
    6,275Property and equipment, at cost less accumulated depreciation
    
    
    695
    
    
    
    746Goodwill, net
    
    
    2,035
    
    
    
    2,039Intangibles, net
    
    
    320
    
    
    
    476Other assets, net
    
    
    20
    
    
    
    8Total assets
    
    $
    12,070
    
    
    $
    13,742LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Short-term borrowings
    
    $
    370
    
    
    $
    250Accounts payable
    
    
    982
    
    
    
    932Deferred revenue
    
    
    8,947
    
    
    
    2,586Deferred gain
    
    
    258
    
    
    
    291Accrued expenses and other current liabilities
    
    
    1,972
    
    
    
    2,037Total current liabilities
    
    
    12,529
    
    
    
    6,096Deferred revenue, net of current portion
    
    
    
    
    
    
    5,060Minority interest
    
    
    1,516
    
    
    
    1,516Commitments and contingencies (note 12)Stockholders equity:Common stock, $0.01 par value, 20,000,000 shares authorized, 4,478,971 shares
issued and outstanding at June 30, 2004 and December 31, 2003
    
    
    45
    
    
    
    45Paid-in capital
    
    
    18,410
    
    
    
    18,410Accumulated other comprehensive loss
    
    
    (80
    )
    
    
    (60
    )Accumulated deficit
    
    
    (20,350
    )
    
    
    (17,325
    )Total stockholders equity
    
    
    (1,975
    )
    
    
    1,070Total liabilities and stockholders equity
    
    $
    12,070
    
    
    $
    13,742
 The accompanying notes are an integral part of these condensed consolidated financial statements. Page 2




---



##### Table of Contents



Intelligent Systems Corporation
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(unaudited; in thousands, except share and per share amounts) Three Months Ended June 30,
    
    Six Months Ended June 30,2004
    
    2003
    
    2004
    
    2003RevenueProducts
    
    $
    1,786
    
    
    $
    1,801
    
    
    $
    5,013
    
    
    $
    3,505Services
    
    
    1,557
    
    
    
    1,020
    
    
    
    2,942
    
    
    
    2,486Total revenue
    
    
    3,343
    
    
    
    2,821
    
    
    
    7,955
    
    
    
    5,991Cost of revenueProducts
    
    
    804
    
    
    
    906
    
    
    
    1,789
    
    
    
    1,665Services
    
    
    707
    
    
    
    792
    
    
    
    1,517
    
    
    
    1,842Total cost of revenue
    
    
    1,511
    
    
    
    1,698
    
    
    
    3,306
    
    
    
    3,507ExpensesMarketing
    
    
    687
    
    
    
    681
    
    
    
    1,347
    
    
    
    1,452General & administrative
    
    
    914
    
    
    
    951
    
    
    
    1,809
    
    
    
    2,034Research & development
    
    
    2,102
    
    
    
    2,100
    
    
    
    4,202
    
    
    
    4,181Loss from operations
    
    
    (1,871
    )
    
    
    (2,609
    )
    
    
    (2,709
    )
    
    
    (5,183
    )Other incomeInterest expense, net
    
    
    (5
    )
    
    
    
    
    
    
    (8
    )
    
    
    (5
    )Investment income (loss), net
    
    
    (371
    )
    
    
    205
    
    
    
    (371
    )
    
    
    3,669Equity in earnings (losses) of affiliate companies
    
    
    51
    
    
    
    34
    
    
    
    13
    
    
    
    (33
    )Other income (loss), net
    
    
    (9
    )
    
    
    187
    
    
    
    50
    
    
    
    214Loss before income tax benefit
    
    
    (2,205
    )
    
    
    (2,183
    )
    
    
    (3,025
    )
    
    
    (1,338
    )Income tax provision (benefit)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (104
    )Net loss
    
    $
    (2,205
    )
    
    $
    (2,183
    )
    
    $
    (3,025
    )
    
    $
    (1,234
    )Basic and diluted net loss per share
    
    $
    (0.49
    )
    
    $
    (0.49
    )
    
    $
    (0.68
    )
    
    $
    (0.28
    )Basic and diluted weighted average shares outstanding
    
    
    4,478,971
    
    
    
    4,485,540
    
    
    
    4,478,971
    
    
    
    4,487,945
 The accompanying notes are an integral part of these condensed consolidated financial statements. Page 3




---



##### Table of Contents



Intelligent Systems Corporation
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW(unaudited, in thousands) Six Months Ended June 30,2004
    
    2003OPERATIONS:Net loss
    
    $
    (3,025
    )
    
    $
    (1,234
    )Adjustments to reconcile net loss to net cash used for operating activities, net of
effects of acquisitions and dispositions:Depreciation and amortization
    
    
    315
    
    
    
    371Deferred gain recognized
    
    
    (33
    )
    
    
    (66
    )Investment (income) loss, net
    
    
    371
    
    
    
    (3,662
    )Equity in income (loss) of affiliate companies
    
    
    (13
    )
    
    
    33Changes in operating assets and liabilities, net of effects of acquisitionAccounts receivable
    
    
    (1,127
    )
    
    
    (1
    )Inventories
    
    
    58
    
    
    
    (113
    )Other current assets
    
    
    387
    
    
    
    78Accounts payable
    
    
    50
    
    
    
    (206
    )Accrued expenses and other liabilities
    
    
    1,224
    
    
    
    1,241Cash used for operating activities
    
    
    (1,793
    )
    
    
    (3,559
    )INVESTING ACTIVITIES:Proceeds from sales of investments
    
    
    1,073
    
    
    
    4,464Distributions from (acquisition of) long-term investments, net
    
    
    124
    
    
    
    (200
    )Repayments under notes receivable
    
    
    15
    
    
    
    79Advances under notes receivable
    
    
    
    
    
    
    (156
    )Purchases of property and equipment
    
    
    (105
    )
    
    
    (119
    )Cash provided by investing activities
    
    
    1,107
    
    
    
    4,068FINANCING ACTIVITIES:Borrowings under short-term borrowing arrangements
    
    
    120
    
    
    
    Purchase and retirement of common stock
    
    
    
    
    
    
    (22
    )Cash provided by (used for) financing activities
    
    
    120
    
    
    
    (22
    )Effects of exchange rate changes on cash
    
    
    (20
    )
    
    
    (20
    )Net (decrease) increase in cash
    
    
    (586
    )
    
    
    467Cash at beginning of period
    
    
    1,133
    
    
    
    2,644Cash at end of period
    
    $
    547
    
    
    $
    3,111SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:Cash paid during the period for interest
    
    $
    5
    
    
    $
    
 The accompanying notes are an integral part of these condensed consolidated financial statements. Page 4




---



##### Table of Contents



Intelligent Systems Corporation
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  1.
    
    Throughout this report, the terms we, us, ours, ISC and company
refer to Intelligent Systems Corporation, including its subsidiaries.2.
    
    The unaudited condensed consolidated financial statements presented in
this Form 10-QSB 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,
2004 and 2003. The interim results for the three and six months ended
June 30, 2004 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, 2003, as filed in our annual report on Form 10-K.3.
    
    Sale of Investment in Cirronet, Inc.  On May 10, 2004, we sold
1,340,990 shares of common stock of Cirronet, Inc., representing all of
the Cirronet stock held by us, in a private transaction for an aggregate
price of $1,073,000, paid in cash at the closing. We recognized a gain of
$256,000 on the transaction in the quarter ended June 30, 2004, on a
carrying value of $817,000 and an original cost basis of $525,000. This
gain is included in investment income (loss) on the Consolidated Statement
of Operations.4.
    
    Write-down of Ardext Technologies, Inc. Our results for the quarter
ended June 30, 2004 include a write-down of the carrying value of our
investment in Ardext Technologies, Inc. to zero. We recorded a charge of
$465,000 against long-term investments and $162,000 against notes and
interest receivable for a total investment write-off of $627,000.
Although Ardext has a promising technology and is making progress in
semiconductor customer trials of its initial software products, the
companys timetable to and ability to fund operations to breakeven is
difficult to predict. Accordingly, as of this filing, we believe it is
unlikely we will recover our investment and accordingly have reserved
against the full carrying value as of June 30, 2004.5.
    
    Sale of Principal Asset of ISC Guernsey, Ltd. We own a 19 percent
interest in ISC Guernsey, Ltd., an entity whose principal asset is an
investment in a U.K. based company. During the second quarter of 2004, we
were informed that ISC Guernsey sold its investment in the U.K. company
for cash and that it expects to distribute a significant portion of the
proceeds to its shareholders in the future, after determining its ongoing
business needs. Based on information communicated to us by ISC Guernsey,
our share of the cash distributions is estimated to be between $3.5
million and $4.5 million in total. We anticipate that an initial
distribution of part of the proceeds will occur in the quarter ended
September 30, 2004, and that other distributions are likely to follow
later in 2004 or early in 2005. However, we are not in a position to
exert influence over the timing or extent of such distributions. At June
30, 2004, the carrying value of our minority owned investment in ISC
Guernsey is $31,000. Based on our current projections, we do not expect
to have any tax withholdings or to incur a tax liability related to these cash distributions.6.
    
    Related Party Transaction As previously disclosed in a Form 8-K filed
on May 11, 2004, the lease on our headquarters and primary facility at
4355 Shackleford Road, Norcross, Georgia expired May 31, 2004. The
current landlord was unwilling to renew this lease and had instead
expressed a desire to sell the facility. On June 1, 2004, ISC Properties,
LLC, an entity controlled by our Chairman and Chief Executive Officer, J.
Leland Strange, purchased the facility from the current landlord and
leased approximately 45 percent of the facility to the company in order to
allow us to stay in the present facility and to avoid the disruption and
expense of a move. After careful consideration, the companys Board of
Directors concluded that the lease transaction was fair to the company and
in the best interests of the company and its shareholders, and approved
the lease transaction between the company and ISC Properties, LLC
effective June 1, 2004. Mr. Strange recused himself form deliberations
concerning, and voting to approve, the lease transaction. In connection
with this approval, the Board of Directors waived the conflict of interest
provisions of our Code of Ethics as they apply to Mr. Strange in
connection with the lease transaction. We also evaluated the arrangement
to determine if ISC Properties, LLC should be considered a Variable
Interest Entity (VIE) within the guidance of Financial Accounting
Standards Board FIN No. 46. After carefully considering the
characteristics of the relationship between the company and ISC
Properties, LLC, it was determined that ISC Properties, LLC did not meet
the criteria of a VIE and, as a result, ISC Properties, LLC is not
consolidated with the company. Page 5




---



##### Table of Contents



7.
    
    Comprehensive Loss In accordance with Financial Accounting Standards Board
Statement No. 130, Reporting Comprehensive Income, comprehensive loss is
the total of net loss and all other non-owner changes in equity in a period.
A summary follows:Consolidated Statements of Comprehensive Loss Three Months Ended June 30
    
    Six Months Ended June 30,(unaudited, in thousands)
    
    2004
    
    2003
    
    2004
    
    2003Net loss
    
    $
    (2,205
    )
    
    $
    (2,183
    )
    
    $
    (3,025
    )
    
    $
    (1,234
    )Other comprehensive loss:Foreign currency translation adjustment
    
    
    4
    
    
    
    (17
    )
    
    
    (20
    )
    
    
    (20
    )Unrealized gain on available-for-sale securities
    
    
    
    
    
    
    33
    
    
    
    
    
    
    
    38Comprehensive loss
    
    $
    (2,201
    )
    
    $
    (2,167
    )
    
    $
    (3,045
    )
    
    $
    (1,216
    )
  8.
    
    Stock-Based Compensation At June 30, 2004, we had two stock-based
compensation plans. We account for the plans under the intrinsic value
recognition and measurement principles of Accounting Principles Board
(APB) No. 25, Accounting for Stock Issued to Employees, and related
interpretations. The intrinsic value recognition is measured by the
difference between the exercise price and the market value of the
underlying securities. Based on the additional disclosure requirements of
Statement of Financial Accounting Standards (SFAS) No. 148, Accounting
for Stock-Based Compensation - Transition and Disclosure - an Amendment to
SFAS No. 123, the following table illustrates the effect of net income
and earnings (loss) per share if we had applied the fair value recognition
provisions of SFAS No. 123, Accounting for Stock Based Compensation. Three Months Ended June 30
    
    Six Months Ended June 30,(unaudited, in thousands, except per share data)
    
    2004
    
    2003
    
    2004
    
    2003Net loss, reported
    
    $
    (2,205
    )
    
    $
    (2,183
    )
    
    $
    (3,025
    )
    
    $
    (1,234
    )Add: stock-based employee compensation included
in reported net loss, net of related tax effect
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Deduct: stock-based compensation expense
determined under fair value based method for
all awards, net of related tax effect
    
    
    (10
    )
    
    
    (9
    )
    
    
    (19
    )
    
    
    (12
    )Pro forma net loss
    
    $
    (2,215
    )
    
    $
    (2,192
    )
    
    $
    (3,044
    )
    
    $
    (1,246
    )Pro forma net loss per common sharebasic and diluted
    
    $
    (0.49
    )
    
    $
    (0.49
    )
    
    $
    (0.68
    )
    
    $
    (0.28
    )
  9.
    
    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. Three Months Ended June 30
    
    Six Months Ended June 30,(unaudited, in thousands)
    
    2004
    
    2003
    
    2004
    
    2003ChemFree Customer A
    
    
    10
    %
    
    
    13
    %
    
    
    
    
    
    
    11
    %ChemFree Customer B
    
    
    
    
    
    
    12
    %
    
    
    
    
    
    
    ChemFree Customer C
    
    
    
    
    
    
    16
    %
    
    
    
    
    
    
    14
    %CoreCard Customer D
    
    
    
    
    
    
    
    
    
    
    16
    %
    
    
    Visaer Customer E
    
    
    11
    %
    
    
    
    
    
    
    
    
    
    
    Visaer Customer F
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    15
    %
  10.
    
    New Accounting Pronouncements In March 2004, the Emerging Issues Tax
Force reached a consensus on Issue No. 03-16, Accounting for Investments
in Limited Liability Companies. The consensus requires an investment in a
Limited Liability Company (LLC) that maintains a specific ownership
account for each investor be viewed as similar to an investment in a
limited partnership for the purposes of determining whether a
noncontrolling investment in an LLC should be accounted for using the cost
method or equity method of accounting. The consensus is effective in the
quarter beginning after June 15, 2004. The implementation of this
consensus is not expected to have a material impact on our financial
position or results of operations. Page 6




---



##### Table of Contents



11.
    
    Industry Segments Our consolidated subsidiaries are involved in two
industry segments: Information Technology products and services, and
Industrial Products. Operations in Information Technology products and
services include development and sales of software licenses and related
professional services and software maintenance contracts provided through
three subsidiaries: QS Technologies, Inc., VISaer, Inc., and CoreCard
Software, Inc. Operations in the Industrial Products segment include the
manufacture and sale of bio-remediating parts washing systems by our
ChemFree Corporation subsidiary. Total revenue by industry segment
includes sales to unaffiliated customers. Sales between our industry
segments are not material. Operating profit (loss) is total revenue less
operating expenses. None of the corporate overhead expense is allocated to
the individual industry segments. Identifiable assets by industry segment
are those assets that are used in our subsidiaries in each industry
segment. Corporate assets are principally cash, notes receivable and
investments.The table following contains segment information for the three and six
months ended June 30, 2004 and 2003. Three Months Ended June 30,
    
    Six Months Ended June 30,(unaudited, in thousands)
    
    2004
    
    2003
    
    2004
    
    2003Information TechnologyRevenue
    
    $
    1,636
    
    
    $
    1,192
    
    
    $
    4,590
    
    
    $
    2,769Operating loss
    
    
    (1,835
    )
    
    
    (2,504
    )
    
    
    (2,513
    )
    
    
    (5,046
    )Industrial ProductsRevenue
    
    
    1,707
    
    
    
    1,629
    
    
    
    3,365
    
    
    
    3,222Operating income (loss)
    
    
    140
    
    
    
    97
    
    
    
    224
    
    
    
    302Consolidated SegmentsRevenue
    
    $
    3,343
    
    
    $
    2,821
    
    
    $
    7,955
    
    
    $
    5,991Operating loss
    
    
    (1,695
    )
    
    
    (2,407
    )
    
    
    (2,289
    )
    
    
    (4,744
    )
 A reconciliation of consolidated segment data above to consolidated loss
follows: Consolidated segments operating loss
    
    $
    (1,695
    )
    
    $
    (2,407
    )
    
    $
    (2,289
    )
    
    $
    (4,744
    )Corporate expenses
    
    
    (176
    )
    
    
    (202
    )
    
    
    (420
    )
    
    
    (439
    )Consolidated operating loss
    
    
    (1,871
    )
    
    
    (2,609
    )
    
    
    (2,709
    )
    
    
    (5,183
    )Interest expense
    
    
    (5
    )
    
    
    
    
    
    
    (8
    )
    
    
    (5
    )Investment income (loss)
    
    
    (371
    )
    
    
    205
    
    
    
    (371
    )
    
    
    3,669Equity of affiliates
    
    
    51
    
    
    
    34
    
    
    
    13
    
    
    
    (33
    )Other income (loss)
    
    
    (9
    )
    
    
    187
    
    
    
    50
    
    
    
    214Loss before taxes
    
    
    (2,205
    )
    
    
    (2,183
    )
    
    
    (3,025
    )
    
    
    (1,338
    )Income tax provision (benefit)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (104
    )Net loss
    
    $
    (2,205
    )
    
    $
    (2,183
    )
    
    $
    (3,025
    )
    
    $
    (1,234
    )Depreciation and AmortizationInformation Technology
    
    $
    95
    
    
    $
    158
    
    
    $
    218
    
    
    $
    307Industrial Products
    
    
    42
    
    
    
    28
    
    
    
    83
    
    
    
    50Consolidated segments
    
    
    137
    
    
    
    186
    
    
    
    301
    
    
    
    357Corporate
    
    
    6
    
    
    
    8
    
    
    
    14
    
    
    
    14Consolidated depreciation and
amortization
    
    $
    143
    
    
    $
    194
    
    
    $
    315
    
    
    $
    371Capital ExpendituresInformation Technology
    
    $
    (15
    )
    
    $
    31
    
    
    $
    1
    
    
    $
    71Industrial Products
    
    
    35
    
    
    
    29
    
    
    
    104
    
    
    
    45Consolidated segments
    
    
    20
    
    
    
    60
    
    
    
    105
    
    
    
    116Corporate
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3Consolidated capital expenditures
    
    $
    20
    
    
    $
    60
    
    
    $
    105
    
    
    $
    119
 June 30, 2004
    
    December 31, 2003(unaudited)Identifiable AssetsInformation Technology
    
    $
    5,992
    
    
    $
    4,740Industrial Products
    
    
    2,344
    
    
    
    2,024Consolidated segments
    
    
    8,336
    
    
    
    6,764Corporate
    
    
    3,734
    
    
    
    6,978Consolidated assets
    
    $
    12,070
    
    
    $
    13,742
 Page 7




---



##### Table of Contents



12.
    
    Commitments and Contingencies- In May 2004, our QS Technologies
subsidiary was awarded a $1.1 million, multi-year software contract with a
state agency that required a performance bond for 10 percent of the
contract value. No revenue has yet been recognized on this contract. To
secure the performance bond, we agreed to guarantee the $115,000 value of
the bond in the event that QS Technologies defaults on the contract.
Initially, we secured the guarantee with a bank Certificate of Deposit in
the amount of $115,000. In July 2004, we substituted a standby letter of
credit that is tied to our $1.5 million bank line of credit for the CD and
converted the CD into unrestricted cash. Based on the successful
performance record of QS Technologies over a twenty-year period, we do not
presently believe the guarantee will be paid; thus no amount has been
accrued with respect to this guarantee. 
 Item 2. Managements Discussion and Analysis or Plan of Operations In addition to historical information, this Form 10-QSB may contain
forward-looking statements relating to ISC. All statements, trend analysis 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, and that actual results may differ materially from those
contemplated by such forward-looking statements including those factors
described below under Factors That May Affect Future Performance. 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, in ISCs Form 10-K for the year ended December 31,
2003 as filed with the Securities and Exchange Commission. Overview Our consolidated subsidiaries operate in two industry segments: Information
Technology Products and Services and Industrial Products. Included in the
Information Technology sector are QS Technologies, Inc. (software for public
health and human services), VISaer, Inc. (software for maintenance, repair and
overhaul operations in the commercial aviation industry) and CoreCard Software,
Inc. (software for managing credit and debit cards). The Industrial Products
segment includes ChemFree Corporation (bio-remediating parts washers). We derive our product revenue from sales of software licenses in our
Information Technology sector and sales and leases of equipment and supplies in
our Industrial Products sector. Our service revenue consists of fees for
implementation, consulting, training, maintenance and support for software
products in our Information Technology sector. Our consolidated revenue is the
aggregate of the revenue generated at our four subsidiary companies. 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.
    
    Economic and marketplace trends may impact our subsidiaries
differently or not at all and two of our software subsidiaries have very
limited experience in their marketplaces which makes it difficult to
identify and evaluate trends that may impact their business.
    
    Two of our software subsidiaries, CoreCard Software and VISaer, have
been involved in major new product development initiatives for the past
three years and have limited experience delivering and installing their
new products at customer sites, making it difficult to predict with
certainty when they will recognize revenue on individual software
contracts.
    
    Our subsidiaries are relatively small in revenue size and, in the
Information Technology sector, license revenue at a subsidiary in a
given period may consist of a relatively small number of contracts.
Consequently, even small delays in a subsidiarys delivery under a
software contract (which may be out of its control) could have a
significant and unpredictable impact on consolidated revenue that we can
recognize in a given quarterly or annual period. The second quarter results reflect a continued deferral of approximately $7.4
million of revenue and approximately $4.9 million in profit contribution. Our
VISaer subsidiary completed a significant software contract in the quarter
ended June 30, 2004. Recognition of revenue was deferred until the third
quarter of 2004 due to the delivery of a then optional specified Page 8




---



##### Table of Contents



upgrade right in the contract in July 2004. Recognition of this revenue will
have a significant positive impact on the companys result of operations for
the third quarter ended September 30, 2004. Frequently we recognize consolidated operating losses on a quarterly and annual
basis and are likely to do so in the future from time to time. Our operating
expenses consist of the aggregate of our four subsidiaries expenses and the
corporate office expenses. Our ChemFree and QS Technologies subsidiaries
usually generate an operating profit on an annual basis but our early stage
subsidiaries, VISaer and CoreCard, presently do not, mainly due to significant
research and development expense that is invested to complete their new product
offerings and the deferral of revenue recognition until such products are
delivered to customers. Depending upon the size and number of software
licenses recognized in a particular period and the level of expenses incurred
to support development and sales activities, our subsidiaries may report
operating profits on an irregular basis as they build their customer base. A
significant portion of our subsidiaries expense is related to personnel which
is relatively fixed in the short-term and we continually evaluate and strive to
balance our financial resources with the resources required to complete
products under development and support our subsidiaries customers. For these
and other reasons, our operating profits or losses may vary from quarter to
quarter and at the present time are generally not predictable with any degree
of certainty. We also frequently generate income or losses from other sources and we may do
so from time to time in the future. Occasionally we derive income from sales of
holdings in affiliate and other minority-owned companies or we 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
affiliate companies accounted for by the equity method. The timing and amount
of gain or loss recognized as a result of a sale or the amount of equity in the
income or losses of affiliates generally are not under our control and are not
necessarily indicative of future results, either on a quarterly or annual
basis. For instance, as explained in Notes 3 and 4 to the financial
statements, in the quarter ended June 30, 2004, we recognized a gain of
$256,000 on the unsolicited sale of our holdings in Cirronet, Inc. and also
wrote down the value of our holdings in Ardext Technologies, Inc. by $627,000
yielding a net investment loss of $371,000 for the quarter. Neither of these
events was predictable by us as to amount or timing with any degree of
confidence in advance. Similarly, as explained in Note 5 to the financial
statements, based on information provided to us, we believe that the value of
our 19 percent interest in ISC Guernsey Ltd. is worth more than its carrying
value of $31,000 as of June 30, 2004. However, in accordance with GAAP, cost
basis investments are not written up for expected cash distributions because we
do not exert any control over ISC Guernsey. As such we will record the
positive financial impact of these expected cash distributions when ISC
Guernsey actually makes cash distributions from the proceeds of its asset sale
to us. From information communicated to us by ISC Guernsey, we believe this
will occur over the next several quarters and will aggregate between $3.5
million and $4.5 million, dependent on the business needs of ISC Guernsey.
Based on our current projections, we do not expect to have any tax
withholdings or to incur a tax liability
related to these cash distributions. The operating loss in the second quarter of 2004 and the continued deferral of
the profit contribution from the VISaer software contract until the third
quarter of 2004 resulted in negative shareholders equity of $1,975,000 as of
June 30, 2004. This negative equity position was a very short-term situation
that has already been rectified in July 2004 with the recognition of the VISaer
contract. Shareholders equity will be further improved when cash
distributions related to the ISC Guernsey sale are recorded, at least part of
which is expected to occur in the quarter ended September 30, 2004. In recent years, most of our cash has been generated on an irregular basis from
sales of our investments in early stage technology companies. We have used a
significant amount of the cash received from these sales to support the
operations of our CoreCard Software and VISaer subsidiaries. We do not expect
the same level of cash investment in the future in these two entities and
presently believe that customer payments on existing and pending software
contracts will be sufficient to fund most of the expenses of VISaers
operations and a growing portion of CoreCards expenses. If the business or
cash flow of either subsidiary does not develop as anticipated, we would expect
to reduce the personnel and overhead expenses to align their cost structure
with their business resources and prospects. 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, 2004
was $3,343,000 and $7,955,000, a 19 percent and 33 percent increase,
respectively, compared to the same periods in 2003. Revenue from products,
which includes sales of equipment in our Industrial Products segment as well as
software license fees related to the Information Technology segment, was
approximately the same in the quarter ended June 30, 2004 as in the second
quarter of 2003 but 43 percent higher in the six month period of 2004 compared
to the six month period in 2003. The increase in product revenue Page 9




---



##### Table of Contents



in the year-to-date period in 2004 is due mainly to the recognition of
$1,377,000 in software license revenue at the CoreCard subsidiary due to
completion of its first major customer installation in the first quarter of
2004. Revenue from ChemFree products represented over 90 percent of our
product revenue in the three month periods ended June 30, 2004 and June 30,
2003 and in the six month period ended June 30, 2003. In the six month period
ended June 30, 2004, ChemFree revenue represented 67 percent of product
revenue, mainly because the $1,377,000 CoreCard license revenue is included in
the six month period. Revenue from ChemFree products increased approximately
five percent during the three and six month periods ended June 30, 2004
compared to the same periods in 2003 mainly due to increased sales of fluid and
filter consumables and greater revenue from leased equipment. We expect that revenue from software licenses at our software subsidiaries in
the second half of 2004 will surpass that in the first half of 2004, although
the specific timing of revenue recognition for software licenses is difficult
to predict with certainty due to a number of factors such as acceptance
criteria or scheduling delays due to customer changes in funding or program
priorities. As explained earlier in this discussion, our VISaer subsidiary
completed a major software contract during the second quarter of 2004 but the
$7.4 million in revenue and $4.9 million of gross profit associated with the
contract was deferred until the third quarter of 2004. Accordingly, we will
record an unusually high level of revenue and the associated gross profit in
the third quarter ended September 30, 2004. At the end of June 30, 2004, the
net deferred revenue of $4.9 million associated with this contract is included
on our balance sheet as a liability in the category of current deferred
revenue. Service revenue increased by fifty-three percent and eighteen percent in the
three and six month periods ended June 30, 2004, respectively, compared to the
same periods in 2003. The principal factor contributing to the second quarter
increase in 2004 was a higher level of professional services at the CoreCard
and VISaer subsidiaries whereas the increase during the six month period of
2004 as compared to the first six months of 2003 was related mainly to higher
levels of annual maintenance contracts at all three software subsidiaries due
to a larger installed base of customers. Cost of Revenue- In the three and six month periods ended June 30, 2004, total
cost of revenue was 45 percent and 42 percent, respectively, of consolidated
revenue compared to 60 percent and 59 percent in the comparative periods in
2003.  
    
    Cost of product revenue was 45 percent of product revenue in the
three month period ended June 30, 2004 compared to 50 percent in the
corresponding three month period in 2003. The principal reason for the
difference is due to the fact that ChemFrees revenue mix in the second
quarter of 2004 included a higher proportion of sales of fluid and
filter consumables which have a lower cost than parts washer machines.
Year-to-date, cost of product revenue was 36 percent of product revenue
in the six month period ended June 30, 2004 compared to 47 percent in
the same period last year, principally because software license revenue,
which has a low cost of sales compared to the ChemFree industrial
products, represented 33 percent of product revenue in the six month
period in 2004 compared to 8 percent in the corresponding period in
2003.
    
    Cost of service revenue (which relates to the software subsidiaries
only) was 45 percent in the three month period ended June 30, 2004
compared to 77 percent in the corresponding period in 2003. For the six
month period ended June 30, 2004, cost of service revenue was 52 percent
of service revenue compared to 74 percent of service revenue in the same
period of 2003. The period-to-period decrease in total cost of service
revenue of $85,000 and $325,000 in the three and six month periods of
2004, respectively, is due to lower costs and more efficient utilization
of professional services employees at the VISaer subsidiary, partially
offset by a slight increase in personnel costs at the QS Technologies
subsidiary due to a larger installed base of customers requiring support
and maintenance services. Operating Expenses- In the three and six month periods ended June 30, 2004,
total consolidated operating expenses decreased by one percent and four
percent, respectively, compared to the corresponding periods in 2003. There
were no material differences in consolidated marketing, general and
administrative and research and development expenses in the three and six month
periods ended June 30, 2004 compared to the same periods in 2003. Investment Income- In the three and six month periods ended June 30, 2004, we
recorded a net investment loss of $371,000 representing an investment gain of
$256,000 on the sale of our Cirronet stock offset by a write-down of our
investment and notes receivable totaling $627,000 related to Ardext
Technologies, Inc., as more fully explained in Notes 3 and 4 to the financial
statements. In the corresponding periods of 2003, we recorded net investment
gains of $205,000 and $3,669,000, respectively, comprising investment income
related to the settlement of an escrow fund in the first and second quarters of
2003 related to the sale of our ownership interest in PaySys International,
Inc., offset in part by a write-down in the first quarter of 2003 to reduce the
carrying value of our investment in RF Solutions, Inc., as more fully explained
in Note 3 to the consolidated financial statements in our Form 10-K for 2003. Equity Earnings (Losses) of Affiliate Companies-On a quarterly basis, we
recognize our pro rata share of the earnings or losses of affiliate companies
that we record on the equity method. We recorded $51,000 and $13,000 in net
equity in income Page 10




---



##### Table of Contents



of affiliate companies in the three and six month periods ended June 30, 2004,
respectively, compared to $34,000 net equity in income and $33,000 net equity
in losses of affiliate companies in the corresponding periods in 2003. These
results include our pro rata share of the net earnings and losses reported by
five affiliate companies (Alliance Technology Ventures, CoreXpand, Riverside
Software, Cirronet and Horizon Software) in 2004 and four affiliate companies
(CoreXpand, Riverside Software, MediZeus, and Horizon Software) in 2003. Other Income (Expense), Net- We recorded $9,000 in other expense and $50,000
in other income in the three and six month periods ended June 30, 2004,
respectively, compared to other income of $187,000 and $214,000 in the
corresponding periods in 2003. In 2004 year-to-date, these amounts include
recognition of deferred gain of $33,000 related to a VISaer product line sale
in July 2000 and $17,000 in other miscellaneous income, the majority of which
relates to foreign currency exchange gains. In 2003, the year-to-date amounts
include principally recognition of deferred gain related to the VISaer product
line sale in July 2000, approximately $64,000 in non-recurring miscellaneous
income and $75,000 in foreign currency exchange gain. Income Taxes- We did not accrue for any income tax liability in year-to-date
2004 because we currently estimate the company will not incur income tax
liability in 2004 and we believe the deferred tax assets should be fully
reserved given their character and our recent losses. The income tax benefit
of $104,000 recorded in 2003 reflects a refund of alternative minimum taxes
paid by the VISaer subsidiary in a prior year. Liquidity and Capital Resources Our cash balance at June 30, 2004 was $547,000 compared to $1,133,000 at
December 31, 2003. The $586,000 decrease in the cash balance was principally
related to operations. The companys principal uses of cash during the six
months ended June 30, 2004 were for corporate office expenses of $420,000, and
an increase of $1,127,000 in accounts receivable reflecting more revenue booked
by ChemFree, QS Technologies and VISaer in the later part of the second quarter
of 2004 as compared to December of 2003. Sources of cash included $1,073,000
from the sale of our investment in Cirronet, Inc., $120,000 from drawings under
our bank line of credit, a net increase of $1,301,000 in total deferred revenue
related to payments by customers for software licenses and annual software
maintenance contracts (mainly at our VISaer subsidiary) for which the related
revenue will be recognized later in 2004, offset by a reduction of $206,000 in
accrued payroll mainly for bonuses earned in 2003 and paid in 2004 and other
minor items. We have several near-term sources of cash to support any negative cash flow
from consolidated operations, including the cash distributions expected related
to the ISC Guernsey transaction as explained in Note 5 to the statements and
periodic draws against our bank line of credit, if needed. As of June 30,
2004, the outstanding balance on our line of credit was $370,000 and the
availability under the line of credit was $1,015,000. Our bank line of credit
expires in September 2004 and we expect to renew the line on similar terms and
conditions. However, there can be no assurance that the line will be renewed
on terms that are acceptable to us, if at all. However, even without the
availability of the bank line of credit, we believe the anticipated cash
distributions from the ISC Guernsey transaction and cash flow from consolidated
operations will provide for our cash requirements for at least the next twelve
months. In addition, if our subsidiaries business operations or cash flows do
not develop as anticipated, we would expect to reduce personnel and overhead
expenses to align their cost structure with their business resources and
prospects. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of
operations are 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, 2003. Reference is also made to the discussion of the application of these
critical accounting policies and estimates contained in Managements Discussion
and Analysis in our annual report on Form 10-K for 2003. During the six months
ended June 30, 2004, 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 for 2003. Page 11




---



##### Table of Contents



Long-Term Contractual Obligations We entered into a new five-year facility lease on our principal facility in
Norcross, GA during the quarter ended June 30, 2004 which is included in the
table below for our operating lease obligations. We have no long-term
contractual obligations other than the operating leases. Payment Due By PeriodContractual Obligations
    
    
    
    
    
    Less than
    
    1-3
    
    3-5
    
    More than(in thousands)
    
    Total
    
    1 year
    
    years
    
    years
    
    5 yearsOperating Lease Obligations
    
    $
    2,349
    
    
    
    264
    
    
    
    1,056
    
    
    
    865
    
    
    
    164
 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, capital expenditures or resources or results of operations. Factors That May Affect Future Operations Our 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 any certainty
mainly because several of our subsidiaries are early stage companies with
limited revenue and experience in their respective markets, all are relatively
small in size and, particularly for our software subsidiaries, revenue tends to
be associated with fewer and larger sales than for our industrial products
subsidiary. Thus 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:  
    
    Delays in software development projects which could cause our
customers to delay implementations, delay payments or cancel contracts,
which would increase our costs and reduce our revenue.
    
    Undetected software errors which 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) which
may cause prospective customers to choose an alternative product
solution, resulting in lower revenue and profits (or increased losses).
    
    The inability of our CoreCard or VISaer subsidiaries to establish a
base of referenceable customers for their new product offerings,
resulting in lower revenue and profits (or increased losses), increased
cash needs and possibly leading to restructuring or cutting back of the
subsidiarys operations.
    
    Failure of our products specifications and features to achieve
market acceptance.
    
    Delays in anticipated customer payments for any reason which would
increase our cash requirements and possibly our losses.
    
    Declines in performance, financial condition or valuation of
minority-owned companies which 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.
    
    A reversal of the improving trend in the commercial aviation industry
worldwide which could impact VISaers short-term customer purchases,
thus increasing its losses and need for cash.
    
    The relatively limited sales and marketing experience of our VISaer
and CoreCard subsidiaries in their respective markets could cause them
to misinterpret or fail to interpret or adjust to a trend in the market
or to underestimate the sales cycle time frame.
    
    In the Industrial Products market, failure by ChemFree to achieve
anticipated growth in the European market or in the domestic national
accounts and non-automotive markets for their products could cause lower
than anticipated sales and profits.
    
    An insufficient number of potential CoreCard customers decide to
purchase and run an in-house software system and instead choose to
outsource their account transaction processing which could result in low
revenue, increased costs and greater cash requirements. Page 12




---



##### Table of Contents




    
    Budget reductions by state and local governments for information
technology products that delay award of contracts or implementations for
our QS Technologies subsidiary.
    
    The recurrence of some incidence such as the SARS epidemic in 2003
that has a negative impact on the aviation industry, resulting in delays
in contract awards and customer implementations similar to the
unforeseen negative impact on cash and profits experienced by VISaer
during the SARS epidemic.
    
    Other general economic and political conditions, particularly those
that may cause international business and domestic government customers
to delay or cancel software purchase decisions. 
 Item 3. Controls and Procedures As of the end of the period covered by this report, the company carried out an
evaluation, under the supervision and with the participation of the companys
management, including the Companys Chief Executive Officer and Chief Financial
Officer, of the effectiveness of the design and operation of the companys
disclosure controls and procedures pursuant to Rule 13a-15(b) under the
Exchange Act. Based upon that evaluation, the Chief Executive Officer and
Chief Financial Officer concluded that the companys disclosure controls and
the procedures are effective. There were no changes in the companys internal
controls over financial reporting or in other factors identified in connection
with this evaluation that occurred during the period covered by this report
that has materially affected, or is reasonably likely to materially affect, the
companys internal control over financial reporting. 
 Part II. OTHER INFORMATION 
 Item 4. Submission of Matters to a Vote of Security Holders At ISCs Annual Meeting of Shareholders on May 27, 2004, the shareholders
reelected Dr. John B. Peatman to serve as a director of the company until the
Annual Meeting of Shareholders in 2007. Dr. Peatman was elected by a vote of
4,126,500 votes FOR and 41,949 votes WITHHELD. 
 Item 6. Exhibits and Reports on Form 8-K We filed the following reports on Form 8-K during the quarter ended June 30,
2004:  
    
    Form 8-K filed on May 11, 2004 disclosing that the Board of Directors
has approved a waiver to the companys Code of Ethics with respect to a
lease transaction between the company and ISC Properties, LLC, a company
controlled by the companys Chairman and Chief Executive Officer.
    
    Form 8-K filed on May 12, 2004 furnishing a press release on May 12,
2004 announcing our financial results for the three month period ended
March 31, 2004. The following exhibits are filed or furnished with this report: 3(i)
    
    Amended and Restated Articles of Incorporation of the Registrant dated
November 14, 1991, as amended November 25, 1997. (Incorporated by
reference to Exhibit 3.1 to the Registrants Annual Report on Form 10-K
for the year ended December 31, 1991 and to Exhibit 3.1 to the
Registrants Report on Form 8-K dated November 25, 1997.)3(ii)
    
    Bylaws of the Registrant dated June 6, 1997. (Incorporated by reference
to Exhibit 3(ii) of the Registrants Form 10-K/A for the year ended
December 31, 1997.)4.1
    
    Rights Agreement dated as of November 25, 1997 between the Registrant and
American Stock Transfer & Trust Company as Rights Agent. (Incorporated by
reference to Exhibit 4.1 of the Registrants Report on Form 8-K dated
November 25, 1997 and filed on December 16, 1997.)4.2
    
    Form of Rights Certificate. (Incorporated by reference to Exhibit 4.2 of
the Registrants Report on Form 8-K dated November 25, 1997 and filed on
December 16, 1997.)31.1
    
    Certification of Chief Executive Officer Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer and Chief Financial Officer
furnished as required by Section 906 of the Sarbanes-Oxley Act of 2002.
 Page 13




---



##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, hereunto duly authorized. INTELLIGENT SYSTEMS CORPORATIONRegistrantDate: August 13, 2004
    
    By:
    
    /s/ J. Leland StrangeJ. Leland StrangeChief Executive Officer, PresidentDate: August 13, 2004
    
    By:
    
    /s/ Bonnie L. HerronBonnie L. HerronChief Financial Officer
 Page 14