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  **UNITED STATES SECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549****FORM 10-KSB**(Mark One)   þ **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934****For the fiscal year ended December 31, 2006****OR**   o **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934****For the transition period from                      to                     ****Commissionfile number 1-9330****INTELLIGENT SYSTEMS CORPORATION** (Name of small business issuer in its charter)   **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)Issuer’s telephone number: **(770) 381-2900****Securities registered pursuant to Section 12(b) of the Act:**   **Title of each class** **Name of each exchange on which registered**   **Common Stock, $.01 par value** **American Stock Exchange****Securities registered pursuant to Section 12(g) of the Act:**NoneCheckwhether the issuer (1)  filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the past 12 months (or for such shorter period thatthe registrant was required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes þ No oCheck ifthere is no disclosure of delinquent filers in response to Item 405 of Regulation S-Bcontained in this form, and no disclosure will be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part III of this Form10-KSB or any amendment to this Form 10-KSB. þIndicated by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o No þState issuer’s revenue for its most recent fiscal year. $14,460,000State the aggregate market value of the voting and non-voting common equity held by non-affiliatescomputed by reference to the price at which the common equity was sold, or the average bid andasked price of such common equity, as of a specified date within the past 60 days. (See definitionof affiliate in Rule 12b-2 of the Exchange Act.)As of February 28, 2007, 4,478,971 shares of Common Stock were outstanding. Theaggregate market value of the Common Stock held by non-affiliates of the registrant on February 28,2007 was $9,985,000 (computed using the closing price of the Common Stock on February 28, 2007 asreported by the American Stock Exchange).DOCUMENTS INCORPORATED BY REFERENCE: Portions of the registrant’s Proxy Statement for the AnnualMeeting of Shareholders are incorporated by reference in Part III hereof.TransitionalSmall Business Disclosure Format:  Yes o No þ  
 

 
**TABLE OF CONTENTS**           **PAGE****Part I**             Item 1. Description of business  3 2. Description of property  8 3. Legal proceedings  8 4. Submission of matters to a vote of security holders  8        **Part II**             5. Market for common equity and related stockholder matters  9 6. Management’s discussion and analysis or plan of operation  9 7. Financial statements  17 8. Changes in and disagreements with accountants on accounting and financial disclosure  17 8A. Controls and procedures  18        **Part III**             9. Directors, executive officers, promoters, control persons and corporate governance: compliance with  Section 16(a) of the Exchange Act  18 10. Executive compensation  18 11. Security ownership of certain beneficial owners and management and related stockholder matters  19 12. Certain relationships and related transactions, and director independence  19 13. Exhibits  19 14. Principal accountant fees and services  21 Signatures  22  EX-10.9 FIFTH MODIFICATION TO LOAN DOCUMENTS EX-21.1 LIST OF SUBSIDIARIES OF THE REGISTRANT EX-23.1 CONSENT OF TAUBER & BALSER, P.C. EX-31.1 SECTION 302 CERTIFICATION OF CEO EX-31.2 SECTION 302 CERTIFICATION OF CFO EX-32.1 SECTION 906 CERTIFICATION OF CEO AND CFO
 

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**PART I****Forward-Looking Statements**  *In addition to historical information, this**Form 10-KSB**may containforward-looking statements relating to Intelligent Systems Corporation (“ISC”).All statements, trend analysis and other information contained in the followingdiscussion relative to markets for our products and trends in revenue, grossmargins and anticipated expense levels, as well as other statements includingwords such as “anticipate”, “believe”, “plan”, “estimate”, “expect”, “likely” and“intend”, and other similar expressions constitute forward-looking statements.Prospective investors are cautioned that any such forward-looking statements arenot guarantees of future performance and involve risks and uncertainties, and thatactual results may differ materially from those contemplated by suchforward-looking statements. A number of the factors that we believe could impactour future operations are discussed in Management’s Discussion and Analysis inItem 6 of this**Form 10-KSB**. ISC undertakes no obligation to update or revise itsforward-looking statements to reflect changed assumptions, the occurrence ofunanticipated events or changes in future operating results.***ITEM 1. DESCRIPTION OF BUSINESS****Overview**Intelligent Systems Corporation, a Georgia corporation, and its predecessor companies have operatedsince 1973 and its securities have been publicly traded since 1981. In this report, sometimes weuse the terms “company”, “we”, “ours” and similar words to refer to Intelligent SystemsCorporation. Our executive offices are located at 4355 Shackleford Road, Norcross, Georgia 30093and our telephone number is (770) 381-2900. Our Internet address is www.intelsys.com. We publishour Securities and Exchange Commission (“SEC”) reports on our website as soon as reasonablypracticable after we file them with or furnish them to the SEC, and shareholders may access anddownload these reports free of charge.Since the early 1980’s, we have conducted our operations principally through majority ownedsubsidiaries or minority owned affiliates to which we devote extensive management resources.Depending upon the needs of each company, we may undertake a variety of roles including day-to-daymanagement of operations, board of director participation, financing, market planning, strategiccontract negotiations, personnel and administrative roles, and similar functions. Currently, oursubsidiary and affiliate companies are primarily in the information technology industry(principally software for business applications) although one of our subsidiary companies is in theindustrial products industry. A common thread in our corporate and subsidiary efforts is bringingnew applications of technologies to business markets. Thus, an important element of our businessmodel is being proactive in identifying emerging technologies, markets, or companies that mayadvance our interests. From time to time, we see promising companies or technologies that may becandidates for acquisition or that we believe are in line with our corporate or subsidiarystrategic direction, thus warranting an investment of our time and money in order to build futureshareholder value. In addition, from time to time, we may sell one of our companies or we mayincrease our investment in a less-than-wholly owned company. As a result, our ownership positionin a given company may change from time to time, our results of operations vary considerably fromquarter-to-quarter and year-to-year, and our past performance is not necessarily indicative offuture results.**Financial Reporting**We consolidate the results of operations of companies in which we own a majority interest or overwhich we exert control. We generally account for investments by the equity method for minorityowned companies (i) in which we own 20 to 50 percent and over which we do not exert control or (ii)entities that are organized as partnerships or limited liability companies. In general, under theequity method, we report our pro rata share of the income or loss generated by each of thesebusinesses as equity income/losses of affiliates on a quarterly basis. These equity losses andincome decrease or increase, respectively, the cost basis of our investment. Privately ownedcorporations in which we own less than 20 percent of the equity are carried at the lower of cost ormarket. We do not mark up the value of privately-owned businesses even when they raise money athigher valuations. We are often actively engaged in managing strategic and operational issues withour non-consolidated companies and devote significant resources to the development of theirbusinesses.Intelligent Systems Corporation
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**Industry Segments Overview**Our consolidated companies operate in two industry segments: Information Technology Products andServices and Industrial Products. The Information Technology Products and Services segmentincludes our VISaer, Inc. and CoreCard Software, Inc. subsidiaries and the Industrial Productssegment includes ChemFree Corporation. As of December 31, 2006, we own 100 percent of ChemFree, 79percent of VISaer and 87 percent of CoreCard Software. On July 31, 2006, we sold the business ofour QS Technologies subsidiary and accordingly, we have classified the QS operations asDiscontinued Operations.Operations in the Information Technology Products and Services segment are involved in the design,development and marketing of application software products that are used by business customers andgovernment agencies to manage aspects of their operations. Our software products are typicallysold in competitive bids with relatively long sales and implementation cycles. We receive softwarelicense fees that vary depending upon the number of licensed users and the number of softwaremodules licensed with total contract revenue typically ranging from $100,000 to over $1 million.We also derive service revenue from implementation, customization, training and support services.Depending on the contract terms and customer implementation and testing schedule, which aretypically outside of our control, the timing of revenue recognition is not generally within ourcontrol or determinable by us with any degree of certainty in advance.The Industrial Products segment includes the design, assembly and sale of equipment and associatedsupplies that are used by commercial, industrial, military and government agencies to maintain andservice machinery or vehicles used in their operations. Our assembled products are shipped toresellers or direct to customer sites and do not require set-up or on-site support from us. Unitpricing varies by model but typical end-user prices are less than $2,000 per unit. Customerspurchase replacement supplies from us after the sale. In some cases, we provide equipment tomulti-site corporate users under leases which typically range between three and four years.Our individual operations in both segments are relatively small in size and are subject toconsiderable fluctuation in revenue and profitability, which in turn affects our consolidatedrevenue and margins. The business in our segments is not seasonal on a consolidated basis althoughthere is generally some slowdown in ChemFree’s European business in late summer. The businessdiscussion which follows contains information on products, markets, competitors, research anddevelopment and manufacturing for our operating subsidiaries, organized by industry segment and bycompany. For further detailed financial information concerning our segments, see Note 16 in theaccompanying Notes to Consolidated Financial Statements. For further information about trends andrisks likely to impact our business, please refer to Management’s Discussion and Analysis in Item 6of this Form 10-KSB.**Industry Segment: Information Technology Products and Services*****VISaer,Inc.***— VISaer develops, sells and supports software for the world-wide aircraft maintenanceand engineering industry. VISaer offers a fully integrated, real time software solution that helpsaviation customers efficiently and cost-effectively manage the technical, commercial andoperational aspects of their maintenance, repair and overhaul (“MRO”) operations while also meetingregulatory requirements, such as those of the Federal Aviation Administration. Headquartered inAndover, Massachusetts, VISaer also has employees in England to support customer service and salesactivities in Europe and a small technical and project management team in Australia. VISaer’sproduct offering includes the following major components: technical records planning andmanagement, MRO operations, materials management, production scheduling, commercial operations andfinancial management. In 2004 and 2005, VISaer focused on developing and delivering to initialcustomers the “go-live” Version 3.4 release of its software, which was achieved in late 2005. In2006, VIsaer continued its focus on product improvements and go-live support of its existingcustomers. By the end of 2006, several customer sites were live, Version 3.5 with some significantenhancements was released and several additional customer sites had signed contracts to implementVersion 3.5 in 2007. In 2007, VISaer expects to remain focused on product improvements and go-livesupport with the goal of having most of the VISaer customer base live and referenceable on Version3.5 and its follow-on versions. VISaer did not allocate significant resources to new sales andmarketing programs in 2006 although it delivered a significant amount of professional services andmaintenance support to its existing base of customers in 2006 and expects to do so again in 2007.Regulatory requirements continue to dictate that airlines manage their MRO processes carefully.There is increased pressure to improve and automate MRO business processes, materials and assetutilization, record-keeping and compliance reporting. VISaer’s software products provide acomprehensive, cost-effective way to do so. We believe significant sales opportunities exist inNorth America as wellas in the Asian Pacific, Latin American and Chinese markets. These markets include MRO serviceoutsourcing companies, low-cost airlines, small to mid-size domestic regional airlines and ITservices hosting companies.Intelligent Systems Corporation
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VISaer markets and sells its software in both domestic and international markets. Internationalcustomers have traditionally represented a significant part of VISaer’s revenue. The markets forVISaer products include both airline-owned maintenance and engineering shops as well as third partyMRO organizations. VISaer’s sales are direct to the customer with VISaer providing a turnkeysolution that covers project management, software, system implementation, training, consulting andsupport. In most cases, sales are made in response to competitive bids and requests for proposalsand have sales cycles of six to eighteen months with implementation periods of an additional six toeighteen months. VISaer provides a full suite of implementation services and post-sales supportand maintenance activities under annual contracts, as well as customization and professionalservices on an as needed basis. VISaer has a number of competitors, some of whom offer MROsoftware as part of a broader enterprise resource planning package and who have more financialresources, larger customer bases and greater market coverage than VISaer. Other competitors aresmall players focused on MRO solutions with resources similar to VISaer. VISaer competes on thebasis that its software provides extensive product functionality using Web-native technology;provides low cost-of-ownership; includes integrated modules offering a complete software andservice solution; and runs on industry standard technology platforms. VISaer believes that itsVersion 3.5 Web-native software is a strong competitive offering, although any technical or qualityproblems that arise could delay the product’s implementation and negatively impact customeracceptance and references**.*****CoreCardSoftware, Inc.***— CoreCard Software was spun off from our former affiliate company, PaySysInternational, in April 2001. CoreCard designs, develops, and markets software to accountsreceivable businesses, banks, credit unions, and retailers to manage their credit and debit card,prepaid cards, merchant, fleet, loyalty, and accounts receivable accounts. CoreCard products allowfinancial institutions and commercial customers to optimize their account management systems,improve customer retention, lower operating costs and create greater market differentiation.CoreCard’s feature-rich, browser-based financial software allows customers to automate, streamlineand optimize business processes associated with the set-up, administration and management of creditcard, merchant and loan accounts, to process transactions and to generate reports and statementsfor these accounts. Because CoreCard’s products are designed to run on PC-based servers, ratherthan mini or mainframe computers, customers benefit from a lower overall cost-of-ownership,scalability, faster implementations and increased flexibility to respond to market conditions.CoreCard’s product functionality includes embedded multilingual, multi-currency support, web-basedinterface, real-time processing, complex rules-based authorizations, account hierarchies, andflexible, customer-defined pricing and payment terms.CoreCard’s initial target markets include accounts receivable businesses, prepaid cards issuers,small and mid-size banks, business to business payment processors, and retail and private-labelissuers in the United States and in emerging international markets. The company expects that asignificant amount of its business will come from international markets, particularly with respectto banks and similar institutions, that are less inclined to outsource their processing than arethe domestic US banks. CoreCard competes with third-party card processors, larger and moreestablished software suppliers, and a number of software solution providers that offer more limitedfunctional modules. CoreCard has relatively limited sales and marketing experience compared tosome of its competitors and potential customers may choose to outsource their account transactionprocessing rather than acquire software to manage their transactions in-house, which could impactnegatively the total addressable market for CoreCard. One challenge facing most new softwarecompanies is overcoming the reluctance of risk-adverse financial customers to acquire software froma company with limited customer installations. Certain of CoreCard’s competitors, includingprocessors, may have significantly more financial, marketing and development resources than doesCoreCard and have large, established customer bases often tied to long-term contracts. CoreCardbelieves it can compete successfully in its selected markets by providing customers with anext-generation technology platform, lower overall cost-of-ownership, greater system flexibility,multilingual/multicurrency capabilities and more customer-driven marketing options. Furthermore,we believe that CoreCard’s products can be configured and deployed to address problems in managingcertain types of financial transactions that are not being addressed by other alternatives. Likemost emerging software companies, CoreCard is focusing its extensive development and limited salesactivities on establishing a growing base of referenceable customers.CoreCard licenses its software products typically for a one-time license fee or, in some cases, foran initial installation charge and a per transaction fee. It provides maintenance and supportservices under annual contracts, as well as professional services for customization, implementationand training activities. Generally, CoreCard expects to sell its products directly to customers inthe domestic U.S. but may work with a small number of resellers and third parties in internationalmarkets to identify, sell and support targeted opportunities. CoreCard completed the initialfunctionality in its core software modules, CoreISSUETM, CoreFRAUDTM and CoreCOLLECTTM in 2003,developed further enhancements in 2004, and in 2005 delivered its first CoreACQUIRETM functionalityas well as product enhancementsto its existing products. In 2006, CoreCard signed several new license contracts that are expectedto be delivered in 2007. In 2007, CoreCard expects to develop additional software functionalityand continue to add aIntelligent Systems Corporation
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limited number of domestic and international customers, including its firstsignificant bank installation. However, delays or problems in completing, testing and deliveringCoreCard’s new products could adversely affect customer acceptance and references.**Industrial Products Segment*****ChemFreeCorporation***— Our only subsidiary in the Industrial Products segment is ChemFreeCorporation. ChemFree designs, manufactures and markets a line of parts washers under theSmartWasher® trademark. SmartWashers® use an advanced bio-remediation system that cleansautomotive and machine parts without using hazardous, solvent-based chemicals. Typically, theSmartWasher® system consists of a molded plastic tub and sink, recirculating pump, heater, controlpanel, filter with microorganisms, and aqueous-based degreasing solutions. Unlike traditionalsolvent-based systems, there are no regulated, hazardous products used or produced in the processand the SmartWasher® system is completely self-cleaning. ChemFree sells replacement fluid andfilters to its customers on a regular basis after the initial parts washer sale.ChemFree’s markets include the automotive, transportation, industrial and military markets. Theautomotive market includes companies and governmental agencies with fleets of vehicles, individualand chain automobile service centers and auto parts suppliers. The industrial market includescustomers with machinery that requires routine maintenance, such as power plants and tool andequipment rental companies. Military applications include vehicle, aircraft and weaponsmaintenance. ChemFree sells its products directly to high volume customers as well as throughseveral distribution channels, including international distributors in Europe, Canada, LatinAmerica and the Pacific Rim. ChemFree also sells under a General Services Administration scheduleto government agencies. Because ChemFree sells in part through large national non-exclusivedistributors such as NAPA and Barnes Group in the United States and exclusive distributors incertain international markets, its results could be impacted negatively if one or more of suchdistributors stops carrying ChemFree products. One of ChemFree’s domestic distributors represented11 percent and nine percent of our consolidated revenue in 2006 and 2005, respectively, and 20percent and 23 percent of our Industrial Products Segment revenue in 2006 and 2005, respectively.Part of ChemFree’s revenue is derived from multi-year lease contracts under which ChemFree providesSmartWashers® and supplies to nationwide chains of auto repair shops, such as Firestone, Tires Plusand Pep Boys. In 2006, ChemFree increased its sales to large corporate customers on a direct basisusing a manufacturer’s representative firm and expects to continue to further develop this saleschannel in addition to its reseller distribution network.ChemFree competes with larger, established companies that offer solvent-based systems, othercompanies that offer aqueous-based systems, and hazardous waste hauling firms. Although smallerthan the established solvent-based firms, ChemFree believes it is competitive based on productfeatures, positive environmental impact, desirable health and safety features, less burdensomeregulatory compliance, and cleaning performance. ChemFree believes that overall market demand forits products could increase significantly if environmental regulations in the U.S. and overseasprohibiting or restricting the use of solvent-based products, with which ChemFree’s productscompete, continue to become increasingly stringent and such regulations are enforced effectively bystate, local and national governments. Moreover, ChemFree believes there is an opportunity toprovide services, either directly or through third parties, to certain customers that prefer tooutsource periodic fluid and filter replenishment activities.Customer and warranty service, typically covering a one-year period, generally consists of shippinga replacement part to the customer or returning a defective product to either ChemFree or itsdistributors and dealers. ChemFree subcontracts the manufacturing of major sub-assemblies built toits specifications to various manufacturers and performs final assembly and testing at its ownfacility. While it is possible to acquire subassemblies from multiple sources, ChemFree frequentlycontracts with a single source for certain components in order to benefit from lower prices andconsistent quality, especially with respect to molded plastic parts which are produced usingChemFree owned molds. In some cases, manufacturers of molded parts establish minimum quantitiesthat may require ChemFree to purchase and carry in inventory a larger number of such parts thanChemFree would otherwise order without such minimum quantities. In the past two years, the cost ofcertain parts have increased significantly due to increases in the cost of plastic materialsresulting from higher oil prices.Intelligent Systems Corporation
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**Incubator Program**For over fifteen years, we have operated the Gwinnett Innovation Park (formerly called theIntelligent Systems Incubator) at our corporate facility in a suburb of Atlanta, Georgia. Inexchange for a monthly facility fee, incubator companies have access to resources such as officespace, conference facilities, telecommunication and network infrastructure, business advice andplanning, and a network of professional services. Income from incubator companies reduces ourtotal corporate facility and personnel costs. Because we have a large facility, we are able tooffer the benefits of the incubator program to companies in which we have no ownership interest.We view this program as a way to stay abreast of new business opportunities and trends which may beof benefit to our company while simultaneously contributing to our local community in a verypositive way.**Minority-Owned Partner Companies**A common thread in our corporate and subsidiary efforts is bringing new applications oftechnologies to business markets. Thus, an important element of our business model is beingproactive in identifying emerging technologies, markets, or companies that may advance ourinterests. Accordingly, we seek to identify companies that we believe are involved in promisingtechnologies or markets with good growth potential. From time to time, we have acquired aninvestment in such companies and expect to continue to do so as a regular part of our strategy.Typically, these companies are privately held, early stage companies in technology-related fields.We are often actively involved in helping the companies develop and implement their business plans.Currently, our largest investment is a 25.5 percent interest in NKD Enterprises, LLC (dbaCoreXpand), a software services company with an e-commerce application that allows customers tocentralize and control purchases of supplies and consumables through an online company “store”.CoreXpand is located in our Gwinnett Innovation Park. In 2006, we sold our 17 percent interest inHorizon Software International, as explained in Note 3 to the Consolidated Financial Statements.**Research and Development**We spent $5.7 million and $6.1 million in the years ended December 31, 2006 and 2005, respectively,on company sponsored research and development. During the years ended December 31, 2006 and 2005,almost all of our consolidated research and development expense related to VISaer and CoreCard,with the balance spent for research at ChemFree. Although the absolute dollar amount of researchand development declined in 2006, the number of employees involved in company-wide research anddevelopment increased in 2006 as the company added development and testing employees in Romania andIndia for CoreCard and VISaer projects, at a lower cost per employee than the domestic workforce.**Patents, Trademarks and Trade Secrets**Our ChemFree subsidiary has 11 U.S. patents issued and 15 patents in foreign jurisdictions issuedand pending covering various aspects of the design and construction of the SmartWasher® system andthe process of bioremediation used in the SmartWasher® system. ChemFree considers these patents animportant component of its overall business strategy. Furthermore, ChemFree considers theproprietary formulation of the chemicals used in its fluids, which ChemFree protects as a tradesecret, to be an important intellectual property asset and competitive advantage. CoreCard has oneU.S. patent issued and several pending patent applications in the U.S. and Europe covering aspectsof its core software engine. It may be possible for competitors to duplicate certain aspects ofour products and processes even though we regard such aspects as proprietary. We have registeredwith the U.S. Patent and Trademark Office and various foreign jurisdictions numerous trademarks andservice marks for our products. We believe that an active trade secret, trade name, trademark, andcopyright protection program is important in developing and maintaining brand recognition andprotecting our subsidiaries’ intellectual property. Our companies presently market their productsunder trademarks and service marks such as SmartWasher®, OzzyJuice®, OzzyBoosterTM ChemFree®,VISaerTM, CoreENGINETM, CoreISSUETM, CoreCOLLECTTM, and others.**Personnel**As of February 28, 2007, we had 231 total and full-time equivalent employees in our company(including our majority-owned subsidiaries in the United States and foreign countries). Ouremployees are not represented by a labor union, we have not had any work stoppages or strikes andwe believe our employee relations are good.Intelligent Systems Corporation
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**Financial Information About Geographic Areas**Refer to Note 14 to the Consolidated Financial Statements for financial information in response tothis item. We do not believe there are any specific risks attendant to our foreign operations thatare significantly different than the general business risks discussed elsewhere in this AnnualReport.**ITEM 2. DESCRIPTION OF PROPERTY**At February 28, 2007, we have leases covering approximately 61,000 square feet in Norcross, GA, and12,000 square feet in Andover, MA, to house our product development, manufacturing, sales, serviceand administration operations, as well as product development offices in Romania and India. Suchleases expire at various dates through July 2010. Approximately 10 percent of the space we leasein Norcross is subleased to non-affiliated businesses in our small business incubator. We believeour facilities are adequate for the foreseeable future.**ITEM 3. LEGAL PROCEEDINGS**Our ChemFree subsidiary devotes considerable resources, including management time and legal fees,to protect its rights in various patents and related contracts and expects to continue to do so inthe foreseeable future. From time to time, these efforts involve initiating legal action such asthe two actions described in this section.In December 2004, ChemFree filed a patent infringement action against J. Walter Co. Ltd. and J.Walter, Inc. in the United States Court for the Northern District of Georgia. The complaintalleges that certain of the defendant’s products infringe various U.S. patents held by ChemFree andseeks a ruling to compel defendant to cease its infringing activities. The defendant has assertedvarious defenses and a counterclaim. The case is pending and no trial date has been set. Whilethe resolution and timing of any legal action is not predictable, ChemFree believes it hassufficient grounds to prevail in these actions although there can be no assurance that the disputeswill be resolved in its favor.In 2005, ChemFree participated in an arbitration proceeding versus ZYMO International, Inc.(“Zymo”), a patent co-owner, that resulted in the issuance of a favorable arbitration ruling forChemFree. In December 2005, ChemFree initiated a proceeding under the Federal Arbitration Act inthe United States District Court for the Northern District of Georgia to obtain judicialconfirmation of the arbitration ruling and to arbitrate a number of other disputes between ChemFreeand Zymo that fall within the arbitration provisions of the co-ownership agreement between theparties. In July 2006, the judge issued a ruling confirming ChemFree’s request to compelarbitration. In the fourth quarter of 2006, an arbitrator was assigned and the parties submittedtheir pleadings to the arbitrator. On February 6, 2007, the arbitrator issued a ruling which foundin ChemFree’s favor on all substantive issues. Among other items, the arbitrator ruled thatChemFree was not in breach of the co-ownership agreement and that Zymo must pay an aggregate of$156,000 to ChemFree for its share of legal expenses and damages for lack of cooperation in patentmatters covered by the co-ownership agreement. The arbitrator also ruled that, if Zymoparticipates in the J. Walter patent infringement action described above after June 30, 2007, itmust pay an additional $27,500 to ChemFree.From time to time we are or may become a party to a number of other legal matters arising in theordinary course of business. It is management’s opinion that none of these other matters will havea material adverse impact on our consolidated financial position or results of operations.**ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**We did not submit any matter to a vote of our shareholders during the fiscal quarter endedDecember 31, 2006.Intelligent Systems Corporation
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**PART II****ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS****Market Information**Our common stock is listed and traded on the American Stock Exchange (“AMEX”) under the symbol“INS”. The following table sets forth, for the periods indicated, the range of high and low salesprices for our common stock as reported by AMEX.                   **2006** **2005****Year Ended December 31,** **High** **Low** **High** **Low** 1st Quarter $2.76  $2.12  $4.52  $2.02 2nd Quarter  2.40   1.95   2.54   1.96 3rd Quarter  2.70   1.92   3.20   2.01 4th Quarter  3.30   2.26   3.61   2.00 We had 344 shareholders of record as of February 28, 2007. This number does not includebeneficial owners of our common stock whose shares are held in the names of various dealers,clearing agencies, banks, brokers and other fiduciaries. The company has in the past paid cashdividends from time to time on an irregular basis but has not in the past paid regular dividendsand does not expect to pay any regular dividends in the foreseeable future. Under our revolvingline of credit facility, we are precluded from paying dividends without obtaining consent from thebank. See Note 6 to the Consolidated Financial Statements.**Equity Compensation Plan Information**The following table sets forth information regarding our equity compensation plans as of December31, 2006:               **Number of securities to**      **be issued upon** **Weighted average exercise**    **exercise of outstanding** **price of outstanding** **Number of securities**  **options, warrants and** **options, warrants and** **remaining available****Plan category** **rights** **rights** **for future issuance** Equity compensationplans approved bysecurity holders  117,666  $1.92   350,000 Equity compensationplans not approvedby security holders  86,000  $3.04   108,000  **Total**  203,666  $2.39   458,000  Refer to Note 14 to the Consolidated Financial Statements for a description of the company’sequity compensation plans.**Recent Sales of Unregistered Securities**There have been no sales of unregistered securities during the period covered by this report.**Repurchases of Securities**The company did not repurchase any of its own shares of common stock during the fourth quarter of2006.**ITEM 6. MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION****Critical Accounting Policies and Estimates**The discussion and analysis of our financial condition and results of operations is based upon ourConsolidated Financial Statements which have been prepared in accordance with accounting principlesgenerally accepted in the United States. The preparation of these financial statements requires usto make estimates and judgments that affect the reported amount of assets, liabilities, revenuesand expenses. We consider certain accounting policies related to revenue recognition, valuation ofacquiredIntelligent Systems Corporation
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intangibles and impairment of long-lived assets, and valuation of investments to becritical policies due to the estimation processes involved in each. For a detailed description onthe application of these and other accounting policies, see Note 1 to the Consolidated FinancialStatements.***RevenueRecognition***— Product revenue consists of fees from software licenses and sales or leasesof industrial products. Service revenue consists of fees for implementation, consulting, training,customization, reimbursable expenses, maintenance and support for software products.We recognize revenue for industrial products when products are shipped, at which time titletransfers to the customer, and there are no remaining future obligations. As an alternative toselling the product, on occasion we may lease our equipment. For leased equipment, we recognizerevenue monthly at the contracted monthly rate during the term of the lease.We recognize software fees in accordance with Statement of Position (“SOP”) No. 97-2, “SoftwareRevenue Recognition”, as amended by SOP No. 98-9, “Software Revenue Recognition, With Respect toCertain Transactions”. Under SOP 97-2, we recognize software license fees when the followingcriteria are met: (1) a signed contract is obtained; (2) delivery of the product has occurred; (3)the license fee is fixed or determinable; and (4) collectibility is probable. Additionally,license fee revenue is not recognized until there are no material uncertainties regarding customeracceptance, cancellation provisions, if any, have expired and there are no significant vendorobligations remaining. SOP No. 98-9 requires recognition of revenue using the “residual method”when (1) there is vendor-specific objective evidence of the fair values of all undelivered elementsin a multiple-element arrangement that is not accounted for using long-term contract accounting;(2) vendor-specific objective evidence of fair value does not exist for one or more of thedelivered elements in the arrangement; and (3) all revenue recognition criteria in SOP No. 97-2other than the requirement for vendor-specific objective evidence of the fair value of eachdelivered element of the arrangement are satisfied. Under the residual method, the fair value ofthe undelivered elements is deferred and the remaining portion of the license fee is recognized asrevenue. For those contracts that contain significant production, modification and/orcustomization, software license fees are recognized utilizing Accounting Research Bulletin (“ARB”)No. 45, “Long-term Construction Type Contracts”, using the relevant guidance in SOP No. 81-1,“Accounting for Performance of Construction Type and Certain Production Type Contracts”.For percentage of completion contracts, we measure the progress toward completion and recognize thesoftware license fees based upon input measures (i.e. in the same proportion that the amount oflabor hours incurred to date bears to the total estimated labor hours required for the contract).If reliable estimates cannot be determined, we follow the completed contract method. Under thecompleted contract method, all revenue is deferred until the customer has accepted the software andany refund rights have expired. The company is presently utilizing the completed contract methodbecause current contracts are for new software products for which it does not have an historicalbasis on which to prepare reliable estimates.A number of internal and external factors could affect our estimates related to software contracts,including labor rates, utilization of resources, changes in specifications or testing requirements,unforeseen technical problems and delays caused by customer issues such as lack of resources orchange in project priorities. If we do not accurately estimate the resources required or the scopeof work to be performed, or we do not manage the contract properly, in future periods we may needto restate revenues, to defer revenue longer than originally anticipated or to incur additionalcost which would impact our margins and reported results.***Valuationof Investments***— We hold minority interests in non-publicly traded companies whose valuesare difficult to determine and are based on management’s estimate of realizability of the value ofthe investment. Future adverse changes in market conditions, poor operating results, lack ofprogress of the underlying investee company or its inability to raise capital to support itsbusiness plan could result in investment losses or an inability to recover the current carryingvalue of the investment. Some of the companies in which we hold non-control, minority positionsare backed by venture capital, and the value of our investment may be impacted by the amount, termsand valuation of the investee’s financial transactions with third party venture funds or the termsof the sale of the investee company to a third party. Our policy with respect to minorityinterests is to record an impairment charge when we believe an investment has experienced a declinein value that is other than temporary. For instance, this could occur if the investee company issold for less than our pro rata carrying value or if a new round of funding is at a lower valuationthan our investment was made or if the financing terms for the new investors (such as preferenceson liquidation) otherwise reduce the estimated value of our investment. We do not write-up thecarrying value of our investments based on favorable changes or financial transactions. At leastquarterly, we review our investments to determine any impairment in their carrying value and wewrite-down any impaired asset at quarter-end to our best estimate of its current realizable value.Any such charges could have a material adverse impact on our financial condition or results ofoperations and are generally not predictable or quantifiable in advance.Intelligent Systems Corporation
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***Valuationof Intangibles***— From time to time in the past, we have acquired companies and we may doso in the future. Occasionally, we may increase our ownership or control of an entity from aminority to a majority position, which generally is treated as an acquisition for accountingpurposes. Purchase accounting for an acquisition requires use of accounting estimates andjudgments to allocate the purchase price to the fair market value of the assets and liabilitiespurchased. Our business acquisitions may result in the allocation of a portion of the purchaseprice to goodwill and other intangible assets. Additionally, we may acquire an intangible assetthrough other means, such as occurred in August 2004, when our ChemFree subsidiary acquiredintellectual property assets in settlement of long-standing legal matters. In 2006 or 2005, we didnot acquire any companies and we did not record any write-downs with respect to goodwill or otherintangibles.The determination of the value of intangible assets requires management to make estimates andassumptions that affect the amount of future period amortization expenses and possible impairmentexpense that we will incur. Sometimes we use the services of a third party appraiser to provide avaluation of material intangible assets. However, often the acquired company is a small entitywith limited operating history on which to base future projections and thus valuing the assetsrequires the use of estimates which are very subjective. Furthermore, the period over which weamortize certain intangibles may change based on future conditions and consequently we may need toadjust the intangible value and/or amortization period, which could require us to increase theamount of amortization expense we record each period or to take a non-cash charge to reduce thevalue of the intangible. On at least an annual basis, we review the values assigned to long-livedassets, generally using an estimate of the undiscounted cash flows of the entity over the remaininglife of the asset. Any resulting impairment could require a write-down that would have a materialadverse impact on our financial condition or results of operations.**Overview**Our consolidated subsidiaries operate in two industry segments: Information Technology Products andServices and Industrial Products. Included in the Information Technology Products and Servicessector are VISaer, Inc. (software for maintenance, repair and overhaul operations in the commercialaviation industry) and CoreCard Software, Inc. (software for managing financial transactionsinvolving credit accounts). The Industrial Products segment includes ChemFree Corporation(bio-remediating parts washers). We sold our former QS Technologies business in July 2006 and haveaccounted for the QS operations as Discontinued Operations in the Consolidated Financial Statementsfor 2006 and 2005.We derive our product revenue from sales of software licenses in our Information Technology sectorand sales and leases of equipment and supplies in our Industrial Products sector. Our servicerevenue consists of fees for implementation, consulting, customization, training, maintenance andsupport for software products in our Information Technology sector. Our consolidated revenue isthe aggregate of the revenue generated at our three subsidiary companies. Our revenue fluctuatesfrom period to period and our results are not necessarily indicative of the results to be expectedin future periods. Period-to-period comparisons may not be meaningful and it is difficult topredict 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 impactconsolidated revenue or be offset by an opposing change at anothersubsidiary.**•** Economic and marketplace trends may impact our subsidiariesdifferently or not at all. Moreover, our software subsidiaries donot have extensive experience in their marketplaces which makes itdifficult to identify and evaluate trends that may impact theirbusiness.**•** Our software subsidiaries, CoreCard Software and VISaer, have beeninvolved in major new product development initiatives for at leastthe past five years and have limited experience delivering andinstalling their current product releases at customer sites,making it difficult to predict with certainty when they willrecognize revenue on individual software contracts.**•** Our subsidiaries are relatively small in revenue size and, in theInformation Technology sector, license revenue at a subsidiary ina given period may consist of a relatively small number ofcontracts. Consequently, even minor delays in a subsidiary’sdelivery under a software contract (which may be out of theircontrol) could have a significant and unpredictable impact on theconsolidated revenue that we can recognize in a given quarterly orannual period.**•** Acquisitions or sales of subsidiaries may affect our revenue andexpense levels, as occurred in 2006 with the sale of our QSbusiness.**•** Customers may decide to postpone or cancel a plannedimplementation of our software for any number of reasons, whichmay be unrelated to our software features or contract performance,but which may affect the amount, timing and characterization ofour deferred and/or recognized revenue.Intelligent Systems Corporation
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Frequently we recognize consolidated operating losses on a quarterly and annual basis and arelikely to do so in the future from time to time. Our operating expenses consist of the aggregateof our three subsidiaries’ expenses and the corporate office expenses. Our ChemFree subsidiarygenerates an operating profit on an annual basis but our earlier stage subsidiaries, VISaer andCoreCard, are not consistently profitable on a quarterly or annual basis, mainly due to significantresearch and development expense that is invested to complete their new product offerings and thedeferral of revenue recognition until such products are delivered to customers. Depending upon thesize and number of software licenses recognized in a particular period and the level of expensesincurred to support development and sales activities, our subsidiaries may report operating profitson an irregular basis, if at all, as they build their customer base. A significant portion of oursubsidiaries’ expense is related to personnel which is relatively fixed in the short-term. Wecontinually evaluate and strive to balance our financial resources with the resources required tocomplete products under development and support our subsidiaries’ customers. For these and otherreasons, our operating profits or losses may vary from quarter to quarter and at the present timeare generally not predictable with any degree of certainty.We also frequently generate income or losses from non-consolidated companies and we may do so fromtime to time in the future. Occasionally we derive income from sales of holdings in affiliate andother minority-owned companies or we record a charge if we believe the value of a non-consolidatedcompany is impaired. We also recognize on a quarterly basis our pro rata share of the income orlosses of affiliate companies accounted for by the equity method. The timing and amount of gain orloss recognized as a result of a sale or the amount of equity in the income or losses of affiliatesgenerally are not under our control and are not necessarily indicative of future results, either ona quarterly or annual basis.In recent years, most of our cash has been generated on an irregular basis from sales of ourinvestments or subsidiaries. We have used a significant amount of the cash received from thesesales to support the operations of our CoreCard Software and VISaer subsidiaries. We do not expectto invest the same level of cash in the future in these two entities and presently believe thatcustomer payments on existing and pending software contracts will be sufficient to fund most of thecash requirements of the VISaer and a growing portion of the CoreCard operations in 2007, althoughthe timing of cash receipts is expected to be irregular on a monthly basis. If the business orcash flow of either subsidiary does not develop as anticipated, we may need to scale back orrestructure their operations, borrow under our line of credit or find alternative sources offunding.Under current SEC rules and regulations, beginning with our 2007 fiscal year we will be required tocomply with the requirements related to internal control over financial reporting of Section 404 ofthe Sarbanes-Oxley Act of 2002 with respect to management’s assessment of internal controls. Weexpect to incur substantial expenses and management and staff time related to compliance withSection 404, including increased audit fees, legal fees, and other administrative expenses. We mayencounter unexpected delays in implementing changes related to our internal control over financialreporting, and we expect that Section 404 compliance efforts may constitute a significant diversionof management time and attention. Therefore, we cannot be certain about the timing of thecompletion of our evaluation, testing and/or remediation actions related to internal control overfinancial reporting, nor can we predict what impact, it any, these activities will have on ouroperations. We are a small company with limited resources, and our efforts to timely comply withSection 404 may constitute a significant strain on these resources. Any failure to timely complywith Section 404 could result in sanctions or other penalties, which could adversely affect ourbusiness or financial results.As explained in our previously filed Forms 10-QSB during 2006, we received a letter from TheAmerican Stock Exchange (“AMEX”) notifying us that AMEX had determined that we do not meet certainof the AMEX continued listing standards. Specifically, AMEX noted we were not in compliance withSection 1003(a)(ii) of the AMEX Company Guide because our shareholders’ equity was less than $4.0million and we had sustained losses in three out of four of our most recent fiscal years. In May2006, we submitted a plan to AMEX to achieve compliance with the continued listing standards and onJuly 21, 2006, AMEX notified us that it had determined we made a reasonable demonstration in theplan of our ability to regain compliance with the continued listing standards by October 27, 2007.As a result of the QS and Horizon sales explained in Notes 2 and 3 to the Consolidated FinancialStatements, as of September 30, 2006 and December 31, 2006, our shareholders’ equity has exceededthe minimum standard. The AMEX rules require two consecutive quarters of shareholders’ equity inexcess of the minimum of $4.0 million before AMEX will determine whether the Company has regainedcompliance with continued listing standards. Accordingly, we will ask AMEX to consider and rule onwhether we have regained compliance with continued listing standards promptly following the filingof this Form 10-KSB.Intelligent Systems Corporation
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**Results of Operations**The following discussion should be read in conjunction with the Consolidated Financial Statementsand the Notes to Consolidated Financial Statements presented in this Annual Report. As explainedin Note 2 to the Consolidated Financial Statements, we sold our former QS Technologies business inJuly 2006 and have accounted for the QS operations as Discontinued Operations in the ConsolidatedFinancial Statements for both 2006 and 2005. Accordingly, management’s discussion of the resultsof operations does not include the QS operations in the discussion of continuing operations foreither period presented.**2006 Compared to 2005*****Revenue***— Total revenue for the year ended December 31, 2006 was $14.5 million compared to $12.9million for the prior year, an increase of 12 percent. Revenue from product sales increased threepercent from $8.2 million in 2005 to $8.4 million in 2006, and service revenue increased 29percent, from $4.7 million in 2005 to $6.1 million in 2006.*Product revenue*includes sales of industrial products by our Industrial Products segment as well assoftware licenses by our Information Technology segment subsidiaries. The increase in productrevenue in 2006 compared to 2005 is the net effect of a $1.7 million (28 percent) increase in salesof industrial products offset in part by a decline of $1.5 million in software license revenue.**•** Sales by our ChemFree subsidiary in the Industrial Productssegment grew by 28 percent in 2006 as compared to 2005. Almostall of the year-to-year growth occurred in the domestic U.S.market with revenue from international markets remainingessentially flat year-to-year. In 2006, ChemFree had asignificant increase in the number of SmartWasher® parts washersold in the U.S. market through both its distributor network and,more significantly, through its expanded direct channel to severallarge corporate customers. While ChemFree’s efforts in its firstfull year of sales through a direct sales channel were successful,the company expects the volume and timing of future sales to largecorporate customers to vary considerably from period to period.ChemFree’s fluid and filters sales to the installed domestic baseof customers increased approximately 13 percent in 2006 ascompared to 2005, due to a larger installed base of customers thatpurchases such consumable supplies. Revenue from leased equipmentin the domestic market also increased 6 percent compared to the2005 level.**•** License revenue generated by our Information Technology segmentwas $1.5 million lower in 2006 than in 2005 mainly due to fewernew licenses sold by our VISaer subsidiary in 2006 as compared to2005. In 2006, most license revenue resulted from additionallicenses sold to VISaer’s existing customer base. Both our VISaerand CoreCard subsidiaries had expected to recognize revenue in2006 on several new customer licenses. Revenue related to theseprojects has been deferred and is now expected to be recognized in2007. As we have frequently cautioned, a number of factors, someof which may be outside of our control, can cause delays indelivery of our software and implementation by the customer. Withmission-critical, complex software systems such as is sold byCoreCard and VISaer, customer requirements, available resourcesand testing cycles may increase the scope and length of time tocomplete the project beyond our original estimates.*Service revenue*generated by our Information Technology subsidiaries increased by 29 percent ($1.3million) in 2006 as compared to 2005. This year-to-year increase is primarily attributable to asingle, multi-year contract at the VISaer subsidiary that was completed and recognized in early2006.In 2006, revenue from sales in our Industrial Products segment represented 92 percent ofconsolidated product revenue and 54 percent of total consolidated revenue, as compared with 74percent of consolidated product revenue and 54 percent of total consolidated revenue in 2005. Thisyear-to-year change in revenue mix is principally related to the significant increase in ChemFree’sdomestic sales of parts washers and consumable supplies and a decline in software license revenuerecognized at our Information Technology companies.***Cost of Revenue***— A comparison of the cost of revenue between 2006 and 2005 is influencedsignificantly by the change in revenue mix between years as described above. Total cost of revenuewas $7.2 million (50 percent of total revenue) in 2006 compared to $6.0 million (46 percent oftotal revenue) in 2005, an increase of 20 percent.**•** Cost of *product*sales in 2006 was $4.4 million (52 percent of total product revenue),compared to $3.4 million (41 percent of total product revenue) in 2005. The differencebetween 2006 and 2005 is due to the proportionately greater amount of product revenuegenerated by our industrial products, which have a higher cost of sales than do our softwarelicense products. In addition, ourindustrial products cost as a percent of sales increased in 2006 as compared to 2005 due tohigher directIntelligent Systems Corporation
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  materials cost and freight-related expenses in 2006. The company experienced anincrease in the cost of certain of its plastics components and in freight costs for incomingmaterials, both related to the increase in the price of oil. These increased costs are likelyto continue in the foreseeable future. The company has implemented price increases for certainof its industrial products, which, depending on the product mix and sales volume, may offset tosome extent the negative impact of the cost of goods increase.**•** Cost of *service*sales (which relates to the Information Technology subsidiaries only) was$2.8 million (46 percent of service revenue) in 2006, as compared to $2.6 million (56 percentof service revenue) in 2005. The reduction in cost of services in 2006 as a percentage ofservice revenue is due to the fact that VISaer had lower personnel costs and more favorablepricing on maintenance and professional services contracts that were delivered in 2006 ascompared to 2005.***Operating Expenses***— Consolidated operating expenses were two percent lower in 2006 than in 2005,with reductions in research and development expenses offset by increases in general andadministrative expenses. Marketing expenses increased by 13 percent ($243,000) year-to-year,mainly due to increased sales commission and advertising expenses at the ChemFree subsidiaryrelated to an increased volume of domestic sales. General and administrative expense in 2006 wasessentially the same as in 2005, with increased costs for accounting, audit and bonuses at thecorporate offices in 2006, offset by reduced legal expenses at ChemFree and administrative costs atVISaer. ChemFree’s legal expenses were lower in 2006 than in 2005 because a favorable arbitrationaward of $107,000 for legal expenses was credited against 2006 actual expenses. Refer to Note 9 tothe Consolidated Financial Statements for details of the arbitration award. Consolidated researchand development expense was $431,000 less in 2006 than in 2005, decreasing from $6.1 million to$5.7 million due to a combination of factors, including a reduction in the use of third partycontractors and the number of domestic personnel at VISaer, offset in part by an increase in costsat the CoreCard subsidiary as the company expanded significantly the number of technical employeesat its India subsidiary. Although the total number of employees and R&D costs increased at ourCoreCard subsidiary, the offshore resources at the company’s offices in Romania and India lower ouraverage employee cost and increase the productivity of the entire workforce.***Operating Loss***— Our loss from operations was $4.0 million in 2006 compared to $4.6 million in2005, a reduction of 13 percent. In 2006, all of the loss from operations is attributable to theCoreCard and corporate operations, offset in part by improved profitability at our VISaer andChemFree subsidiaries.***Interest Income****—*We recognized net interest income of $57,000 and $22,000 in 2006 and 2005,respectively. The increase in 2006 reflects interest earned on the notes receivable related to thesales of our QS Technologies business and our Horizon Software International investment, asdescribed in Notes 2 and 3 to the Consolidated Financial Statements, offset in part by a higherlevel of borrowings under our bank line of credit during the first seven months of 2006.***Investment Income***— We recognized $2.5 million and $1.9 million in net investment income in 2006and 2005, respectively. The 2006 investment income reflects mainly the gain of $2.6 million on thesale of our Horizon Software International investment, offset in part by a charge of $98,000 toreduce the carrying value of our investment in Paymetric, a privately held company. Included ininvestment income in 2005 is a gain of $2.1 million related to our holdings in ISC Guernsey, offsetby investment losses and reserves totaling $234,000 related to our holdings in AderisPharmaceuticals, Lancope and Anadigics (RF Solutions, Inc.). Refer to Note 3 to the ConsolidatedFinancial Statements for more details on the transactions noted in this section.***Equity Earnings of Affiliate Companies***— We recognize our pro rata share of the earnings or lossesof affiliate companies that we record on the equity method. The amount recorded is not generallypredictable or indicative of future results because it is the aggregate earnings (losses) ofseveral companies operating in different industries and thus aggregate earnings (losses) aresubject to considerable fluctuation from quarter-to-quarter and year-to-year. In 2006 and 2005, werecorded $374,000 and $366,000, respectively, in net equity earnings of three affiliate companies(Horizon Software International, NKD Enterprises and Alliance Technology Ventures). We did notrecord equity income related to Horizon Software International after the August 31, 2006 sale ofour interest.***Other Income, net —***In 2005, we recorded $20,000 in other expense, the majority of which is due tocurrency exchange losses.***Income taxes***— We did not accrue for any income tax liability in 2006 and we believe our deferredtax assets should be fully reserved given their character and our historical losses.Intelligent Systems Corporation
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**Discontinued Operations*****NetIncome from Discontinued Operations*****—**The amounts recorded in 2006 and 2005 reflect the resultsof operations of the QS Technologies subsidiary which has been classified as a discontinuedoperation as a result of the sale of the QS business, as disclosed in more detail in Note 2 to theConsolidated Financial Statements.***Gainon Sale of Discontinued Operations***— We recorded a gain of $4.9 million on the sale of the QSbusiness.**Liquidity and Capital Resources**Our cash balance at December 31, 2006 was $2.1 million, an increase of $1.8 million compared to ourcash balance of $378,000 at December 31, 2005. During the year ended December 31, 2006, ourprincipal sources of cash were $3.0 million from sales of investments, of which $2.9 millionrelated to the sale of our Horizon Software investment, $1.9 million from the sale of our QSTechnologies business, aggregate borrowings under our line of credit of $2.3 million, $385,000 indistributions from minority owned investments and $143,000 in principal payments on notesreceivable. During 2006, we used $2.4 million of that cash to pay down our line of credit in fulland used approximately $3.5 million in the aggregate to support our CoreCard subsidiary’s U.S. andinternational operations, and to a lesser extent, our ViSaer subsidiary operations.In recent years, most of our cash has been generated on an irregular basis from sales of assets, asexemplified by the QS Technologies and Horizon Software International transactions in 2006. Wehave used a significant amount of the cash received from such sales to support the operations ofour CoreCard and VISaer subsidiaries. In 2006, we used more cash than originally forecasted tosupport CoreCard and VISaer because we experienced delays in meeting certain milestones thattrigger customer payments under several contracts. The delays resulted from a combination offactors including complex customer requirements that resulted in more time than estimated tocomplete initial statements of work, longer than expected review and approval cycles by largecustomers, and more time than anticipated for testing and quality assurance cycles. In 2007, we donot expect the same level of cash investment in these two subsidiaries. We believe our estimateson the timing of milestone payments on contracts should be more reliable because the scope of thecontracts is more certain and contracts are closer to completion. Based on recent trends andcurrent projections, we presently believe that scheduled customer payments on existing and pendingsoftware contracts will be sufficient to fund substantially all of VISaer’s and a significantportion of CoreCard’s operations on an annual basis, although monthly cash flows are expected to beirregular. A significant amount of our consolidated expenses are related to personnel, none ofwhom are represented by a union or have employment contracts.In January 2007, we received cash of $2.9 million representing payment in full of the note andinterest receivable related to the sale of our Horizon Software International investment in August2006. We currently project that we will have sufficient liquidity from cash on hand, payments onnotes receivable related to the QS Technologies’ sale and milestone payments on software contractsto meet our operating needs in the foreseeable future. We renewed our $2.0 million line of crediton December 1, 2006 and will use it if necessary to support any short-term cash needs, although wedo not expect significant, if any, borrowings in the foreseeable future. Delays in meeting projectmilestones or software delivery commitments could cause customers to postpone payments and increaseour need for cash during 2007. Presently, we do not believe there is a material risk tosuccessfully performing under these 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 wecould require more cash than planned.Beyond 2007, we currently expect that liquidity will continue to improve and consolidatedoperations will generate sufficient cash to fund their requirements with use of our credit facilityto accommodate short-term needs. Other long-term sources of liquidity include potential sales ofinvestments, subsidiaries or other assets although the timing and amount of any such transactionsare uncertain and, to the extent they involve non-consolidated companies, generally not within ourcontrol.**Off-Balance Sheet Arrangements**We do not currently have any off-balance sheet arrangements that are reasonably likely to have acurrent or future material effect on our financial condition, liquidity or results of operations.Intelligent Systems Corporation
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**Factors That May Affect Future Operations**Future operations in both the Information Technology and Industrial Products segments are subjectto risks and uncertainties that may negatively impact our future results of operations or projectedcash requirements. It is difficult to predict future quarterly and annual results with anycertainty mainly because our software subsidiaries are early stage companies with limited revenueand experience in their respective markets, all are relatively small in size and, particularly inthe Information Technology sector, revenue tends to be associated with fewer and larger sales thanin the Industrial Products segment. Thus any trend or delay that affects even one of oursubsidiaries could have a negative impact on the company’s consolidated results of operations orcash requirements on a quarterly or annual basis. In addition, the carrying value of ourinvestments is impacted by a number of factors which are generally beyond our control since we aretypically a non-control shareholder in a private company with limited liquidity.Among the numerous factors that may affect our consolidated results of operations or financialcondition are the following:**•** Delays in software development projects which could cause our customers to delay implementations, delay payments orcancel contracts, which would increase our costs and reduce our revenue.**•** Undetected software errors or poor quality control which may delay product releases, increase our costs, result innon-acceptance of our software by customers or delay revenue recognition.**•** Competitive pressures (including pricing, changes in customer requirements and preferences, and competitor productofferings) which may cause prospective customers to choose an alternative product solution, resulting in lower revenueand profits (or increased losses).**•** The inability of our CoreCard or VISaer subsidiaries to establish a base of referenceable customers for their newproduct offerings, resulting in lower revenue and profits (or increased losses), increased cash needs and possiblyleading to restructuring or cutting back of the subsidiary’s operations.**•** Failure of our products’ specifications and features to achieve market acceptance.**•** The inability of our software subsidiaries to retain key software developers and managers who have accumulated years ofknow-how in our target markets and company products, or failure to attract and train a sufficient number of newsoftware developers and testers to support our product development plans and customer requirements at projected costlevels.**•** Further increases in the price of oil, which could increase ChemFree’s product costs and which could affect VISaer’sresults if potential aviation customers delay or cancel purchases of software or services in the face of decliningindustry trends or poor financial condition.**•** Delays in anticipated customer payments for any reason which would increase our cash requirements and possibly ourlosses.**•** Declines in performance, financial condition or valuation of minority-owned companies which could cause us towrite-down the carrying value of our investment or postpone an anticipated liquidity event, which could negativelyimpact our earnings and cash.**•** Increased operating expenses and diversion of resources related to compliance with the internal control over financialreporting requirements of Section 404 of the Sarbanes-Oxley Act of 2002.**•** Negative trends affecting the commercial aviation industry worldwide which could impact VISaer’s short-term customerpurchases, thus increasing its losses and need for cash.**•** In the Industrial Products market, failure by ChemFree to protect its intellectual property assets or to prevail inlegal matters described in Item 3 of this report, which could increase competition in the marketplace and result ingreater price pressure and lower margins, thus impacting sales, profits and projected cash flow.**•** An insufficient number of potential CoreCard customers decide to purchase and run an in-house software system andinstead choose to outsource their account transaction processing which could result in lower revenue and greater cashrequirements.**•** Other general economic and political conditions that cause customers to delay or cancel software purchases.We have certain lease commitments, legal matters and contingent liabilities described in detail inNote 9 to the Consolidated Financial Statements. We are not aware presently of any facts orcircumstances related to these that are likely to have a material negative impact on our results ofoperations or financial condition.**Recent Accounting Pronouncements**In December 2004, the FASB issued FASB Statement No. 151, “Inventory Costs – An amendment of ARBNo. 43”. SFAS No. 151 clarifies that certain abnormal amounts of production related expensesshould be expensed as incurred and not included in overhead. Further, it requires that allocationof fixed production overheads to conversion costs should be based on normal capacityIntelligent Systems Corporation
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of productionfacilities. We adopted FASB No. 151 effective January 1, 2006. The adoption of this standard didnot have a material impact on our financial position and results of operations.In December 2004, the FASB issued FASB Statement No. 123R, “Share Based Payment”, which replacesAPB No. 25 and SFAS No. 123. The change was effective for small business issuers for the firstinterim or annual reporting period that began after December 15, 2005. FASB No. 123R requirescompanies to recognize in financial statements the cost of employee services received in exchangefor awards of equity instruments based on the grant-date fair value of those awards. We adoptedthe statement on January 1, 2006. The adoption of this statement did not have a material impact onour results of operations or financial condition. In the discussion of Stock-Based Compensation inNote 1 to the Consolidated Financial Statements, we disclose the effect of the use of thefair-value provisions of SFAS No. 123R on historical results of operations.On July 13, 2006, the FASB issued FASB Interpretation No. 48 (FIN 48), “Accounting for Uncertaintyin Income Taxes”. FIN 48 prescribes a comprehensive model for how a company should recognize,measure, present and disclose in its financial statements uncertain tax positions that the companyhas taken or expects to take on a tax return. FIN 48 is applicable to all uncertain positions fortaxes accounted for under FASB Statement 109, “Accounting for Income Taxes” and requires that acompany record any change in net assets that results from the application of the interpretation asan adjustment to retained earnings. The interpretation is effective for fiscal years that startafter December 15, 2006 and, accordingly we have adopted FIN 48 effective January 1, 2007. We arecurrently evaluating whether the adoption of this interpretation will have a material impact on ourfinancial statements.In September 2006, the FASB issued FASB Statement No. 157, “Fair Value Measurements” to increaseconsistency and comparability in fair value measurements. FASB No. 157 defines fair value,establishes a framework for measuring fair value, and expands disclosures about fair valuemeasurements of certain assets, liabilities and items in stockholders’ equity that are measured atfair value. FASB No. 157 is effective for financial statements issued for fiscal years beginningafter November 15, 2007, although early adoption is encouraged. We have not yet determined when wewill adopt the standard or the impact that the adoption of the standard will have on our financialstatements.On February 15, 2007, the FASB issued Statement No. 159, “The Fair Value Option for FinancialAssets and Financial Liabilities: Including an amendment of FASB Statement No. 115”. Statement No.159, which builds on other Statements related to fair value such as Statement No. 157 above,permits entities to elect to measure many financial instruments and certain other items at fairvalue with changes in value reported in earnings. It is designed to mitigate earnings volatilitythat arises when assets and liabilities are measured differently. FASB No. 159 is effective forfinancial statements issued for fiscal years beginning after November 15, 2007, although earlieradoption is permitted. We have not yet determined when we will adopt the standard or the impactthat the adoption of the standard will have on our financial statements.**ITEM 7. FINANCIAL STATEMENTS**The following consolidated financial statements and related report of independent registered publicaccounting firm are included in this report and are incorporated by reference in Part II, Item 7hereof. See Index to Financial Statements on page F-1 hereof.Report of Independent Registered Public Accounting FirmConsolidated Balance Sheets at December 31, 2006 and 2005Consolidated Statements of Operations for the years ended December 31, 2006 and 2005ConsolidatedStatements of Stockholders’ Equity and Comprehensive Income (Loss)  for the years ended December 31, 2006 and 2005Consolidated Statements of Cash Flows for the years ended December 31, 2006 and 2005Notes to Consolidated Financial Statements**ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**NoneIntelligent Systems Corporation
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**ITEM 8A. CONTROLS AND PROCEDURES**As of the end of the period covered by this report, we carried out an evaluation, under thesupervision and with the participation of the company’s management, including the company’s ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of the design and operation ofthe 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 thatthe company’s disclosure controls and the procedures are effective. There were no significantchanges in the company’s internal controls over financial reporting or in other factors identifiedin connection with this evaluation that occurred during the period covered by this report that hasmaterially affected, or is reasonably likely to materially affect, the company’s internal controlover financial reporting.**PART III****ITEM 9.** **DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS, CONTROL PERSONS AND CORPORATE GOVERNANCE:COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT**Please refer to the subsection entitled “Proposal 1 — The Election of One Director — Nominee” and“Proposal 1 — The Election of One Director — Executive Officers” in our Proxy Statement for the2007 Annual Meeting of Shareholders (the “Proxy Statement”) for information about the individualnominated as a director and about the directors and executive officers of the company. Thisinformation is incorporated into this Item 9 by reference. Information regarding compliance bydirectors and executive officers of the company and owners of more than 10 percent of our commonstock with the reporting requirements of Section 16(a) of the Securities Exchange Act of 1934, asamended, is contained under the caption “Section 16(a) Beneficial Ownership Reporting Compliance”in this Proxy Statement. This information is incorporated into this Item 9 by reference.Information regarding the company’s Audit Committee and its composition is contained under thecaption “Proposal 1 — The Election of One Director — Nominee” and “Proposal 1 — The Election of OneDirector — Meetings and Committees of the Board of Directors” in this Proxy Statement. Thisinformation is incorporated into this Item 9 by reference.There have been no material changes to the procedures by which shareholders may recommend nomineesto the company’s Board of Directors.We have a Code of Ethics that applies to all directors, officers, and employees. The Code ofEthics is posted on our website at www.intelsys.com. We also disclose on our website, within thetime required by the rules of the SEC, any waivers of, or amendments to, the Code of Ethics for thebenefit of an executive officer.**ITEM 10. EXECUTIVE COMPENSATION**Please refer to the subsection entitled “Proposal 1 — The Election of One Director — ExecutiveCompensation” in the Proxy Statement referred to in Item 9 for information about managementcompensation. This information is incorporated into this Item 10 by reference.Intelligent Systems Corporation
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**ITEM 11.** **SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS*****Securities Authorized for Issuance Under Equity Compensation Plans***                       (c) Number of securities remaining  (a) Number of securities to be (b) Weighted-average available for future issuance under  issued upon exercise of exercise price of equity compensation plans  outstanding options, warrants outstanding options, (excluding securities reflected inPlan category and rights warrants and rights column (a)) Equity compensationplans approved bysecurity holders  117,666  $1.92   350,000 Equity compensationplans not approvedby security holders  86,000  $3.04   108,000        Total  203,666  $2.39   458,000 The company instituted the 1991 Incentive Stock Plan (the “1991 Plan”) in December 1991 andthe 1991 Plan expired in December 2001. Effective August 22, 2000, the company adopted theNon-Employee Director Stock Option Plan (the “Director Plan”). Up to 200,000 shares of common stockmay be issued under the Director Plan to non-employee directors with each director receiving aninitial grant of 5,000 options followed by annual grants of 4,000 options on the date of eachsubsequent Annual Meeting. The company instituted the 2003 Incentive Stock Plan (the “2003 Plan”)in March 2003. The 2003 Plan authorizes the issuance of up to 450,000 options to purchase sharesof common stock to officers and key employees. No options were granted under the 2003 Plan in2005 or 2006 and no options were granted under the Director Plan in 2006. Non-qualified stockoptions are granted under the company’s equity compensation plans at fair market value on the dateof grant and vest ratably over two or three year periods after the date of grant.Pleaserefer to the subsection entitled “Voting — Security Ownership of Certain Beneficial Ownersand Management” in the Proxy Statement referred to in Item 9 for information about the ownership ofour $0.01 par value common stock by certain persons. This information is incorporated into thisItem 11 by reference.**ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE**The lease on our headquarters and primary facility at 4355 Shackleford Road, Norcross, Georgia isheld by ISC Properties, LLC, an entity controlled by J. Leland Strange, our Chairman and ChiefExecutive Officer. Mr. Strange holds a 100% ownership interest in ISC Properties, LLC. In eachof the years ending December 31, 2005 and 2006, we paid ISC Properties, LLC $393,000 in rent.Please refer to the subsection entitled “Proposal 1 — The Election of One Nominee” in the ProxyStatement referred to in Item 9 for information regarding the independence of the company’sdirectors. This information is incorporated into this Item 12 by reference.**ITEM 13. EXHIBITS**We are filing the following exhibits with this report or incorporating them by reference to earlierfilings. Shareholders may request a copy of any exhibit by contacting Bonnie L. Herron, Secretary,Intelligent Systems Corporation, 4355 Shackleford Road, Norcross, Georgia 30093; telephone (770)381-2900. There is a charge of $.50 per page to cover expenses of copying and mailing.3(i) Amended and Restated Articles of Incorporation of the Registrant dated November 14, 1991, asamended November 25, 1997. (Incorporated by reference to Exhibit 3.1 to the Registrant’sAnnual Report on Form 10-K for the year ended December 31, 1991 and to Exhibit 3.1 to theRegistrant’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) ofthe 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 StockTransfer & Trust Company as Rights Agent. (Incorporated by reference to Exhibit 4.1 of theRegistrant’s Report on Form 8-K dated November 25, 1997 and filed on December 16, 1997.)Intelligent Systems Corporation
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4.2 Form of Rights Certificate. (Incorporated by reference to Exhibit 4.2 of the Registrant’sReport on Form 8-K dated November 25, 1997 and filed on December 16, 1997.) 10.1 Lease Agreement dated June 1, 2004, between the Registrant and ISC Properties, LLC.(Incorporated by reference to Exhibit 10.1 of the Registrant’s Form 10-KSB for the year endedDecember 31, 2004.) 10.2 Management Compensation Plans and Arrangements: (a) Intelligent Systems Corporation 2003 Stock Incentive Plan  (b) Intelligent Systems Corporation Change in Control Plan for Officers  (c) Intelligent Systems Corporation Outside Director’s Retirement Plan  (d) Non-Employee Directors Stock Option Plan  Exhibit 10.2(a) is incorporated by reference to Exhibit 10.2(a) to the Registrants Form 10-Kfor the year ended December 31, 2003.   Exhibits 10.2(b) and (c) are incorporated by reference to Exhibit 10.4 to the Registrant’sForm 10-K for the year ended December 31, 1993.   Exhibit 10.2(d) is incorporated by reference to Exhibit 10.3 to the Registrant’s Form 10-K forthe year ended December 31, 2000.10.3 Loan Agreement by and among Intelligent Systems Corporation and Fidelity Bank dated October1, 2003. (Incorporated by reference to Exhibit 10.3 to the Registrant’s Form 10-K for theyear ended December 31, 2003.) 10.4 Security Agreement by and among Intelligent Systems Corporation and Fidelity Bank dated as ofOctober 1, 2003. (Incorporated by reference to Exhibit 10.4 to the Registrant’s Form 10-K forthe year ended December 31, 2003.) 10.5 Form of Security Agreement by and among majority owned subsidiary companies of IntelligentSystems Corporation and Fidelity Bank as of October 1, 2003. (Incorporated by reference toExhibit 10.5 to the Registrant’s Form 10-K for the year ended December 31, 2003.) 10.6 Negative Pledge Agreement by and among Intelligent Systems Corporation and Fidelity Bankdated October 1, 2003. (Incorporated by reference to Exhibit 10.6 to the Registrant’s Form10-K for the year ended December 31, 2003.) 10.7 Commercial Promissory Note and Rider thereto of Intelligent Systems Corporation in favor ofFidelity Bank dated October 1, 2004. (Incorporated by reference to Exhibit 10.7 to theRegistrant’s Form 10-K for the year ended December 31, 2003.) 10.8 Form of Guarantee of majority owned subsidiaries of Intelligent Systems Corporation in favorof Fidelity Bank dated October 1, 2003. (Incorporated by reference to Exhibit 10.3 to theRegistrant’s Form 10-K for the year ended December 31, 2003.) 10.9 Fifth Modification to Loan Documents by and among Intelligent Systems Corporation andFidelity Bank dated December 1, 2006. 10.10 Asset Purchase Agreement dated as of July 31, 2006 by and between QS Technologies, Inc. andIntelligent Systems Corporation, as Sellers, and Netsmart Public Health, Inc. as Buyer andNetsmart Technologies, Inc. (Incorporated by reference to Exhibit 2.1 of the Registrant’s Form8-K dated July 31, 2006.) 10.11 Promissory Note of Netsmart Technologies, Inc. dated July 31, 2006. (Incorporated byreference to Exhibit 2.2 to the Registrant’s Form 8-K dated July 31, 2006.) 10.12 Interest Purchase and Transfer Agreement by and between Horizon Software Holdings, Inc. andIntelligent Systems Corporation dated August 31, 2006. (Incorporated by reference to Exhibit2.1 to Registrant’s Form 8-K dated August 31, 2006.) 10.13 Promissory Note of Horizon Software Holdings, Inc. dated August 31, 2006. (Incorporated byreference to Exhibit 2.2 to Registrant’s Form 8-K dated August 31, 2006.)Intelligent Systems Corporation
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10.14 Security Agreement and Assignment of Interest in Limited Liability Company by and betweenHorizon Software Holding, Inc. and Intelligent Systems Corporation dated August 31, 2006.(Incorporated by reference to Exhibit 2.3 to Registrant’s Form 8-K dated August 31, 2006.) 10.15 Form of Guaranty of Payment of Shareholders of Buyer dated August 31, 2006. (Incorporated byreference to Exhibit 2.4 to Registrant’s Form 8-K dated August 31, 2006.) 21.1 List of subsidiaries of Registrant. 23.1 Consent of Tauber & Balser, P.C. 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 Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of theSarbanes-Oxley Act of 2002.**ITEM14. PRINCIPAL ACCOUNTANT FEES AND SERVICES**Please refer to the subsection entitled “Independent Public Accountants” in the Proxy Statementreferred to in Item 9 for information about the fees paid to and services performed by ourindependent public accountants. This information is incorporated into this Item 14 by reference.Intelligent Systems Corporation
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**SIGNATURES**Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, theRegistrant has duly caused this Annual Report to be signed on its behalf by the undersigned,thereunto duly authorized.      INTELLIGENT SYSTEMS CORPORATION