Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
In addition to historical information, this Form 10-Q may contain forward-looking statements relating to ISC. All statements, trend analyses and other information relative to markets for our products and trends in revenue, gross margins and anticipated expense levels, as well as other statements including words such as “anticipate”, “believe”, “plan”, “estimate”, “expect”, and “intend”, and other similar expressions, constitute forward-looking statements. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties including those factors described below under “Factors That May Affect Future Operations”, and that actual results may differ materially from those contemplated by such forward-looking
statements. ISC undertakes no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes in future operating results.
For purposes of this discussion and analysis, we are assuming and relying upon the reader’s familiarity with the information contained in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, in the Form 10-K for the year ended December 31,
2017
as filed with the Securities and Exchange Commission.
Overview
Our consolidated operations consist of our CoreCard Software subsidiary and its affiliate companies in Romania and India, as well as the corporate office which provides significant administrative, human resources and executive management support to CoreCard.
We provide technology solutions and processing services to the financial services market, commonly referred to as the FinTech industry. Our
service
revenue consists of fees for software maintenance and support for licensed software products, fees for processing services that we provide to companies that outsource their financial transaction processing functions to us, and professional services primarily for software customizations provided to both license and processing customers. We derive our
product
revenue from licensing our comprehensive suite of financial transaction management software to accounts receivable businesses, financial institutions, retailers and processors to manage their credit and debit cards, prepaid cards, private label cards, fleet cards, loyalty programs, and accounts receivable and small loan transactions.
We have frequently recognized consolidated operating losses on a quarterly and annual basis. As we continue to grow our customer base and scale operations, we may, in the future, report operating profits on a quarterly and annual basis. Our results vary in part depending on the size and number of software licenses recognized as well the value and number of professional services contracts recognized in a particular period. As an example, for the quarter ended March 31, 2018, we reported consolidated operating income, in part, due to revenue associated with professional services provided to both a new customer, with a potential long-term commitment, and to an existing global license customer for customizations of our base product offering as well as the recognition of a third license for the same global license customer. In addition, we recognized revenue, with no associated cost of revenue, on a one-time contractual minimum guarantee arrangement. As we continue to grow our Processing Services business, we continue to gain economies of scale on the investment we have made in the infrastructure, resources, processes and software features developed over the past number of years to support this growing side of our business. We are adding new processing customers at a faster pace than we are adding new license customers, resulting in steady growth in the processing revenue stream. The infrastructure of our multi customer environment is scalable for the future. A significant portion of our expenses is related to personnel, including approximately 360 employees located in India and Romania. In the fourth quarter of 2017, we opened a second office in India, located near Mumbai, to enable us to attract additional talent required for our software development and testing. In addition, we have certain corporate office expenses associated with being a public company that impact our operating results.
Our revenue fluctuates from period to period and our results are not necessarily indicative of the results to be expected in future periods. It is difficult to predict the level of consolidated revenue on a quarterly or annual basis for a number of reasons, including the following:
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Software license revenue in a given period may consist of a relatively small number of contracts and contract values can vary considerably depending on the software product and scope of the license sold. Consequently, even minor delays in delivery under a software contract (which may be out of our control) could have a significant and unpredictable impact on the consolidated revenue that we recognize in a given quarterly or annual period.
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Customers may decide to postpone or cancel a planned implementation of our software for any number of reasons, which may be unrelated to our software or contract performance, but which may affect the amount, timing and characterization of our deferred and/or recognized revenue.
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Customers typically require our professional services to modify or enhance their CoreCard software implementation based on their specific business strategy and operational requirements, which vary from customer to customer and period to period.
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The timing of new processing customer implementations is often dependent on third party approvals or processes which are typically not under our direct control.
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We continue to maintain a strong cash position. In the latter part of December, 2017 and in the first quarter of 2018, we purchased additional hardware and software for our processing environment in anticipation of a contract currently being negotiated with a potential customer that may result in increased revenue over the next few years. While there is no assurance that the contemplated agreement will be finalized, management believes it will have a successful outcome and in the event the agreement is not finalized, the potential customer has agreed to take title to and reimburse us for the equipment purchases. We intend to use cash balances to support the domestic and international operations associated with our CoreCard business and to expand our operations in the FinTech industry through financing the growth of CoreCard and, if appropriate opportunities become available, through acquisitions of businesses in this industry.
Results of Operations
The following discussion should be read in conjunction with the Consolidated Financial Statements and the notes to Consolidated Financial Statements presented in this quarterly report.
Revenue
– Total revenue in the three month period ended March 31, 2018 was $4,058,000 which represents a 139 percent increase over the first quarter of 2017.
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Revenue from
services
was $3,963,000 in the first quarter of 2018 compared to $1,699,000 in the first quarter of 2017. Revenue from transaction processing services, software maintenance and support services, and professional services were greater in the first quarter of 2018 as compared to the first quarter of 2017 due to an increase in the number of customers and accounts on file, an increase in the number and value of professional services contracts completed during the first quarter of 2018, and a one-time contractual minimum guarantee maintenance support service recognition. We expect that processing services will continue to grow as our customer base increases; however, the time required to implement new customer programs has proven longer than anticipated due to delays in third party integration and approval processes. It is not possible to predict with any accuracy the number and value of professional services contracts that our customers will require in a given period. Customers typically request our professional services to modify or enhance their CoreCard® software implementation based on their specific business strategy and operational requirements, which vary from customer to customer and period to period.
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Revenue from
products
, which is primarily software license fees, was $95,000 in the three month period ended March 31, 2018, compared to $0 in the three month period ended March 31, 2017. The increase is due to the recognition of the third license implementation for a global license customer. Monthly support fees previously bundled with the applicable license have been reclassified as service revenue as a result of the adoption of ASU 2014-09, Revenue from Contracts with Customers Topic 606.
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Cost of Revenue
– Total cost of revenue was 43 percent and 53 percent of total revenue in the three month period ended March 31, 2018 and 2017, respectively.
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Cost of
service
revenue as a percentage of total service revenue was 41 percent in the first quarter of 2018 compared to 53 percent in the first quarter of 2017. Cost of service revenue includes three components: costs to provide annual maintenance and support services to our installed base of licensed customers, costs to provide professional services, and costs to provide our financial transaction processing services. The cost and gross margins on such services vary considerably depending on the customer mix, customer requirements and project complexity as well as the mix of our U.S. and offshore employees working on the various aspects of services provided. In 2018, our cost of service revenue was more heavily weighted towards our professional services component which, historically, has utilized relatively more offshore employees at a lower cost. As a result, our cost of services revenue percentage in 2018 is below the 2017 percentage. In addition, the one-time recognition of contractual minimum guarantee maintenance support service revenue had no cost of revenue associated with the revenue recognition. We continue to devote the resources necessary to support our growing processing business, including direct costs for regulatory compliance, infrastructure, network certifications, and customer support. However, we are continuing to experience economies of scale in our processing environment, and did experience a decrease year over year for our cost of financial transaction processing services as a percentage of transaction processing services revenue. This may be subject to change in the future if new regulations or processing standards are implemented causing us to incur additional costs to comply.
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Cost of product revenue as a percent of product revenue was 143 percent in the period ended March 31, 2018. The cost associated with the implementation of the license recognized was greater than the related revenue. This is not an uncommon occurrence, as a customer’s contract profitability is recognized over the life of the contract. The future benefit of the contractual maintenance support services revenue will provide a steady revenue stream to services revenue.
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Operating Expenses
– In the three month period ended March 31, 2018, total operating expenses from consolidated operations were greater than in the corresponding period in 2017 primarily as the result of increased research and development expenses. Research and development expenses were 21 percent higher in 2018 as compared to 2017, mainly due to payroll and related expense for additional offshore technical personnel, expanding our hiring capabilities of technical resources by opening a second office located near Mumbai, India and a recognition based bonus accrual. General and administrative expenses were lower in 2018 than in 2017, due to lower personnel-related expense at the corporate offices in 2018. Marketing expenses decreased 14 percent year over year as we continued to place less focus on marketing initiatives for CoreCard in 2018. Our client base increased in 2017 and continues to increase in 2018 with minimal marketing efforts as we continue to have prospects contact us via online searches; however, we will continue to re-evaluate our marketing expenditures as needed to competitively position the Processing Services business.
Other Income (Loss)
– In the quarter ended March 31, 2018, we recorded $72,000 in other income, comprised primarily of income earned on our cash balances and interest income on our Notes Receivable as described in more detail in Note 3.
Liquidity and Capital Resources
Our cash balance at March 31, 2018 was $10,183,000 compared to $14,024,000 at December 31, 2017. The principal use of cash during the period was the prepayment of approximately $2,580,000 for processing equipment, software and related licenses. This prepayment was in addition to approximately $1,745,000 for comparable equipment purchased in the latter part of December 2017. The processing equipment is being installed to enhance our processing environment in anticipation of a significant contract under negotiations. As the potential customer has agreed to take title and reimburse us for the equipment purchases, the prepayment is shown in “Other Current Assets” at March 31, 2018. In addition, we advanced $250,000 on a Promissory Note and we advanced $235,000 on a Convertible Loan Agreement, both of which are described in more detail in Note 3 to the Consolidated Financial Statements.
During the three months ended March 31, 2018, we used $3,187,000 cash for operations. The most significant working capital change since December 31, 2017 was an increase in other current assets of $2,673,000, of which $2,580,000 relates to the aforementioned equipment and software purchases on behalf of a potential new customer and an increase in accounts receivable of $1,716,000, of which our three largest customers comprising the majority of the increase in accounts receivable remitted payment in April 2018 of approximately $1,566,000 in total.
We used $170,000 cash to acquire computer equipment primarily for the technical resources added in our India office and to upgrade our existing processing environment in the U.S.
We expect to have sufficient liquidity from cash on hand as well as projected customer payments to support our operations and capital equipment purchases in the foreseeable future. Currently we expect to use cash in excess of what is required for our current operations for opportunities we believe will expand our CoreCard and FinTech business, although there can be no assurance that appropriate opportunities will arise.
Off-Balance Sheet Arrangements
We do not currently have any off-balance sheet arrangements that are reasonably likely to have a current or future material effect on our financial condition, liquidity or results of operations.
Critical Accounting Policies and Estimates
The discussion and analysis of our financial condition and results of operations is based upon our Consolidated Financial Statements which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of assets, liabilities, revenues and expenses. We consider certain accounting policies related to revenue recognition, valuation of investments and accrued costs and expenses to be critical policies due to the estimation processes involved in each. Management discusses its estimates and judgments with the Audit Committee of the Board of Directors. For a detailed description on the application of these and other accounting policies, see Note 1 to the Consolidated Financial Statements contained in our Annual Report on Form 10-K for the fiscal year ended December 31, 2017. Reference is also made to the discussion of the application of these critical accounting policies and estimates contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for 2017. During the three month period ended March 31, 2018, there were no significant or material changes in the application of critical accounting policies, other than the adoption of ASU 2014-09, Revenue from Contracts with Customers (Topic 606) and the related reclassifications as describe further in Notes 1 and 2 to the Consolidated Financial Statements, that would require an update to the information provided in the Form 10-K for 2017.
Factors That May Affect Future Operations
Future operations are subject to risks and uncertainties that may negatively impact our future results of operations or projected cash requirements. It is difficult to predict future quarterly and annual results with certainty.
Among the numerous factors that may affect our consolidated results of operations or financial condition are the following:
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Weakness or instability in the global financial markets could have a negative impact due to potential customers (most of whom perform some type of financial services) delaying decisions to purchase software or initiate processing services.
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Increased federal and state regulations and reluctance by financial institutions to act as sponsor banks for prospective customers could increase our losses and cash requirements.
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Delays in software development projects could cause our customers to postpone implementations or delay payments, which would increase our costs and reduce our revenue and cash.
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Our processing business involves the processing and storage of sensitive business and personal information about our clients and their customers. Any type of security breach, attack, or misuse of data could deter clients from using our services and expose us to liability to parties whose data has been compromised, fines from regulatory authorities, and other material adverse consequences.
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We could fail to deliver software products which meet the business and technology requirements of its target markets within a reasonable time frame and at a price point that supports a profitable, sustainable business model.
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Our processing business is impacted, directly or indirectly, by more regulations than our licensed software business. If we fail to provide services that comply with (or allow our customers to comply with) applicable regulations or processing standards, we could be subject to financial or other penalties that could negatively impact our business.
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Software errors or poor quality control may delay product releases, increase our costs, result in non-acceptance of our software by customers or delay revenue recognition.
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We could fail to expand our base of customers as quickly as anticipated, resulting in lower revenue and profits (or increased losses) and increased cash needs.
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We could fail to retain key software developers and managers who have accumulated years of know-how in our target markets and company products, or fail to attract and train a sufficient number of new software developers and testers to support our product development plans and customer requirements at projected cost levels.
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Increasing and changing government regulations in the United States and foreign countries related to such issues as data privacy, financial and credit transactions could require changes to our products and services which could increase our costs and could affect our existing customer relationships or prevent us from getting new customers.
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Delays in anticipated customer payments for any reason would increase our cash requirements and possibly our losses.
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Competitive pressures (including pricing, changes in customer requirements and preferences, and competitor product offerings) may cause prospective customers to choose an alternative product solution, resulting in lower revenue and profits (or increased losses).
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Our future capital needs are uncertain and depend on a number of factors; additional capital may not be available on acceptable terms, if at all.
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Other general economic and political conditions could cause customers to delay or cancel purchases.
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