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, 2018 as filed with the Securities and Exchange Commission.
Overview
Our consolidated operations consist of our CoreCard Software subsidiary and its affiliate companies in India and Romania, 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.
Our results vary in part depending on the size and number of software licenses recognized as well as the value and number of professional services contracts recognized in a particular period. 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. However, we are also experiencing growth in our license revenue and associated professional services due to the addition of a large new customer in 2018. In total, this customer represented 50 percent of our consolidated revenues for the first six months of 2019. We expect future professional services, maintenance, and license revenue from this customer in 2019 and future years; however, the amount and timing will be dependent on various factors not in our control such as the number of accounts on file and the level of customization needed by the customer. License revenue from this customer, similar to other license arrangements, is tiered based on the number of active accounts on the system. Once the customer achieves each tier level they receive a perpetual license up to that number of accounts; inactive accounts do not count toward the license tier. The customer receives an unlimited perpetual license at a maximum tier level that allows them to utilize the software for any number of active accounts. They currently use the software for a single institution, additional license fees apply if multiple institutions are added. Support and maintenance fees are charged based on the tier level achieved and increase at new tier levels.
The infrastructure of our multi customer environment is scalable for the future. A significant portion of our expense is related to personnel, including approximately 460 employees located in India and 10 employees located in Romania. Our ability to hire and train employees on our processes and software impacts our ability to onboard new customers and deliver professional services for software customizations. 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:
●
|
Software license revenue in a given period may consist of a relatively small number of contracts and contract values can vary considerably depending on the software product and scope of the license sold. Consequently, even minor delays in delivery under a software contract (which may be out of our control) could have a significant and unpredictable impact on the consolidated revenue that we recognize in a given quarterly or annual period.
|
●
|
Customers may decide to postpone 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.
|
●
|
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.
|
●
|
The timing of new processing customer implementations is often dependent on third party approvals or processes which are typically not under our direct control.
|
We continue to maintain a strong cash position. 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. In November 2018, our Board of Directors authorized a share repurchase program of $5 million. We did not make any share repurchases in 2018 or 2019.
Results of Operations
The following discussion should be read in conjunction with the Consolidated Financial Statements and the notes to Consolidated Financial Statements presented in this quarterly report.
Revenue
– Total revenue in the three and six month periods ended June 30, 2019 was $7,512,000 and $14,478,000, respectively, which represents increases of 64 percent and 68 percent compared to the respective periods in 2018.
●
|
Revenue from
services
was $6,812,000 and $12,978,000 in the three and six month periods ended June 30, 2019, respectively, which represents an increase of 51 percent and 53 percent compared to the respective periods in 2018. Revenue from transaction processing services, software maintenance and support services, and professional services were greater in the second quarter and year-to-date periods of 2019 as compared to the same periods of 2018 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 second quarter and year-to-date period of 2019, primarily related to the large new license customer we added in 2018. We expect that processing services will continue to grow as our customer base increases; however, the time required to implement new customer programs could be delayed due to third party integration and approval processes and other factors. 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.
|
●
|
Revenue from
products
, which is primarily software license fees, was $700,000 and $1,500,000 in the three and six month periods, respectively, ended June 30, 2019, compared to $65,000 and $160,000 in the respective comparable periods of 2018. The increase is primarily due to the new license customer, as discussed above.
|
Cost of Revenue
– Total cost of revenue was 39 percent and 38 percent of total revenue in the three and six month periods ended June 30, 2019, respectively, compared to 45 percent and 44 percent of total revenue in the corresponding periods of 2018. The decrease in cost of revenue as a percentage of revenue is primarily driven by increased product sales with low associated costs. Cost of revenue includes 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 revenues can vary considerably from period to period 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 addition, 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.
Operating Expenses
– In the three and six month periods ended June 30, 2019, total operating expenses from consolidated operations were greater than in the corresponding period in 2018 primarily as the result of increased research and development expenses as well as higher general and administrative expenses. Research and development expenses were 21 percent and 24 percent higher in three and six month periods in 2019, respectively, as compared to the same periods in 2018, mainly due to payroll and related expense for additional offshore technical personnel and a recognition based bonus accrual. General and administrative expenses were higher in 2019 than in 2018, due to higher legal and advisory expenses related to continuing contract negotiations and strategic initiatives of the Board as well as higher personnel-related expense at the corporate offices in 2019. Marketing expenses decreased for the three and six month periods in 2019 as compared to the respective periods in 2018 as we continued to place less focus on marketing initiatives for CoreCard in 2019. Our client base continues to increase 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 three and six months ended June 30, 2019, we recorded income of $125,000 and $253,000, respectively, compared to a loss of $189,000 and $117,000 for the comparable 2018 periods. The increase is primarily due to 2018 investment activity that did not recur in 2019 as well as higher income earned on our cash balances. Both 2018 periods are primarily comprised of the write-down of $250,000 on an investment, as described in more detail in Note 3 to the Consolidated Financial Statements, offset in part by income earned on our cash balances.
Income Taxes
– Our effective tax rate for the three and six months ended June 30, 2019 was 22.7 percent and 23.4 percent, respectively, compared to 6.2 percent and 3.5 percent for the respective periods in 2018. The increase is due to utilization of net operating loss carryforwards in 2018.
Liquidity and Capital Resources
Our cash balance at June 30, 2019, was $21,875,000 compared to $18,919,000 at December 31, 2018. During the six months ended June 30, 2019, cash provided by operations was $5,954,000 compared to cash used in operations of $1,955,000 for the six months ended June 30, 2018. The increase is primarily due to the 2018 prepayment of approximately $2,580,000 for processing equipment, software and related licenses that did not recur in 2019, higher net income and an increase in other current liabilities, primarily income taxes payable. In addition, we advanced $1,500,000 on a Promissory Note and a Loan Agreement which is described in more detail in Note 4 to the Consolidated Financial Statements.
We used $1,521,000 to acquire computer equipment primarily for enhancements to our processing environment in the U.S. and the technical resources added in our India offices.
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 and valuation of investments to be critical policies due to the estimation processes involved in each. Management discusses its estimates and judgments with the Audit Committee of the Board of Directors. For a detailed description on the application of these and other accounting policies, see Note 1 to the Consolidated Financial Statements contained in our Annual Report on Form 10-K for the fiscal year ended December 31, 2018. 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 2018. During the six month period ended June 30, 2019, there were no significant or material changes in the application of critical accounting policies, other than the adoption of ASU 2016-02, Leases (Topic 842) as described further in Note 1 and 8 to the Consolidated Financial Statements, that would require an update to the information provided in the Form 10-K for 2018.
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:
●
|
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.
|
●
|
Increased federal and state regulations and reluctance by financial institutions to act as sponsor banks for prospective customers could result in losses and additional cash requirements.
|
●
|
In 2018, we added a large new license customer that represented approximately 53 percent and 50 percent of our consolidated revenues for the three and six months ended June 30, 2019, respectively. Failure to meet our responsibilities under the related contract could result in breach of contract and loss of the customer and related future revenues.
|
●
|
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.
|
●
|
We could fail to deliver software products which meet the business and technology requirements of our target markets within a reasonable time frame and at a price point that supports a profitable, sustainable business model.
|
●
|
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.
|
●
|
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.
|
●
|
We could fail to expand our base of customers as quickly as anticipated, resulting in lower revenue and profits and increased cash needs.
|
●
|
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.
|
●
|
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.
|
●
|
Delays in anticipated customer payments for any reason would increase our cash requirements and could adversely impact our profits.
|
●
|
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 losses).
|
●
|
Our future capital needs are uncertain and depend on a number of factors; additional capital may not be available on acceptable terms, if at all.
|
●
|
Other general economic and political conditions could cause customers to delay or cancel purchases.
|