INS: A Wolf in Pete’s Clothing

IMPORTANT – Please read this Disclaimer in its entirety before continuing to read our research opinion.  The information set forth in this report does not constitute a recommendation to buy or sell any security. This report represents the opinion of the author as of the date of this report. This report contains certain “forward-looking statements,” which may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential,” “outlook,” “forecast,” “plan” and other similar terms. All are subject to various factors, any or all of which could cause actual events to differ materially from projected events. This report is based upon information reasonably available to the author and obtained from sources the author believes to be reliable; however, such information and sources cannot be guaranteed as to their accuracy or completeness. The author makes no representation as to the accuracy or completeness of the information set forth in this report and undertakes no duty to update its contents. The author encourages all readers to do their own due diligence.

You should assume that as of the publication date of his reports and research, Aurelius and possibly any companies affiliated with him and their members, partners, employees, consultants, clients and/or investors (the “Aurelius Affiliates”) have a short position in the stock (and/or options, swaps, and other derivatives related to the stock) and bonds of Intelligent Systems. They therefore stand to realize significant gains in the event that the prices of either equity or debt securities of Intelligent Systems decline.  Aurelius and the Aurelius Affiliates intend to continue transactions in the securities of Intelligent Systems for an indefinite period after his first report on a subject company at any time hereafter regardless of initial position and the views stated in Aurelius’ research.  Aurelius will not update any report or information on this website to reflect such positions or changes in such positions.

Please note that Aurelius, the author of this report, and the “Aurelius Affiliates” are not in any way associated with Aurelius Capital Management, LP, a private investment firm based in New York, and any affiliates of or funds managed by the latter company.

We are short Intelligent Systems (NYSE: INS).

Relentless hype on social media has propelled shares to all-time highs and a monster valuation of roughly 15x trailing sales and 40x trailing EBITDA. While INS is touted as a fintech set to disrupt the payments space with breakthrough technology, we believe the company is merely a glorified Indian outsourcing business that, like so many other stock promotions, will leave investors chasing the prospect of quick riches disappointed by the underlying economics and growth prospects.

INS features a problematic cast of cronies, including the disgraced former CEO of MiMedx, Parker “Pete” Petit, whom INS made the “financial expert” of its Audit Committee, even though he orchestrated a giant fraud at MiMedx that has thus far cost investors over $1.5 Billion in losses. Although INS claims Petit is independent, we found undisclosed financial dealings between Petit and INS’ CEO Leland Strange, who have been business partners for decades. We discovered that Strange himself has personal entanglements with the company’s auditor and may have also engaged in undisclosed related party dealings related to the company’s venture capital portfolio.

INS shares have surged from $13 to as high as $48 this year following a March Bloomberg report that Goldman Sachs hired CoreCard, INS’ primary operating subsidiary, to help handle payments for its planned credit-card partnership with Apple.   Bulls have used this headline to run wild on social media with projections of massive near-term revenue growth leading to a $1B+ business or buyout.

This report explains in detail why we believe they company’s prospects are dramatically over-hyped. Even if the Apple Card is a spectacular success, the company is likely to receive far less money than some have touted. INS is miscast as a highly-scalable software business that, instead, is largely a bill-per-hour Indian outsourcer that has substantial capacity constraints that inherently limit its growth potential. Our research also found that INS operates in a processing niche that has increasingly been commoditized and lacks the innovative technology add-ons fueling the industry and that dominant card processors have invested large sums to create.

As the reality of the business sets in and the promotion fades, we believe it’s only a matter of time until the stock reverts to a valuation that reflects the underlying economics. If INS were to trade at 2-5x sales, multiples typical of Indian outsourcing businesses and larger processors, the stock would be worth roughly $5 to $12 per share (70% downside). The mere presence of Parker Petit makes any equity he’s involved with un-investible and, in our opinion, the undisclosed relationships between various gatekeepers at INS introduce additional risks and dysfunction that are simply not being properly discounted by investors.

We therefore see substantial downside potential.

INS’ Problematic Cast of Cronies

Farcically, INS has declared Parker Petit, the “financial expert” of its Audit Committee. INS’ SEC Filings claim Petit is qualified for this role based on his experience “in overseeing the preparation of financial statements” at public companies, which INS reiterated even after Petit was terminated “for cause” by MiMedx in 2018.

This assertion appears particularly absurd after yesterday, when MiMedx announced the damning results of its internal investigation which detailed the elaborate lengths that Petit and his confederates went to hide the pervasive malfeasance at MiMedx. MiMedx’s findings include that Petit made false statements to the SEC and Board, submitted false documents to the auditors, “purposely took action to disregard revenue recognition rules under GAAP” and directed “Project Snow White”, which involved a secret surveillance system used to retaliate against whistleblowers. The company also warns that “if Mr. Petit were to be re-hired in any management capacity, there would be a very high risk that the Company could not engage a new auditor or any previously engaged auditor would resign”.

            Source: MiMedx 5/23/2019 8-K filing

So what is Petit doing on INS’ Board and Audit Committee? We note that at MiMedx, Petit had multiple undisclosed personal ties to company gatekeepers he falsely championed as independent. INS has also declared Petit as independent, even though documents show that Petit and Strange have had undisclosed financial dealings. We learned that the two have partnered together on real estate deals in Naples as demonstrated by a 2014 corporate filing (below) that lists them as co-officers of a Florida entity named Atrix Realty, Inc., a relationship that we have not found disclosed in INS’ SEC Filings (Petit has been on the INS board since 1996).

Source: Florida Sunbiz

Documents also show that Strange was a Director at Healthdyne Technologies, one of Petit’s old companies. Petit and Strange are also listed as Trustees Emeritus of the Georgia Tech Foundation along with another INS Director classified as Independent, A. Russell Chandler, who has appeared with Petit in filings related to the GRA Venture fund. The only other outside INS Director, a lawyer named Philip Moise, represented INS for decades as outside counsel while in private practice and before joining the Board.

Importantly, we also learned that Strange has undisclosed personal ties to INS’ auditor, Nicolas Cauley, a Georgia outfit whose only publicly traded audit client is INS. Strange and the audit engagement partner, Ian Waller, serve as leaders of the same church according to a book published by the church pastor in 2017, which states that Strange and Waller helped lead a five-month development process together. How can Waller independently audit INS’ financials while simultaneously leading a church with the company’s CEO? We note that the SEC requires auditors be “capable of exercising objective and impartial judgement on all issues” and has announced enforcement actions related to auditor independence issues involving undisclosed personal relationships with management in recent years.

We also found evidence of potential undisclosed related party dealings involving Lumense, a failed gas sensor venture that both INS and the GRA Venture fund made minority investments in. We learned that Strange was the Chairman of Lumense and appears to have also held a personal stake, according to online reports. But INS never disclosed Strange’s role as Chairman of Lumense or his apparent personal financial stake, and INS eventually wrote down its entire investment in 2016.

We also note that two CFOs and the former Chairwoman of the Audit Committee have departed INS in the last 3 years, with the latest CFO departure occurring in January 2019.

The Recent INS Stock Promotion

INS shares have surged from $13 to as high as $48 this year following a March Bloomberg report that Goldman Sachs hired CoreCard, INS’ primary operating subsidiary, to help handle payments for its planned credit-card partnership with Apple.   While Strange appears to have largely tried to temper growth expectations, a parade of tout pieces and social media promotion has fueled expectations of massive near-term revenue growth leading to a $1B+ business or buyout.

Due to a significant new customer (presumably Goldman), INS doubled its revenues in 2018 to $20 million from $9 million the prior year. Strange has cautioned about extrapolating this kind of growth into the future and said on the March conference call he would “be happy to scale at 25% a year, maybe higher” over the next five years. Yet online promoters have advanced notion that the business will grow far faster, with one bull modeling that the company will generate more than $40 million in revenues this year growing to over $100 million in sales in 2021.

At its current valuation, INS (CoreCard) is now valued as if it’s a highly scalable SaaS (software as a service) business with disruptive technology. But we view CoreCard as merely a glorified Indian business process outsourcing company that is unlikely to produce anywhere near the kind of growth now baked into the stock’s current market price.

CoreCard performs most of its services in India, where the bulk of the company’s 430 employees reside. The company also has operations in Romania, but this appears to be a relatively obscure location that Romanian legal filings state has only 8 employees.

Above: (Left) Photo from investigator’s visit to India (Right) Google Street View of Romanian Address

CoreCard is typically hired to help set its clients up as processors through a back-end system that CoreCard customizes for specific card programs. Most clients pay a relatively small upfront fee to license CoreCard’s system, with CoreCard earning the bulk of its revenue from bill-per-hour professional services tied to the substantial customization and ongoing configuration work that must be performed by CoreCard’s staff.

Our research leads us to believe that Goldman selected CoreCard because Goldman wanted to build a customized system to conduct processing in-house and that large processors such as First Data are less than eager to assist with this kind of work, creating an opportunity for CoreCard. Strange wrote in his 2019 investor letter that “truth be told, we got ‘lucky’ when a big opportunity arose that CoreCard was uniquely positioned to handle”. We note that Goldman lifted out the team from Final, Inc. in 2018, this was a private card venture that INS owned a minority stake in, a deal we speculate got CoreCard in the door at Goldman.

Revenue Potential From Goldman Deal Is Over-Hyped

Before the Goldman deal, a key customer didn’t believe CoreCard’s equity was even worth $20 million in total at the end of 2017. Central National Bank (CNB), received an option to buy 5% of CoreCard for $1 million (at an implied $20 million value for the entire company) in 2012 in exchange for becoming a processing customer and agreeing to provide consulting expertise. CNB declined to exercise the option before it expired worthless in December 2017, a decision that has looked quite foolish as the company’s market cap has skyrocketed to as high as $400 million earlier this month. But while the Goldman deal is clearly positive for CoreCard, we doubt it’s anywhere near as valuable as implied by the meteoric rise of INS’ share price.

Much of the online promotion is premised on the notion that CoreCard now has an open-ended license stream and is set to earn $1+ for each Apple credit card issued in perpetuity. This has led to wild projections on social media of near-term cash windfalls for INS as high $100-$200 million (example below).

Strange explained on a conference call earlier this year that CoreCard’s license contracts typically have tiers, where the company can collect an additional one-time payment per customer account over time. Our discussions with industry experts suggest that CoreCard is unlikely to receive a one-time payment of much more than $1 per customer account, and possible significantly less. These deals also typically contain sunset provisions, where license income per account begins to decline and end completely after the first few years, an arrangement that would further limit the aggregate amount of money that INS could earn.

This means that even if the Apple Card is a spectacular success, INS will likely receive far less than promoters tout. For example, if Apple gathered a full 27 million accounts over the first 3 years, equal to the entire number of American Express basic consumer cards-in-force in the U.S., INS would likely receive no more than $27 million in cumulative non-recurring payments ($9 million per year). Bulls have pointed to estimates by an HSBC analyst that the Apple Card could onboard as many as 15 million customers per year, but that report specifically cautioned that take up rates would fall significantly if Apple / Goldman decides to limit the card to customers with prime credit scores (which we expect they will). There is also reason to doubt that Apple will get as much traction as hoped because, even with a strong brand, it’s not easy to penetrate a saturated market like credit cards, which is dominated by entrenched players. We note that reviews on the benefits offered by the Apple Card have been underwhelming and are informed that card launches by IKEA and Uber, for example, both have failed to capture more than 2 million accounts.

Furthermore, even though CoreCard has done work for other multi-billion dollar companies for years, we calculate that INS has recognized less than $4 million in total license revenue since inception. In 2016 Strange stated that INS customers have “easily recognizable names but contracts prohibit disclosure”. We learned that a major INS customer has been Wirecard, the large German payments company currently embroiled in scandals involving fraud and money laundering allegations, according to multiple online postings made by employees of both companies. But of course, the public disclosure of Wirecard as an INS customer doesn’t have the same promotional impact or appeal of Goldman Sachs / Apple.

CoreCard’s Business is Capacity-Constrained and Difficult to Scale

Because many investors mistakenly view CoreCard as a highly-scalable SaaS business, the Goldman deal has been promoted as heralding a “Sea Change” set to unlock exponential near-term growth. But we believe investors are overlooking the reality that CoreCard has substantial capacity constraints that inherently limit its ability to grow.

CoreCard relies on labor-intensive processing and configuration work to drive revenues. The company’s own financial statements show that more than 90% of revenue over the past three years was earned from services, as opposed to product licenses. Similar to Indian outsourcers, INS has minimal amounts of deferred licensing revenue because most of its fees are earned from hourly billings of its engineers and techs.

Pictured Above: Workers in CoreCard’s Indian Office

Most of CoreCard’s recent revenue growth has been a direct product of the substantial upfront customization and configuration that the company’s workers have been doing for Goldman, which is largely non-recurring in nature. As a result, Strange said his team was “100 plus percent utilized” during 2018 and had to “slow down working” with some customers and “politely decline” new business. Capacity will begin to free up when CoreCard’s work for Goldman begins to decline, but then the company will need to add new customers just to replace the lost revenues. Strange himself explained on the May 2019 earnings call that:

we’re still very much totally absorbed personnel-wise with the large licensing client …we don’t have the capacity to add more large ones [customers] and what is traditionally thought of as a pipeline”.

Fast growing SaaS businesses don’t have these kind of capacity constraints and, conversely, tend to have virtually unlimited capacity to sell additional licenses and scale rapidly. Yes, CoreCard can hire more people, but Strange has repeatedly articulated a controlled-growth philosophy and said that it takes about two years for new hires to become productive. This puts a ceiling on INS’ revenue growth potential, a dynamic which Strange also referenced on the March 2019 call when he said that:

if I had about 20 more people that had 15 years of experience using CoreCard software, I could grow faster and there’s no magic wand that can make that happen”.

This is exactly why we believe INS compares similarly to Indian outsourcers such as Syntel, Wipro, and Infosys when measured on a sales per employee basis (below). But the $46k that INS generates per worker is only a fraction of the efficiency of a sampling of SaaS businesses:

Source: Internal analysis using Bloomberg data

CoreCard Lacks Technology to Compete with Dominant Players

INS has said it wants to grow CoreCard’s in-house processing business where, unlike the Goldman deal, CoreCard itself becomes a card processor for clients. Although CoreCard’s processing revenues are very small, a mere $1.8 million in Q1 2019, they tend to be recurring and bulls argue that CoreCard is well positioned to start taking large clients and real market share from dominant players such as First Data (FDC) and Total System Services (TSS). But our research indicates that CoreCard’s capabilities are significantly over-hyped.

We spoke to an industry expert with over 15 years of experience managing various facets of credit card programs who is deeply familiar with the card processing and outsourcing landscape.   The expert explained that CoreCard is technically able to do many of the same things as others in its base processing business but the expert was not impressed by the “overall robustness” of CoreCard’s offering. The expert felt that CoreCard could be a good fit for smaller retailers and loyalty/fleet card programs, but that large banks and issuers typically avoid smaller processors like CoreCard due to concerns about scale, integration and security and compliance infrastructure.

The expert also explained that base processing services, where CoreCard is relatively strong, have increasingly become commoditized and subject to pricing pressures. Most of the value proposition, especially for large clients, is in add-on features and technologies that are included in a suite of processing services provided by the larger processors. The large processors have spent significant sums of money to build or acquire these add-on technologies, which is where most of the innovation (and margin) exists in the industry. The expert mentioned several examples of technologies valued by large clients that were also highlighted by a Total System Services executive at the company’s 2018 analyst day:

Furthermore and contrary to suggestions by some bulls, First Data remains a strategic partner of Apple’s and provides a variety of technologies that are integral to Apple Pay.

We note that First Data is associated with more than 1,500 Patents on Google and spent $293 million on R&D over the past two years. By contrast, CoreCard has only a single patent we’re aware of (filed in 2006) and has spent less than $11 million over the past three years on R&D. On the most recent conference call, Strange said the future expiration of CoreCard’s patent is “not a concern at all” because “we haven’t actively used that per se”.

We note that in a 2016 video, a CoreCard VP explainsour bread and butter is the systems that have been around for 20 years” and multiple Indian employees have complained online that CoreCard uses outdated technology (below). After all, if CoreCard possessed technology set to disrupt the industry, wouldn’t CNB, a consultant and one of CoreCard’s oldest processing customers, have had enough confidence to exercise its option at a mere $20 million equity valuation in 2017?

Yes, CoreCard can probably continue to grow its processing business over time, but we are highly skeptical the company will on-board new clients at either the pace or size currently anticipated by many. We note that Strange stated on the May 2019 conference call that “No, there are no other multi-million processing customers in the pipeline” and referenced conversations with some larger enterprises that are “not going to happen this year or probably even in the next twelve months”.

We See Substantial Downside Potential

We view INS as largely a niche Indian outsourcing business miscast by investors as a disruptive SaaS company. In our opinion, shares have been propelled to highs by speculators chasing recent headlines in pursuit of quick profits. But as the reality of the business sets in, we believe it’s only a matter of time until the stock reverts to a valuation more reflective of the underlying economics.

At its current $350 million market cap, INS trades at premium valuation of 15x trailing revenues and 40x trailing EBITDA. If INS were to revert to a valuation of around 2-5x trailing sales, a multiple typical of Indian outsourcing businesses such as Syntel and Wipro as well as larger processing companies such as First Data, the stock would be worth roughly $5 to $12 per share (70%+ downside).

We also don’t think investors should count on spectacular management execution. To Strange’s credit, he has not participated in the kind of promotional theatrics we have grown accustomed to seeing from other small cap CEOs. But evidence points to a culture of cronyism within INS that we find highly problematic and unworthy of a premium valuation. We also believe the presence of Parker Petit and undisclosed relationships between various parties at INS introduce additional risks and dysfunction that are simply not being properly discounted by investors.

We therefore see substantial downside potential and are short INS.

All investors are encouraged to conduct their own due diligence in