L e t t e r  t o  S h a r e h o l d e r s

I have said it before, but it bears repeating. The nature of our business – working with and investing in small start-ups and turnarounds – highlights current losses while postponing observable value increases until a liquidating event. Furthermore, the accounting rules treat our investments in companies differently depending upon our ownership percentage, a situation that further obscures the underlying value that we believe is being created in our partnership companies and that may skew, for better or worse, the consolidated revenue we report.

For instance, if we own more than 50 percent of a company, we consolidate its results of operations and balance sheet. If we own between 20 percent and 50 percent of a company, we account for the investment on the equity method. This means that each quarter we include our pro rata share of the income or losses of that business as investment income. In addition, such income or loss amounts can increase or decrease the carrying value of our investment. If we own less than 20 percent of a privately held entity, we record this investment at our cost and do not write up the value even if the entity has raised new funds at a higher valuation. Furthermore, if we increase or decrease our ownership over time, the accounting method could change.

Year-to-year comparisons of operating results are not particularly meaningful. Most of our income comes on an irregular basis as a result of a liquidating event that allows us to quantify the underlying value of an investment. For instance, we recently sold our InterQuad Services subsidiary in exchange for a 19 percent interest in a privately held U.K. company whose major asset is an ownership interest in a business that provides computer hardware, software, training and consulting services to business customers. This means that, going forward, we will no longer consolidate the revenue and losses of InterQuad Services but we will own a minority interest with potential upside in a company with a broader mix of products and services and a new infusion of capital. At the time of the sale, the net book value of InterQuad Services was zero, due to historical losses.

Similarly, in 1998, we sold our Intelligent Enclosures business in exchange for common stock of Daw Technologies, a publicly traded company. As of the sale date, we no longer include Intelligent Enclosures in our consolidated results. We carry the $1.3 million sale price (which is a guaranteed value in shares of Daw common stock) on our balance sheet as "other asset" until April 2000 at which time certain conditions expire. After that time, the carrying value will fluctuate in response to the market price of Daw stock.

As you may know, we became involved with PaySys in a turnaround situation in late 1993. PaySys sells software and services that allow financial institutions and retailers to run their credit processing operations. In 1998, PaySys’ revenue topped $45 million, a 40 percent increase over 1997. Since 1993, we have invested $3.0 million in PaySys. In the past two years, PaySys raised two significant rounds of venture capital from Oak Partners, Advent and others and we sold a portion of our holdings, generating $4.5 million in cash. PaySys’ extensive multi-year investment in research and development should yield a new product architecture in 1999. Although we own approximately 30 percent of PaySys on a fully diluted basis, under the equity method of accounting our investment in PaySys is recorded as zero on our balance sheet due to historical losses. However, along with the other investors, we believe PaySys has created significant value that we hope will be demonstrated at a future liquidity event.

We own approximately 34 percent of Visibility, a firm that sells software to help companies manage complex engineer-to-order sales transactions. Visibility’s 1998 revenue grew more than 38 percent to $30.2 million, marking an important turnaround for the business. A major new software product is extending Visibility’s reach into the aircraft maintenance industry. Since early 1997, we have invested $4.6 million in Visibility; however, our carrying value is $5.6 million which includes our pro rata share of Visibility income under the equity method.

Just these few examples illustrate the impact of various accounting treatments on the reported values of some of our companies. It is possible that this complexity often confuses shareholders as they try to reconcile reported values with what we believe to be the underlying business value.

ChemFree, one of our consolidated companies, experienced a year of solid revenue growth and increasing product visibility. ChemFree’s bio-remediating SmartWasherÒ parts washer recently was named Product of the Year by a leading industry publication. In 1998, ChemFree extended its distribution into new foreign markets, signed contracts with several large automotive chains to replace solvent-based parts washers with the SmartWasher and introduced new product models. Recently, ChemFree was chosen as national Incubator Manufacturing Client of the Year, recognizing both ChemFree’s progress and the contribution of our Shared Resource Technology Center small business incubator program.

For HumanSoft, another consolidated company, 1998 began with promise but ended in Chapter 11 reorganization. Despite a significant investment of time and expense, HumanSoft failed in a roll-up strategy that involved acquiring two competitors and combining the three businesses into one that would become the dominant industry player. A variety of factors contributed to the situation, including technical problems, difficulties rationalizing product offerings and resistance by customers. HumanSoft is preparing a reorganization plan for the vote of its creditors. Meanwhile, the QS Technologies subsidiary continues to provide software and services to its customers and we will consolidate the results of QS Technologies for the foreseeable future.

Our PsyCare consolidated company operated fewer inpatient RaphaÒ treatment programs in 1998 than in prior years, although expense cuts led to improved profitability. Reductions in length of hospital stay and reimbursement rates under managed health care make our programs less attractive to hospitals. Given the market outlook, we will not invest new funds in PsyCare but are hopeful it can continue to serve its patients on a self-sustaining basis.

In addition to the companies mentioned above, we own interests in Risk Laboratories (software) and Digital Wireless (wireless communications) that are accounted for by the equity method. We own from 1 percent to 19 percent of more than ten businesses that are accounted for under the cost method, including emerging internet companies Media Metrix, TransNexus and VerticalOne, and software firms, BT Squared Technologies and InfoWave Technologies. We devote substantial time to a number of these businesses and are actively engaged in evaluating other opportunities. However, until there is a major liquidity event involving one of our existing companies, we do not expect to make significant new investments.

This letter accompanies our Report on Form10-K for 1998. I encourage you to read the Report and to visit our company website, www.intelsys.com, on a regular basis.

 

J. Leland Strange

Chairman of the Board and President