**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

----

 

**FORM 10-Q**

 

----

 

| **ý** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|------------|----------------------------------------------------------------------------------------------|

 

**For the quarterly period ended September 30, 2002**

** **

**OR**

** **

| **o** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|-------|-----------------------------------------------------------------------------------------------|

** **

**For the transition period from              to              **

** **

**Commission File Number  0-20191**

** **

**INTRUSION INC.**

(Exactname of Registrant as specified in its charter)

 

| **Delaware**                                                     |   | **75-1911917**                         |
|------------------------------------------------------------------|--------|----------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |   | (I.R.S.  Employer  Identification No.) |
|                                                             |   |                                   |
| **1101 East Arapaho Road, Richardson, Texas 75081**              |
| (Address  of principal executive offices)                        |
| (Zip  Code)                                                      |
|                                                             |   |                                   |
| **(972) 234-6400**                                               |
| (Registrant’s  telephone number, including area code)       |
|                                                             |   |                                   |
| **Not Applicable**                                               |
| Former  name, if changed since last report)                      |

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days:

Yes  ý  No  o

 

The number of sharesoutstanding of the Registrant’s Common Stock, $.01 par value, on October 31,2002 was 20,646,425.

 

 

----

 

**INTRUSIONINC.**

 

INDEX

 
| **PART I - FINANCIAL  INFORMATION**                                                                                                         |
|---------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                        |   |
| Item 1.                                                                                                                                     | Financial Statements  (Unaudited) |
|                                                                                                                                        |   |
| Condensed  Consolidated Balance Sheets as of September 30, 2002 and December 31, 2001                                                       |
|                                                                                                                                        |   |
| Condensed  Consolidated Statements of Operations for the three months and nine months  ended September 30, 2002 and September 30, 2001 |
|                                                                                                                                        |   |
| Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2002 and September 30, 2001                       |
|                                                                                                                                        |   |
| Notes  to Condensed Consolidated Financial Statements                                                                                       |
|                                                                                                                                        |   |
| Item  2.                                                                                                                                    | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
|                                                                                                                                        |   |
| Item  3.                                                                                                                                    | Quantitative  and Qualitative Disclosures About Market Risk |
|                                                                                                                                        |   |
| Item 4.                                                                                                                                     | Controls and Procedures |
|                                                                                                                                        |   |
| **PART II - OTHER INFORMATION**                                                                                                             |
|                                                                                                                                        |   |
| Item 1.                                                                                                                                     | Legal Proceedings |
|                                                                                                                                        |   |
| Item 6.                                                                                                                                     | Exhibits and  Reports on Form 8-K |
|                                                                                                                                        |   |
| Signature Page                                                                                                                              |

 

2

----

 

**PART  I  - FINANCIAL INFORMATION**

 

Item 1.  FINANCIAL STATEMENTS

 

**INTRUSIONINC. AND SUBSIDIARIES**

CONDENSEDCONSOLIDATED BALANCE SHEETS

(Inthousands, except par value amounts)

(Unaudited)

 
|                                                                                                                                                                 |   | **Sept 30,********2002** |   | **Dec 31,****2001** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|---------------------|--------|
| **ASSETS**                                                                                                                                                           |   |                     |   |                |   |
| Current  Assets:                                                                                                                                                     |   |                     |   |                |   |
| Cash  and cash equivalents                                                                                                                                           |   | $                        | 7,947  |                | $      | 15,783 |   |
| Short-term  investments                                                                                                                                              |   | 5,215                    |   | 4,652               |   |
| Accounts  receivable, less allowance for doubtful accounts of $827 in 2002 and $797 in  2001                                                                         |   | 3,143                    |   | 5,206               |   |
| Income  taxes receivable                                                                                                                                             |   | —                   |   | 2,779               |   |
| Inventories,  net                                                                                                                                                    |   | 2,699                    |   | 5,016               |   |
| Other  assets                                                                                                                                                        |   | 992                      |   | 601                 |   |
| Total current assets                                                                                                                                                 |   | 19,996                   |   | 34,037              |   |
| Property  and equipment, net - continuing operations                                                                                                                 |   | 2,092                    |   | 3,603               |   |
| Property  and equipment, net - discontinued operations                                                                                                               |   | —                   |   | 741                 |   |
| Intangible assets, net                                                                                                                                               |   | 3,209                    |   | 3,807               |   |
| Other  assets                                                                                                                                                        |   | 88                       |   | 107                 |   |
| TOTAL  ASSETS                                                                                                                                                        |   | $                        | 25,385 |                | $      | 42,295 |   |
|                                                                                                                                                                 |   |                     |   |                |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                        |   |                     |   |                |   |
| Current  Liabilities:                                                                                                                                                |   |                     |   |                |   |
| Accounts  payable and accrued expenses                                                                                                                               |   | $                        | 3,679  |                | $      | 6,000 |   |
| Deferred  revenue                                                                                                                                                    |   | 1,541                    |   | 1,658               |   |
| Total  current liabilities - continued operations                                                                                                                    |   | 5,220                    |   | 7,658               |   |
| Total  current liabilities - discontinued operations                                                                                                                 |   | 402                      |   | 1,139               |   |
| Total  current liabilities                                                                                                                                           |   | 5,622                    |   | 8,797               |   |
| Stockholders’  Equity:                                                                                                                                          |   |                     |   |                |   |
| Preferred  stock, $.01 par value, authorized shares - 5,000, no shares issued and  outstanding                                                                       |   | —                   |   | —              |   |
| Common  stock, $.01 par value, authorized shares - 80,000  Issued shares - 20,686 in 2002 and 20,649 in 2001  Outstanding shares - 20,646 in 2002 and 20,609 in 2001 |   | 207                      |   | 206                 |   |
| Common  stock held in treasury, at cost - 40 shares                                                                                                                  |   | (362                     | )      | (362                | )      |
| Additional  paid-in capital                                                                                                                                          |   | 47,371                   |   | 47,320              |   |
| Accumulated  deficit                                                                                                                                                 |   | (27,026                  | )      | (13,327             | )      |
| Foreign  currency translation adjustment                                                                                                                             |   | (427                     | )      | (339                | )      |
| Total  stockholders’ equity                                                                                                                                     |   | 19,763                   |   | 33,498              |   |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                     |   | $                        | 25,385 |                | $      | 42,295 |   |

 

Seeaccompanying notes.

 

3

----

 

**INTRUSIONINC. AND SUBSIDIARIES**

CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS

(Inthousands, except per share amounts)

(Unaudited)

 
|                                                           |   | **Three Months Ended**      |   | **Nine Months Ended** |   |
|----------------------------------------------------------------|--------|-----------------------------|--------|-----------------------|--------|
|                                                           |   | **Sept****30,********2002** |   | **Sept 30,  2001**    |   | **Sept****30,  2002** |   | **Sept 30,  2001** |   |
| Net  Sales                                                     |   | $                           | 2,394  |                  | $      | 3,612 |   | $ | 6,373 |   | $ | 13,381 |   |
|                                                           |   |                        |   |                  |   |   |   |   |   |
| Cost  of sales                                                 |   | 1,322                       |   | 2,354                 |   | 4,173 |   | 11,249 |   |
|                                                           |   |                        |   |                  |   |   |   |   |   |
| Gross  profit                                                  |   | 1,072                       |   | 1,258                 |   | 2,200 |   | 2,132 |   |
|                                                           |   |                        |   |                  |   |   |   |   |   |
| Operating  expenses:                                           |   |                        |   |                  |   |   |   |   |   |
| Sales  and marketing                                           |   | 2,507                       |   | 4,597                 |   | 9,606 |   | 19,123 |   |
| Research  and development                                      |   | 1,398                       |   | 2,933                 |   | 4,762 |   | 10,472 |   |
| General  and administrative                                    |   | 693                         |   | 894                   |   | 2,016 |   | 3,704 |   |
| Amortization  of intangibles                                   |   | 199                         |   | 182                   |   | 598 |   | 852 |   |
| Restructuring  and other charges                               |   | —                      |   | —                |   | 200 |   | 3,973 |   |
|                                                           |   |                        |   |                  |   |   |   |   |   |
| Operating  loss                                                |   | (3,725                      | )      | (7,348                | )      | (14,982 | ) | (35,992 | ) |
|                                                           |   |                        |   |                  |   |   |   |   |   |
| Interest  income, net                                          |   | 83                          |   | 334                   |   | 281 |   | 1,436 |   |
| Other  income (loss)                                           |   | (7                          | )      | 51                    |   | (7 | ) | 112 |   |
|                                                           |   |                        |   |                  |   |   |   |   |   |
| Loss  before income taxes                                      |   | (3,649                      | )      | (6,963                | )      | (14,708 | ) | (34,444 | ) |
|                                                           |   |                        |   |                  |   |   |   |   |   |
| Income  tax benefit                                            |   | —                      |   | (74                   | )      | (608 | ) | (1,694 | ) |
| Loss  from continuing operations                               |   | (3,649                      | )      | (6,889                | )      | (14,100 | ) | (32,750 | ) |
|                                                           |   |                        |   |                  |   |   |   |   |   |
| Gain  (loss) from discontinued operations                      |   | —                      |   | —                |   | 401 |   | (6,164 | ) |
|                                                           |   |                        |   |                  |   |   |   |   |   |
| Net  loss                                                      |   | $                           | (3,649 | )                     | $      | (6,889 | ) | $ | (13,699 | ) | $ | (38,914 | ) |
|                                                           |   |                        |   |                  |   |   |   |   |   |
| Basic  and diluted loss per share, continuing operations       |   | $                           | (0.18  | )                     | $      | (0.33 | ) | $ | (0.68 | ) | $ | (1.59 | ) |
|                                                           |   |                        |   |                  |   |   |   |   |   |
| Basic  and diluted loss per share                              |   | $                           | (0.18  | )                     | $      | (0.33 | ) | $ | (0.66 | ) | $ | (1.89 | ) |
|                                                           |   |                        |   |                  |   |   |   |   |   |
| Weighted  average common shares outstanding, basic and diluted |   | 20,645                      |   | 20,592                |   | 20,640 |   | 20,550 |   |

 

Seeaccompanying notes.

 

4

----

 

**INTRUSIONINC. AND SUBSIDIARIES**

CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS

(Inthousands)

(Unaudited)

 
|                                                                                                                          |   | **Nine Months Ended** |    |
|-------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|---------|
|                                                                                                                          |   | **Sept 30,  2002**    |    | **Sept 30,  2001** |   |
| Operating  Activities:                                                                                                        |   |                  |    |   |   |
| Loss  from continuing operations                                                                                              |   | $                     | (14,100 | ) | $ | (32,750 | ) |
| Adjustments  to reconcile loss from continuing operations to net cash used in operating  activities of continuing operations: |   |                  |    |   |   |
| Depreciation  and amortization                                                                                                |   | 2,165                 |    | 3,442 |   |
| Impairment  of intangible assets                                                                                              |   | —                |    | 3,109 |   |
| Deferred  income tax expense                                                                                                  |   | —                |    | 1,923 |   |
| Changes  in operating assets and liabilities:                                                                                 |   |                  |    |   |   |
| Accounts  receivable                                                                                                          |   | 2,063                 |    | 1,230 |   |
| Income  taxes receivable                                                                                                      |   | 2,779                 |    | (1,814 | ) |
| Inventories                                                                                                                   |   | 2,317                 |    | 2,742 |   |
| Other  assets                                                                                                                 |   | (372                  | )       | 683 |   |
| Accounts  payable and accrued expenses                                                                                        |   | (2,321                | )       | (3,065 | ) |
| Deferred  revenue                                                                                                             |   | (117                  | )       | 117 |   |
| Net  cash used in operating activities of continuing operations                                                               |   | (7,586                | )       | (24,383 | ) |
| Investing  Activities:                                                                                                        |   |                  |    |   |   |
| Purchases  of short-term investments                                                                                          |   | (12,565               | )       | (10,629 | ) |
| Maturities  of short-term investments                                                                                         |   | 12,002                |    | 28,313 |   |
| Net  purchases of property and equipment                                                                                      |   | (56                   | )       | (247 | ) |
| Net  cash provided by (used in) investing activities of continuing operations                                                 |   | (619                  | )       | 17,437 |   |
| Financing  Activities:                                                                                                        |   |                  |    |   |   |
| Exercise  of warrants and employee stock options                                                                              |   | 51                    |    | 405 |   |
| Issuance  of shares in employee stock purchase plan                                                                           |   | 1                     |    | — |   |
| Net  re-payment of capital leases                                                                                             |   | —                |    | (2 | ) |
| Net  cash provided by financing activities of continuing operations                                                           |   | 52                    |    | 403 |   |
|                                                                                                                          |   |                  |    |   |   |
| Net  cash provided by discontinued operations                                                                                 |   | 405                   |    | 3,404 |   |
| Effect  of foreign currency translation adjustments on cash and cash equivalents                                              |   | (88                   | )       | 44 |   |
| Net  decrease in cash and cash equivalents                                                                                    |   | (7,836                | )       | (3,095 | ) |
| Cash  and cash equivalents at beginning of period                                                                             |   | 15,783                |    | 20,345 |   |
| Cash  and cash equivalents at end of period                                                                                   |   | $                     | 7,947   |   | $ | 17,250 |   |

 

Seeaccompanying notes.

 

5

----

 

**INTRUSIONINC. AND SUBSIDIARIES**

NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

1.  Description of Business

 

Wedevelop, market and support a family of security software and appliances thataddress electronic security issues facing organizations deploying businessapplications over the Internet or internally via Intranets.  We currently provide e-security solutionsincluding intrusion detection systems, virtual private network appliances andfirewall appliances.

 

Wemarket and distribute our products through a direct sales force to end-users,distributors and by numerous domestic and international system integrators,service providers and value-added resellers. Our end-user customers include high-technology, manufacturing,telecommunications, retail, transportation, health care, insurance, entertainment,utilities and energy companies, government agencies, financial institutions,and academic institutions.

 

Ourcompany was organized in Texas in September 1983 and reincorporated in Delawarein October 1995.  For more than 15years, we provided local area networking equipment and were known as OpticalData Systems or ODS Networks.  On April17, 2000, we announced plans to sell, or otherwise dispose of, our networkingdivisions, which included our Essential Communications division and our local areanetworking assets.  In accordance withthese plans, we have accounted for these businesses as discontinuedoperations.  On June 1, 2000, we changedour name from ODS Networks, Inc. to Intrusion.com, Inc., and our NASDAQ tickersymbol from ODSI to INTZ to reflect our focus on e-security solutions.  On November 1, 2001, we changed our namefrom Intrusion.com, Inc. to Intrusion Inc.

 

Ourprincipal executive offices are located at 1101 E. Arapaho Road, Richardson,Texas 75081, and our telephone number is (972) 234-6400.  References to “we”, “us”, “our” or“Intrusion Inc.” refer to Intrusion Inc. and its subsidiaries.

 

2.  Basis of Presentation

 

Theaccompanying unaudited condensed consolidated financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States for interim financial information and with the instructions toForm 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States forcomplete financial statements.  TheDecember 31, 2001 balance sheet was derived from audited financial statements,but does not include all the disclosures required by accounting principlesgenerally accepted in the United States. However, we believe that the disclosures are adequate to make theinformation presented not misleading. In our opinion, all the adjustments (consisting of normal recurringadjustments) considered necessary for fair presentation have beenincluded.  The results of operations forthe three and nine month periods ending September 30, 2002 are not necessarilyindicative of the results that may be achieved for the full fiscal year or forany future period.  The condensedconsolidated financial statements included herein should be read in conjunctionwith the consolidated financial statements and notes thereto included in theCompany’s annual report on Form 10-K for the year ended December 31, 2001.

 

6

----

 

3.  Recently Adopted Accounting Pronouncements

 

*Goodwilland Other Intangible Assets*

 

EffectiveJanuary 1, 2002, we adopted Statements of Financial Accounting Standards(“SFAS”) No. 142 “Goodwill and Other Intangible Assets”, which requirescompanies to stop amortizing goodwill and certain intangible assets with anindefinite useful life.  Instead, SFASNo. 142 requires that goodwill and intangible assets deemed to have anindefinite useful life be reviewed for impairment upon adoption of SFAS No. 142(January 1, 2002), annually thereafter and upon the occurrence of any eventthat indicates potential impairments. The Company will perform its annual impairment review during the fourthquarter of each year, commencing in the fourth quarter of 2002.

 

SFASNo. 142 prescribes a two-phase process for impairment testing of goodwill. Thefirst phase screens for potential impairment; while the second phase (ifnecessary), measures the impairment. Goodwill is potentially impaired if the net book value of a reportingunit exceeds its estimated fair value. We have determined that we have one reporting unit.  This methodology differs from the Company’sprevious policy, as permitted under accounting standards existing at that time,of using undiscounted cash flows on an enterprise-wide basis to determine ifgoodwill is recoverable.

 

Upon adoption of SFASNo. 142 and completion of the required transition testing, we determined thatthe carrying value of goodwill of $354 thousand was not impaired.

 

*Long-livedAssets*

 

InOctober 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment ofDisposal of Long-Lived Assets, which supersedes SFAS No. 121, “Accounting forthe Impairment of Long-Lived Assets and for Long-Lived Assets to be disposedof.”  The primary objectives of SFASNo.144 are to develop one accounting model based on the framework establishedin SFAS no. 121 for long-lived assets to be disposed of by sale, and to addresssignificant implementation issues.  Weadopted SFAS No. 144 as of January 1, 2002. There has been no significant impact resulting from the adoption of SFASNo. 144.

 

TheCompany records impairment losses on long-lived assets when events andcircumstances indicate that such assets might be impaired and the estimatedfair value of the asset is less than its recorded amount.  Conditions that would necessitate animpairment assessment included material adverse changes in operations,significant adverse differences in actual results in comparison with initialvaluation forecasts prepared at the time of acquisition, a decision to abandonacquired products, services or technologies, or other significant adversechanges that would indicate the carrying amount of the recorded asset might notbe recoverable.

 

Wereview long-lived assets and certain intangible assets for impairment on aquarterly basis or whenever events or changes in circumstances indicate thatthe carrying amount of an asset may not be recoverable.  Recoverability of assets held and used ismeasured by a comparison of the carrying amount of an asset to undiscountedpre-tax future net cash flows expected to be generated by that asset.  An impairment loss is recognized for theamount by which the carrying amount of the assets exceeds the fair value of theassets.

 

7

----

 

4.  Inventories (In thousands)

 
|                     |   | **Sept 30,  2002** |   | **December 31,  2001** |   |
|--------------------------|--------|--------------------|--------|------------------------|--------|
|                     |   |               |   |                   |   |
| Inventories  consist of: |   |               |   |                   |   |
| Raw  materials           |   | $                  | 259    |                   | $      | 661 |   |
| Finished  goods          |   | 2,349              |   | 4,002                  |   |
| Demonstration  systems   |   | 91                 |   | 353                    |   |
| Net  inventory           |   | $                  | 2,699  |                   | $      | 5,016 |   |

 

5.  Intangible Assets

 

Amortizationof intangibles is comprised of the following:

 
|                     |   | **Three Months Ended  September 30** |   | **Nine Months Ended  December 31** |   |
|--------------------------|--------|--------------------------------------|--------|------------------------------------|--------|
|                     |   | **2002**                             |   | **2001**                           |   | **2002** |   | **2001** |   |
| Goodwill                 |   | $                                    | — |                               | $      | 16 |   | $ | — |   | $ | 48 |   |
| Purchased  Software      |   | 129                                  |   | 96                                 |   | 387 |   | 583 |   |
| Other  Intangible Assets |   | 70                                   |   | 70                                 |   | 211 |   | 221 |   |
| Total  Amortization      |   | $                                    | 199    |                               | $      | 182 |   | $ | 598 |   | $ | 852 |   |

 

Theallocation of intangible assets following our adoption of SFAS No. 142 issummarized in the following table:

 
|                              |   | **September 30, 2002**      |   | **December 31, 2001**         |   |
|-----------------------------------|--------|-----------------------------|--------|-------------------------------|--------|
|                              |   | **Gross  Carrying  Amount** |   | **Accumulated  Amortization** |   | **Gross  Carrying  Amount** |   | **Accumulated  Amortization** |   |
| Intangibles  no longer amortized: |   |                        |   |                          |   |   |   |   |   |
| Goodwill                          |   | $                           | 354    |                          | $      | — |   | $ | 450 |   | $ | 96 |   |
| Amortizable  intangibles:         |   |                        |   |                          |   |   |   |   |   |
| Purchased  Software               |   | $                           | 3,610  |                          | $      | 1,161 |   | $ | 3,610 |   | $ | 774 |   |
| Other  Intangible Assets          |   | $                           | 1,040  |                          | $      | 634 |   | $ | 1,040 |   | $ | 423 |   |

 

8

----

 

Theestimated future annual amortization expense for Purchased Software and OtherIntangible Assets is as follows:

 
|   |   | **Other Intangible  Assets** |   | **Purchased  Software** |   |
|--------|--------|------------------------------|--------|-------------------------|--------|
| 2002*  |   | $                            | 283    |                    | $      | 516 |   |
| 2003   |   | $                            | 283    |                    | $      | 516 |   |
| 2004   |   | $                            | 51     |                    | $      | 516 |   |
| 2005   |   | —                       |   | $                       | 516    |   |
| 2006   |   | —                       |   | $                       | 516    |   |

 

----

*  Includes nine months ended September 30,2002

 

Thedifferences between reported net loss and net loss adjusted for goodwillamortization for the three-month and nine-month periods ended September 30,2001 are not material.

 

6.  New Accounting Pronouncements

 

InJuly 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated withExit or Disposal Activities.”  SFAS No.146 addresses financial accounting and reporting for costs associated with exitor disposal activities, such as restructurings, involuntarily terminatingemployees and consolidating facilities. SFAS No. 146 excludes from its scope exit and disposal activitiesconducted in connection with a business combination and those activities towhich SFAS Nos. 143 and 144 are applicable. SFAS No. 146 is effective for exit and disposal activities that areinitiated after December 31, 2002.  Wedo not expect the adoption of this statement to have a material effect on ourconsolidated financial position or results of operations.

 

7.  Income Taxes

 

Oureffective tax rate differs from the amount expected by applying the statutoryrate as we recognize a valuation allowance on all net deferred tax assets untilit is more likely than not such assets will be realized.  During the second quarter 2002, an ongoingInternal Revenue Service audit was settled in our favor; we therefore recordeda benefit of $608 thousand to reverse an income tax payable previouslyaccrued.  We will recognize the benefitof our remaining net deferred tax assets, principally net operating losscarryforwards, when we generate taxable income and can be assured that suchdeferred tax assets can be realized.

 

9

----

 

8.  Earnings per Share (In thousands, except pershare amounts)

 
|                                                                                                            |   | **Three Months Ended**   |   | **Nine Months Ended**    |   |
|-----------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|--------------------------|--------|
|                                                                                                            |   | **Sept 30,********2002** |   | **Sept 30,********2001** |   | **Sept 30,  2002** |   | **Sept 30,  2001** |   |
| Numerator:                                                                                                      |   |                     |   |                     |   |   |   |   |   |
| Net  loss and numerator for Basic and diluted earnings per share                                                |   | $                        | (3,649 | )                        | $      | (6,889 | ) | $ | (13,699 | ) | $ | (38,914 | ) |
| Loss  from continuing operations and numerator for basic and diluted earnings per  share, continuing operations |   | $                        | (3,649 | )                        | $      | (6,889 | ) | $ | (14,100 | ) | $ | (32,750 | ) |
| Denominator:                                                                                                    |   |                     |   |                     |   |   |   |   |   |
| Denominator  for basic earnings per share weighted average common shares outstanding                            |   | 20,645                   |   | 20,592                   |   | 20,640 |   | 20,550 |   |
| Effect  of dilutive securities:                                                                                 |   |                     |   |                     |   |   |   |   |   |
| Stock  options and warrants                                                                                     |   | —                   |   | —                   |   | — |   | — |   |
| Denominator  for diluted earnings per share - adjusted weighted average common shares  outstanding              |   | 20,645                   |   | 20,592                   |   | 20,640 |   | 20,550 |   |
|                                                                                                            |   |                     |   |                     |   |   |   |   |   |
| Basic  and diluted loss per share, continuing operations                                                        |   | $                        | (0.18  | )                        | $      | (0.33 | ) | $ | (0.68 | ) | $ | (1.59 | ) |
|                                                                                                            |   |                     |   |                     |   |   |   |   |   |
| Basic  and diluted loss per share                                                                               |   | $                        | (0.18  | )                        | $      | (0.33 | ) | $ | (0.66 | ) | $ | (1.89 | ) |

 

Totalweighted stock options outstanding at September 30, 2002 and September 30, 2001that are not included in the diluted earnings per share computation due to theantidilutive effect are 2.0 million and 2.1 million for the three months endedSeptember 30, 2002 and September 30, 2001, respectively, and 2.1 millionand 2.1 million for the nine months ended September 30, 2002 andSeptember 30, 2001, respectively. Such options are excluded due to our incurring net losses during theseperiods.

 

9.  Comprehensive Loss

 

Thereare no significant differences between net loss and comprehensive loss for thethree months and nine months ended September 30, 2002 and 2001.

 

10.  Discontinued Operations

 

InMarch 2002 we sold the assets of our last remaining discontinued operation, ourEssential Communications division, for $1 million generating a gain of $0.4million, which we have shown as a gain from discontinued operations in theaccompanying financial statements. Terms of the sale included transferring $0.7 million in net property,plant and equipment, $0.1 million in current liabilities and productmaintenance of which $0.4 million was recorded in deferred revenue at December31, 2001.  Included in the gain on thesale of Essential is a $0.3 million reserve to terminate an office lease, whichis the equivalent of 2 years’ lease and maintenance of the facility.  Successful termination for less than 2 yearswill result in a greater gain on disposition of Essential.  Termination for more than $0.3 million willreduce the gain on disposition of Essential. The contractual term of the lease runs through February 2009 and remainingcontractual

 

10

----

 

lease payments total$1.0 million at September 30, 2002. During the nine months ended September 30, 2002, we used $78 thousand ofthe $0.3 million reserve for lease payments.

 

Duringthe first quarter of 2001, we closed the sale of our legacy local areanetworking division generating a gain of $2.1 million which was used to reducethe estimated net realizable value of the net assets of Essential.

 

Thefollowing represents a summary of assets and liabilities classified asdiscontinued operations (In thousands):

 
|                                  |   | **Sept 30,  2002** |   | **December 31,  2001** |   |
|---------------------------------------|--------|--------------------|--------|------------------------|--------|
|                                  |   |               |   |                   |   |
| Property  and equipment, net          |   | $                  | — |                   | $      | 741 |   |
| Intangible assets, net                |   | —             |   | —                 |   |
| Discontinued  assets                  |   | $                  | — |                   | $      | 741 |   |
| Discontinued  liabilities consist of: |   |               |   |                   |   |
| Deferred  revenue                     |   | $                  | — |                   | $      | 594 |   |
| Accrued  expenses                     |   | 402                |   | —                 |   |
| Accrued  operating losses             |   | —             |   | 545                    |   |
| Discontinued  liabilities             |   | $                  | 402    |                   | $      | 1,139 |   |

 

Thefollowing represents a summary of gains and losses from discontinued operations(In thousands):

 
|                                      |   | **Three Months Ended**   |   | **Nine Months Ended**    |   |
|-------------------------------------------|--------|--------------------------|--------|--------------------------|--------|
|                                      |   | **Sept 30,********2002** |   | **Sept 30,********2001** |   | **Sept 30,********2002** |   | **Sept 30,********2001** |   |
| Net  sales                                |   | $                        | — |                     | $      | 1,077 |   | $ | 727 |   | $ | 3,606 |   |
| Cost  of sales                            |   | —                   |   | 529                      |   | 323 |   | 2,635 |   |
|                                      |   |                     |   |                     |   |   |   |   |   |
| Gross  profit                             |   | —                   |   | 548                      |   | 404 |   | 971 |   |
|                                      |   |                     |   |                     |   |   |   |   |   |
| Operating  expenses                       |   | —                   |   | 925                      |   | 502 |   | 3,877 |   |
| Operating  loss                           |   | —                   |   | (377                     | )      | (98 | ) | (2,906 | ) |
|                                      |   |                     |   |                     |   |   |   |   |   |
| Other,  net                               |   | —                   |   | 377                      |   | — |   | (3,644 | ) |
| Gain  on sale                             |   | —                   |   | —                   |   | 499 |   | — |   |
| Gain  (loss) before income taxes          |   | —                   |   | —                   |   | 401 |   | (6,550 | ) |
|                                      |   |                     |   |                     |   |   |   |   |   |
| Income  tax benefit                       |   | —                   |   | —                   |   | — |   | (386 | ) |
|                                      |   |                     |   |                     |   |   |   |   |   |
| Gain  (loss) from discontinued operations |   | $                        | — |                     | $      | — |   | $ | 401 |   | $ | (6,164 | ) |

 

11

----

 

11.  Commitments and Contingencies

 

Weare subject to legal proceedings and claims that arise in the ordinary courseof business.  We do not believe that theoutcome of those matters will have a material adverse affect on ourconsolidated financial position, operating results or cash flows.  However, there can be no assurance suchlegal proceedings will not have a material impact.

 

On March 22, 2002, Morgan Newton Company,L.P. (“Morgan Newton”) filed suit against us in Dallas County District Court,Case No. DV02-02339-C, alleging claims for breach of contract, promissory estoppel,and fraud.  The claims arise out of analleged oral representation to Morgan Newton concerning a request for quotationfor the purchase of a large amount of Morgan Newton’s products.  Morgan Newton has not specified the amountof damages it is seeking in the lawsuit, but it is possible that Morgan Newtonmay be seeking damages in excess of $2 million.  In addition to actual damages, Morgan Newton is also seekingattorney’s fees and punitive damages. We believe Morgan Newton’s claims are without merit and intend tovigorously defend this lawsuit.  OnApril 22, 2002, we filed our response to Morgan Newton’s lawsuit, generallydenying all claims and asserting certain affirmative defenses.  As of this time, discovery is substantiallyunderway, and trial has been scheduled for early 2003.

 

Item 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Thisreport contains forward-looking statements, within the meaning of Section 27Aof the Securities Act of 1933 and Section 21E of the Securities Exchange Act of1934, that involve risks and uncertainties, such as statements concerning: the difficulties in forecasting future sales caused by currenteconomic and market conditions, the effect of military actions on government andcorporate spending on information security products, the impact of our costreduction programs, the difficulties and uncertainties in successfullydeveloping and introducing new products, our ability to continue to meetoperating expenses through current cash flow or additional financings, thecontinuance and strength of our relationship with Check Point, the highlycompetitive market for our products, difficulties in accurately estimatingmarket growth, the consolidation of the information security industry, theimpact of changing economic conditions, business conditions in the informationsecurity industry, our ability to manage acquisitions effectively, our abilityto manage discontinued operations effectively, the impact of market peers andtheir products as well as risks concerning future technology and othersidentified in our Annual Report on Form 10-K and other Securities and ExchangeCommission filings.  Suchforward-looking statements are generally accompanied by words such as “plan,”“estimate,” “expect,” “believe,” “should,” “would,” “could,” “anticipate,”“may” or other words that convey uncertainty of future events or outcomes.  These forward-looking statements and otherstatements made elsewhere in this report are made in reliance on the PrivateSecurities Litigation Reform Act of 1995. The section below entitled “Factors That May Affect Future Results ofOperations” sets forth and incorporates by reference certain factors that couldcause actual future results of the company to differ materially from thesestatements.

 

12

----

 

Overview

 

Wedevelop, market and support a family of security software and appliances thataddress electronic security issues facing organizations deploying businessapplications over the Internet or internally via Intranets.  We currently provide e-security solutionsincluding intrusion detection systems, virtual private network appliances andfirewall appliances.  On June 1, 2000,we changed our name from ODS Networks, Inc. to Intrusion.com Inc. and ourNASDAQ ticker symbol from ODSI to INTZ to reflect our focus on e-securitysolutions.  On November 1, 2001, wechanged our name from Intrusion.com, Inc. to Intrusion Inc.  During the second quarter of 2000, weannounced our plan to sell, or otherwise dispose of, our networking divisionswhich included our Essential Communications division and our local areanetworking assets and began accounting for these networking divisions asdiscontinued operations.

 

Thefollowing management’s discussion and analysis of financial condition andresults of operations pertains only to our continuing operations unlessotherwise disclosed.  Certain prior yearinformation has been reclassified to conform with the current presentation.

 

Critical Accounting Policies and Estimates

 

Management’sdiscussion and analysis of financial condition and results of operations arebased upon our condensed consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States.  The preparation of thesefinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingent assets and liabilities.  On an on-going basis, we evaluate our estimates, including thoserelated to product returns, bad debts, inventories, intangible assets, incometaxes, warranty obligations, restructuring, maintenance contracts andcontingencies.  We base our estimates onhistorical experience and on various other assumptions that are believed to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.

 

We believethe following critical accounting policies affect our more significantjudgments and estimates used in the preparation of our condensed consolidatedfinancial statements.

 

*Revenue Recognition*

 

Wegenerally recognize product revenue upon shipment of product.  We accrue for estimated warranty costs,sales returns and other allowances at the time of shipment based on ourexperience.  Revenue from maintenancecontracts is deferred and recognized over the contractual period the servicesare performed.  To date, warranty costsand sales returns have not been material. There is a risk that technical issues on new products could result inunexpected warranty costs and returns.

 

Werecognize software revenue from the licensing of our software products inaccordance with Statement of Position (“SOP”) No. 97-2 “Software RevenueRecognition” and SOP 98-9 “Modification of 97-2, Software Revenue Recognition,with respect to certain transactions” whereby revenue from the licensing of ourproducts is not recognized until all four of the following have been met: i)execution of a written purchase order, license agreement or contract; ii)shipment

 

13

----

 

of the product hasoccurred; iii) the license fee is fixed and determinable; and iv)collectibility is probable.  The Companydefers and recognizes maintenance and support revenue over the term of the contractperiod, which is generally one year.

 

Wehave signed distribution agreements with distributors in the United States,Europe and Asia.  In general, theserelationships are non-exclusive. Distributors typically maintain an inventory of our products.  Under these agreements, we provide certainprotection to the distributors for their inventory of our products for pricereductions as well as products that are slow-moving or have been discontinuedby us.  Recognition of sales todistributors and related gross profits are deferred until the merchandise isresold by the distributors.  However,since we have legally sold the inventory to the distributor and we no longerhave care, custody or control over the inventory, we recognize the tradeaccounts receivable and reduce inventory related to the sale at the time ofshipment to the distributor.  Revenue,offset by deferred cost of sales, is included in deferred revenue in theaccompanying financial statements.

 

*Allowance for DoubtfulAccounts and Returns*

 

We maintainallowances for doubtful accounts for estimated losses resulting from theinability of our customers to make required payments.  If the financial condition of our customers were to deteriorate,resulting in an impairment of their ability to make payments, additionalallowances may be required.

 

*Inventory*

 

We write downour inventory for estimated obsolescence or unmarketable inventory equal to thedifference between the cost of inventory and the estimated market value basedupon assumptions about future demand and market conditions. If actual marketconditions are less favorable than those projected by management, additionalinventory write-downs may be required.

 

*Discontinued Operations*

 

Inthe second quarter of 2000, we discontinued our networking operations andaccordingly have shown the networking operations as discontinued in theaccompanying financial statements.

 

Duringthe first quarter of 2001, we closed the sale of our legacy local areanetworking division generating a gain of $2.1 million, which was used to reducethe estimated net realizable value of the net assets of EssentialCommunications.

 

InMarch 2002 we sold the assets of our last remaining discontinued operation, ourEssential Communications division, for $1 million generating a gain of $0.4million, which we have shown as a gain from discontinued operations in theaccompanying financial statements. Terms of the sale included transferring $0.7 million in net property,plant and equipment, $0.1 million in current liabilities and productmaintenance of which $0.4 million was recorded in deferred revenue at December31, 2001.  Included in the gain on thesale of Essential is a $0.3 million reserve to terminate an office lease, whichis the equivalent of 2 years’ lease and maintenance of the facility.  Successful termination for less than 2 yearswill result in a greater gain on disposition of Essential.  Termination for more than $0.3 million willreduce the gain on disposition of Essential. The contractual term of the lease runs through February 2009 andremaining contractual lease payments total $1.0 million at September 30,2002.  During the nine months

 

14

----

 

ended September 30,2002, we used $78 thousand of the $0.3 million reserve for lease payments.

 

Results of Operations

 

Thefollowing table sets forth, for the periods indicated, certain financial dataas a percentage of net sales. The period-to-period comparison of financialresults is not necessarily indicative of future results.

 
|                                      |   | **Three Months Ended** |   | **Nine Months Ended**    |   |
|-------------------------------------------|--------|------------------------|--------|--------------------------|--------|
|                                      |   | **Sept 30,  2002**     |   | **Sept 30,********2001** |   | **Sept 30,********2002** |   | **Sept 30,  2001** |   |
| Net  sales                                |   | 100.0                  | %      | 100.0                    | %      | 100.0 | % | 100.0 | % |
| Cost  of sales                            |   | 55.2                   |   | 65.2                     |   | 65.5 |   | 84.1 |   |
| Gross  profit                             |   | 44.8                   |   | 34.8                     |   | 34.5 |   | 15.9 |   |
| Operating  expenses:                      |   |                   |   |                     |   |   |   |   |   |
| Sales  and marketing                      |   | 104.7                  |   | 127.3                    |   | 150.7 |   | 142.9 |   |
| Research  and development                 |   | 58.4                   |   | 81.2                     |   | 74.7 |   | 78.3 |   |
| General  and administrative               |   | 28.9                   |   | 24.8                     |   | 31.6 |   | 27.7 |   |
| Amortization  of intangibles              |   | 8.3                    |   | 5.0                      |   | 9.4 |   | 6.4 |   |
| Restructuring  costs and other charges    |   | —                 |   | —                   |   | 3.1 |   | 29.7 |   |
| Operating  loss                           |   | (155.6                 | )      | (203.4                   | )      | (235.1 | ) | (269.0 | ) |
|                                      |   |                   |   |                     |   |   |   |   |   |
| Interest  income, net                     |   | 3.5                    |   | 9.2                      |   | 4.4 |   | 10.7 |   |
| Other  income                             |   | (0.3                   | )      | 1.4                      |   | (0.1 | ) | 0.8 |   |
| Loss  before income taxes                 |   | (152.4                 | )      | (192.8                   | )      | (230.8 | ) | (257.4 | ) |
|                                      |   |                   |   |                     |   |   |   |   |   |
| Income  tax benefit                       |   | —                 |   | (2.0                     | )      | (9.5 | ) | (12.7 | ) |
|                                      |   |                   |   |                     |   |   |   |   |   |
| Loss  from continuing operations          |   | (152.4                 | )      | (190.7                   | )      | (221.2 | ) | (244.8 | ) |
| Gain  (loss) from discontinued operations |   | —                 |   | —                   |   | 6.3 |   | (46.1 | ) |
| Net  loss                                 |   | (152.4                 | )      | (190.7                   | )      | (215.0 | ) | (290.8 | ) |

 
|              |   | **Three Months Ended** |   | **Nine Months Ended**    |   |
|-------------------|--------|------------------------|--------|--------------------------|--------|
|              |   | **Sept 30,  2002**     |   | **Sept 30,********2001** |   | **Sept 30,********2002** |   | **Sept 30,  2001** |   |
| Domestic  sales   |   | 69.2                   | %      | 49.2                     | %      | 69.0 | % | 65.0 | % |
| Export  sales to: |   |                   |   |                     |   |   |   |   |   |
| Europe            |   | 17.7                   |   | 40.8                     |   | 12.0 |   | 23.6 |   |
| Canada            |   | 2.3                    |   | 5.4                      |   | 5.2 |   | 3.9 |   |
| Asia              |   | 10.6                   |   | 4.0                      |   | 13.6 |   | 6.7 |   |
| Latin  America    |   | 0.2                    |   | 0.6                      |   | 0.2 |   | 0.8 |   |
|              |   |                   |   |                     |   |   |   |   |   |
| Net  sales        |   | 100.0                  | %      | 100.0                    | %      | 100.0 | % | 100.0 | % |

 

15

----

 

**Net Sales**. Net sales for the quarter and nine months ended September 30, 2002decreased to $2.4 million and $6.4 million, respectively, compared to $3.6million and $13.4 million, respectively, for the same periods of 2001 as salesfrom our first generation security products decreased.  Included in the $2.4 million of sales forthe quarter ended September 30, 2002 was $0.4 million of sales related to aretroactive billing related to a SecureCom maintenance contract, which wasbooked and fully recognized in the quarter due to extended customernegotiations resulting in a delay of the order.

 

**Export Sales**. Export sales for the quarter and nine months ended September 30, 2002decreased to $0.7 million and $2.0 million, respectively, compared to $1.8million and $4.7 million, respectively, for the same period of 2001 as sales fromour SecureNet Pro intrusion detection product family, PDS security appliancefamily and other security product lines declined.  Though we expect increased sales from export sales going forward,such export sales may vary as a percentage of net sales in the future.

 

**Concentration of Sales**.  There were no significant concentrations ofsales (i.e. greater than 10%) to any one single customer during the first ninemonths of 2002 and 2001.  Sales to allU.S Government entities in total was $0.7 million or 27.7% of net sales for thequarter ended September 30, 2002 compared to $0.5 million or 14.6% of net salesfor the quarter ended September 30, 2001. Government sales for the nine months ended September 30, 2002 was $1.1million or 17.9% of net sales compared to $3.2 million or 23.7% for same periodin 2001.

 

**Gross Profit**. Gross profit was $1.1 million or 44.8% of net sales for the quarterended September 30, 2002, compared to $1.3 million or 34.8% of net sales forthe quarter ended September 30, 2001. For the nine months ended September 30,2002, gross profit decreased to $2.2 million or 34.5% of net sales compared to$2.1 million or 15.9% of net sales for the same period in the prior year. Grossprofit margins as a percentage of net sales were up for the quarter and ninemonths ended September 30, 2002 primarily because of the change in product mixfrom lower margin hardware products to higher margin intrusion detectionproducts.  Included in the higher marginproduct mix in the third quarter 2002 was $0.4 million of gross profit relatedto a retroactive billing related to a SecureCom maintenance contract, which wasbooked and fully recognized in the quarter due to extended customernegotiations resulting in a delay of the order.

 

Grossprofit as a percentage of net sales is impacted by several factors, includingshifts in product mix, changes in channels of distribution, sales volume,fluctuations in manufacturing costs, pricing strategies, and fluctuations insales of integrated third-party products.

 

**Sales and Marketing**.  Sales and marketing expenses decreased to$2.5 million for the quarter ended September 30, 2002, compared to $4.6 millionfor the quarter ended September 30, 2001. Sales and marketing expensesdecreased to $9.6 million for the nine months ended September 30, 2002 comparedto $19.1 million for the same period of 2001. Sales and marketing expensesdecreased in the quarter and nine months ended September 30, 2002, compared tothe same period of 2001, primarily due to the reorganization of our sales andmarketing departments and other cost reduction initiatives.  We expect sales and marketing expenses todecline modestly in the fourth quarter of 2002, in comparison to the thirdquarter of 2002.  Sales and marketingexpenses may vary as a percentage of net sales in the future.

 

**Research and Development**.  Research and development expenses decreasedto $1.4 million for the quarter ended September 30, 2002, compared to $2.9million

 

16

----

 

for the quarter endedSeptember 30, 2001. Research and development costs for the nine months endedSeptember 30, 2002 decreased to $4.8 million compared to $10.5 million for thesame period in 2001. Research and development costs are expensed in the periodincurred.  Research and developmentexpenses decreased in the quarter and nine months ended September 30, 2002,compared to the same periods in 2001 as we focused more of our developmentefforts on our core security products, SecureNet Pro and PDS securityappliances, while reducing efforts on our other security products. Research anddevelopment expenses may vary as a percentage of net sales in the future.

 

**General and Administrative**.  General and administrative expensesdecreased to $0.7 million for the quarter ended September 30, 2002, compared to$0.9 million for the quarter ended September 30, 2001. General andadministrative expensed decreased to $2.0 million for the nine months endingSeptember 30, 2002, compared to $3.7 million for the nine months ending September30, 2001. General and administrative expenses decreased in the quarter and ninemonths ending September 30, 2002 compared to the same periods of 2001,primarily due to the restructuring done in 2001 and 2002 and other costreduction initiatives.  It is expectedthat general and administrative expenses will continue to decrease slightly inthe fourth quarter of 2002, in comparison to the third quarter of 2002.  General and administrative expense may varyas a percentage of net sales in the future.

 

**Amortization**. Amortization expenses remained constant at $0.2 million for the quarterended September 30, 2002, compared to $0.2 million for the quarter endedSeptember 30, 2001.  Amortizationexpenses for the nine months ended September 30, 2002 decreased to $0.6 millioncompared to $0.9 million for the same period in 2001. Amortization expensesdecreased in the nine month period ended September 30, 2002, compared with thesame periods in 2001, as a result of the June 30, 2001 write off of certainimpaired intangible assets and intellectual properties acquired from ScienceApplications International Corporate (“SAIC”) in 1998 and the discontinuance ofthe amortization of goodwill effective January 1, 2002. Absent subsequentacquisitions, all future amortization will continue to be associated only withidentifiable intangibles acquired in connection with our acquisition ofMimestar, Inc. and will be approximately $0.2 million per quarter.

 

**Restructuring Charges.   **Restructuringcharges of $0.2 million for 2002 consists of severance expense related toadditional streamlining of our organization. In June 2001, we recorded a charge of $4.0 million for restructuringcosts and other special charges consisting primarily of a $3.1 millionimpairment charge related to intangible assets of our SecurityAnalyst andSecureEnterprise product lines and $0.8 million for severance as a result ofreductions in force.

 

**Interest**. Net interest income decreased to $0.1 million for the quarter endedSeptember 30, 2002, compared to $0.3 million for the same period in 2001.  Net interest income decreased to $.3 millionfor the nine months ended September 30, 2002, compared to $1.4 million for thenine months ended September 30, 2001. The net interest income decreases wereprimarily due to the reduced overall cash balances resulting from operatinglosses.  Net interest income may vary inthe future based on our cash flow and rate of return on investments.

 

**Income Taxes**. Our effective tax rate for the quarter ended September 30, 2002 was 0%,compared to 1.1% for the quarter ended September 30, 2001.  Our effective tax rate for the nine monthsended September 30, 2002 was 4.2%, compared to 4.9% for the nine months endedSeptember 30, 2001.  During the secondquarter of 2002, an ongoing Internal Revenue Service audit was settled in ourfavor; we therefore recorded a benefit of $608 thousand to reverse an incometax payable

 

17

----

 

previously accrued.  We will recognize the benefit of ourremaining net deferred tax assets, primarily operating loss carryforwards, whenwe generate taxable income and can be assured that such deferred tax assets canbe realized.

 

Liquidity and CapitalResources

 

Ourprincipal source of liquidity at September 30, 2002 is approximately $8.0million of cash and cash equivalents and $5.2 million of short-terminvestments.  As of September 30, 2002working capital was $14.4 million compared to $25.2 million as of December 31,2001.

 

Cashused in continuing operations for the nine months ended September 30, 2002 was$7.6 million, primarily due to an operating loss from continuing operations of$14.1 million, offset by a decrease in income taxes receivable, accountsreceivable and inventories.  Futurefluctuations in inventory balances, accounts receivable and accounts payablewill be dependent upon several factors, including, but not limited to,quarterly sales, our strategy in building inventory in advance of receivingorders from customers, and the accuracy of our forecasts of product demand andcomponent requirements.

 

Cashused in investing activities of continuing operations in the nine months endedSeptember 30, 2002 was $0.6 million, which consisted primarily of the netpurchases of short-term investments.

 

Cashprovided by financing activities of continuing operations in the nine monthsended September 30, 2002 was $52 thousand, which was primarily the result ofthe issuance of common stock upon the exercise of employee stock options.

 

Netcash provided by discontinued operations in the nine months ended September 30,2002 was $0.4 million, which consisted primarily of the net proceeds of thesale of the assets of Essential Communications.

 

AtSeptember 30, 2002, the Company did not have any material commitments forcapital expenditures.

 

Duringthe nine months ended September 30, 2002, the Company funded its operationsthrough the use of cash and cash equivalents.

 

Althoughwe believe we have sufficient cash resources to finance our operations andexpected capital expenditures for the remainder of 2002 and the year 2003, thesufficiency of our cash resources may depend to a certain extent on generaleconomic, financial, competitive or other factors beyond our control.  Moreover, despite actions to reduce ourcosts and improve our profitability, we expect our operating losses and netoperating cash outflows to continue for the remainder of 2002 and into2003.  As a result, we may not be ableto achieve the revenue and gross margin objectives necessary to achievepositive cash flow or profitability without obtaining additionalfinancing.  We do not currently have anyarrangements for financing, and we may not be able to secure additional debt orequity financing on terms acceptable to us, or at all, at the time when we needsuch funding.  If our business does notgenerate sufficient cash flow from operations and sufficient future financingsare not available, we may not be able to operate or grow our business, pay ourexpenses when due or fund our other liquidity needs.

 

Weintend to explore the possible acquisitions of businesses, products andtechnologies that are complementary to our existing business.  We are continuing to identify and prioritizeadditional security technologies which we may wish to

 

18

----

 

develop, eitherinternally or through the licensing or acquisition of products from thirdparties.  While we engage from time totime in discussions with respect to potential acquisitions, there can be noassurances that any such acquisitions will be made or that we will be able tosuccessfully integrate any acquired business. In order to finance such acquisitions and working capital it may benecessary for us to raise additional funds through public or privatefinancings.  Any equity or debtfinancings, if available at all, may be on terms which are not favorable to usand, in the case of equity financings, may result in dilution to ourstockholders.

 

Factors That May AffectFuture Results of Operations 

 

Numerousfactors may affect our business and future results of operations.  These factors include, but are not limitedto, current economic and market conditions, the effect of military actions ongovernment and corporate spending on information security products,technological changes, competition and market acceptance, acquisitions, producttransitions, timing of orders, manufacturing and suppliers, reliance onoutsourcing vendors and other partners, intellectual property and licenses,third-party products, dependence on government customers, internationaloperations, intellectual property issues, liquidity and cash resources andeffects of restructuring plans and cost reductions.  The discussion below addresses some of these and other factors.  For a more thorough discussion of these andother factors that may affect our business and future results, see thediscussion under the caption “Factors That May Affect Future Results ofOperations” in our Annual Report on Form 10-K for the year ended December 31,2001.

 

**Technological Changes.**   The market for our products is characterizedby frequent product introductions, rapidly changing technology and continuedevolution of new industry standards. The market for security products requires our products to be compatibleand interoperable with products and architectures offered by various vendors,including other security products, networking products, workstation andpersonal computer architectures and computer and network operatingsystems.  Our success will depend to asubstantial degree upon our ability to develop and introduce in a timely mannernew products and enhancements to our existing products that meet changingcustomer requirements and evolving industry standards.  The development of technologically advancedproducts is a complex and uncertain process requiring high levels of innovationas well as the accurate anticipation of technological and market trends.  There can be no assurance that we will beable to identify, develop, manufacture, market and support new or enhancedproducts successfully in a timely manner. Further, we or our competitors may introduce new products or productenhancements that shorten the life cycle of or make obsolete our existingproduct lines, any of which could have a material adverse effect on our business,operating results and financial condition.

 

**MarketAcceptance.**  We are pursuing a strategy to increase the percentage of our revenuegenerated through indirect sales channels including distributors, value addedresellers, system integrators, original equipment manufacturers and managedservice providers.  There can be noassurance that our products will gain market acceptance in these indirect saleschannels.  Further, competition amongsecurity companies to sell products through these indirect sales channels couldresult in significant price competition and reduced profit margins.

 

Weare also pursuing a strategy to further differentiate our product line byintroducing complementary security products and incorporating new technologiesinto our existing product line.  Therecan be no assurance that we will

 

19

----

 

successfully introducethese products or that such products will gain market acceptance.  We anticipate competition from networkingcompanies, network security companies and others in each of our productlines.  We anticipate that profitmargins will vary among our product lines and that product mix fluctuationscould have an adverse effect on our overall profit margins.

 

**DiscontinuedOperations.  **In the second quarter of 2000, we discontinued our networkingoperations and accordingly have shown the networking operations as discontinuedin the accompanying financial statements.

 

In March 2002 we sold the assets of our lastremaining discontinued operation, Essential Communications division, for $1million generating a gain of $0.4 million. Included in the gain on the sale of Essential is a $0.3million reserve to terminate the lease which is the equivalent of 2 years’lease and maintenance of the facility. Successful termination for less than 2 years will result in a greatergain on disposition of Essential. Termination for more than $0.3 million will reduce the gain on dispositionof Essential.  The contractual term ofthe lease runs through February 2009 and remaining contractual lease paymentstotal $1.0 million at September 30, 2002.

 

**Acquisitions.**   Symantec, ISS, Cisco, Enterasys, NFR,Nokia, Celestix, IBM, Compaq and other competitors have acquired severalsecurity companies with complementary technologies, and we anticipate that suchacquisitions will continue in the future. These acquisitions may permit such competitors to accelerate thedevelopment and commercialization of broader product lines and morecomprehensive solutions than we currently offer.  In the past, we have relied upon a combination of internalproduct development and partnerships with other security vendors to providecompetitive solutions to customers. Certain of the recent and future acquisitions by our competitors may havethe effect of limiting our access to commercially significanttechnologies.  Further, the businesscombinations and acquisitions in the security industry are creating companieswith larger market shares, customer bases, sales forces, product offerings andtechnology and marketing expertise. There can be no assurance that we will be able to compete successfullyin such an environment.

 

We have made acquisitions in the past, andwe may, in the future, acquire or invest in additional companies, business units,product lines, or technologies to accelerate the development of products andsales channels complementary to our existing products and sales channels.  Acquisitions involve numerous risks,including: difficulties in assimilation of operations, technologies, andproducts of the acquired companies; risks of entering markets in which we haveno or limited direct prior experience and where competitors in such marketshave stronger market positions; the potential loss of key employees of theacquired company; and the diversion of our attention from normal dailyoperation of our business.  There can beno assurance that any other acquisition or investment will be consummated orthat such acquisition or investment will be realized.

 

**ProductTransitions.**   Once current security products have been inthe market place for a period of time and begin to be replaced by higherperformance products (whether of our design or a competitor’s design), weexpect the net sales of such products to decrease.  In order to achieve revenue growth in the future, we will berequired to design, develop and successfully commercialize higher performanceproducts in a timely manner.  There canbe no assurance that we will be able to introduce new products and gain marketacceptance quickly enough to avoid adverse revenue transition patterns duringcurrent or future product transitions. Nor can there be any assurance that we will be able to respondeffectively to

 

20

----

 

technologicalchanges or new product announcements by competitors, which could renderportions of our inventory obsolete.

 

**Manufacturingand Suppliers.  **Our operational strategy relies on outsourcing of product assembly andcertain other operations.  There can beno assurance that we will effectively manage our third-party contractors orthat these contractors will meet our future requirements for timely delivery ofproducts of sufficient quality and quantity. Further, we intend to introduce a number of new products and productenhancements in the remainder of 2002 and 2003 that will require that werapidly achieve volume production of those new products by coordinating ourefforts with those of our suppliers and contractors.  The inability of the third-party contractors to provide us withadequate supplies of high-quality products could cause a delay in our abilityto fulfill orders and could have an adverse effect on our business, operatingresults and financial condition.

 

All of the materials used in our products arepurchased under contracts or purchase orders with third parties.  While we believe that many of the materialsused in the production of our products are generally readily available from avariety of sources, certain components such as microprocessors and mother boardsare available from one or a limited number of suppliers.  The lead times for delivery of componentsvary significantly and can exceed twelve weeks for certain components.  If we should fail to forecast ourrequirements accurately for components, we may experience excess inventory orshortages of certain components that could have an adverse effect on ourbusiness and operating results. Further, any interruption in the supply of any of these components, orthe inability to procure these components from alternative sources atacceptable prices within a reasonable time, could have an adverse effect on ourbusiness and operating results.

 

**Intellectual Property and Licenses.**   There are many patentsheld by companies which relate to the design and manufacture of data securitysystems.  Potential claims ofinfringement could be asserted by the holders of those patents.  We could incur substantial costs indefending ourself and our customers against any such claim regardless of themerits of such claims.  In the event ofa successful claim of infringement, we may be required to obtain one or morelicenses from third parties.  There canbe no assurance that we could obtain the necessary licenses on reasonableterms.

 

**Sufficiencyof Cash Flow.**   As of September 30, 2002, we had cash, cashequivalents and investments in the amount of approximately $13.2 million, downfrom approximately $20.4 million as of December 31, 2001.  Although we believe we have sufficient cashresources to finance our operations and expected capital expenditures for theremainder of 2002 and the year 2003, the sufficiency of our cash resources maydepend to a certain extent on general economic, financial, competitive or otherfactors beyond our control.  Moreover,despite actions to reduce our costs and improve our profitability, we expectour operating losses and net operating cash outflows to continue during 2002and into 2003.  As a result, we may notbe able to achieve the revenue and gross margin objectives necessary to achievepositive cash flow or profitability without obtaining additionalfinancing.  We do not currently have anyarrangements for financing, and we may not be able to secure additional debt orequity financing on terms acceptable to us, or at all, at the time when we needsuch funding.  If our business does notgenerate sufficient cash flow from operations and sufficient future financingsare not available, we may not be able to operate or grow our business, pay ourexpenses when due or fund our other liquidity needs.

 

21

----

 

**Dependenceon Check Point Technologies**.   A large percentage of our sales arerepresented by our PDS family of security appliances which are integrated withCheck Point Software Technologies’ market-leading virtual private network andfirewall security software.  We expectthe percentage of sales represented by these products to decrease in thefuture.  Although we are a certifiedappliance partner of Check Point and our PDS products have received certificationfrom Check Point, we have no long-term agreement or exclusive relationship withCheck Point.  As a result, the loss orsignificant change in our relationship with Check Point, the failure of futurePDS products to receive Check Point certification, the business failure ofCheck Point or its acquisition by or of one of our competitors, and the loss ofmarket share of Check Point or market acceptance of its products could eachhave a material adverse effect on our business, financial condition and resultsof operations.

 

**Third-PartyProducts.**   We believe that it is beneficial to work with third parties withcomplementary technologies to broaden the appeal of our security products.  These alliances allow us to provideintegrated solutions to our customers by combining our developed technologywith third-party products.  As we alsocompete with these technology partners in certain segments of the market, therecan be no assurance that we will have access to all of the third-party productsthat may be desirable or necessary in order to offer fully integrated solutionsto our customers.

 

**International Operations.**  Our international operations may be affectedby changes in demand resulting from fluctuations in currency exchange rates andlocal purchasing practices, including seasonal fluctuations in demand, as wellas by risks such as increases in duty rates, difficulties in distribution,regulatory approvals and other constraints upon international trade.  Our sales to foreign customers are subjectto export regulations.  In particular,certain sales of our data security products require clearance and exportlicenses from the U.S. Department of Commerce under these regulations.  Any inability to obtain such clearances orany required foreign regulatory approvals on a timely basis could have amaterial adverse effect on our operating results.

 

**Impact of Government Customers.***** *** $0.7 million or 27.7% of revenue in thequarter ended September 30, 2002 was derived from sales to all U.S.government entities compared to $0.5 million or 14.6% of revenue in the quarterended September 30, 2001.  Sales tothe government present risks in addition to those involved in sales tocommercial customers, including potential disruptions due to appropriation andspending patterns and the government’s reservation of the right to cancelcontracts and purchase orders for its convenience.

 

**Effects of RecentTerrorist Attacks and Military Actions.**  Terrorist attacks inthe United States on September 11, 2001, as well as military actions or otherevents occurring in response or in connection to them, including futureterrorist attacks against United States targets, actual conflicts involving theUnited States or it allies or military or trade disruptions could impact ouroperations, including by:

 

•                  reducing government or corporate spending on network securityproducts;

•                  increasing the cost and difficulty in obtaining materials orshipping products; and

•                  affecting our ability to conduct business internationally.

 

22

----

 

Should such events occur, our business, operating results andfinancial condition could be materially and adversely affected.

 

**Restructuring and CostReductions.  **Weimplemented a restructuring plan in 2001 and April 2002.  The objective of our restructuring plan wasto reduce our cost structure to a sustainable level that is consistent with thecurrent macroeconomic environment.  Wealso implemented other strategic initiatives designed to strengthen ouroperations.  These plans involved, amongother things, reductions in our workforce and facilities, aligning ourorganization around our business objectives, realignment of our sales force andchanges in our sales management.  Theworkforce reductions could result in temporary reduced productivity of ourremaining employees.  Additionally, ourcustomers and prospects may delay or forgo purchasing our products due to aperceived uncertainty caused by the restructuring and other changes.  Failure to achieve the desired results ofour initiatives could seriously harm our business, results of operations andfinancial condition.

 

**Potential Nasdaq Delisting**.  The Nasdaq National Market maintains certain minimum requirements tomaintain the Nasdaq listing for our common stock.  These requirements include a minimum bid price for our commonstock of $1.00.  The trading price ofour common stock has not been in compliance with these requirements for morethan 30 consecutive business days, and we received a notification ofnoncompliance from Nasdaq on August 12, 2002. Because the minimum bid price of our stock was not at least $1.00 forany 10 consecutive business days during the 90 day period ending November 11,2002, Nasdaq may seek to delist our common stock.  We have applied to transfer our common stock for listing on theNasdaq SmallCap Market and expect to continue to have the opportunity to regaincompliance for listing on the Nasdaq National Market.  Although we believe we meet all the criteria to have our commonstock listed on the Nasdaq SmallCap Market, we cannot assure you that Nasdaqwill approve the transfer or that, once transferred, we will be able tomaintain compliance with the minimum bid price or other continued listingrequirements.

 

Ifwe are unable to regain compliance with the minimum bid price requirement orfail to comply with other Nasdaq continued listing requirements, our commonstock likely would trade in a less efficient market, such as the OTC BulletinBoard or in the “pink sheets” maintained by the National Quotation Bureau,Inc.  Because these alternativesgenerally are considered to be less efficient markets, our stock price, theliquidity of our common stock and our general business reputation may beadversely impacted.

 

**General.**   Sales of our productsfluctuate, from time to time, based on numerous factors, including customers’capital spending levels and general economic conditions.  While certain industry analysts believe thatthere is a significant market for data security products, there can be noassurance as to the rate or extent of the growth of such market or thepotential adoption of alternative technologies.  Currently, capital spending for information technology products,including security products is being adversely affected by uncertain economicconditions.  Future declines in datasecurity product sales as a result of general economic conditions, adoption ofalternative technologies or any other reason could have a material adverseeffect on our business, operating results and financial condition.

 

Due to the factors noted above and in“Management’s Discussion and Analysis of Financial Condition and Results ofOperations”, our future earnings and common stock price may be subject tosignificant volatility, particularly on a quarterly basis.  Past financial performance should not beconsidered a reliable indicator

 

23

----

 

of future performance and investors should not use historicaltrends to anticipate results or trends in future periods.  Any shortfall in revenue and earnings fromthe levels anticipated by securities analysts could have an immediate andsignificant effect on the trading price of our common stock in any givenperiod.  Also, we participate in a highlydynamic industry which often results in volatility of our common stock price.

 

Item 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK

 

**Foreign Exchange**.  Revenue originating outside the U.S. in the quarters ended September 30,2002 and 2001 was 30.8% and 50.8% of total revenues, respectively.International sales are made mostly from our foreign sales subsidiaries in thelocal countries and are typically denominated in U.S. dollars.  These subsidiaries incur most of theirexpenses in the local currency.

 

Ourinternational business is subject to risks typical of an internationalbusiness, including, but not limited to: differing economic conditions, changesin political climate, differing tax structures, other regulations andrestrictions and foreign exchange rate volatility.  Accordingly, our future results could be materially adverselyaffected by changes in these or other factors. The effect of foreign exchange rate fluctuations on us in 2002, 2001 and2000 was not material.

 

**Interest Rates**. We invest our cash in a variety offinancial instruments, including bank time deposits, fixed rate obligations ofcorporations, municipalities, and state and national governmental entities andagencies.  These investments aredenominated in U.S. dollars.  Cashbalances in foreign currencies overseas are operating balances and are investedin short-term time deposits of the local operating bank.

 

Interestincome on our investments is carried in “Interest income, net”.  We account for our investment instruments inaccordance with Statement of Financial Accounting Standards No. 115,“Accounting for Certain Investments in Debt and Equity Securities” (“SFAS115”).  All of the cash equivalents andshort-term investments are treated as available-for-sale under SFAS 115.

 

Investmentsin fixed rate interest earning instruments carry a degree of interest raterisk.  Fixed rate securities may havetheir fair market value adversely impacted due to a rise in interestrates.  Due in part to these factors,our future investment income may fall short of expectations due to changes ininterest rates or we may suffer losses in principal if forced to sellsecurities, which have seen a decline in market value due to changes ininterest rates.  Our investmentsecurities are held for purposes other than trading.  The weighted-average interest rate on investment securities atSeptember 30, 2002 was 6.94%.  The fairvalue of investments held at September 30, 2002 approximated amortized cost.

 

Item 4.                                     CONTROLS AND PROCEDURES

 

(a)                                  Evaluation of disclosure controlsand procedures.  Within 90 days prior to the filing of thisQuarterly Report on Form 10-Q, we carried out an evaluation, under thesupervision and the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, of the design and operation ofthese disclosure controls and procedures pursuant to Exchange Act of Rule13a-14.  Based upon that evaluation, ourChief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures are effective in timely

 

24

----

 

alertingthem to material information relating to the Company (including ourconsolidated subsidiaries) required to be included in our periodic SEC filings.

 

(b)                                 Changes in internal controls. There were no significant changes in internal controls or other factorsthat could significantly affect our internal controls subsequent to the date ofour evaluation.

 

**PART II - OTHER INFORMATION**

 

Item 1.            LEGAL PROCEEDINGS

 

We are subject to legal proceedings and claims thatarise in the ordinary course of business. We do not believe that the outcome of those matters will have a materialadverse affect on our consolidated financial position, operating results orcash flows.  However, there can be noassurance such legal proceedings will not have a material impact.

 

On March 22, 2002, Morgan Newton Company,L.P. (“Morgan Newton”) filed suit against us in Dallas County District Court,Case No. DV02-02339-C, alleging claims for breach of contract, promissory estoppel,and fraud.  The claims arise out of analleged oral representation to Morgan Newton concerning a request for quotationfor the purchase of a large amount of Morgan Newton’s products.  Morgan Newton has not specified the amountof damages it is seeking in the lawsuit, but it is possible that Morgan Newtonmay be seeking damages in excess of $2 million.  In addition to actual damages, Morgan Newton is also seekingattorney’s fees and punitive damages. We believe Morgan Newton’s claims are without merit and intend tovigorously defend this lawsuit.  OnApril 22, 2002, we filed our response to Morgan Newton’s lawsuit, generallydenying all claims and asserting certain affirmative defenses.  As of this time, discovery is substantiallyunderway, and trial has been scheduled for early 2003.

 

Item 6.            EXHIBITS AND REPORTS ON FORM 8-K

 

During the quarter ended September 30, 2002, we filed thefollowing reports on Form 8-K:

 

•                  Report on Form 8-K (Item 5) filed onAugust 20, 2002 announcing that we had received a notification of noncompliancefrom Nasdaq and attaching the related press release.

 

25

----

 

**S I G N A T U R E S**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 

 
|                     |   | **INTRUSION  INC.**                                                                                                  |   |
|--------------------------|--------|----------------------------------------------------------------------------------------------------------------------|--------|
|                     |   |
| Date: November 14,  2002 |   | /s/ Michael L. Paxton                                                                                                |   |
|                     |   | Michael  L. Paxton                                                                                                   |   |
|                     |   | Vice  President, Chief Financial Officer,  Treasurer & Secretary  (Principal Financial & Accounting Officer) |   |

 

26

----

 

**CERTIFICATION**

 

I, G. Ward Paxton, certify that:

 

1.               I have reviewed this Quarterly Report onForm 10-Q of Intrusion Inc.;

 

2.               Based on my knowledge, this quarterly reportdoes not contain any untrue statement of material fact or omit to state amaterial fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading withrespect to the period covered by this quarterly report;

 

3.               Based on my knowledge, the financialstatements, and other financial information included in this quarterly report,fairly present in all material respects the financial condition, results ofoperations and cash flows of the registrant as of, and for, the periodspresented in this quarterly report;

 

4.               The registrant’s other certifyingofficers and I are responsible for establishing and maintaining disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14)for the registrant and we have:

 

a.               designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this quarterly reportis being prepared;

 

b.              evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this quarterly report (the “Evaluation Date”); and

 

c.               presented in this quarterly report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

5.               The registrant’s other certifyingofficers and I have disclosed, based on our most recent evaluation, to theregistrant’s auditors and audit committee of registrant’s board of directors(or persons performing the equivalent function):

 

a.               all significant deficiencies in thedesign or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and

 

b.              any fraud, whether or not material, thatinvolves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.               The registrant’s other certifying officerand I have indicated in this quarterly report whether or not there weresignificant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 

 
| Date:   November 14, 2002 | By:    | /s/  G. Ward  Paxton            |   |
|--------------------------------|--------|--------------------------------------|--------|
|                           |   | G. Ward Paxton                       |   |
|                           |   | Chairman and Chief Executive Officer |

 

27

----

 

**CERTIFICATION**

 

I, Michael L. Paxton, certify that:

 

1.               I have reviewed this Quarterly Report onForm 10-Q of Intrusion Inc.;

 

2.               Based on my knowledge, this quarterlyreport does not contain any untrue statement of material fact or omit to statea material fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading withrespect to the period covered by this quarterly report;

 

3.               Based on my knowledge, the financialstatements, and other financial information included in this quarterly report,fairly present in all material respects the financial condition, results ofoperations and cash flows of the registrant as of, and for, the periodspresented in this quarterly report;

 

4.               The registrant’s other certifyingofficers and I are responsible for establishing and maintaining disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14)for the registrant and we have:

 

a.               designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this quarterly reportis being prepared;

 

b.              evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this quarterly report (the “Evaluation Date”); and

 

c.               presented in this quarterly report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

5.               The registrant’s other certifyingofficers and I have disclosed, based on our most recent evaluation, to theregistrant’s auditors and audit committee of registrant’s board of directors(or persons performing the equivalent function):

 

a.               all significant deficiencies in thedesign or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and

 

b.              any fraud, whether or not material, thatinvolves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.               The registrant’s other certifying officerand I have indicated in this quarterly report whether or not there weresignificant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 

 
| Date:   November 14, 2002 | By:    | /s/  Michael  L. Paxton                                      |   |
|--------------------------------|--------|-------------------------------------------------------------------|--------|
|                           |   | Michael L. Paxton                                                 |
|                           |   | Vice President,  Chief Financial Officer  Treasurer and Secretary |   |
|                                |        |                                                                   |        |  |

 

28

----