**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 

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| **ý**                                                                                                                                                                                                                                                                                                                                                                                             |   | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                                                                   |   |                                                                                          |
| **For  the quarterly period ended March 31, 2003**                                                                                                                                                                                                                                                                                                                                                     |
|                                                                                                                                                                                                                                                                                                                                                                                                   |   |                                                                                          |
| **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.**                                              |
|------------------------------------------------------------------|
| (Exact name 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 by Section13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (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

 

Indicate by check markwhether the Registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).  Yes  o    No  ý

 

The number of sharesoutstanding of the Registrant’s Common Stock, $0.01 par value, on May 9, 2003was 20,648,425.

 

 

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**INTRUSION INC.**

 

INDEX

 
| **PART I -  FINANCIAL INFORMATION**                                                                              |
|------------------------------------------------------------------------------------------------------------------|
|                                                                                                             |
| Item 1.    Financial Statements                                                                        |
|                                                                                                             |
| Condensed  Consolidated Balance Sheets as of March 31, 2003 and December 31, 2002                                |
|                                                                                                             |
| Condensed  Consolidated Statements of Operations for the three months ended March 31,  2003 and March 31, 2002   |
|                                                                                                             |
| Condensed  Consolidated Statements of Cash Flows for the three months ended March 31,  2003 and March 31, 2002   |
|                                                                                                             |
| 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

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**PARTI****- FINANCIAL INFORMATION**

 

Item1.             FINANCIALSTATEMENTS

 

**INTRUSIONINC. AND SUBSIDIARIES**CONDENSED CONSOLIDATEDBALANCE SHEETS(In thousands, except par value amounts)

 
|                                                                                                                                                                                |   | **March 31,  2003** |   | **Dec 31,  2002** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|--------|-------------------|--------|
|                                                                                                                                                                                |   | **(Unaudited)**     |   | **(Audited)**     |   |
| **ASSETS**                                                                                                                                                                          |   |                |   |              |   |
| Current  Assets:                                                                                                                                                                    |   |                |   |              |   |
| Cash  and cash equivalents                                                                                                                                                          |   | $                   | 945    |              | $      | 2,898 |   |
| Short-term  investments                                                                                                                                                             |   | 7,300               |   | 7,825             |   |
| Accounts  receivable, less allowance for doubtful accounts $755 in 2003 and $934 in  2002                                                                                           |   | 1,556               |   | 2,363             |   |
| Inventories,  net                                                                                                                                                                   |   | 1,726               |   | 1,411             |   |
| Other  assets                                                                                                                                                                       |   | 796                 |   | 759               |   |
| Total current assets                                                                                                                                                                |   | 12,323              |   | 15,256            |   |
| Property  and equipment, net                                                                                                                                                        |   | 1,222               |   | 1,597             |   |
| Other  assets                                                                                                                                                                       |   | 87                  |   | 86                |   |
| TOTAL  ASSETS                                                                                                                                                                       |   | $                   | 13,632 |              | $      | 16,939 |   |
|                                                                                                                                                                                |   |                |   |              |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                      |   |                |   |              |   |
|                                                                                                                                                                                |   |                |   |              |   |
| Current  Liabilities:                                                                                                                                                               |   |                |   |              |   |
| Accounts  payable and accrued expenses                                                                                                                                              |   | $                   | 2,740  |              | $      | 2,905 |   |
| Deferred  revenue                                                                                                                                                                   |   | 1,289               |   | 1,650             |   |
| Total  current liabilities                                                                                                                                                          |   | 4,029               |   | 4,555             |   |
| 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 – 20,688 in  2003 and 20,686 in 2002 Outstanding shares – 20,648 in 2003 and 20,646 in  2002 |   | 207                 |   | 207               |   |
| Common  stock held in treasury, at cost – 40 shares                                                                                                                            |   | (362                | )      | (362              | )      |
| Additional  paid-in capital                                                                                                                                                         |   | 47,371              |   | 47,371            |   |
| Accumulated  deficit                                                                                                                                                                |   | (37,385             | )      | (34,604           | )      |
| Accumulated  other comprehensive loss                                                                                                                                               |   | (228                | )      | (228              | )      |
| Total  stockholders’ equity                                                                                                                                                    |   | 9,603               |   | 12,384            |   |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                    |   | $                   | 13,632 |              | $      | 16,939 |   |

 

See accompanyingnotes.

 

3

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**INTRUSIONINC. AND SUBSIDIARIES**CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS(In thousands, except per share amounts)(Unaudited)

 

 
|                                                           |   | **Three  Months Ended** | ** ** |
|----------------------------------------------------------------|--------|-------------------------|------------|
|                                                           |   | **March 31,  2003**     |       | **March 31,  2002** | ** ** |
| Net  sales                                                     |   | $                       | 1,476      |   | $ | 2,514 |   |
|                                                           |   |                    |       |   |   |
| Cost  of sales                                                 |   | 1,004                   |       | 1,709 |   |
|                                                           |   |                    |       |   |   |
| Gross  profit                                                  |   | 472                     |       | 805 |   |
|                                                           |   |                    |       |   |   |
| Operating  expenses:                                           |   |                    |       |   |   |
| Sales  and marketing                                           |   | 1,863                   |       | 3,902 |   |
| Research  and development                                      |   | 923                     |       | 1,879 |   |
| General  and administrative                                    |   | 402                     |       | 709 |   |
| Amortization  of intangibles                                   |   | —                  |       | 199 |   |
| Severance  costs                                               |   | 126                     |       | — |   |
|                                                           |   |                    |       |   |   |
| Operating  loss                                                |   | (2,842                  | )          | (5,884 | ) |
|                                                           |   |                    |       |   |   |
| Interest  income, net                                          |   | 61                      |       | 89 |   |
|                                                           |   |                    |       |   |   |
| Loss  before income tax provision                              |   | (2,781                  | )          | (5,795 | ) |
|                                                           |   |                    |       |   |   |
| Income  tax provision                                          |   | —                  |       | — |   |
|                                                           |   |                    |       |   |   |
| Loss  from continuing operations                               |   | (2,781                  | )          | (5,795 | ) |
|                                                           |   |                    |       |   |   |
| Income  from discontinued operations                           |   | —                  |       | 401 |   |
|                                                           |   |                    |       |   |   |
| Net  loss                                                      |   | $                       | (2,781     | ) | $ | (5,394 | ) |
|                                                           |   |                    |       |   |   |
| Basic  and diluted loss per share, continuing operations       |   | $                       | (0.13      | ) | $ | (0.28 | ) |
|                                                           |   |                    |       |   |   |
| Basic  and diluted loss per share                              |   | $                       | (0.13      | ) | $ | (0.26 | ) |
|                                                           |   |                    |       |   |   |
| Weighted  average common shares outstanding, basic and diluted |   | 20,648                  |       | 20,632 |   |

 

See accompanyingnotes.

 

4

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**INTRUSIONINC. AND SUBSIDIARIES**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)(Unaudited)

 
|                                                                                                                          |   | **Three  Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|------------|
|                                                                                                                          |   | **March 31,  2003**     |       | **March 31,  2002** | ** ** |
| Operating  Activities:                                                                                                        |   |                    |       |   |   |
| Loss  from continuing operations                                                                                              |   | $                       | (2,781     | ) | $ | (5,795 | ) |
| Adjustments  to reconcile loss from continuing operations to net cash used in operating  activities of continuing operations: |   |                    |       |   |   |
| Depreciation  and amortization                                                                                                |   | 445                     |       | 725 |   |
| Changes  in operating assets and liabilities:                                                                                 |   |                    |       |   |   |
| Accounts  receivable                                                                                                          |   | 807                     |       | 1,084 |   |
| Income  taxes receivable                                                                                                      |   | —                  |       | 1,940 |   |
| Inventories                                                                                                                   |   | (315                    | )          | 867 |   |
| Other  assets                                                                                                                 |   | (38                     | )          | (342 | ) |
| Accounts  payable and accrued expenses                                                                                        |   | (165                    | )          | (623 | ) |
| Deferred  revenue                                                                                                             |   | (361                    | )          | (230 | ) |
| Net  cash used in operating activities of continuing operations                                                               |   | (2,408                  | )          | (2,374 | ) |
| Investing  Activities:                                                                                                        |   |                    |       |   |   |
| Purchases  of short-term investments                                                                                          |   | (1,000                  | )          | (4,525 | ) |
| Maturities  of short-term investments                                                                                         |   | 1,525                   |       | 3,752 |   |
| Net  purchases of property and equipment                                                                                      |   | (70                     | )          | (4 | ) |
| Net  cash provided by (used in) investing activities of continuing operations                                                 |   | 455                     |       | (777 | ) |
| Financing  Activities:                                                                                                        |   |                    |       |   |   |
| Exercise  of warrants and employee stock options                                                                              |   | —                  |       | 50 |   |
| Issuance  of shares in employee stock purchase plan                                                                           |   | —                  |       | 1 |   |
| Other                                                                                                                         |   | —                  |       | (21 | ) |
| Net  cash provided by financing activities of continuing operations                                                           |   | —                  |       | 30 |   |
|                                                                                                                          |   |                    |       |   |   |
| Net  cash provided by discontinued operations                                                                                 |   | —                  |       | 596 |   |
| Effect  of foreign currency translation adjustments on cash and cash equivalents                                              |   | —                  |       | 6 |   |
| Net  decrease in cash and cash equivalents                                                                                    |   | (1,953                  | )          | (2,519 | ) |
| Cash  and cash equivalents at beginning of period                                                                             |   | 2,898                   |       | 15,783 |   |
| Cash  and cash equivalents at end of period                                                                                   |   | $                       | 945        |   | $ | 13,264 |   |

 

See accompanyingnotes.

 

5

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**INTRUSION INC. AND SUBSIDIARIES**

NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

1.                  Description ofBusiness

 

We develop, market andsupport network intrusion detection systems and VPN/firewall appliances thataddress vital security issues facing organizations deploying businessapplications over the Internet or internally via Intranets.

 

We market and distributeour products through a direct sales force to end-users, distributors and bynumerous domestic and international system integrators, managed serviceproviders and value-added resellers. Our end-user customers include manufacturing, technology,telecommunications, retail, transportation, health care, insurance,entertainment, utilities and energy companies, government agencies, financialinstitutions, and academic institutions.

 

We organized in Texas inSeptember 1983 and reincorporated in Delaware in October 1995.  For more than 15 years, we provided localarea networking equipment and were known as Optical Data Systems or ODSNetworks.  On April 17, 2000, weannounced plans to sell, or otherwise dispose of, our networking divisions,which include our Essential Communications Division (“Essential”) and our localarea networking assets.  This plan wascompleted during March 2002.  We haveaccounted for these businesses as discontinued operations.  On June 1, 2000, we changed our name fromODS Networks, Inc. to Intrusion.com, Inc., and our NASDAQ ticker symbol fromODSI to INTZ to reflect our focus on intrusion detection solutions.  On November 1, 2001, we changed our namefrom Intrusion.com, Inc. to Intrusion Inc.

 

Our principal executiveoffices are located at 1101 East Arapaho Road, Richardson, Texas 75081, and ourtelephone number is (972) 234-6400.  Ourwebsite URL is www.intrusion.com. References to “we”, “us”, “our” or “Intrusion Inc.” refer to IntrusionInc. and its subsidiaries.

 

As of March 31, 2003, wehad cash, cash equivalents and short-term investments in the amount of approximately$8.2 million, down from approximately $10.7 million as of December 31,2002.  Although we believe we havesufficient cash resources to finance our operations and expected capitalexpenditures for the next twelve months, the sufficiency of our cash resourcesmay depend to a certain extent on general economic, financial, competitive orother factors beyond our control. Moreover, despite actions to reduce our costs and improve ourprofitability, we expect our operating losses and net operating cash outflowsto continue during 2003.  As a result,we may not be able to achieve the revenue and gross margin objectives necessaryto achieve positive 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.

 

2.                  Basis ofPresentation

 

The accompanyingunaudited condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesfor interim financial information and with the instructions to Form 10-Q andArticle 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, 2002

 

6

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balance sheet was derivedfrom audited financial statements, but does not include all the disclosuresrequired by accounting principles generally accepted in the United States.  However, we believe that the disclosures areadequate to make the information presented not misleading.  In our opinion, all the adjustments(consisting of normal recurring adjustments) considered necessary for fairpresentation have been included.  Theresults of operations for the three months ending March 31, 2003 are notnecessarily indicative of the results that may be achieved for the full fiscalyear or for any future period.  Thecondensed consolidated financial statements included herein should be read inconjunction with the consolidated financial statements and notes theretoincluded in the Company’s annual report on Form 10-K for the year endedDecember 31, 2002.

 

3.               Recent AccountingPronouncements

 

In July 2002, the FASBissued SFAS No. 146, “Accounting for Costs Associated with Exit or DisposalActivities.”  SFAS No. 146 addressesfinancial accounting and reporting for costs associated with exit or disposalactivities, such as restructurings, involuntarily terminating employees andconsolidating facilities.  SFAS No. 146excludes from its scope exit and disposal activities conducted in connectionwith a business combination and those activities to which SFAS Nos. 143 and 144are applicable.  SFAS No. 146 iseffective for exit and disposal activities that are initiated after December31, 2002.  We do not expect the adoptionof this statement to have a material effect on our consolidated financialposition or results of operations.

 

In December 2002, the FASB issued SFAS No.148, “Accounting for Stock-Based Compensation-Transition and Disclosure” (“SFAS148”).  SFAS 148 amends FASB StatementNo. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), to providealternative methods of transition to SFAS 123’s fair value method of accountingfor stock-based employee compensation.

 

SFAS 148 also amends the disclosureprovisions of SFAS 123 and APB Opinion No. 28, “Interim Financial Reporting,”to require disclosure in the summary of significant accounting policies of theeffects of an entity’s accounting policy with respect to stock-based employeecompensation on reported net income and earnings per share in annual andinterim financial statements. While SFAS 148 does not amend SFAS 123 to requirecompanies to account for employee stock options using the fair value method,the disclosure provisions of SFAS 148 are applicable to all companies withstock-based employee compensation, regardless of whether they account for thatcompensation using the fair value method of SFAS 123 or the intrinsic valuemethod of APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). Under APB 25, if the exercise priceof an employee’s stock option equals or exceeds the market price of theunderlying stock on the date of grant, no compensation expense isrecognized.  As allowedby SFAS 123 and 148, the Company has elected to continue to utilize theaccounting method prescribed by APB 25 and has adopted the disclosurerequirements of SFAS 123 and SFAS 148.

 

4.               Foreign Currency Translation

 

OnJanuary 1, 2003, the Company elected to change the functional currency ofits foreign operations to the United States dollar. This change in functionalcurrency is supported by the fact that all foreign operations are fundedmonthly in United States dollars and the majority of revenue contracts aredenominated in United States dollars. Under United States dollar functional currency, the financial statementsof foreign locations are remeasured from the recording currency to the UnitedStates dollar. The resulting remeasurement adjustment is recorded as foreignexchange gain or loss in the statement of operations. There is

 

7

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notranslation adjustment to the separate component of stockholders’ equity oradjustment to comprehensive income. The effect of the change in functionalcurrency had no material impact on results of operations. The accumulation ofprior years’ translation adjustments remains on the balance sheet as a separatecomponent of stockholders’ equity until part, or all, of the respectiveentities are disposed. During 2002, the financial statements were preparedusing the local currency as the functional currency. All balance sheet accountsof foreign subsidiaries were translated at the current exchange rate as of theend of the accounting period. The resulting translation adjustment waspreviously recorded as a separate component of stockholders’ equity. Incomestatement items were previously translated at average currency exchange rates.

 

5.                  Inventories (Inthousands)

 
| Inventories  consist of: |   |                |       |                    |       |
|--------------------------|--------|---------------------|------------|-------------------------|------------|
|                     |   | **March 31,  2003** | ** ** | **December  31,  2002** | ** ** |
|                     |   |                |       |                    |       |
| Raw  materials           |   | $                   | —     |                    | $          | 70 |   |
| Finished  goods          |   | 1,593               |       | 1,157                   |       |
| Demonstration  systems   |   | 133                 |       | 184                     |       |
| Net  inventory           |   | $                   | 1,726      |                    | $          | 1,411 |   |

 

6.                  Accounting forStock-Based Compensation

 

We account for employee stock-basedcompensation under APB 25.  Thefollowing table summarizes relevant information as to the reported resultsunder our intrinsic value method of accounting for stock awards, withsupplemental information as if the fair value recognition provision of SFAS 123had been applied for the quarters ended March 31, 2003 and March 31, 2002 (inthousands, except per share data):

 
|                                               |                                                                                  | **March 31,  2003** |   | **March 31,  2002** | ** ** |
|----------------------------------------------------|---------------------------------------------------------------------------------------|---------------------|--------|---------------------|------------|
|                                               |                                                                                  |                |   |                |       |
| Net loss, as reported                              |                                                                                  | $                   | (2,781 | )                   | $          | (5,394 | ) |
| Deduct:                                            | Total stock-based compensationdetermined under fair value-based method for all awards |                | 332    |                | (452       | ) |
| Pro forma net loss                                 |                                                                                  | $                   | (2,449 | )                   | $          | (5,846 | ) |
| Net loss per share:                                |                                                                                  |                |   |                |       |
| Basic, as reported                                 |                                                                                  | $                   | (0.13  | )                   | $          | (0.26 | ) |
| Basic, pro forma                                   |                                                                                  | $                   | (0.12  | )                   | $          | (0.28 | ) |
| Diluted, as reported                               |                                                                                  | $                   | (0.13  | )                   | $          | (0.26 | ) |
| Diluted, pro forma                                 |                                                                                  | $                   | (0.12  | )                   | $          | (0.28 | ) |
| Weighted–average shares used in  computation: |                                                                                  |                |   |                |       |
| Basic and Diluted                                  |                                                                                  | 20,648              |   | 20,632              |       |
|                                                    |                                                                                       |                     |        |                     |            |  |  |  |

 

As required, the proforma disclosures above include options granted since January 1, 1995.  Consequently, the effects of applying SFAS123 for providing pro forma disclosures may not be representative of the effectson reported operating results for future years until all options outstandingare included in the pro forma disclosures. For purposes of pro forma disclosures, the estimated fair

 

8

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value of stock-basedcompensation plans and other options are amortized to expense primarily overthe vesting period.

 

7.               Net Loss Per Share

 

We report two separateearnings per share (“EPS”) numbers, basic EPS and diluted EPS with additionaldisclosure made between continuing and discontinued operations.  Basic net loss per share is computed bydividing net loss for the period by the weighted average number of commonshares outstanding for the period. Diluted net loss per share is computed by dividing the net loss by theweighted average number of common shares and common stock equivalentsoutstanding for the period.  Our commonstock equivalents are not included in the diluted loss per share for thethree-month periods ended March 31, 2003 and 2002 as they are antidilutive.  Such options are excluded due to incurring anet loss per share in the three-month periods or due to exercise pricesexceeding the average market value of our common stock in the applicableperiod.

 

8.               DiscontinuedOperations

 

In March 2002 we sold theassets of our last remaining discontinued operation, our EssentialCommunications division, for $1.0 million, generating a gain on sale of $0.4million, which we have shown as a gain from discontinued operations in theaccompanying financial statements.

 

A condition of the salewas to give Essential personnel 60 days to exit Essential’s leased facility,the obligation for which we retained as part of the sale.  Included in the gain on the sale ofEssential was management’s estimate of $0.3 million to terminate this leaseagreement, which was equivalent to 2 years lease and maintenance of thefacility.  The contractual term of thelease ran through February 2009. Successful termination of the lease during the fourth quarter of 2002for less than $0.3 million resulted in additional gain on sale of $0.1 million.

 

The following representsa summary of gains and losses from discontinued operations (In thousands):

 
|                                 |   | **Three  Months Ended****March 31,  2002** |   |
|--------------------------------------|--------|--------------------------------------------|--------|
| Net  sales                           |   | $                                          | 727    |   |
| Cost  of sales                       |   | 323                                        |   |
| Gross  profit                        |   | 404                                        |   |
|                                 |   |                                       |   |
| Operating  expenses                  |   | 502                                        |   |
| Operating  loss                      |   | (98                                        | )      |
|                                 |   |                                       |   |
| Gain  on sale                        |   | 499                                        |   |
| Income  before income taxes          |   | 401                                        |   |
|                                 |   |                                       |   |
| Income  tax benefit                  |   | —                                     |   |
|                                 |   |                                       |   |
| Income  from discontinued operations |   | $                                          | 401    |   |

 

9

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9.               Commitments andContingencies

 

We are subject to legalproceedings and claims that arise in the ordinary course of business.  We do not believe that the outcome of thosematters will have a material adverse affect on our consolidated financial position,operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact.

 

On March 22, 2002, MorganNewton Company, L.P. (“Morgan Newton”) filed suit against us in Dallas CountyDistrict Court, Case No. DV02-02339-C, alleging claims for breach of contract,promissory estoppel, and fraud.  Theclaims arise out of an alleged oral representation to Morgan Newton concerninga request for quotation for the purchase of a large amount of Morgan Newton’sproducts.  Morgan Newton has notspecified the amount of damages it is seeking in the lawsuit, but it ispossible that Morgan Newton may be seeking damages in excess of $2.0million.  In addition to actual damages,Morgan Newton is also seeking attorney’s fees and punitive damages.  We believe Morgan Newton’s claims arewithout merit and intend to vigorously defend this lawsuit, generally denyingall claims and asserting certain affirmative defenses.  As of this time, discovery is substantiallyunderway, and trial has been scheduled for October 2003.  Due to the uncertainty of the ultimateresult of this suit, we have not recorded a liability related to the suit atMarch 31, 2003 or December 31, 2002.

 

Item 2.                                                             MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

This report containsforward-looking statements, within the meaning of Section 27A of the SecuritiesAct of 1933 and Section 21E of the Securities Exchange Act of 1934, thatinvolve risks and uncertainties, such as statements concerning: the difficulties in forecastingfuture sales caused by current economic and market conditions, the effect ofmilitary actions on government and corporate spending on information securityproducts, the impact of our cost reduction programs and our refocused productline, the difficulties and uncertainties in successfully developing andintroducing new products, our ability to continue to meet operating expensesthrough current cash flow or additional financings, the continuance andstrength of our relationship with Check Point, the highly competitive marketfor our products, difficulties in accurately estimating market growth, theconsolidation of the information security industry, the impact of changingeconomic conditions, business conditions in the information security industry,our ability to manage acquisitions effectively, our ability to managediscontinued operations effectively, the impact of market peers and theirproducts as well as risks concerning future technology and others identified inour Annual Report on Form 10-K and other Securities and Exchange Commissionfilings.  Such forward-lookingstatements are generally accompanied by words such as “plan,” “estimate,”“expect,” “believe,” “should,” “would,” “could,” “anticipate,” “may” or otherwords 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.

 

Overview

 

We develop, market andsupport network intrusion detection systems and VPN/firewall appliances thataddress vital security issues facing organizations deploying businessapplications over the Internet or internally via Intranets.

 

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We market and distributeour products through a direct sales force to end-users, distributors and bynumerous domestic and international system integrators, managed serviceproviders and value-added resellers. Our end-user customers include manufacturing, technology,telecommunications, retail, transportation, health care, insurance,entertainment, utilities and energy companies, government agencies, financialinstitutions, and academic institutions.

 

We organized in Texas inSeptember 1983 and reincorporated in Delaware in October 1995.  For more than 15 years, we provided localarea networking equipment and were known as Optical Data Systems or ODSNetworks.  On April 17, 2000, we announcedplans to sell, or otherwise dispose of, our networking divisions, which includeEssential and our local area networking assets.  In accordance with these plans, we have accounted for thesebusinesses as discontinued operations. On June 1, 2000, we changed our name from ODS Networks, Inc. toIntrusion.com, Inc., and our NASDAQ ticker symbol from ODSI to INTZ to reflectour focus on intrusion detection solutions. On November 1, 2001, we changed our name from Intrusion.com, Inc. toIntrusion Inc.

 

Our principal executiveoffices are located at 1101 East Arapaho Road, Richardson, Texas 75081, and ourtelephone number is (972) 234-6400.  Ourwebsite URL is www.intrusion.com. References to “we”, “us”, “our” or “Intrusion Inc.” refer to IntrusionInc. and its subsidiaries.

 

CriticalAccounting Policies and Estimates

 

Management’s discussion and analysis offinancial condition and results of operations are based upon our condensedconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States.  The preparation of these financialstatements requires us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues and expenses, and related disclosureof contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those relatedto product returns, bad debts, inventories, intangible assets, income taxes,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 believe the following criticalaccounting policies affect our more significant judgments and estimates used inthe preparation of our condensed consolidated financial statements.

 

*Revenue Recognition*

 

We generally recognizeproduct revenue upon shipment of product. We accrue for estimated warranty costs, sales returns and otherallowances at the time of shipment based on our experience.  Revenue from maintenance contracts isdeferred and recognized over the contractual period the services areperformed.  To date, warranty costs andsales returns have not been material. There is a risk that technical issues on new products could result inunexpected warranty costs and returns.

 

We recognize softwarerevenue from the licensing of our software products in accordance withStatement of Position (“SOP”) No. 97-2 “Software Revenue

 

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Recognition” and SOP 98-9“Modification of 97-2, Software Revenue Recognition, with respect to certaintransactions” whereby revenue from the licensing of our products is notrecognized until all four of the following have been met: i) execution of awritten purchase order, license agreement or contract; ii) shipment of theproduct has occurred; 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 thecontract period, which is generally one year.

 

We have signeddistribution agreements with distributors in the United States, Europe andAsia.  In general, these relationshipsare non-exclusive.  Distributorstypically maintain an inventory of our products.  Under these agreements, we provide certain protection to thedistributors for their inventory of our products for price reductions as wellas products that are slow-moving or have been discontinued by us.  Recognition of sales to distributors andrelated gross profits are deferred until the merchandise is resold by thedistributors.  However, since we havelegally sold the inventory to the distributor and we no longer have care,custody or control over the inventory, we recognize the trade accountsreceivable and reduce inventory related to the sale at the time of shipment tothe distributor.  The deferred revenuein the accompanying financial statements is offset by deferred cost of sales.

 

*Allowance for DoubtfulAccounts and Returns*

 

We maintain allowances for doubtfulaccounts for estimated losses resulting from the inability of our customers tomake required payments.  If thefinancial condition of our customers were to deteriorate, resulting in animpairment of their ability to make payments, additional allowances may berequired.

 

*Inventory*

 

We write down our inventory for estimatedobsolescence or unmarketable inventory equal to the difference between the costof inventory and the estimated market value based upon assumptions about futuredemand and market conditions. If actual market conditions are less favorablethan those projected by management, additional inventory write-downs may berequired.

 

Results of Operations

 

The following table setsforth, for the periods indicated, certain financial data as a percentage of netsales. The period-to-period comparison of financial results is not necessarilyindicative of future results.

 
|                                 |   | **Three  Months Ended** | ** ** |
|--------------------------------------|--------|-------------------------|------------|
|                                 |   | **March 31,  2003**     |       | **March 31,  2002** | ** ** |
| Net  sales                           |   | 100.0                   | %          | 100.0 | % |
| Cost  of sales                       |   | 68.0                    |       | 68.0 |   |
| Gross  profit                        |   | 32.0                    | %          | 32.0 | % |
| Operating  expenses:                 |   |                    |       |   |   |
| Sales  and marketing                 |   | 126.2                   |       | 155.2 |   |
| Research  and development            |   | 62.5                    |       | 74.7 |   |
| General  and administrative          |   | 27.2                    |       | 28.2 |   |
| Amortization  of intangibles         |   | —                  |       | 7.9 |   |
| Severance  costs                     |   | 8.5                     |       | — |   |
| Operating  loss                      |   | (192.4                  | )          | (234.0 | ) |
|                                 |   |                    |       |   |   |
| Interest  income, net                |   | 4.1                     |       | 3.5 |   |
| Loss  before income tax provision    |   | (188.3                  | )          | (230.5 | ) |
|                                 |   |                    |       |   |   |
| Income  tax provision                |   | —                  |       | — |   |
|                                 |   |                    |       |   |   |
| Loss  from continuing operations     |   | (188.3                  | )          | (230.5 | ) |
| Income  from discontinued operations |   | —                  |       | 16.0 |   |
|                                 |   |                    |       |   |   |
| Net  loss                            |   | (188.3                  | )          | (214.5 | ) |

 

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|              |   | **Three  Months Ended** | ** ** |
|-------------------|--------|-------------------------|------------|
|              |   | **March 31,  2003**     |       | **March 31,  2002** | ** ** |
| Domestic  sales   |   | 48.4                    | %          | 70.4 | % |
| Export  sales to: |   |                    |       |   |   |
| Europe            |   | 37.3                    |       | 7.3 |   |
| Canada            |   | (0.7                    | )          | 4.9 |   |
| Asia              |   | 15.0                    |       | 17.3 |   |
| Latin  America    |   | 0.0                     |       | 0.1 |   |
|              |   |                    |       |   |   |
| Net  sales        |   | 100.0                   | %          | 100.0 | % |

 

**NetSales**.  Net sales forthe quarter ended March 31, 2003 decreased to $1.5 million compared to $2.5million for the same period of 2002 as sales from our first generation securityproducts decreased.  In addition, badeconomic conditions and the war in Iraq negatively impacted our sales ofSecureNet network intrusion detection products and PDS security applianceproducts.

 

**ExportSales**.  Export salesfor the quarter ended March 31, 2003 increased to $0.8 million compared to $0.7million for the same period of 2002 as sales from our SecureNet Pro intrusiondetection product family, PDS security appliance family and other securityproduct lines increased.

 

**Concentrationof Sales**.  Sales tothe U.K. Government were 11.4% of total sales for the quarter ended March 31,2003, compared to 0.0% for the same period of 2002.  Sales to Unipalm Corporation were 9.9% of total sales for thequarter ended March 31, 2003, compared to 5.1% for the same period of2002.  Sales to Westcon were 0.0% forthe quarter ended March 31, 2003, compared to 13.4% for the same period of2002.  Sales to Computer ScienceCorporation were 0.4% for the quarter ended March 31, 2003 compared to 10.4%for the same period of 2002.  Sales toall U.S Government entities in total was $0.1 million or 6.4% of net sales forthe quarter ended March 31, 2003 compared to $0.4 million or 14.3% of net salesfor the quarter ended March 31, 2002. We expect the concentration of sales to continue with various customers,as the concentration mix may vary depending upon the timing of certain sales.

 

**GrossProfit**.  Gross profitwas $0.5 million or 32.0% of net sales for the quarter ended March 31, 2003,compared to $0.8 million or 32.0% of net sales for

 

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the quarter ended March31, 2002. Gross profit margins as a percentage of net sales were consistentwith the same period in the prior year.

 

Gross profit as apercentage of net sales is impacted by several factors, including shifts inproduct mix, changes in channels of distribution, sales volume, fluctuations inmanufacturing costs, pricing strategies, and fluctuations in sales ofintegrated third-party products.

 

**Salesand Marketing**.  Salesand marketing expenses decreased to $1.9 million for the quarter ended March31, 2003, compared to $3.9 million for the quarter ended March 31, 2002,primarily due to the reorganization of our sales and marketing departments,including a reduction in headcount, and other cost reduction initiatives.  We expect to continue to implement costreduction initiatives in the second quarter 2003.  Sales and marketing expenses may vary as a percentage of netsales in the future.

 

**Researchand Development**. Research and development expenses decreased to $0.9 million for thequarter ended March 31, 2003, compared to $1.9 million for the quarter endedMarch 31, 2002. Research and development costs are expensed in the periodincurred.  Research and developmentexpenses decreased in the quarter ended March 31, 2003, compared to the sameperiod in 2002 as we reduced the research and development workforce and focusedmore of our development efforts on our core security products, SecureNet Proand PDS security appliances, while reducing efforts on our other securityproducts. Research and development expenses may vary as a percentage of netsales in the future.

 

**Generaland Administrative**. General and administrative expenses decreased to $0.4 million for thequarter ended March 31, 2003, compared to $0.7 million for the quarter endedMarch 31, 2002, primarily due to the restructuring done in 2002, including areduction in headcount, and other cost reduction initiatives.  It is expected that general and administrativeexpenses will remain relatively constant throughout the remainder of theyear.  General and administrativeexpense may vary as a percentage of net sales in the future.

 

**Amortization**.  Amortization expenses ceased at December 31,2002 due to the impairment charge taken during December 2002 to write down thebalance of all intangible assets to zero. Amortization expense for the three months ended March 31, 2003 decreasedto $0.0 million compared to $0.2 million for the same period in 2002.

 

**SeveranceCosts. **Severancecosts of $0.1 million for the three-month period ended March 31, 2003 consistsof severance expense as a result of additional reductions in force.  There were no severance charges for the sameperiod in the prior year.

 

**Interest**.  Net interest income remained relativelyconstant at $0.1 million for the quarter ended March 31, 2003 and 2002.  The slight decrease in interest income wasprimarily 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.

 

Liquidity and CapitalResources

 

Our principal source ofliquidity at March 31, 2003 is approximately $0.9 million of cash and cashequivalents and $7.3 million of short-term investments.  As of March 31, 2003 working capital was$8.3 million compared to $21.4 million as of March 31, 2002.

 

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Cash used in continuingoperations for the three months ended March 31, 2003 was $2.4 million,primarily due to an operating loss from continuing operations of $2.8 million,which is offset by depreciation expense and a decrease in accounts receivable,compared to cash used in operations of $2.4 million for the three months endedMarch 31, 2002, primarily due to an operating loss from continuing operationsof $5.8 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.

 

Cash provided ininvesting activities of continuing operations in the three months ended March31, 2003 was $0.5 million, which consisted primarily of the net maturity ofshort-term investments, compared to cash used in investing activities of $0.8million for the three months ended March 31, 2002, which also consistedprimarily of the net maturity of short-term investments.

 

Cash provided byfinancing activities of continuing operations in the three months ended March31, 2003 was $0.5 thousand, as there were two thousand shares issued throughthe employee stock purchase plan during the quarter, compared to $30.0 thousandduring the three months ended March 31, 2002, which was primarily the result ofthe exercise of employee stock options.

 

At March 31, 2003, theCompany did not have any material commitments for capital expenditures.

 

During the three monthsended March 31, 2003, the Company funded its operations through the use of cashand cash equivalents.

 

Although we believe wehave sufficient cash resources to finance our operations and expected capitalexpenditures for the next twelve months, the sufficiency of our cash resourcesmay depend to a certain extent on general economic, financial, competitive orother factors beyond our control. Moreover, despite actions to reduce our costs and improve ourprofitability, we expect our operating losses and net operating cash outflowsto continue during 2003.  As a result,we may not be able to achieve the revenue and gross margin objectives necessaryto achieve positive 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.

 

We intend to explore thepossible acquisitions of businesses, products and technologies that arecomplementary to our existing business. We are continuing to identify and prioritize additional securitytechnologies which we may wish to develop, either internally or through thelicensing or acquisition of products from third parties.  While we engage from time to time indiscussions with respect to potential acquisitions, there can be no assurancesthat any such acquisitions will be made or that we will be able to successfullyintegrate any acquired business.  Inorder to finance such acquisitions and working capital it may be necessary forus to raise additional funds through public or private financings.  Any equity or debt financings, if availableat all, may be on terms, which are not

 

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favorable to us and, inthe case of equity financings, may result in dilution to our stockholders.

 

Factors That May AffectFuture Results of Operations 

 

Numerous factors mayaffect our business and future results of operations.  These factors include, but are not limited to, current economicand market conditions, the effect of military actions on government andcorporate spending on information security products, technological changes,competition and market acceptance, acquisitions, product transitions, timing oforders, manufacturing and suppliers, reliance on outsourcing vendors and otherpartners, intellectual property and licenses, third-party products, dependenceon government customers, international operations, intellectual propertyissues, liquidity and cash resources and effects of restructuring plans andcost reductions.  The discussion belowaddresses some of these and other factors. For a more thorough discussion of these and other factors that mayaffect our business and future results, see the discussion under the caption“Factors That May Affect Future Results of Operations” in our Annual Report onForm 10-K for the year ended December 31, 2002.

 

**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 ourbusiness, operating results and financial condition.

 

**MarketAcceptance.**  We arepursuing a strategy to increase the percentage of our revenue generated throughindirect sales channels including distributors, value added resellers, systemintegrators, original equipment manufacturers and managed serviceproviders.  There can be no assurancethat 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.

 

We are also pursuing astrategy to further differentiate our product line by introducing complementarysecurity products and incorporating new technologies into our existing productline.  There can be no assurance that wewill successfully introduce these products or that such products will gainmarket acceptance.  We anticipatecompetition from networking companies, network security companies and others ineach of our product lines.  Weanticipate that profit margins will vary among our product lines and thatproduct mix fluctuations could have an adverse effect on our overall profitmargins.

 

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**Acquisitions.**Some of our competitors have acquired several security companies withcomplementary technologies, and we anticipate that such acquisitions willcontinue in the future.  Theseacquisitions may permit such competitors to accelerate the development andcommercialization of broader product lines and more comprehensive solutionsthan we currently offer.  In the past,we have relied upon a combination of internal product development andpartnerships with other security vendors to provide competitive solutions tocustomers.  Certain of the recent andfuture acquisitions by our competitors may have the effect of limiting ouraccess to commercially significant technologies.  Further, the business combinations and acquisitions in thesecurity industry are creating companies with larger market shares, customer bases,sales forces, product offerings and technology and marketing expertise.  There can be no assurance that we will beable to compete successfully in such an environment.

 

Wehave made acquisitions in the past, and we may, in the future, acquire or investin additional companies, business units, product lines, or technologies toaccelerate the development of products and sales channels complementary to ourexisting products and sales channels. Acquisitions involve numerous risks, including: difficulties inassimilation of operations, technologies, and products of the acquiredcompanies; risks of entering markets in which we have no or limited directprior experience and where competitors in such markets have stronger marketpositions; the potential loss of key employees of the acquired company; and thediversion of our attention from normal daily operation of our business.  There can be no assurance that any otheracquisition or investment will be consummated or that such acquisition orinvestment 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 technological changes or new product announcements bycompetitors, which could render portions of our inventory obsolete.

 

**Manufacturingand Suppliers. **Our operational strategy relies onoutsourcing of product assembly and certain other operations.  There can be no assurance that we will effectivelymanage our third-party contractors or that these contractors will meet ourfuture requirements for timely delivery of products of sufficient quality andquantity.  Further, we intend tointroduce a number of new products and product enhancements in the remainder of2003 and 2004 that will require that we rapidly achieve volume production ofthose new products by coordinating our efforts with those of our suppliers andcontractors.  The inability of thethird-party contractors to provide us with adequate supplies of high-qualityproducts could cause a delay in our ability to fulfill orders and could have anadverse effect on our business, operating results and financial condition.

 

Allof the materials used in our products are purchased under contracts or purchaseorders with third parties.  While webelieve that many of the materials used in the production of our products aregenerally readily available from a variety of sources, certain components suchas microprocessors and mother boards are available from one or a limited numberof suppliers.  The lead times fordelivery of components vary significantly and can exceed twelve weeks forcertain components.  If we should failto forecast our requirements accurately for

 

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components,we may experience excess inventory or shortages of certain components thatcould have an adverse effect on our business and operating results.  Further, any interruption in the supply ofany of these components, or the inability to procure these components fromalternative sources at acceptable prices within a reasonable time, could havean adverse effect on our business and operating results.

 

**Intellectual Property and Licenses.** There are many patents held by companies, which relate to the design andmanufacture of network security systems. Holders of those could assert potential claims of infringement.  We could incur substantial costs in defendingour company and our customers against any such claim regardless of the meritsof such claims.  In the event of asuccessful 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 March 31, 2003, we had cash, cashequivalents and investments in the amount of approximately $8.2 million, downfrom approximately $10.7 million as of December 31, 2002.  Although we believe we have sufficient cashresources to finance our operations and expected capital expenditures for thenext twelve months, the sufficiency of our cash resources may depend to acertain extent on general economic, financial, competitive or other factorsbeyond our control.  Moreover, despiteactions to reduce our costs and improve our profitability, we expect ouroperating losses and net operating cash outflows to continue during 2003 andinto 2004.  As a result, we may not beable 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.

 

**Dependenceon Check Point Technologies**.  A large percentage of oursales are represented by our PDS family of security appliances which areintegrated with Check Point Software Technologies’ market-leading virtualprivate network and firewall security software.  We expect the percentage of sales represented by these productsto decrease in the future.  Although weare a certified appliance partner of Check Point and our PDS products havereceived certification from Check Point, we have no long-term agreement orexclusive relationship with Check Point. As a result, the loss or significant change in our relationship withCheck Point, the failure of future PDS products to receive Check Pointcertification, the business failure of Check Point or its acquisition by or ofone of our competitors, and the loss of market share of Check Point or marketacceptance of its products could each have a material adverse effect on ourbusiness, financial condition and results of operations.

 

**Third-PartyProducts.**  We believe that it is beneficial to workwith third parties with complementary technologies to broaden the appeal of oursecurity products.  These alliancesallow us to provide integrated solutions to our customers by combining ourdeveloped technology with third-party products.  As we also compete with these technology partners in certainsegments of the market, there can be no assurance that we will have access toall of the third-party products that may be desirable or necessary in order tooffer fully integrated solutions to our customers.

 

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**International Operations.**  Our international operations may be affected by changes in demandresulting from fluctuations in currency exchange rates and local purchasingpractices, including seasonal fluctuations in demand, as well as by risks suchas increases in duty rates, difficulties in distribution, regulatory approvalsand other constraints upon international trade.  Our sales to foreign customers are subject to export regulations.  In particular, certain sales of our datasecurity products require clearance and export licenses from the U.S.Department of Commerce under these regulations.  Any inability to obtain such clearances or any required foreignregulatory approvals on a timely basis could have a material adverse effect onour operating results.

 

**Impact of Government Customers.******** $0.1 million or 6.4% of revenue in the quarter ended March 31,2003 was derived from sales to all U.S. government entities compared to $0.4 millionor 14.3% of revenue in the quarter ended March 31, 2002.  $0.2 million or 11.4% of revenue in thequarter ended March 31, 2003 was derived from sales to all U.K. governmententities compared to $0.0 million or 0.0% of revenue in the quarter ended March31, 2002.  We expect sales to the U.S.and foreign governments to represent a significant portion of our revenue infuture periods.  Sales to the governmentpresent risks in addition to those involved in sales to commercial customers,including potential disruptions due to appropriation and spending patterns andthe government’s reservation of the right to cancel contracts and purchaseorders for its convenience.

 

**Effects of Military Actions.** The United States military actions or other events occurring in responseor in connection to them, including future terrorist attacks against UnitedStates targets, actual conflicts involving the United States or it allies ormilitary or trade disruptions could impact our operations, including by:

 

•                  reducing government or corporatespending on network security products;

•                  increasing the cost and difficultyin obtaining materials or shipping products; and

•                  affecting our ability to conductbusiness internationally.

 

Shouldsuch events occur, our business, operating results and financial conditioncould be materially and adversely affected. The war in Iraq significantly reduced government spending in our marketspace and negatively impacted our first quarter earnings, as evidenced by thesignificant reduction in sales to U.S. government entities.

 

**Restructuring and CostReductions. **Weimplemented a restructuring plan in April 2002.  The objective of our restructuring plan was to reduce our coststructure to a sustainable level that is consistent with the current macroeconomicenvironment.  We also implemented otherstrategic initiatives designed to strengthen our operations.  These plans involved, among other things,reductions in our workforce and facilities, aligning our organization aroundour business objectives, realignment of our sales force and changes in oursales management.  The workforcereductions, which continued into 2003, could result in temporary reducedproductivity of our remaining employees. Additionally, our customers and prospects may delay or forgo purchasingour products due to a perceived uncertainty caused by the restructuring andother changes.  Failure to achieve thedesired results of our initiatives could seriously harm our business, resultsof operations and financial condition.

 

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**Potential Nasdaq Delisting**. The Nasdaq Stock Market maintains certain minimum requirements tomaintain the listing for our common stock. These requirements include a minimum bid price for our common stock of$1.00.  The trading price of our commonstock has not been at least $1.00 since June 27, 2002, and we received a noticeof noncompliance from Nasdaq on August 12, 2002.  In order to take advantage of additional grace periods forcompliance, we transferred the listing of our common stock from the NasdaqNational Market to the Nasdaq SmallCap Market, effective December 4, 2002.  Although we expect to continue to have theopportunity to regain compliance for listing on the Nasdaq National Market, ifthe minimum bid price of our common stock is not at least $1.00 for at least 10consecutive trading days on or prior to August 7, 2003, Nasdaq may seek todelist our common stock from the Nasdaq SmallCap Market.  We cannot assure you that we will be able tomeet the minimum bid price requirement prior to the deadline in order tomaintain our listing on the Nasdaq SmallCap Market or that we will be able tomaintain compliance with Nasdaq’s other continued listing requirements.

 

If we are unable to regain compliance withthe minimum bid price requirement or fail to comply with other Nasdaq continuedlisting requirements, our common stock likely would trade in a less efficientmarket, such as the OTC Bulletin Board or in the “pink sheets” maintained bythe National Quotation Bureau, Inc. Because these alternatives generally are considered to be less efficientmarkets, our stock price, the liquidity of our common stock and our generalbusiness reputation may be adversely 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 network 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 economic conditionsand world events such as the war in Iraq. Future declines in network security product sales as a result of generaleconomic conditions, adoption of alternative technologies or any other reasoncould have a material adverse effect on our business, operating results andfinancial condition.

 

Dueto the factors noted above and in “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations”, our future earnings and commonstock price may be subject to significant volatility, particularly on aquarterly basis.  Past financialperformance should not be considered a reliable indicator of future performanceand investors should not use historical trends to anticipate results or trendsin future periods.  Any shortfall inrevenue and earnings from the levels anticipated by securities analysts couldhave an immediate and significant effect on the trading price of our commonstock in any given period.  Also, weparticipate in a highly dynamic industry, which often results in volatility ofour common stock price.

 

Item3.             QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

**ForeignExchange**.  Revenueoriginating outside the U.S. in the quarters ended March 31, 2003 and 2002 was51.6% and 29.6% of total revenues, respectively. International sales are mademostly from our foreign sales subsidiaries in the local countries and aretypically denominated in U.S. dollars. These subsidiaries incur most of their expenses in the local currency.

 

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Our international business is subject to risks typicalof an international business, including, but not limited to: differing economicconditions, changes in political climate, differing tax structures, otherregulations and restrictions and foreign exchange rate volatility.  Accordingly, our future results could bematerially adversely affected by changes in these or other factors.  The effect of foreign exchange ratefluctuations on us in 2003, 2002 and 2001 was not material.

 

*Foreign Currency Translation –* On January 1, 2003, theCompany elected to change the functional currency of its foreign operations tothe United States dollar. This change in functional currency is supported bythe fact that all foreign operations are funded monthly in United Statesdollars and the majority of a revenue contracts are denominated in UnitedStates dollars.  Under United Statesdollar functional currency, the financial statements of foreign locations areremeasured from the recording currency to the United States dollar. Theresulting remeasurement adjustment is recorded as foreign exchange gain or lossin the statement of operations. There is no translation adjustment to theseparate component of stockholders’ equity or adjustment to comprehensiveincome. The effect of the change in functional currency had no material impacton results of operations. The accumulation of prior years’ translationadjustments remains on the balance sheet as a separate component ofstockholders’ equity until part, or all, of the respective entities aredisposed. During 2002, the financial statements were prepared using the localcurrency as the functional currency. All balance sheet accounts of foreignsubsidiaries were translated at the current exchange rate as of the end of the accountingperiod. The resulting translation adjustment was recorded as a separatecomponent of stockholders’ equity. Income statement items were translated ataverage currency exchange rates.

 

**InterestRates**. We invest our cash in a variety of financial instruments,including bank time deposits, fixed rate obligations of corporations,municipalities, and state and national governmental entities and agencies.  These investments are denominated in U.S.dollars.  Cash balances in foreigncurrencies overseas are operating balances and are invested in short-term timedeposits of the local operating bank.

 

Interest income on ourinvestments is carried in “Interest income, net”.  We account for our investment instruments in accordance withStatement of Financial Accounting Standards No. 115, “Accounting for CertainInvestments in Debt and Equity Securities” (“SFAS 115”).  All of the cash equivalents and short-terminvestments are treated as available-for-sale under SFAS 115.

 

Investments in fixed rateinterest earning instruments carry a degree of interest rate risk.  Fixed rate securities may have their fairmarket value adversely impacted due to a rise in interest rates.  Due in part to these factors, our futureinvestment income may fall short of expectations due to changes in interestrates or we may suffer losses in principal if forced to sell securities, whichhave seen a decline in market value due to changes in interest rates.  Our investment securities are held for purposesother than trading.  The weighted-averageof the stated coupon interest rate on investment securities at March 31, 2003was 6.61%.  Due to amortization ofpremiums and discounts paid, the actual rate of return will vary from theweighted-average stated coupon interest rate. The fair value of investments held at March 31, 2003 approximatedamortized 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 

21

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Officer and Chief Financial Officer, of the design and operationof these 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 alerting them tomaterial information relating to the Company (including our consolidatedsubsidiaries) 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.

 

**PARTII****- OTHER INFORMATION**

 

Item 1.                                                             LEGAL PROCEEDINGS

 

We are subject to legalproceedings and claims that arise in the ordinary course of business.  We do not believe that the outcome of thosematters will have a material adverse affect on our consolidated financialposition, operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact.

 

On March 22, 2002, MorganNewton Company, L.P. (“Morgan Newton”) filed suit against us in Dallas CountyDistrict Court, Case No. DV02-02339-C, alleging claims for breach of contract,promissory estoppel, and fraud.  Theclaims arise out of an alleged oral representation to Morgan Newton concerninga request for quotation for the purchase of a large amount of Morgan Newton’sproducts.  Morgan Newton has notspecified the amount of damages it is seeking in the lawsuit, but it ispossible that Morgan Newton may be seeking damages in excess of $2.0million.  In addition to actual damages,Morgan Newton is also seeking attorney’s fees and punitive damages.  We believe Morgan Newton’s claims arewithout merit and intend to vigorously defend this lawsuit, generally denying allclaims and asserting certain affirmative defenses.  As of this time, discovery is substantially underway, and trialhas been scheduled for October 2003. Due to the uncertainty of the ultimate result of this suit, we have notrecorded a liability related to the suit at March 31, 2003 or December 31,2002.

 

Item 6.                                                             EXHIBITS AND REPORTS ON FORM 8-K

 

During the quarter endedMarch 31, 2003, we filed the following reports on Form 8-K:

 

•                   Report onForm 8-K filed on March 11, 2003, announcing the appointment of KBA Group LLPas our independent auditors.

 

The following Exhibitsare attached:

 

•                   Exhibit10.1 – Employment Agreement for Aaron Bawcom

 

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•                   Exhibit99.1 – Chief Executive Officer Certification Pursuant to 18 U.S.C. Section1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

•                  Exhibit99.2 – Chief Financial Officer Certification Pursuant to 18 U.S.C. Section1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 

 

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**S****IGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
|               | **INTRUSION  INC.**                             |
|--------------------|-------------------------------------------------|
|               |                                            |
|               |                                            |
| Date: May 13, 2003 | /s/ Michael L.  Paxton                          |
|               | Michael  L. Paxton                              |
|               | Vice  President, Chief Financial Officer,       |
|               | Treasurer  & Secretary                      |
|               | (Principal  Financial & Accounting Officer) |

 

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**CERTIFICATION**

 

I, G. Ward Paxton,certify that:

 
| 1.     | I have reviewed this  Quarterly Report on Form 10-Q of Intrusion Inc.;                                                                                                                                                                                                                                                                                                                             |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
| 2.     | Based on my knowledge,  this quarterly report does not contain any untrue statement of material fact  or omit to state a material fact necessary to make the statements made, in  light of the circumstances under which such statements were made, not  misleading with respect to the period covered by this quarterly report;                                                                   |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
| 3.     | Based on my knowledge,  the financial statements, and other financial information included in this quarterly  report, fairly present in all material respects the financial condition,  results of operations and cash flows of the registrant as of, and for, the  periods presented in this quarterly report;                                                                                    |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
| 4.     | The registrant’s other  certifying officers and I are responsible for establishing and maintaining  disclosure controls and procedures (as defined in Exchange Act Rules 13a-14  and 15d-14) for the registrant and we have:                                                                                                                                                                  |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
|   |                                                                                                                                                                                                                                                                                                                                                                                               | a. | designed such  disclosure controls and procedures to ensure that material information  relating to the registrant, including its consolidated subsidiaries, is made  known to us by others within those entities, particularly during the period  in which this quarterly report is being prepared; |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
|   |                                                                                                                                                                                                                                                                                                                                                                                               | b. | evaluated the  effectiveness of the registrant’s disclosure controls and procedures as of a  date within 90 days prior to the filing date of this quarterly report (the  “Evaluation Date”); and |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
|   |                                                                                                                                                                                                                                                                                                                                                                                               | c. | presented in this  quarterly report our conclusions about the effectiveness of the disclosure  controls and procedures based on our evaluation as of the Evaluation Date; |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
| 5.     | The registrant’s other  certifying officers and I have disclosed, based on our most recent  evaluation, to the registrant’s auditors and audit committee of registrant’s  board of directors (or persons performing the equivalent function):                                                                                                                                       |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
|   |                                                                                                                                                                                                                                                                                                                                                                                               | a. | all significant  deficiencies in the design or operation of internal controls which could  adversely affect the registrant’s ability to record, process, summarize and  report financial data and have identified for the registrant’s auditors any  material weaknesses in internal controls; and |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
|   |                                                                                                                                                                                                                                                                                                                                                                                               | b. | any fraud, whether or  not material, that involves management or other employees who have a  significant role in the registrant’s internal controls; and |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
| 6.     | The registrant’s other  certifying officer and I have indicated in this quarterly report whether or  not there were significant changes in internal controls or in other factors  that could significantly affect internal controls subsequent to the date of  our most recent evaluation, including any corrective actions with regard to  significant deficiencies and material weaknesses. |

 

 
| Date:  May 13, 2003 | By:    | /s/  G. Ward Paxton              |
|--------------------------|--------|---------------------------------------|
|                     |   | G. Ward Paxton                        |
|                     |   | Chairman and Chief  Executive Officer |

 

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**CERTIFICATION**

 

I, Michael L. Paxton,certify that:

 
| 1.     | I have reviewed this  Quarterly Report on Form 10-Q of Intrusion Inc.;                                                                                                                                                                                                                                                                                                                             |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
| 2.     | Based on my knowledge,  this quarterly report does not contain any untrue statement of material fact  or omit to state a material fact necessary to make the statements made, in  light of the circumstances under which such statements were made, not  misleading with respect to the period covered by this quarterly report;                                                                   |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
| 3.     | Based on my knowledge,  the financial statements, and other financial information included in this  quarterly report, fairly present in all material respects the financial  condition, results of operations and cash flows of the registrant as of, and  for, the periods presented in this quarterly report;                                                                                    |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
| 4.     | The registrant’s other  certifying officers and I are responsible for establishing and maintaining  disclosure controls and procedures (as defined in Exchange Act Rules 13a-14  and 15d-14) for the registrant and we have:                                                                                                                                                                  |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
|   |                                                                                                                                                                                                                                                                                                                                                                                               | a. | designed such  disclosure controls and procedures to ensure that material information  relating to the registrant, including its consolidated subsidiaries, is made  known to us by others within those entities, particularly during the period  in which this quarterly report is being prepared; |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
|   |                                                                                                                                                                                                                                                                                                                                                                                               | b. | evaluated the  effectiveness of the registrant’s disclosure controls and procedures as of a  date within 90 days prior to the filing date of this quarterly report (the  “Evaluation Date”); and |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
|   |                                                                                                                                                                                                                                                                                                                                                                                               | c. | presented in this  quarterly report our conclusions about the effectiveness of the disclosure  controls and procedures based on our evaluation as of the Evaluation Date; |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
| 5.     | The registrant’s other  certifying officers and I have disclosed, based on our most recent  evaluation, to the registrant’s auditors and audit committee of registrant’s  board of directors (or persons performing the equivalent function):                                                                                                                                       |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
|   |                                                                                                                                                                                                                                                                                                                                                                                               | a. | all significant  deficiencies in the design or operation of internal controls which could  adversely affect the registrant’s ability to record, process, summarize and  report financial data and have identified for the registrant’s auditors any  material weaknesses in internal controls; and |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
|   |                                                                                                                                                                                                                                                                                                                                                                                               | b. | any fraud, whether or  not material, that involves management or other employees who have a  significant role in the registrant’s internal controls; and |
|   |                                                                                                                                                                                                                                                                                                                                                                                               |   |   |
| 6.     | The registrant’s other  certifying officer and I have indicated in this quarterly report whether or  not there were significant changes in internal controls or in other factors  that could significantly affect internal controls subsequent to the date of  our most recent evaluation, including any corrective actions with regard to  significant deficiencies and material weaknesses. |

 

 
| Date:  May 13, 2003 | By:    | /s/  Michael L. Paxton                                       |
|--------------------------|--------|-------------------------------------------------------------------|
|                     |   | Michael L. Paxton                                                 |
|                     |   | Vice President, Chief  Financial Officer  Treasurer and Secretary |

 

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