**UNITED STATESSECURITIES 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 September 30, 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 Registrantas 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 telephonenumber, including area code)

 

**NotApplicable**

Former name, if changedsince last report)

 

* * * * * * * * * *

 

Indicate by check mark whether the Registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the Registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days:

Yes ý  No o

 

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

 

The number of shares outstanding of the Registrant’s Common Stock,$0.01 par value, on November 13, 2003 was 20,650,425.

 

 

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**INTRUSIONINC.**

 

INDEX

 
| **PART I - FINANCIAL  INFORMATION**                                                                                                          |
|----------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                         |
| Item 1.                                                                                                                                      | Financial Statements |
|                                                                                                                                         |
| Condensed  Consolidated Balance Sheets as of September 30, 2003 and December 31, 2002                                                        |
|                                                                                                                                         |
| Condensed  Consolidated Statements of Operations for the three months and nine months  ended September 30, 2003 and September 30, 2002. |
|                                                                                                                                         |
| Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2003 and September 30, 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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**PART I- FINANCIAL INFORMATION**

** **

Item1.             FINANCIAL STATEMENTS

 

**INTRUSIONINC. AND SUBSIDIARIES**

CONDENSEDCONSOLIDATED BALANCE SHEETS

(In thousands, except par value amounts)

** **
|                                                                                                                                                                                 |   | **Sept  30,  2003****** |   | **Dec  31,  2002****** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|--------|------------------------|--------|
|                                                                                                                                                                                 |   | **(Unaudited)**         |   | **(Audited)**          |   |
| **ASSETS**                                                                                                                                                                           |   |                    |   |                   |   |
|                                                                                                                                                                                 |   |                    |   |                   |   |
| Current Assets:                                                                                                                                                                      |   |                    |   |                   |   |
| Cash and cash  equivalents                                                                                                                                                           |   | $                       | 1,691  |                   | $      | 2,898 |   |
| Short-term  investments                                                                                                                                                              |   | 2,950                   |   | 7,825                  |   |
| Accounts  receivable, less allowance for doubtful accounts $620 in 2003 and $934 in  2002                                                                                            |   | 824                     |   | 2,363                  |   |
| Inventories, net                                                                                                                                                                     |   | 1,489                   |   | 1,411                  |   |
| Other assets                                                                                                                                                                         |   | 358                     |   | 759                    |   |
| Total current assets                                                                                                                                                                 |   | 7,312                   |   | 15,256                 |   |
| Property and equipment, net                                                                                                                                                          |   | 492                     |   | 1,597                  |   |
| Other assets                                                                                                                                                                         |   | 82                      |   | 86                     |   |
| TOTAL ASSETS                                                                                                                                                                         |   | $                       | 7,886  |                   | $      | 16,939 |   |
|                                                                                                                                                                                 |   |                    |   |                   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                       |   |                    |   |                   |   |
|                                                                                                                                                                                 |   |                    |   |                   |   |
| Current Liabilities:                                                                                                                                                                 |   |                    |   |                   |   |
| Accounts payable  and accrued expenses                                                                                                                                               |   | $                       | 2,737  |                   | $      | 2,905 |   |
| Deferred revenue                                                                                                                                                                     |   | 893                     |   | 1,650                  |   |
| Total current liabilities                                                                                                                                                            |   | 3,630                   |   | 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 – 20,690 in 2003  and 20,686 in 2002, Outstanding shares – 20,650 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                                                                                                                                                                  |   | (42,732                 | )      | (34,604                | )      |
| Accumulated  other comprehensive loss                                                                                                                                                |   | (228                    | )      | (228                   | )      |
| Total stockholders’ equity                                                                                                                                                      |   | 4,256                   |   | 12,384                 |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                      |   | $                       | 7,886  |                   | $      | 16,939 |   |

 

See accompanying notes.

 

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**INTRUSION INC. AND SUBSIDIARIES**

CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS

(In thousands, except pershare amounts)

(Unaudited)

 
|                                                           |   | **Three Months Ended**  |   | **Nine Months Ended**   |   |
|----------------------------------------------------------------|--------|-------------------------|--------|-------------------------|--------|
|                                                           |   | **September 30,  2003** |   | **September 30,  2002** |   | **September 30,  2003** |   | **September 30,  2002** |   |
| Net sales                                                      |   | $                       | 1,556  |                    | $      | 2,394 |   | $ | 4,515 |   | $ | 6,373 |   |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Cost of sales                                                  |   | 895                     |   | 1,322                   |   | 2,991 |   | 4,173 |   |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Gross profit                                                   |   | 661                     |   | 1,072                   |   | 1,524 |   | 2,200 |   |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Operating  expenses:                                           |   |                    |   |                    |   |   |   |   |   |
| Sales and marketing                                            |   | 1,313                   |   | 2,507                   |   | 5,099 |   | 9,606 |   |
| Research and  development                                      |   | 860                     |   | 1,398                   |   | 2,684 |   | 4,762 |   |
| General and  administrative                                    |   | 374                     |   | 693                     |   | 1,222 |   | 2,016 |   |
| Amortization of  intangibles                                   |   | —                  |   | 199                     |   | — |   | 598 |   |
| Litigation  settlement                                         |   | 450                     |   | —                  |   | 450 |   | — |   |
| Severance costs                                                |   | 119                     |   | —                  |   | 363 |   | 200 |   |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Operating loss                                                 |   | (2,455                  | )      | (3,725                  | )      | (8,294 | ) | (14,982 | ) |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Other income                                                   |   | —                  |   | (7                      | )      | 10 |   | (7 | ) |
| Interest income, net                                           |   | 43                      |   | 83                      |   | 156 |   | 281 |   |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Loss before income tax provision                               |   | (2,412                  | )      | (3,649                  | )      | (8,128 | ) | (14,708 | ) |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Income tax benefit                                             |   | —                  |   | —                  |   | — |   | (608 | ) |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Loss from continuing operations                                |   | (2,412                  | )      | (3,649                  | )      | (8,128 | ) | (14,100 | ) |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Gain from  discontinued operations, net of taxes               |   | —                  |   | —                  |   | — |   | 401 |   |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Net loss                                                       |   | $                       | (2,412 | )                       | $      | (3,649 | ) | $ | (8,128 | ) | $ | (13,699 | ) |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Basic and  diluted loss per share, continuing operations       |   | $                       | (0.12  | )                       | $      | (0.18 | ) | $ | (0.39 | ) | $ | (0.68 | ) |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Basic and  diluted loss per share                              |   | $                       | (0.12  | )                       | $      | (0.18 | ) | $ | (0.39 | ) | $ | (0.66 | ) |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Weighted average  common shares outstanding, basic and diluted |   | 20,650                  |   | 20,645                  |   | 20,649 |   | 20,640 |   |

 

See accompanying notes.

 

4

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**INTRUSIONINC. AND SUBSIDIARIES**

CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 
|                                                                                                                          |   | **Nine Months Ended**   |   |
|-------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|--------|
|                                                                                                                          |   | **September 30,  2003** |   | **September 30,  2002** |   |
| Operating Activities:                                                                                                         |   |                    |   |   |   |
| Loss from continuing operations                                                                                               |   | $                       | (8,128 | ) | $ | (14,100 | ) |
| Adjustments to  reconcile loss from continuing operations to net cash used in operating  activities of continuing operations: |   |                    |   |   |   |
| Depreciation and  amortization                                                                                                |   | 1,182                   |   | 2,165 |   |
| Provision for  doubtful accounts                                                                                              |   | (314                    | )      | — |   |
| Changes in operating assets and liabilities:                                                                                  |   |                    |   |   |   |
| Accounts  receivable                                                                                                          |   | 1,853                   |   | 2,063 |   |
| Income taxes  receivable                                                                                                      |   | —                  |   | 2,779 |   |
| Inventories                                                                                                                   |   | (78                     | )      | 2,317 |   |
| Other assets                                                                                                                  |   | 405                     |   | (372 | ) |
| Accounts payable  and accrued expenses                                                                                        |   | (168                    | )      | (2,321 | ) |
| Deferred revenue                                                                                                              |   | (757                    | )      | (117 | ) |
| Net cash used in operating activities of continuing  operations                                                               |   | (6,005                  | )      | (7,586 | ) |
| Investing Activities:                                                                                                         |   |                    |   |   |   |
| Purchases of  short-term investments                                                                                          |   | (3,450                  | )      | (12,565 | ) |
| Maturities of  short-term investments                                                                                         |   | 8,325                   |   | 12,002 |   |
| Net purchases of  property and equipment                                                                                      |   | (78                     | )      | (56 | ) |
| Net cash  provided by (used in) investing activities of continuing operations                                                 |   | 4,797                   |   | (619 | ) |
| Financing Activities:                                                                                                         |   |                    |   |   |   |
| Exercise of  warrants and employee stock options                                                                              |   | —                  |   | 51 |   |
| Issuance of  shares in employee stock purchase plan                                                                           |   | 1                       |   | 1 |   |
| Net cash provided by financing activities of continuing  operations                                                           |   | 1                       |   | 52 |   |
|                                                                                                                          |   |                    |   |   |   |
| Net cash  provided by discontinued operations                                                                                 |   | —                  |   | 405 |   |
| Effect of  foreign currency translation adjustments on cash and cash equivalents                                              |   | —                  |   | (88 | ) |
| Net decrease in  cash and cash equivalents                                                                                    |   | (1,207                  | )      | (7,836 | ) |
| Cash and cash  equivalents at beginning of period                                                                             |   | 2,898                   |   | 15,783 |   |
| Cash and cash  equivalents at end of period                                                                                   |   | $                       | 1,691  |   | $ | 7,947 |   |

 

See accompanying notes.

 

5

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**INTRUSIONINC. AND SUBSIDIARIES**

NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS (Unaudited)

 

1.  Description of Business

 

We develop, market and support network intrusiondetection systems (IDS) and VPN/firewall appliances that address vital securityissues facing enterprise and government entities that rely on their networksfor daily operations.

 

Our Intrusion SecureNet network intrusion detectionsystem provides users a broad and accurate detection technology, simpledeployment options and a highly intuitive management interface. The SecureNetSensor can be deployed on 10, 100, 250Mb/s and Gigabit networks as either anall-inclusive Hardware-Appliance or using Intrusion’s Software-Appliance CD,which can turn certain standard network servers into IDS Sensors. BothHardware-Appliances and Software-Appliances take advantage of the IntrusionSecureNet WBI Sensor web-browser management interface that can be accessed fromanywhere in the enterprise. Centralized event monitoring and system managementis done with the Intrusion SecureNet Provider, three-tier centralizedmanagement system.

 

We market and distribute our products through a directsales force to end-users, distributors and by numerous domestic andinternational system integrators, managed service providers and value-addedresellers.  Our end-user customersinclude manufacturing, technology, telecommunications, retail, transportation,health care, insurance, entertainment, utilities and energy companies,government agencies, financial institutions, and academic institutions.

 

We organized in Texas in September 1983 andreincorporated in Delaware in October 1995. For more than 15 years, we provided local area networking equipment andwere known as Optical Data Systems or ODS Networks.  On April 17, 2000, we announced plans to sell, or otherwisedispose of, our networking divisions, which included our EssentialCommunications Division (“Essential”) and our local area networkingassets.  This plan was completed duringMarch 2002.  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 executive offices are located at 1101East Arapaho Road, Richardson, Texas 75081, and our telephone number is (972)234-6400.  Our website URL iswww.intrusion.com.  References to “we”,“us”, “our” or “Intrusion Inc.” refer to Intrusion Inc. and its subsidiaries.

 

2.  Basis of Presentation

 

The accompanying unaudited condensed consolidatedfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States for interim financial informationand with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States for complete financial statements.  The December 31, 2002 balance sheet wasderived from audited financial statements, but does not include all thedisclosures required by accounting principles generally accepted in the UnitedStates.  However, we believe that thedisclosures are adequate to make the information presented not misleading.  In our opinion, all

 

6

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the adjustments (consisting of normal recurring adjustments) considerednecessary for fair presentation have been included.  The results of operations for the three and nine month periodsending September 30, 2003 are not necessarily indicative of the results thatmay be achieved for the full fiscal year or for any future period.  The condensed consolidated financialstatements included herein should be read in conjunction with the consolidatedfinancial statements and notes thereto included in the Company’s annual reporton Form 10-K for the year ended December 31, 2002.

 

At September 30, 2003, the Company had approximately$4.6 million of unrestricted cash, cash equivalents and short-term investments, down from approximately $10.7 million as ofDecember 31, 2002.  The Company fundedits operations and met cash requirements during the quarter by selling aportion of short-term investments. Although we believe that we have sufficient cash resources to financeour operations and expected capital expenditures for the next twelve monthsbased on our internal estimates and our operating plan, the sufficiency of ourcash resources may depend to a certain extent on general economic, financial,competitive or other factors beyond our control.  This plan is benefited by further cost reduction actions thathave already been taken, which should reduce expenses in the fourth quarter2003 and first quarter 2004.  Thesereductions are primarily the result of a reduction in international salespersonnel.  Additionally, the Companyplans to allocate resources to markets and opportunities that offer highermargins and larger sales dollars. Despite actions to reduce our costs and improve our profitability, weexpect our operating losses and net operating cash outflows to continue atleast through March 31, 2004.  As aresult, we may not be able to achieve the revenue and gross margin objectivesnecessary to achieve positive cash flow or profitability without obtainingadditional financing.  However,there is no assurance that financing will be available on acceptable terms orin a timely manner, if at all.  If ourbusiness does not generate sufficient cash flow from operations and sufficientfuture financings are not available, we may not be able to operate or grow ourbusiness, pay our expenses when due or fund our other liquidity needs.

 

The consolidated financial statements do not includeany adjustments that might result from the outcome of any of the uncertaintiesdiscussed above.

 

3.  Recent Accounting Pronouncements

 

InDecember 2002, the FASB issued SFAS No. 148, “Accounting for Stock-BasedCompensation-Transition and Disclosure” (“SFAS 148”).  SFAS 148 amends FASB Statement No. 123, “Accounting forStock-Based Compensation” (“SFAS 123”), to provide alternative methods oftransition to SFAS 123’s fair value method of accounting for stock-basedemployee compensation.

 

SFAS148 also amends the disclosure provisions of SFAS 123 and APB Opinion No. 28,“Interim Financial Reporting,” to require disclosure in the summary ofsignificant accounting policies of the effects of an entity’s accounting policywith respect to stock-based employee compensation on reported net income andearnings per share in annual and interim financial statements. While SFAS 148does not amend SFAS 123 to require companies to account for employee stockoptions using the fair value method, the disclosure provisions of SFAS 148 areapplicable to all companies with stock-based employee compensation, regardlessof whether they account for that compensation using the fair value method ofSFAS 123 or the intrinsic value method of APB Opinion No. 25, “Accounting for Stock Issued to Employees”(“APB 25”). UnderAPB 25, if the exercise price of an employee’s stock option equals or exceedsthe market price of the underlying stock on the date of grant, no compensationexpense is recognized.  As allowed

 

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by SFAS 123and 148, the Company has elected to continue to utilize the accounting methodprescribed by APB 25 and has adopted the disclosure requirements of SFAS 123and SFAS 148.

 

4.  ForeignCurrency Translation

 

On January 1,2003, the Company elected to change the functional currency of its foreignoperations to the United States dollar. This change in functional currency issupported by the fact that all foreign operations are funded monthly in UnitedStates dollars and the majority of 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 theaccounting period. The resulting translation adjustment was previously recordedas a separate component of stockholders’ equity. Income statement items werepreviously translated at average currency exchange rates.

 

5.  Inventories (In thousands)

 
| **Inventories  consist of:** |   | **September 30,  2003** |   | **December 31,  2002** |   |
|------------------------------|--------|-------------------------|--------|------------------------|--------|
|                         |   |                    |   |                   |   |
| Raw materials                |   | $                       | — |                   | $      | 70 |   |
|                         |   |                    |   |                   |   |
| Finished goods               |   | 1,105                   |   | 1,157                  |   |
|                         |   |                    |   |                   |   |
| Work in process              |   | 203                     |   | —                 |   |
|                         |   |                    |   |                   |   |
| Demonstration systems        |   | 181                     |   | 184                    |   |
|                         |   |                    |   |                   |   |
| Net inventory                |   | $                       | 1,489  |                   | $      | 1,411 |   |

 

6.  Accounting for Stock-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, with supplementalinformation as if the fair value recognition provision of SFAS 123 had beenapplied for the quarters ended September 30, 2003 and September 30, 2002 andthe nine months ended September 30, 2003 and September 30, 2002 (in thousands,except per share data):

 

8

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|                                                                                                        |   | **Quarter  Ended  September  30, 2003** |   | **Quarter  Ended  September  30, 2002** |   | **Nine  Months  September  30, 2003** |   | **Nine  Months  September  30, 2002** |   |
|-------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------|--------|-----------------------------------------|--------|---------------------------------------|--------|---------------------------------------|--------|
|                                                                                                        |   |                                    |   |                                    |   |                                  |   |                                  |   |
| Net loss, as reported                                                                                       |   | $                                       | (2,412 | )                                       | $      | (3,649                                | )      | $                                     | (8,128 | ) | $ | (13,699 | ) |
| Add (Deduct):  Total stock-based compensation determined  under fair value-based method for all awards |   | (3                                      | )      | (51                                     | )      | 331                                   |   | (488                                  | )      |
| Pro forma net loss                                                                                          |   | $                                       | (2,415 | )                                       | $      | (3,700                                | )      | $                                     | (7,797 | ) | $ | (14,187 | ) |
|                                                                                                        |   |                                    |   |                                    |   |                                  |   |                                  |   |
| Net loss per share:                                                                                         |   |                                    |   |                                    |   |                                  |   |                                  |   |
| Basic, as  reported                                                                                         |   | $                                       | (0.12  | )                                       | $      | (0.18                                 | )      | $                                     | (0.39  | ) | $ | (0.66 | ) |
| Basic, pro forma                                                                                            |   | $                                       | (0.12  | )                                       | $      | (0.18                                 | )      | $                                     | (0.38  | ) | $ | (0.69 | ) |
| Diluted, as  reported                                                                                       |   | $                                       | (0.12  | )                                       | $      | (0.18                                 | )      | $                                     | (0.39  | ) | $ | (0.66 | ) |
| Diluted, pro  forma                                                                                         |   | $                                       | (0.12  | )                                       | $      | (0.18                                 | )      | $                                     | (0.38  | ) | $ | (0.69 | ) |
| Weighted-average shares used in computation:                                                                |   |                                    |   |                                    |   |                                  |   |                                  |   |
| Basic and  diluted                                                                                          |   | 20,650                                  |   | 20,645                                  |   | 20,649                                |   | 20,640                                |   |

 

As required, the pro forma disclosures aboveinclude options granted since January 1, 1995. Consequently, the effects of applying SFAS 123 for providing pro formadisclosures may not be representative of the effects on reported operatingresults for future years until all options outstanding are included in the proforma disclosures.  For purposes of proforma disclosures, the estimated fair value of stock-based compensation plans andother options are amortized to expense primarily over the vesting period.

 

7.  NetLoss Per Share

 

We report two separate earnings per share (“EPS”)numbers, basic EPS and diluted EPS. Basic net loss per share is computed by dividing net loss for the periodby the weighted average number of common shares outstanding for theperiod.  Diluted net loss per share iscomputed by dividing the net loss by the weighted average number of commonshares and common stock equivalents outstanding for the period.  Our common stock equivalents are notincluded in the diluted loss per share for the three and nine-month periodsended September 30, 2003 and 2002, as they are antidilutive.  Such options are excluded due to incurring anet loss per share in the applicable period.

 

8.  Discontinued Operations

 

In March 2002 we sold the assets of our last remainingdiscontinued operation, our Essential Communications division, for $1.0million, generating a gain on sale of $0.4 million, which we have shown as again from discontinued operations in the accompanying financial statements.

 

A condition of the sale was to give Essentialpersonnel 60 days to exit Essential’s leased facility, the obligation for whichwe retained as part of the sale. Included in the gain on the sale of Essential was management’s estimateof $0.3 million to terminate this lease agreement, which was equivalent to 2years lease and maintenance of the facility. The contractual term of the lease

 

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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 represents a summary of gains and lossesfrom discontinued operations (In thousands):

 
|                                 |   | **Nine Months Ended****September  30, 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.  Commitments and Contingencies

 

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

 

On March 22, 2002, Morgan Newton Company, L.P.(“Morgan Newton”) filed suit against us in Dallas County District Court, CaseNo. DV02-02339-C, alleging claims for breach of contract, promissory estoppel,and fraud.  The claims arise out of analleged oral representation to Morgan Newton concerning a request for quotationfor the purchase of a large amount of Morgan Newton’s products.  During the quarter ended September 30, 2003,Morgan Newton and Intrusion settled this matter, which resulted in a paymentthat is due to Morgan Newton during the fourth quarter of 2003.  The amount due of $450,000 was recorded aslitigation settlement during the quarter ended September 30, 2003 and isincluded in accrued expenses at September 30, 2003.

 

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

 

This report contains forward-looking statements,within the meaning of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934, that involve risks and uncertainties,such as statements concerning: the difficulties in forecasting future sales caused by currenteconomic and market conditions, the effect of military actions on governmentand corporate spending on information security products, the impact of our costreduction programs and our refocused product line, the difficulties anduncertainties in successfully developing and introducing new products, ourability to continue to meet operating expenses through current cash flow or

 

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additional financings, thecontinuance and strength of our relationship with Check Point, a market-leading virtual private network andfirewall security software company, the highly competitive market for our products, difficulties inaccurately estimating market growth, the consolidation of the informationsecurity industry, the impact of changing economic conditions, businessconditions in the information security industry, our ability to manageacquisitions effectively, our ability to manage discontinued operationseffectively, the impact of market peers and their products as well as risksconcerning future technology and others identified in our Annual Report on Form10-K and other Securities and Exchange Commission filings.  Such forward-looking statements aregenerally accompanied by words such as “plan,” “estimate,” “expect,” “believe,”“should,” “would,” “could,” “anticipate,” “may” or other words that conveyuncertainty of future events or outcomes. These forward-looking statements and other statements made elsewhere inthis report are made in reliance on the Private Securities Litigation ReformAct of 1995.  The section below entitled“Factors That May Affect Future Results of Operations” sets forth andincorporates by reference certain factors that could cause actual futureresults of the company to differ materially from these statements.

 

Overview

 

We develop, market and support network intrusiondetection systems and VPN/firewall appliances that address vital securityissues facing enterprise and government entities that rely on their networksfor daily operations.

 

Our Intrusion SecureNet network IDS provides users abroad and accurate detection technology, simple deployment options and a highlyintuitive management interface. The SecureNet Sensor can be deployed on 10, 100,250Mb/s and Gigabit networks as either an all-inclusive Hardware-Appliance orusing Intrusion’s Software-Appliance CD, which can turn certain standardnetwork servers into IDS Sensors. Both Hardware-Appliances andSoftware-Appliances take advantage of the Intrusion SecureNet WBI Sensorweb-browser management interface that can be accessed from anywhere in theenterprise. Centralized event monitoring and system management is done with theIntrusion SecureNet Provider, three-tier centralized management system.

 

Wemarket and distribute our products through a direct sales force to end-users,distributors and by numerous domestic and international system integrators,managed service providers 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.

 

Weorganized in Texas in September 1983 and reincorporated in Delaware in October1995.  For more than 15 years, weprovided local area networking equipment and were known as Optical Data Systemsor ODS Networks.  On April 17, 2000, weannounced plans to sell, or otherwise dispose of, our networking divisions,which include Essential and our local area networking assets.  In accordance with these plans, 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.

 

Ourprincipal executive offices are located at 1101 East Arapaho Road, Richardson,Texas 75081, and our telephone number is (972) 234-6400.  Our

 

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website URL iswww.intrusion.com.  References to “we”,“us”, “our” or “Intrusion Inc.” refer to Intrusion Inc. and its subsidiaries.

 

Critical Accounting Policies and Estimates

 

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

 

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

 

*Revenue Recognition*

 

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

 

Werecognize software revenue from the licensing of our software products inaccordance with Statement of Position (“SOP”) No. 97-2 “Software RevenueRecognition” and SOP 98-9 “Modification of 97-2, Software Revenue Recognition,with respect to certain transactions” whereby revenue from the licensing of ourproducts is not recognized until all four of the following conditions have beenmet: i) execution of a written purchase order, license agreement or contract;ii) shipment of the product has occurred; iii) the license fee is fixed anddeterminable; and iv) collectibility is probable.  The Company defers and recognizes maintenance and support revenueover the term of the contract period, which is generally one year.

 

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

 

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revenue in theaccompanying financial statements is offset by deferred cost of sales.

 

*Allowance for Doubtful Accounts*

 

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

 

*Inventory*

 

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

 

Resultsof Operations

 

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

 
|                                             |   | **Three Months Ended**         |   | **Nine Months Ended**          |   |
|--------------------------------------------------|--------|--------------------------------|--------|--------------------------------|--------|
|                                             |   | **September  30,********2003** |   | **September  30,********2002** |   | **September  30,********2003** |   | **September  30,********2002** |   |
| Net sales                                        |   | 100.0                          | %      | 100.0                          | %      | 100.0 | % | 100.0 | % |
| Cost of sales                                    |   | 57.5                           |   | 55.2                           |   | 66.2 |   | 65.5 |   |
| Gross profit                                     |   | 42.5                           |   | 44.8                           |   | 33.8 |   | 34.5 |   |
| Operating expenses:                              |   |                           |   |                           |   |   |   |   |   |
| Sales and marketing                              |   | 84.4                           |   | 104.7                          |   | 113.0 |   | 150.7 |   |
| Research and  development                        |   | 55.3                           |   | 58.4                           |   | 59.4 |   | 74.7 |   |
| General and  administrative                      |   | 24.0                           |   | 28.9                           |   | 27.1 |   | 31.6 |   |
| Amortization of  intangibles                     |   | —                         |   | 8.3                            |   | — |   | 9.4 |   |
| Litigation Settlement                            |   | 28.9                           |   | —                         |   | 10.0 |   | — |   |
| Severance costs                                  |   | 7.7                            |   | —                         |   | 8.0 |   | 3.1 |   |
| Operating loss                                   |   | (157.8                         | )      | (155.6                         | )      | (183.7 | ) | (235.1 | ) |
| Other income                                     |   | —                         |   | (0.3                           | )      | 0.2 |   | (0.1 | ) |
| Interest income, net                             |   | 2.7                            |   | 3.5                            |   | 3.5 |   | 4.4 |   |
| Loss before income tax  provision                |   | (155.1                         | )      | (152.4                         | )      | (180.0 | ) | (230.8 | ) |
|                                             |   |                           |   |                           |   |   |   |   |   |
| Income tax benefit                               |   | —                         |   | —                         |   | — |   | (9.5 | ) |
|                                             |   |                           |   |                           |   |   |   |   |   |
| Loss from continuing  operations                 |   | (155.1                         | )      | (152.4                         | )      | (180.0 | ) | (221.2 | ) |
| Gain from discontinued  operations, net of taxes |   | —                         |   | —                         |   | — |   | 6.3 |   |
|                                             |   |                           |   |                           |   |   |   |   |   |
| Net loss                                         |   | (155.1                         | )      | (152.4                         | )      | (180.0 | ) | (215.0 | ) |

 

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|             |   | **Three Months Ended**         |   | **Nine Months Ended**          |   |
|------------------|--------|--------------------------------|--------|--------------------------------|--------|
|             |   | **September  30,********2003** |   | **September  30,********2002** |   | **September  30,********2003** |   | **September  30,********2002** |   |
| Domestic sales   |   | 76.8                           | %      | 69.2                           | %      | 64.2 | % | 65.0 | % |
| Export sales to: |   |                           |   |                           |   |   |   |   |   |
| Europe           |   | 16.9                           |   | 17.7                           |   | 26.1 |   | 23.6 |   |
| Canada           |   | 0.6                            |   | 2.3                            |   | 0.6 |   | 3.9 |   |
| Asia             |   | 5.6                            |   | 10.6                           |   | 9.0 |   | 6.7 |   |
| Latin America    |   | 0.1                            |   | 0.2                            |   | 0.1 |   | 0.8 |   |
|             |   |                           |   |                           |   |   |   |   |   |
| Net sales        |   | 100.0                          | %      | 100.0                          | %      | 100.0 | % | 100.0 | % |

 

**Net Sales**. Net sales for the quarter and nine months ended September 30, 2003 were$1.6 million and $4.5 million, respectively, compared to $2.4 million and $6.4million, respectively, for the same periods of 2002.  Sales from our first generation security products continued todecrease and our sales of SecureNet network intrusion detection products increased.  The worldwide economic conditions continuedto negatively impact our sales.

 

**Export Sales**. Export sales for the quarter and nine months ended September 30, 2003were $0.4 million and $1.6 million respectively, compared to $0.7 million and$2.0 million, respectively, for the same period of 2002.  The worldwide economic slow down coupledwith our cost-cutting initiatives to concentrate our sales efforts on moreprofitable regions negatively impacted our export sales for the quarter.

 

**Concentration of Sales**.  There were no significant concentrations ofsales (i.e. greater than 10%) during the third quarter or first nine months of2002 or 2003. We expect the lack of a concentration of sales to continue as wesell to various customers, and the concentration mix may vary depending uponthe timing of certain sales.  Althoughsales through direct and indirect channels to the U.S. Government entitiestotaled 19.1% and 13.2% of revenue for the three and nine-month periods endedSeptember 30, 2003, respectively, sales to one U.S. government entity or salesthrough one indirect channel did not exceed 10% of revenue for either of theaforementioned periods.

 

**Gross Profit**. Gross profit was $0.7 million or 42.5% of net sales for the quarterended September 30, 2003, compared to $1.1 million or 44.8% of net sales forthe quarter ended September 30, 2002. For the nine months ended September 30,2003, gross profit decreased to $1.5 million or 33.8% of net sales compared to$2.2 million or 34.5% of net sales for the same period in the prior year. Grossprofit as a percentage of net sales is impacted by several factors, includingshifts in product mix, changes in channels of distribution, sales volume,fluctuations in manufacturing costs, pricing strategies, and fluctuations insales of integrated third-party products.

 

**Sales and Marketing**.  Sales and marketing expenses decreased to$1.3 million for the quarter ended September 30, 2003, compared to $2.5 millionfor the quarter ended September 30, 2002. Sales and marketing expensesdecreased to $5.1 million for the nine months ended September 30, 2003 comparedto $9.6 million for the same period of 2002. Sales and marketing expensesdecreased in the quarter and nine months ended September 30, 2003, compared tothe same periods of 2002, primarily due to the reorganization of our sales andmarketing departments and other cost reduction initiatives.  We expect sales and marketing expenses tocontinue to decline in the fourth quarter of 2003, in comparison to

 

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the third quarter of2003 as we recognize the full benefit of our cost reduction initiatives.  Sales and marketing expenses may vary as apercentage of net sales in the future.

 

**Research and Development**.  Research and development expenses decreasedto $0.9 million for the quarter ended September 30, 2003, compared to $1.4million for the quarter ended September 30, 2002. Research and developmentcosts for the nine months ended September 30, 2003 decreased to $2.7 millioncompared to $4.8 million for the same period in 2002. Research and developmentcosts are expensed in the period incurred. Research and development expenses decreased in the quarter and ninemonths ended September 30, 2003, compared to the same periods in 2002 as wereduced the research and development workforce and focused more of ourdevelopment efforts on our core security products — SecureNet Network IntrusionDetection Systems and security appliances. Research and development expenses may vary as a percentage of net salesin the future.

 

**General and Administrative**.  General and administrative expensesdecreased to $0.4 million for the quarter ended September 30, 2003, compared to$0.7 million for the quarter ended September 30, 2002. General andadministrative expensed decreased to $1.2 million for the nine months endingSeptember 30, 2003, compared to $2.0 million for the nine months endingSeptember 30, 2002. General and administrative expenses decreased in thequarter and nine months ending September 30, 2003 compared to the same periodsof 2002, primarily due to restructuring activities in 2003, includingreductions in personnel, and other cost reduction initiatives.  It is expected that general andadministrative expenses will remain relatively constant throughout theremainder of the year.  General andadministrative expense may vary as a percentage of net sales in the future.

 

**Amortization**. Amortization expenses ceased at December 31, 2002 due to the impairmentcharge taken during December 2002 to write down the balance of all intangibleassets to zero.

 

**Severance Costs. **Severancecosts of $0.1 million for the three-month period ended September 30, 2003 and$0.4 million for the nine-month period ended September 30, 2003 consists ofseverance expense as a result of additional reductions in force.  There were no severance charges for thethree-month period ended September 30, 2002 and $0.2 million for the nine-monthperiod ended September 30, 2002.

 

**Litigation Settlement. **Litigation settlement charges relate to the litigationsettlement agreement between Intrusion and Morgan Newton as discussed in PartII, Item 1 of this report.  Charges of$0.5 million, which were paid in October, were recognized and accrued duringthe quarter ended September 30, 2003. This settlement concludes all obligations related to this litigationsettlement.  There were no litigationsettlement charges for the quarter or nine-month period ended September 30,2002.

 

**Interest**. Net interest income decreased to $0.0 million for the quarter endedSeptember 30, 2003, compared to $0.1 million for the same period in 2002.  Net interest income decreased to $0.2million for the nine months ended September 30, 2003, compared to $0.3 millionfor the nine months ended September 30, 2002. The net interest income decreaseswere primarily due to the reduced overall cash balances and decreased rates ofreturn.  Net interest income may vary inthe future based on our cash flow and rate of return on investments.

 

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Liquidityand Capital Resources

 

Ourprincipal source of liquidity at September 30, 2003 is approximately $1.7million of cash and cash equivalents and $2.9 million of short-terminvestments.  As of September 30, 2003working capital was $3.7 million compared to $14.4 million as of September 30,2002.

 

Cashused in continuing operations for the nine months ended September 30, 2003 was$6.0 million, primarily due to an operating loss from continuing operations of$8.1 million, the provision for doubtful accounts and an increase in inventories,as well as decreases in accounts payable and accrued expenses and deferredrevenue, which are offset by depreciation expense and decreases in accountsreceivable and other assets, compared to cash used in operations of $7.6million for the nine months ended September 30, 2002, primarily due to anoperating loss from continuing operations of $14.1 million, which is offset bya decrease in income taxes receivable, accounts receivable andinventories.  Future fluctuations ininventory balances, accounts receivable and accounts payable will be dependentupon several factors, including, but not limited to, quarterly sales, ourstrategy in building inventory in advance of receiving orders from customers,and the accuracy of our forecasts of product demand and component requirements.

 

Cashprovided by investing activities in the nine months ended September 30, 2003was $4.8 million, which consisted primarily of purchases and maturities ofshort-term investments, compared to cash used in investing activities of $0.6million for the nine months ended September 30, 2002, which also consistedprimarily of purchases and maturities of short-term investments.

 

Cashprovided by financing activities in the nine months ended September 30, 2003was $1.0 thousand, as there were four thousand shares issued through theemployee stock purchase plan during the period, compared to $52.0 thousandduring the nine months ended September 30, 2002, which was primarily the resultof the exercise of employee stock options.

 

AtSeptember 30, 2003, the Company did not have any material commitments forcapital expenditures.

 

Duringthe nine months ended September 30, 2003, the Company funded its operationsthrough the use of cash and cash equivalents.

 

Basedon the Company’s financial projections, the Company expects that cash on hand,along with short-term investments, and cash from its operations will besufficient to fund operations for the next 12 months.  However, that plan is dependent upon decreases in operatingexpenses.  The Company funded its operations and met cash requirements during thequarter by selling a portion of short-term investments.  Although we believe that we have sufficientcash resources to finance our operations and expected capital expenditures forthe next twelve months based on our internal estimates and our operating plan,the sufficiency of our cash resources may depend to a certain extent on generaleconomic, financial, competitive or other factors beyond our control.  This plan is benefited by further costreduction actions that have already been taken, which should reduce expenses inthe fourth quarter 2003 and first quarter 2004.  These reductions are primarily the result of a reduction ininternational sales personnel. Additionally, the Company plans to allocate resources to markets andopportunities that offer higher margins and larger sales dollars.  Despite actions to reduce our costs andimprove our profitability, we expect our operating losses and net operatingcash outflows to continue at least through

 

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March31, 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 additional financing.  However, there is no assurance thatfinancing will be available on acceptable terms or in a timely manner, if atall.  If our business does not generatesufficient cash flow from operations and sufficient future financings are notavailable, we may not be able to operate or grow our business, pay our expenseswhen due or fund our other liquidity needs.

 

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

 

FactorsThat May Affect Future Results of Operations 

 

Numerousfactors may affect our business and future results of operations.  These factors include, but are not limitedto, current economic and market conditions, the effect of military actions ongovernment and corporate spending on information security products,technological changes, competition and market acceptance, acquisitions, producttransitions, timing of orders, manufacturing and suppliers, reliance onoutsourcing vendors and other partners, intellectual property and licenses,third-party products, dependence on government customers, internationaloperations, intellectual property issues, liquidity and cash resources andeffects of restructuring plans and cost reductions.  The discussion below addresses some of these and otherfactors.  For a more thorough discussionof these and other factors that may affect our business and future results, seethe discussion under the caption “Factors That May Affect Future Results of Operations”in our Annual Report on Form 10-K for the year ended December 31, 2002.

 

**Sufficiencyof Cash Flow.**  At September 30, 2003, the Company hadapproximately $4.6 million of unrestricted cash, cash equivalents andshort-term investments, down fromapproximately $10.7 million as of December 31, 2002.  The Company funded its operations and met cash requirementsduring the quarter by selling a portion of short-term investments.  Although we believe that we have sufficientcash resources to finance our operations and expected capital expenditures forthe next twelve months based on our internal estimates and our operating plan,the sufficiency of our cash resources may depend to a certain extent on generaleconomic, financial, competitive or other factors beyond our control.  This plan is benefited by further costreduction actions that have already been taken, which should reduce expenses inthe fourth quarter 2003 and first quarter 2004.  These reductions are primarily the result of a reduction ininternational sales personnel. Additionally, the Company plans to allocate resources to markets andopportunities that offer higher margins and larger sales dollars.  Despite actions to reduce our costs andimprove our profitability, we expect our operating losses and net operatingcash outflows to continue at least through March 31, 2004.  As a result, we may not be able to achievethe revenue and gross margin objectives necessary to achieve positive cash flowor profitability without obtaining additional financing.  However,

 

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there is no assurancethat financing will be available on acceptable terms or in a timely manner, ifat all.  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.

 

**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 are pursuing a strategy to increase the percentage of our revenuegenerated through indirect sales channels including distributors, value addedresellers, system integrators, original equipment manufacturers and managedservice providers.  There can be 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.

 

Weare also pursuing a strategy to further differentiate our product line byintroducing complementary security products and incorporating new technologiesinto our existing product line.  Therecan be no assurance that we will successfully introduce these products or thatsuch products will gain market acceptance. We anticipate competition from networking companies, network securitycompanies and others in each of our product lines.  We anticipate that profit margins will vary among our productlines and that product mix fluctuations could have an adverse effect on ouroverall profit margins.

 

**Acquisitions.** Some of ourcompetitors have acquired several security companies with complementarytechnologies, and we anticipate that such acquisitions will continue in thefuture.  These acquisitions may permitsuch competitors to accelerate the development and commercialization of broaderproduct lines and more comprehensive solutions than we currently offer.  In the past, we have relied upon acombination of internal product development and partnerships with othersecurity vendors to provide competitive solutions to customers.  Certain of the recent and futureacquisitions by our competitors may have the effect of limiting our access tocommercially significant technologies. Further, the business combinations and acquisitions in the securityindustry 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.

 

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

 

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

 

**Manufacturingand Suppliers. **Our operational strategy relies on outsourcing of product assembly andcertain other operations.  There can beno assurance that we will effectively manage our third-party contractors orthat these contractors will meet our future requirements for timely delivery ofproducts of sufficient quality and quantity. Further, we intend to introduce a number of new products and productenhancements in the remainder of 2003 and 2004 that will require that werapidly achieve volume production of those new products by coordinating ourefforts with those of our suppliers and contractors.  The inability of the third-party contractors to provide us withadequate supplies of high-quality products could cause a delay in our abilityto fulfill orders and could have an adverse effect on our business, operatingresults and financial condition.

 

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

 

**Intellectual Property and Licenses.**  There are many patentsheld by companies, which relate to the design and manufacture of networksecurity systems.  Holders of thosecould assert potential claims of infringement. We could incur substantial costs in defending our company and ourcustomers against any such claim regardless of the merits of such claims.  In the event of a

 

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successful claim of infringement, we may be required to obtainone or more licenses from third parties. There can be no assurance that we could obtain the necessary licenses onreasonable terms.

 

**Dependence on Check Point Technologies**.  A percentage of our sales arerepresented by our PDS family of security appliances, which are integrated withCheck Point Software Technologies’ market-leading virtual private network andfirewall security software.  We expectthe percentage of sales represented by these products to decrease in thefuture.  Although we are a certifiedappliance partner of Check Point and our PDS products have receivedcertification from Check Point, we have no long-term agreement or exclusiverelationship with Check Point.  As aresult, the loss or significant change in our relationship with Check Point,the failure of future PDS products to receive Check Point certification, thebusiness failure of Check Point or its acquisition by or of one of ourcompetitors, and the loss of market share of Check Point or market acceptanceof its products could each have a material adverse effect on our business,financial condition and results of operations.

 

**Third-Party Products.**  We believe that it isbeneficial to work with third parties with complementary technologies tobroaden the appeal of our security products. These alliances allow us to provide integrated solutions to ourcustomers by combining our developed technology with third-party products.  As we also compete with these technologypartners in certain segments of the market, there can be no assurance that wewill have access to all of the third-party products that may be desirable ornecessary in order to offer fully integrated solutions to our customers.

 

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

 

**Impact of GovernmentCustomers.**  $0.3million or 19.1% and $0.6 million or 13.2% of revenue in the quarter and ninemonths ended September 30,2003, respectively, was derived from sales to the U.S. government, eitherdirectly by Intrusion or through system integrators and other resellerscompared to $0.7 million or 27.7% and $1.1 million or 17.9% of revenue for thesame periods in 2002.  $0.2 million or3.7% of revenue in the nine-month period ended September 30, 2003 was derived from sales to all U.K. government entitiescompared to $0.0 million or 0.0% of revenue for the same period ended September 30, 2002.  We expectsales to the U.S. and foreign governments to represent a significant portion ofour revenue in future periods.  Sales tothe government present risks in addition to those involved in sales tocommercial customers, including potential disruptions due to appropriation andspending patterns and the government’s reservation of the right to cancelcontracts and purchase orders for its convenience.

 

**Effects of MilitaryActions.**  The United States military actions or otherevents occurring in response or in connection to them, including futureterrorist attacks against United States targets, actual conflicts involving the

 

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United States or its allies, or military or trade disruptionscould impact our operations, including by:

 

**•**                  reducing government or corporate spending on network securityproducts;

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

•                  affecting our ability to conduct business internationally.

 

Should such events occur, our business,operating results and financial condition could be materially and adverselyaffected.  The war in Iraq significantlyreduced government spending in our market space and negatively impacted ourfirst, second and third quarter earnings, as evidenced by the significantreduction in sales to U.S. government entities.

 

**Restructuring and CostReductions. **Weimplemented a restructuring plan in April 2002 and are adopting additionalcost-cutting initiatives.  The objectiveof these plans is to reduce our cost structure to a sustainable level that isconsistent with the current macroeconomic environment and our cash flowprojections.  We have also implementedother strategic 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.

 

**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.  We received a notice ofnoncompliance 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.  Pursuant to Nasdaq rules, in order to regaincompliance for listing on the Nasdaq Stock Market, the minimum bid price of ourcommon stock had to be at least $1.00 for at least 10 consecutive trading dayson or prior to November 5, 2003.

 

Although ourclosing bid price was equal to or greater than $1.00 for 10 consecutive tradingdays prior to November 5, 2003, Nasdaq exercised its discretion to requireadditional days to evidence our long-term compliance with the minimum bid pricerequirement and contends that we failed to meet all of the requirements forcontinued listing on the Nasdaq Stock Market. As a result, Nasdaq sent us a notification of delisting on November 6,2003.  In accordance with Nasdaq rules,we have requested a hearing before a Nasdaq Listing Qualifications Panel inorder to appeal the grounds for delisting and to present a plan for long-termcompliance with Nasdaq’s continued listing requirements.  We are awaiting further notice from Nasdaqas to the date of our hearing. However, until the issuance of a writtendetermination by the Listing Qualifications Panel regarding our appeal, ourstock will continue to trade on the Nasdaq SmallCap Market.

 

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Nasdaq hasbroad authority to determine compliance and continued listing on the NasdaqStock Market.  Therefore, we cannotassure you that we will be successful in our appeal, nor can we be certain howlong the entire process will take. Furthermore, even if the Listing Qualifications Panel accepts our appealor our compliance plan, we cannot assure you that we will be successful inexecuting our plan or that we will remain in compliance with all of Nasdaq’scontinued listing standards in the future.

 

If we areunsuccessful in our attempt to obtain reinstatement from Nasdaq, if we fail toexecute on our proposed compliance plan or if we fail to comply with other Nasdaqcontinued listing requirements, our common stock likely would trade in a lessefficient market, such as the OTC Bulletin Board or in the “pink sheets”maintained by the National Quotation Bureau, Inc.  Because these alternatives generally are considered to be lessefficient markets, our stock price, the liquidity of our common stock and ourgeneral business 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 the potentialadoption of alternative technologies. Currently, capital spending for information technology products,including security products is being adversely affected by uncertain economicconditions and world events such as current military conflicts in Iraq andelsewhere.  Future declines in networksecurity product sales as a result of general economic conditions, adoption ofalternative technologies or any other reason could have a material adverseeffect on our business, operating results and financial condition.

 

Due to the factors noted above and in“Management’s Discussion and Analysis of Financial Condition and Results ofOperations”, our future earnings and common stock price may be subject tosignificant volatility, particularly on a quarterly basis.  Past financial performance should not beconsidered a reliable indicator of future performance and investors should notuse historical trends to anticipate results or trends in future periods.  Any shortfall in revenue and earnings fromthe levels anticipated by securities analysts could have an immediate andsignificant effect on the trading price of our common stock in any givenperiod.  Also, we participate in ahighly dynamic industry, which often results in volatility of our common stockprice.

 

Item3.             QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

**Foreign Exchange**. Revenue originating outside the U.S. in the quarters ended September 30,2003, 2002 and 2001 was 23.2%, 30.8% and 50.8% of total revenues, respectively.Revenue originating outside the U.S. in the nine months ended September 30,2003, 2002 and 2001 was 35.8%, 35.0% and 35.0% of total revenues,respectively.  International sales aremade mostly 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.

 

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

 

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factors.  The effect of foreign exchange ratefluctuations on us in 2003, 2002 and 2001 was not material.

 

*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 a 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 no translationadjustment to the separate component of stockholders’ equity or adjustment tocomprehensive income. The effect of the change in functional currency had nomaterial impact on results of operations. The accumulation of prior years’translation adjustments 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 theaccounting period. The resulting translation adjustment was recorded as aseparate component of stockholders’ equity. Income statement items aretranslated at average currency exchange rates.

 

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

 

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

 

Investmentsin fixed rate interest earning instruments carry a degree of interest raterisk.  Fixed rate securities may havetheir fair market value adversely impacted due to a rise in interestrates.  Due in part to these factors,our future investment income may fall short of expectations due to changes ininterest rates or we may suffer losses in principal if forced to sellsecurities, which have seen a decline in market value due to changes ininterest rates.  Our investmentsecurities are held for purposes other than trading.  The weighted-average of the stated coupon interest rate oninvestment securities at September 30, 2003 was 5.9%.  Due to the amortization of premiums and discounts paid, theactual rate of return will vary from the weighted-average of the stated couponinterest rate.  The fair value ofinvestments held at September 30, 2003 approximated amortized cost.

 

Item4.             CONTROLS AND PROCEDURES

 

We have carried outan evaluation, under the supervision and the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures as of September 30,2003 pursuant to Rule 13a-15(b) under the Exchange Act.  Based upon that evaluation, our ChiefExecutive Officer and Chief

 

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Financial Officer concluded that ourdisclosure controls and procedures are effective in ensuring that informationrequired to be disclosed is recorded, processed, summarized and reported in atimely manner.

 

We have carried outan evaluation, under the supervision and participation of our management,including our Chief Executive Officer and Chief Financial Officer, of anychanges in our internal controls over financial reporting that occurred duringthe quarterly period ended September 30, 2003, and our Chief Executive Officerand Chief Financial Officer have concluded that there was no change during thequarterly period ended September 30, 2003 that has a materially affected or isreasonably expected to materially affect our internal control over financialreporting.

 

**PART II - OTHER INFORMATION**

 

Item 1.             LEGALPROCEEDINGS

 

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

 

OnMarch 22, 2002, Morgan Newton Company, L.P. (“Morgan Newton”) filed suitagainst us in Dallas County District Court, Case No. DV02-02339-C, allegingclaims for breach of contract, promissory estoppel, and fraud.  The claims arise out of an alleged oralrepresentation to Morgan Newton concerning a request for quotation for thepurchase of a large amount of Morgan Newton’s products.  During the quarter ended September 30, 2003,Morgan Newton and Intrusion settled this matter, which resulted in a paymentthat is due to Morgan Newton during the fourth quarter of 2003.  The amount due of $450,000 was recorded aslitigation settlement during the quarter ended September 30, 2003 and isincluded in accrued expenses at September 30, 2003.

 

Item 6.             EXHIBITS AND REPORTS ON FORM 8-K

 

During the quarter ended September 30, 2003, there were noreports filed on Form 8-K.

 

Thefollowing Exhibits are attached:

 

•                  31.1 Certification of Chief Executive OfficerPursuant To 18 U.S.C. Section 1350, As Adopted Pursuant To Section 302 Of TheSarbanes-Oxley Act of 2002

 

•                  31.2 Certification of Chief Financial OfficerPursuant To 18 U.S.C. Section 1350, As Adopted Pursuant To Section 302 Of TheSarbanes-Oxley Act of 2002

 

•                  32.1 Certification of Chief Executive OfficerPursuant To 18 U.S.C. Section 1350, As Adopted Pursuant To Section 906 Of TheSarbanes-Oxley Act of 2002

 

•                  32.2 Certification of Chief Financial OfficerPursuant To 18 U.S.C. Section 1350, As Adopted Pursuant To Section 906 Of TheSarbanes-Oxley Act of 2002

 

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

 

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

 

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

 

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