**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**FORM 10-QSB**

 

----

 
| **ý**                                                                                                                               | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**  |
|------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------|
|                                                                                                                                     |
| **For the quarterly period ended June 30, 2005**                                                                                    |
|                                                                                                                                     |
| **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 small business issuer as specified in its charter)

 
| **Delaware**                                                    | ** ** | **75-1911917**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |

 

**1101 East Arapaho Road, Richardson, Texas 75081**

(Address of principal executive offices)

(Zip Code)

 

**(972) 234-6400**

(Issuer’s telephone number, including area code)

 

**Not Applicable**

Former name, if changed since last report)

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days:

Yes  ý    No  o

 

The number of sharesoutstanding of the Registrant’s Common Stock, $0.01 par value, on July 26,2005 was 6,573,230.

 

Transitional Small BusinessDisclosure Forman (check one):  Yes  o    No  ý

 

 

----

 

**INTRUSION INC.**

 

INDEX

 
| **PART I – FINANCIAL INFORMATION**                                                                               |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                       |   |
| Item 1. Financial Statements                                                                                               |   |
|                                                                                                                       |   |
| Unaudited Condensed  Consolidated Balance Sheets as of June 30, 2005 and December 31,  2004                      |   |
|                                                                                                                       |   |
| Unaudited Condensed  Consolidated Statements of Operations for the three and six months ended June 30,  2005 and 2004 |   |
|                                                                                                                       |   |
| Unaudited Condensed  Consolidated Statements of Cash Flows for the six months ended June 30,  2005 and 2004           |   |
|                                                                                                                       |   |
| Notes to Unaudited Condensed  Consolidated Financial Statements                                                            |   |
|                                                                                                                       |   |
| Item 2. Management’s  Discussion and Analysis of Financial Condition and Results of Operations                        |   |
|                                                                                                                       |   |
| Item 3. Controls and Procedures                                                                                            |   |
|                                                                                                                       |   |
| **PART II – OTHER INFORMATION**                                                                                  |   |
|                                                                                                                       |   |
| Item 1. Legal Proceedings                                                                                                  |   |
|                                                                                                                       |   |
| Item 4. Submission of Matters to a Vote of Security  Holders                                                               |   |
|                                                                                                                       |   |
| Item 6. Exhibits and Reports  on Form 8-K                                                                             |   |
|                                                                                                                       |   |
| Signature Page                                                                                                             |   |

 

2

----

 

**PART I – FINANCIAL INFORMATION**

 

Item1. FINANCIAL STATEMENTS

 

**INTRUSION INC. AND SUBSIDIARIES**

UNAUDITEDCONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except par value amounts)

 
| ** **                                                                                                                                                                                             | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                                             |       |                    |       |                        |       |
| Current  Assets:                                                                                                                                                                                       |       |                    |       |                        |       |
| Cash and  cash equivalents                                                                                                                                                                             |       | $                       | 1,284      |                        | $          | 2,315 |   |
| Short-term  investments                                                                                                                                                                                |       | 2,350                   |       | 75                          |       |
| Accounts  receivable, less allowance for doubtful accounts of $243 in 2005 and $508 in  2004                                                                                                           |       | 480                     |       | 1,220                       |       |
| Inventories,  net                                                                                                                                                                                      |       | 840                     |       | 950                         |       |
| Prepaid  expenses                                                                                                                                                                                      |       | 255                     |       | 393                         |       |
| Total current assets                                                                                                                                                                                   |       | 5,209                   |       | 4,953                       |       |
| Property and  equipment, net                                                                                                                                                                           |       | 340                     |       | 299                         |       |
| Other assets                                                                                                                                                                                           |       | 43                      |       | 64                          |       |
| TOTAL ASSETS                                                                                                                                                                                           |       | $                       | 5,592      |                        | $          | 5,316 |   |
|                                                                                                                                                                                                   |       |                    |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                         |       |                    |       |                        |       |
|                                                                                                                                                                                                   |       |                    |       |                        |       |
| Current  Liabilities:                                                                                                                                                                                  |       |                    |       |                        |       |
| Accounts  payable and accrued expenses                                                                                                                                                                 |       | $                       | 1,389      |                        | $          | 1,667 |   |
| Deferred revenue                                                                                                                                                                                       |       | 914                     |       | 799                         |       |
| Total  current liabilities                                                                                                                                                                             |       | 2,303                   |       | 2,466                       |       |
| Stockholders’  Equity:                                                                                                                                                                            |       |                    |       |                        |       |
| Preferred  stock – $.01 par value; authorized shares – 5,000 5% shares issued and  outstanding – 389 in 2005 and 840 in 2004 Liquidation preference of $1,970 as  of June 30, 2005 |       | 1,375                   |       | 2,968                       |       |
| Series 2  5% shares issued and outstanding – 720 Liquidation preference of $1,808 as of  June 30, 2005                                                                                  |       | 1,132                   |       | —                      |       |
| Common stock  – $.01 par value; authorized shares – 80,000; Issued shares – 6,493 in 2005  and 5,431 in 2004; Outstanding shares – 6,483 in 2005 and 5,421in 2004                  |       | 65                      |       | 54                          |       |
| Common stock  held in treasury, at cost – 10 shares                                                                                                                                               |       | (362                    | )          | (362                        | )          |
| Additional  paid-in capital                                                                                                                                                                            |       | 51,951                  |       | 49,095                      |       |
| Accumulated  deficit                                                                                                                                                                                   |       | (50,693                 | )          | (48,732                     | )          |
| Accumulated  other comprehensive loss                                                                                                                                                                  |       | (179                    | )          | (173                        | )          |
| Total  stockholders’ equity                                                                                                                                                                       |       | 3,289                   |       | 2,850                       |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                       |       | $                       | 5,592      |                        | $          | 5,316 |   |

 

See accompanying notes.

 

3

----

 

**INTRUSION INC. AND SUBSIDIARIES**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share amounts)

 
| ** **                                                                 | ** ** | **Three Months Ended** | ** ** | **Six Months Ended**   | ** ** |
|----------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                 | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** |
| Net product  revenue                                                       |       | $                      | 1,323      |                   | $          | 644 |   | $ | 2,194 |   | $ | 1,215 |   |
| Net customer  support and maintenance revenue                              |       | 386                    |       | 459                    |       | 700 |   | 1,155 |   |
| Total  revenue                                                             |       | 1,709                  |       | 1,103                  |       | 2,894 |   | 2,370 |   |
| Cost of  product revenue                                                   |       | 719                    |       | 453                    |       | 1,221 |   | 728 |   |
| Cost of  customer support and maintenance revenue                          |       | 21                     |       | 124                    |       | 46 |   | 485 |   |
| Total cost  of revenue                                                     |       | 740                    |       | 577                    |       | 1,267 |   | 1,213 |   |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Gross profit                                                               |       | 969                    |       | 526                    |       | 1,627 |   | 1,157 |   |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Operating  expenses:                                                       |       |                   |       |                   |       |   |   |   |   |
| Sales and  marketing                                                       |       | 873                    |       | 1,013                  |       | 1,632 |   | 1,973 |   |
| Research and  development                                                  |       | 703                    |       | 732                    |       | 1,405 |   | 1,334 |   |
| General and  administrative                                                |       | 304                    |       | 315                    |       | 532 |   | 579 |   |
| Severance  and related costs                                               |       | 55                     |       | 34                     |       | 55 |   | 130 |   |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Operating  loss                                                            |       | (966                   | )          | (1,568                 | )          | (1,997 | ) | (2,859 | ) |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Other  income, net                                                         |       | 2                      |       | 40                     |       | 2 |   | 40 |   |
| Interest  income, net                                                      |       | 29                     |       | 7                      |       | 33 |   | 26 |   |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Loss before  income tax provision                                          |       | (935                   | )          | (1,521                 | )          | (1,962 | ) | (2,793 | ) |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Income tax  provision                                                      |       | —                 |       | —                 |       | — |   | — |   |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Net loss                                                                   |       | $                      | (935       | )                      | $          | (1,521 | ) | $ | (1,962 | ) | $ | (2,793 | ) |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Preferred  stock dividends accrued                                         |       | (56                    | )          | (62                    | )          | (85 | ) | (62 | ) |
| Beneficial  conversion feature on preferred stock                          |       | —                 |       | —                 |       | (919 | ) | (938 | ) |
| Net loss  attributable to common stockholders                              |       | $                      | (991       | )                      | $          | (1,583 | ) | $ | (2,966 | ) | $ | (3,793 | ) |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Net loss per  share attributable to common stockholders, basic and diluted |       | $                      | (0.16      | )                      | $          | (0.31 | ) | $ | (0.49 | ) | $ | (0.73 | ) |
|                                                                       |       |                   |       |                   |       |   |   |   |   |
| Weighted  average common shares outstanding, basic and diluted             |       | 6,182                  |       | 5,166                  |       | 6,110 |   | 5,165 |   |

 

See accompanying notes.

 

4

----

 

**INTRUSION INC. AND SUBSIDIARIES**UNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)

 
| ** **                                                                      | ** ** | **Six Months Ended**    | ** ** |
|---------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                      | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** |
| Operating  Activities:                                                          |       |                    |       |   |   |
| Net loss                                                                        |       | $                       | (1,962     | ) | $ | (2,793 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities:    |       |                    |       |   |   |
| Depreciation  and amortization                                                  |       | 94                      |       | 144 |   |
| Provision  for doubtful accounts                                                |       | (177                    | )          | — |   |
| Changes in  operating assets and liabilities:                                   |       |                    |       |   |   |
| Accounts  receivable                                                            |       | 917                     |       | 384 |   |
| Inventories                                                                     |       | 110                     |       | (96 | ) |
| Prepaid expenses  and other assets                                              |       | 159                     |       | 196 |   |
| Accounts  payable and accrued expenses                                          |       | (248                    | )          | (558 | ) |
| Deferred  revenue                                                               |       | 116                     |       | 131 |   |
| Net cash  used in operating activities                                          |       | (991                    | )          | (2,592 | ) |
| Investing  Activities:                                                          |       |                    |       |   |   |
| Purchases of  short-term investments                                            |       | (2,350                  | )          | (3,100 | ) |
| Maturities  of short-term investments                                           |       | 75                      |       | 1,705 |   |
| Purchases of  property and equipment                                            |       | (134                    | )          | (82 | ) |
| Net cash  used in investing activities                                          |       | (2,409                  | )          | (1,477 | ) |
| Financing  Activities:                                                          |       |                    |       |   |   |
| Proceeds  from the exercise of employee stock options                           |       | —                  |       | 6 |   |
| Dividends  paid on preferred stock                                              |       | (115                    | )          | — |   |
| Proceeds  from the issuance of preferred stock and warrants, net                |       | 2,490                   |       | 4,725 |   |
| Net cash  provided by financing activities                                      |       | 2,375                   |       | 4,731 |   |
|                                                                            |       |                    |       |   |   |
| Effect of  foreign currency translation adjustment on cash and cash equivalents |       | (6                      | )          | — |   |
|                                                                            |       |                    |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                           |       | (1,031                  | )          | 662 |   |
| Cash and  cash equivalents at beginning of period                               |       | 2,315                   |       | 974 |   |
| Cash and  cash equivalents at end of period                                     |       | $                       | 1,284      |   | $ | 1,636 |   |
|                                                                            |       |                    |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF NON CASH FINANCING ACTIVITIES:                      |       |                    |       |   |   |
|                                                                            |       |                    |       |   |   |
| Fair value  of warrants issued in connection with sale of preferred stock       |       | $                       | 815        |   | $ | 1,191 |   |
| Amortization  of preferred stock beneficial conversion feature                  |       | $                       | (919       | ) | $ | (938 | ) |
| Preferred  stock dividends accrued                                              |       | $                       | 85         |   | $ | 62 |   |

 

See accompanying notes.

 

5

----

 

**INTRUSION INC. AND SUBSIDIARIES**

NOTESTO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.               Description of Business

 

We develop, market andsupport a family of regulated information compliance and data privacyprotection products, entity identification systems along with network intrusionprevention and detection systems that address vital security issues facingorganizations with mission critical business applications or housingclassified, confidential, or customer information assets.  We currentlyprovide network security and regulated information compliance solutions withour Compliance CommanderTM for regulated information and data privacyprotection, TraceCopTM identification and location service, SpySnareTM forreal-time inline blocking of spyware and unwanted peer-to-peer applications andSecureNetTM for network intrusion prevention and detection.

 

Wemarket and distribute our products through a direct sales force to end-usersand distributors and by numerous domestic and international system integrators,managed service providers and value-added resellers.  Our end-user customers include hightechnology, manufacturing, telecommunications, retail, transportation, healthcare, insurance, entertainment, utilities and energy companies, governmententities, financial institutions, and academic institutions.

 

Wewere organized in Texas in September 1983 and reincorporated in Delawarein October 1995.  For more than 15years, we provided local area networking equipment and were known as OpticalData Systems or ODS Networks.  On June 1,2000, we changed our name from ODS Networks, Inc. to Intrusion.com, Inc.,and our NASDAQ ticker symbol from ODSI to INTZ to reflect our focus onintrusion detection solutions.  On November 1,2001, we changed our name from 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 website URL is www.intrusion.com.  Information contained in or linked to ourwebsite are not a part of this report. References to “we,” “us” and “our” in this report refer to IntrusionInc. and its subsidiaries.

 

Asof June 30, 2005, we had cash, cash equivalents and short-term investmentsin the amount of approximately $3.6 million, up from approximately $2.4 millionas of December 31, 2004.  This cashincrease is primarily the result of the Preferred Stock transaction discussedin Note 7.  Although we believe we havesufficient cash resources to finance our operations and expected capitalexpenditures for the next twelve months, based on our internal estimates andour operating plan, the sufficiency of our cash resources may depend to acertain extent on general economic, financial, competitive or other factorsbeyond our control.  Moreover, despiteactions to reduce our costs and improve our profitability, our operating lossesand net operating cash outflows may continue through at least the third quarterof 2005.  As a result, we may not be ableto achieve the revenue and gross margin objectives necessary to achieve positivecash flow or profitability or to remain in compliance with Nasdaq’scontinued listing requirement of at least $2.5 million of stockholders’ equitywithout obtaining additional equity financing. We do not currently have any arrangements for financing and we may notbe able to secure additional debt or equity financing on terms acceptable tous, or at all, at the time when we need such funding.  If our business does not generate sufficientcash flow from operations and sufficient future financings are not available,we may not be able to operate or grow our business, pay our expenses when due,fund our other liquidity needs or maintain our listing on the Nasdaq SmallCapMarket.

 

2.               Basis of Presentation

 

Theaccompanying unaudited condensed consolidated financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States for interim financial information and with the instructions to Form 10-QSBand Article 10 of Regulation S-B. Accordingly, they do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States forcomplete financial statements.  The December 31,2004 balance sheet was derived from audited financial statements, but does notinclude all the disclosures required by accounting principles generallyaccepted in the United States.  However,we believe that the disclosures are adequate to make the information presentednot misleading.  In our opinion, all theadjustments (consisting of normal recurring adjustments) considered necessaryfor fair presentation have been included. The results of operations for the three and six month periods ending June 30,2005 are not necessarily indicative of the results that may be achieved for thefull fiscal year or for any future period. The unaudited condensed consolidated financial statements includedherein should be read in conjunction with the consolidated financial statementsand notes thereto included in the Company’s annual report on Form 10-KSBfor the year ended December 31, 2004.

 

6

----

 

3.               Inventories (In thousands)

 
| ** **               | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------|------------|-------------------------|------------|------------------------|------------|
|                     |       |                    |       |                   |       |
| Inventories  consist of: |       |                    |       |                   |       |
|                     |       |                    |       |                   |       |
| Finished  goods          |       | $                       | 703        |                   | $          | 743 |   |
| Work in  progress        |       | 80                      |       | 18                     |       |
| Demonstration  systems   |       | 57                      |       | 189                    |       |
| Net  inventory           |       | $                       | 840        |                   | $          | 950 |   |

 

4.               Accounting for Stock-Based Compensation

 

Weaccount for employee stock-based compensation in accordance with APB 25.  The following table summarizes relevantinformation as to the reported results under our intrinsic value method ofaccounting for stock awards, with supplemental information as if the fair valuerecognition provision of SFAS 123 as amended by SFAS 148 had been applied thequarters and six months ended June 30, 2005 and June 30, 2004 (in thousands,except per share data).

 
| ** **                                                                                       | ** ** | **Quarter  Ended  June 30,  2005** | ** ** | **Quarter  Ended  June 30,  2004** | ** ** | **Six  Months  June 30,  2005** | ** ** | **Six  Months  June 30,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|
|                                                                                             |       |                                    |       |                                    |       |                                 |       |                                 |       |
| Net loss  attributable to common stockholders                                                    |       | $                                       | (991       | )                                       | $          | (1,583                               | )          | $                                    | (2,966     | ) | $ | (3,793 | ) |
| Deduct:  Total stock-based compensation determined under fair value-based method for  all awards |       | (175                                    | )          | (46                                     | )          | (306                                 | )          | (119                                 | )          |
| Pro forma  net loss attributable to common stockholders                                          |       | $                                       | (1,166     | )                                       | $          | (1,629                               | )          | $                                    | (3,272     | ) | $ | (3,912 | ) |
| Net loss per  share attributable to common stockholders:                                         |       |                                    |       |                                    |       |                                 |       |                                 |       |
| as reported  (basic and diluted)                                                                 |       | $                                       | (0.16      | )                                       | $          | (0.31                                | )          | $                                    | (0.49      | ) | $ | (0.73 | ) |
| pro forma  (basic and diluted)                                                                   |       | $                                       | (0.19      | )                                       | $          | (0.32                                | )          | $                                    | (0.54      | ) | $ | (0.76 | ) |
| Weighted-average  shares used in computation:                                                    |       |                                    |       |                                    |       |                                 |       |                                 |       |
| Basic and  diluted                                                                               |       | 6,182                                   |       | 5,166                                   |       | 6,110                                |       | 5,165                                |       |

 

Asrequired, the pro forma disclosures above include options granted since January 1,1995.  Consequently, the effects ofapplying SFAS 123 and SFAS 148 for providing pro forma disclosures may not berepresentative of the effects on reported operating results for future yearsuntil all options outstanding are included in the pro forma disclosures.  For purposes of pro forma disclosures, theestimated fair value of stock-based compensation plans and other options areamortized to expense primarily over the vesting period.

 

In December 2004, the FinancialAccounting Standards Board issued Statement of Financial Accounting Standards No. 123(revised 2004), “Share-Based Payment” (SFAS 123R), which replaces SFAS 123 andsupersedes APB Opinion No. 25. SFAS 123R requires all share-based paymentsto employees, including grants of employee stock options, to be recognized inthe financial statements based on their fair values. The pro forma disclosurespreviously permitted under SFAS 123 no longer will be an alternative tofinancial statement recognition. For the Company, SFAS 123R is effective forperiods beginning after December 15, 2005. Early application of SFAS 123Ris encouraged, but not required. We plan to adopt SFAS 123R on January 1,2006 using the modified prospective application method described in thestatement. Under the modified prospective application method, we will apply thestandard to new awards and to awards modified, repurchased, or cancelled afterthe required effective date. Additionally, compensation cost for the unvestedportion of awards outstanding as of the required effective date will berecognized as compensation expense as the requisite service is rendered afterthe required effective date.

 

We are evaluating the impact of adopting SFAS123R and expect that we will record substantial non-cash stock compensationexpenses. The adoption of SFAS 123R is not expected to have a significanteffect on our financial condition or cash flows but is expected to have a significant,adverse effect on our results of operations. The future impact of the adoption of SFAS 123R cannot be predicted atthis time because it will depend on levels of share-based payments granted byus in the future.  However, had weadopted SFAS 123R in prior periods, the impact of that standard would haveapproximated the impact of SFAS 123 as described in the disclosure of pro formanet loss attributable to common stockholders included above.

 

7

----

 

5.               Net Loss Per Share

 

Basicnet loss per share is computed by dividing net loss attributable to commonstockholders for the period by the weighted average number of common sharesoutstanding for the period.  Diluted netloss per share is computed by dividing the net loss attributable to commonstockholders by the weighted average number of common shares and common stockequivalents outstanding for the period. Our common stock equivalents include all common stock issuable uponconversion of convertible preferred stock and the exercise of outstandingoptions and warrants.  The aggregatenumber of common stock equivalents excluded from the loss per share calculationfor the three and six-month periods ended June 30, 2005 and 2004 are3,471,285 and 2,594,849, respectively. Our common stock equivalents are not included in the diluted loss pershare for the three and six-month periods ended June 30, 2005 and 2004, asthey are antidilutive.

 

6.               Commitments and Contingencies

 

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

 

7.               PreferredStock

 

On March 28, 2005, we completed a $2.7million private placement of Series 2 5% Convertible Preferred Stock andwarrants.  In the private placement, wesold 1,065,200 shares of preferred stock at a price of $2.50 per share forgross proceeds of $2.7 million, less $173,000 of issuance costs.  The shares of Series 2 5% preferredstock are convertible into 1,065,200 shares of common stock at an initialconversion price of $2.50 per share. Holders of the Series 2 5% preferred stock include 160,000 sharespurchased by our CEO and 60,000 shares purchased by a director of the Company.

 

The 5% dividends accruing on the Series 25% preferred stock are required to be paid quarterly on the first business dayin March, June, September and December of each year, beginning with June 2005.  The liquidation preference for the preferredstock is an amount equal to $2.50 per share plus any accrued and unpaiddividends.  Holders of our Series 2preferred stock have liquidation preference rights over our 5% preferred stockholders as well as our common stock holders. The holders of the Series 2 5% preferred stock are not entitled tovote on any matter, except as otherwise required by law or with respect tocertain limited matters specified in the Certificate of Designations creatingthe Series 2 5% preferred stock.

 

Included in this transaction were warrants topurchase 532,600 shares of common stock at an exercise price of $2.77 pershare.  Warrant holders include 80,000held by our CEO and 30,000 held by a director of the Company.  The relative fair value of these warrants wasvalued at $0.7 million using the Black-Scholes model and has been recorded as adiscount to the Series 2 5% Preferred Stock and an increase in additionalpaid-in capital.  The issuance of thesewarrants also resulted in a beneficial conversion feature to the Series 25% preferred stock valued at $0.9 million. In accordance with EITF 98-5, the beneficial conversion feature wasfully amortized in the first quarter of 2005, as the preferred stock does nothave a stated maturity and is immediately convertible into common stock.  This beneficial conversion feature isincluded in the net loss attributed to common stockholders.  In connection with the closing of thisprivate placement, we issued warrants to purchase 60,390 shares of our commonstock at an exercise price of $2.77 per share to two affiliates of ourfinancial advisor for assistance with the private placement.  These warrants were valued at $0.1 millionusing the Black-Scholes model and have been recorded as a discount to the Series 25% Preferred Stock and an increase to additional paid-in capital.

 

The Series 2 5% preferred stock wasrecorded as the net of the proceeds of $2.7 million less $173,000 issuancecosts and the fair value of the warrants issued in conjunction with the Series 25% preferred stock totaling $0.8 million.

 

Holders of Series 25% preferred stock have the right to require us redeem any or all of the theirshares upon the occurrence of certain events within the Company’s control thatare defined in Certificate of Designation at a price equal the sum of (1) thegreater of $3.25****and the productof the volume weighted average price of our common stock on the trading dayimmediately preceding the event multiplied by $2.50 divided by the conversionprice then in effect plus (2) any accrued but unpaid dividends on the Series 25% preferred stock plus (3) all liquidated damages or other amountspayable to the holders of Series 2 5% preferred stock.

 

8.               Common Stock

 

During the three monthsended June 30, 2005, 345,200 shares of our Series 2 5% PreferredStock were converted into 345,200 shares of common stock.  In addition, 50,304 shares of our 5%Preferred Stock were converted into 80,000 shares of common stock.  During the three months ended March 31,2005, 400,608 shares of our 5% preferred stock were converted into 637,102shares of common stock.  In addition, anemployee exercised stock options to purchase 167 shares of common stock.

 

8

----

 

9.               Comprehensive Loss

 

SFAS No. 130,Reporting Comprehensive Income, establishes standards for the reporting anddisplay of comprehensive loss and its components.  SFAS No. 130 requires, among otherthings, that foreign currency translation adjustments be included in othercomprehensive loss.  The followingstatement presents comprehensive loss for the three and six months ended June 30,2005 and 2004 (in thousands):

 
| ** **                                    | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                    | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                    | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss  attributable to common shareholders |       | $                      | (991       | )                    | $          | (1,583 | ) | $ | (2,966 | ) | $ | (3,793 | ) |
| Other  comprehensive income (loss):           |       |                   |       |                 |       |   |   |   |   |
| Foreign  currency translation adjustment      |       | —                 |       | —               |       | 6 |   | — |   |
| Comprehensive  loss                           |       | $                      | (991       | )                    | $          | (1,583 | ) | $ | (2,960 | ) | $ | (3,793 | ) |

 

Item 2.                                MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS

 

Thisreport contains forward-looking statements, within the meaning of Section 27Aof the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934, that involve risks and uncertainties, such as statementsconcerning: 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, spending patterns of,and appropriations to, U.S. government departments, the impact of our costreduction programs and our refocused product line, the difficulties anduncertainties in successfully developing and introducing new products, marketacceptance of our products, the impact of sustained losses on our ability tosuccessfully operate and grow our business, our stock price and our ongoingNasdaq eligibility, the highly competitive market for our products, the effectsof sales and implementation cycles for our new products on our quarterlyresults, difficulties in accurately estimating market growth, the consolidationof the information security industry, the impact of changing economicconditions, business conditions in the information security industry, ourability to manage acquisitions effectively, our ability to manage discontinuedoperations effectively, the impact of market peers and their products as wellas risks concerning future technology and others identified in our AnnualReport on Form 10-KSB and other Securities and Exchange Commissionfilings.  Such forward-looking statementsare generally 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 belowentitled “Factors That May Affect Future Results of Operations” sets forthand incorporates by reference certain factors that could cause actual futureresults of the company to differ materially from these statements.

 

Critical Accounting Policiesand Estimates

 

Management’sdiscussion and analysis of financial condition and results of operations arebased upon our unaudited condensed consolidated financial statements, whichhave been prepared in accordance with accounting principles generally acceptedin the United States.  The preparation ofthese financial statements requires us to make estimates and judgments thataffect the reported amounts of assets, liabilities, revenues and expenses, andrelated disclosure of contingent assets and liabilities.  On an on-going basis, we evaluate ourestimates, including those related to product returns, bad debts, inventories,income taxes, warranty obligations, restructuring, maintenance contracts andcontingencies.  We base our estimates onhistorical experience and on various other assumptions that we believe arereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.

 

Webelieve the following critical accounting policies affect our more significantjudgments and estimates used in the preparation of our unaudited condensedconsolidated financial statements.

 

9

----

 

*RevenueRecognition*

 

Wegenerally recognize product revenue upon shipment of product. We accrue forestimated warranty costs and sales returns at the time of shipment based on ourexperience. Revenue from maintenance contracts is deferred and recognized overthe contractual period the services are performed, generally one year.  There is a risk that technical issues on newproducts could result in unexpected warranty costs and returns.  However, as we migrate to more of asoftware-based business model, our warranty costs should continue todecline.  To the extent that they dodecline, our warranty reserve from current sales will decrease.  If our warranty costs exceed ourexpectations, we will increase our warranty reserve to compensate for theadditional expense expected to be incurred. We review these estimates periodically and determine the appropriatereserve percentage.  However, to date,warranty costs and sales returns have not been material.  Historically, our estimates for these itemshave not differed materially from actual results.  We believe that our revenue recognitionpolicy does not include significant or subjective estimates.

 

Werecognize software revenue from the licensing of our software products inaccordance with Statement of Position (“SOP”) No. 97-2 “Software RevenueRecognition”, SOP 98-9 “Modification of 97-2, Software Revenue Recognition,with respect to certain transactions” and Staff Accounting Bulletin (“SAB”) No. 104,“Revenue Recognition” whereby revenue from the licensing of our products is notrecognized until all four of the following have been met: (1) execution ofa written agreement; (2) delivery of the product has occurred; (3) thefee is fixed and determinable; and (4) collectibility is probable. Bundledhardware and perpetual software product sales are recognized at time ofdelivery, as our licenses are not sold on a subscription basis.  In the case of multiple product and servicesales, we perform a Vendor Specific Objective Evidence analysis toappropriately determine the amount of revenue derived from eachdeliverable.  If our license strategychanges and we begin to offer licenses on a subscription basis, we wouldperform this analysis in a similar manner. Under these circumstances, the revenue related to the license would berecognized ratably over the subscription period.  Market values are easily obtained for all ofour product offerings, as we have historical sales information on our productofferings.  We defer and recognizemaintenance and support revenue over the term of the contract period, which isgenerally one year.

 

Wehave signed distribution agreements with distributors in the United States,Europe and Asia. In general, these relationships are non-exclusive.Distributors typically maintain an inventory of our products. Under theseagreements, we provide certain protection to the distributors for theirinventory of our products for price reductions as well as products that areslow moving or have been discontinued by us. Historically, returns from our distributors and charges related to pricereductions on inventory held by distributors have not been material.  Recognition of sales to distributors andrelated gross profits are deferred until the distributors resell themerchandise. However, since we have legally sold the inventory to thedistributor and we no longer have care, custody or control over the inventory,we recognize the trade accounts receivable and reduce inventory related to thesale at the time of shipment to the distributor. Revenue, offset by deferredcost of sales, is included in deferred revenue in the accompanying financialstatements.  Since the net balance indeferred revenue represents the sales price less the cost of the productmaintained by the distributors, the deferred costs of these products areincluded in our obsolescence and slow-moving analysis and are written downaccording to their current value.  Thistransaction, effectively recognizes expense for the write-down, if any, andincreases the net liability in the deferred revenue account.

 

Wegenerally recognize service revenue upon delivery of the contractedservice.  Service revenue, primarilyincluding maintenance, training and installation are recognized upon deliveryof the service and typically are unrelated to product sales.  These services are not essential to thefunctionality of the delivered product. To date, training and installation revenue has not been material.

 

*Allowancefor Doubtful Accounts and Returns*

 

Tradeaccounts receivable are stated at the amount we expect to collect.  We maintain allowances for doubtful accountsfor estimated losses resulting from the inability of our customers to makerequired payments.  Management considersthe following factors when determining the collectibility of specific customeraccounts:  customer credit-worthiness,past transaction history with the customer, current economic industry trends,and changes in customer payment terms. Our receivables are uncollateralized and we expect to continue thispolicy in the future.  If the financialcondition of our customers were to deteriorate, adversely affecting theirability to make payments, additional allowances would be required.  Based on management’s assessment, we providefor estimated uncollectible amounts through a charge to earnings and a creditto a valuation allowance.  Balances that remain outstanding after we have used reasonablecollection efforts are written off through a charge to the valuation allowanceand a credit to accounts receivable. Historically, our estimates for sales returns and doubtful accounts havenot materially differed from actual results.

 

*Inventory*

 

Wewrite down our inventory for estimated obsolescence or unmarketable inventoryequal to the difference between the cost of inventory and the estimated marketvalue based upon assumptions about future demand and market conditions. Ifactual market conditions are less favorable than those projected by management,additional inventory write-downs may be required.  Historically, our estimates for inventoryobsolescence have not differed materially from actual results.

 

10

----

 

Results of Operations

 

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

 
| ** **                                        | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**    | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                        | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** |
| Net product  revenue                              |       | 77.4                    | %          | 58.4                    | %          | 75.8 | % | 51.3 | % |
| Net customer  support and maintenance revenue     |       | 22.6                    |       | 41.6                    |       | 24.2 |   | 48.7 |   |
| Total  revenue                                    |       | 100.0                   |       | 100.0                   |       | 100.0 |   | 100.0 |   |
| Cost of  product revenue                          |       | 42.1                    |       | 41.1                    |       | 42.2 |   | 30.7 |   |
| Cost of  customer support and maintenance revenue |       | 1.2                     |       | 11.2                    |       | 1.6 |   | 20.5 |   |
| Total cost  of revenue                            |       | 43.3                    |       | 52.3                    |       | 43.8 |   | 51.2 |   |
| Gross profit                                      |       | 56.7                    |       | 47.7                    |       | 56.2 |   | 48.8 |   |
| Operating  expenses:                              |       |                    |       |                    |       |   |   |   |   |
| Sales and  marketing                              |       | 51.1                    |       | 91.8                    |       | 56.4 |   | 83.2 |   |
| Research and  development                         |       | 41.1                    |       | 66.4                    |       | 48.5 |   | 56.3 |   |
| General and  administrative                       |       | 17.8                    |       | 28.6                    |       | 18.4 |   | 24.4 |   |
| Severance  and related costs                      |       | 3.2                     |       | 3.1                     |       | 1.9 |   | 5.5 |   |
| Operating  loss                                   |       | (56.5                   | )          | (142.2                  | )          | (69.0 | ) | (120.6 | ) |
|                                              |       |                    |       |                    |       |   |   |   |   |
| Other  income, net                                |       | 0.1                     |       | 3.6                     |       | 0.0 |   | 1.7 |   |
| Interest  income, net                             |       | 1.7                     |       | 0.6                     |       | 1.2 |   | 1.1 |   |
| Loss before  income tax provision                 |       | (54.7                   | )          | (137.9                  | )          | (67.8 | ) | (117.8 | ) |
|                                              |       |                    |       |                    |       |   |   |   |   |
| Income tax  provision                             |       | —                  |       | —                  |       | — |   | — |   |
|                                              |       |                    |       |                    |       |   |   |   |   |
| Net loss                                          |       | (54.7                   | )%         | (137.9                  | )%         | (67.8% | ) | (117.8% | ) |
| Preferred  stock dividends accrued                |       | (3.3                    | )          | (5.6                    | )          | (2.9 | ) | (2.6 | ) |
| Beneficial  conversion feature on preferred stock |       | —                  |       | —                  |       | (31.8 | ) | (39.6 | ) |
|                                              |       |                    |       |                    |       |   |   |   |   |
| Net loss  attributable to common stockholders     |       | (58.0                   | )%         | (143.5                  | )%         | (102.5 | )% | (160.0 | )% |

 
| ** **           | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**    | ** ** |
|----------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **           | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** |
| Domestic  revenues   |       | 89.7                    | %          | 84.6                    | %          | 88.2 | % | 73.7 | % |
| Export  revenues to: |       |                    |       |                    |       |   |   |   |   |
| Europe               |       | 7.4                     |       | 5.7                     |       | 7.6 |   | 16.6 |   |
| Canada               |       | 1.0                     |       | 7.5                     |       | 0.6 |   | 5.5 |   |
| Asia                 |       | 1.8                     |       | 1.9                     |       | 3.5 |   | 3.9 |   |
| Latin  America       |       | 0.1                     |       | 0.3                     |       | 0.1 |   | 0.3 |   |
|                 |       |                    |       |                    |       |   |   |   |   |
| Net revenues         |       | 100.0                   | %          | 100.0                   | %          | 100.0 | % | 100.0 | % |

 

**Net Revenues**.  Net revenues for the quarter and sixmonths ended June 30, 2005 were $1.7 million and $2.9 million,respectively, compared to $1.1 million and $2.4 million for the same periods in2004.  Product revenues increased $0.7million and $1.0 million for the quarter and six months ended June 30,2005 compared to the same periods in 2004. Customer support and maintenance revenue decreased $0.1 million and $0.5million for the quarter and six months ended June 30, 2005 compared to thesame periods in 2004.  Consistent withour strategic move to concentrate on our SecureNet products, total revenues (includingmaintenance and support) for the quarter and six months ended June 30,2005 from our SecureNet product line increased to $1.6 million and $2.7 millionfrom $1.0 million and $2.1 million for the same periods in 2004.  Our first generation product sales, includingPDS and SecureCom remained constant for the quarter and six months ended June 30,2005 at $0.1 million and $0.2 million when compared to the same periods in2004.

 

**Export Revenues**.  Export revenues for thequarter and six months ended June 30, 2005 decreased to $0.2 million and$0.3 million from $0.2 million and $0.6 million compared to the same periods in2004 as revenues from our PDS security appliance family decreased and wefocused more of our resources domestically.

 

11

----

 

**Concentration of Revenues**.  Revenues from sales to variousU.S. government entities totaled $1.3 million, or 76.7% of revenues, for thequarter ended June 30, 2005 compared to $0.4 million, or 37.6% ofrevenues, for the same period in 2004. Revenues from sales to various U.S. government entities totaled $2.1million, or 71.0% of revenues, for the six months ended June 30, 2005compared to $0.9 million, or 38.5% of revenues, for the same period in2004.  Although, we expect ourconcentration of revenues to vary among customers in future quarters dependingupon the timing of certain sales, we anticipate that sales to governmentcustomers will continue to account for a significant portion of our revenues infuture quarters.  Sales to the governmentpresent risks in addition to those involved in sales to commercial customerswhich could adversely affect our revenues, including potential disruption toappropriation and spending patterns and the government’s reservation of the rightto cancel contracts and purchase orders for its convenience.  Although we do not believe that thecancellation of any particular order would have a material adverse effect onour financial results or that any of our revenues with government customers aresubject to renegotiation, a large number of cancelled or renegotiatedgovernment orders could possibly have a material adverse effect on ourfinancial results.  Currently, we are notaware of any proposed cancellation or renegotiation of any of our existingarrangement with government entities and, historically, government entitieshave not cancelled or renegotiated orders which had a material adverse effecton our business.

 

**Gross Profit**.  Gross profit was $1.0 million or 56.7%of net revenues for the quarter ended June 30, 2005, compared to $0.5million or 47.7% of net revenues for the quarter ended June 30, 2004.Gross profit was $1.6 million or 56.2% of net revenues for the six months endedJune 30, 2005, compared to $1.2 million or 48.8% of net revenues for thesix months ended June 30, 2004. Gross profit margins as a percentage ofnet revenues increased from the same period in the prior year due to acontinued shift in product mix, to our more profitable SecureNet productline.  Gross profit on product revenuesfor the quarter and six months ended June 30, increased from 29.7% and40.0%, respectively, in 2004 to 45.6% and 44.3%, respectively, in 2005 due tothe transition to our more profitable software-based products.  Gross profit on customer support andmaintenance revenues for the quarter and six months ended June 30,increased from 73.0% and 58.0%, respectively, in 2004 to 94.7% and 93.4%,respectively, in 2005, as less repair costs associated with maintenancecontracts were incurred during the quarter in conjunction with our transitionto software-based products.

 

Grossprofit as a percentage of net revenues is impacted by several factors,including shifts in product mix, changes in channels of distribution, revenuevolume, fluctuations in third-party assembly costs, pricing strategies, andfluctuations in revenues of integrated third-party products.

 

**Sales and Marketing**.  Sales and marketingexpenses decreased to $0.9 million for the quarter ended June 30, 2005,compared to $1.0 million for the quarter ended June 30, 2004. Sales andmarketing expenses decreased to $1.6 million for the six months ended June 30,2005, compared to $2.0 million for the six months ended June 30, 2004.This cost reduction was primarily due to the reorganization of our sales andmarketing departments, including a reduction in headcount, and other costreduction initiatives.  Sales andmarketing expenses may vary as a percentage of net sales in the future.  However, we believe that these costs willremain relatively constant through the end of the year.

 

**Research and Development**.  Research and developmentexpenses remained constant at $0.7 million for the quarters ended June 30,2005 and 2004. Research and development expenses increased to $1.4 million forthe six months ended June 30, 2005, compared to $1.3 million for the sixmonths ended June 30, 2004. Research and development costs are expensed inthe period incurred.  Research anddevelopment expenses increased slightly in the six months ended June 30,2005, compared to the same periods in 2004 as we incurred slightly moreresearch and development costs during the period. Research and developmentexpenses may vary as a percentage of net sales in the future; however, webelieve that these costs will remain relatively constant through the end of theyear.

 

**General and Administrative**.  General andadministrative expenses remained constant at $0.3 million for the quartersended June 30, 2005 and 2004. General and administrative expenses decreased to $0.5 million for thesix months ended June 30, 2005, compared to $0.6 million for the sixmonths ended June 30, 2004.  Thisdecrease was primarily due to the restructuring done in 2004, including areduction in headcount, and other cost reduction initiatives.  It is expected that general andadministrative expenses will remain relatively constant throughout theremainder of the year, as no further headcount reductions are anticipated.  General and administrative expense may varyas a percentage of net sales in the future.

 

**Severance and Related Costs.**** **We did not incur severance and related costsduring the quarter ended June 30, 2005 compared to $96 thousand for thesame period in 2004.  Severancecosts decreased to $55 thousand for the six-month period ended June 30,2005, compared to $130 thousand for the six month period ended June 30,2004.  Severance and related costs duringthe six-month period ended June 30, 2005 consisted primarily of paymentsmade during the periods as a result of prior reductions in force.  Severance and related costs for the six-monthperiod ended June 30, 2004 consisted of reductions in force made duringthose periods.

 

12

----

 

**Interest**.  Net interest income increased to $29thousand for the quarter ended June 30, 2005 compared to $7 thousand forthe same period in 2004.  Net interestincome increased to $33 thousand for the six months ended June 30, 2005compared to $26 thousand for the same period in 2004.  The increase in interest income was primarilydue to better returns over prior year and relatively constant cash andshort-term investment balances when compared to prior year.  Net interest income may vary in the futurebased on our cash flow and rate of return on investments.

 

Liquidity and CapitalResources

 

Ourprincipal source of liquidity at June 30, 2005 is approximately $1.3million of cash and cash equivalents and $2.3 million of short-terminvestments.  At June 30, 2005working capital was $2.9 million compared to $4.3 million at June 30,2004.

 

Cash used in operations for the six months ended June 30, 2005 was$1.0 million, primarily due to a net loss of $2.0 million, a decrease inaccounts payable and accrued expenses of $0.2 million and a reduction in theprovision for doubtful accounts of $0.2 million.  This cash decrease was partially offset bydepreciation expense of $0.1 million, a decrease in accounts receivable of $0.9million, an increase in deferred revenue of $0.1 million, a decrease ininventories of $0.1 million and a decrease in prepaid expenses and other assetsof $0.2 million.  Cash used in operationsfor the six months ended June 30, 2004 was $2.6 million, primarily due toa net loss of $2.8 million, an increase in inventories of $0.1 million and adecrease in accounts payable and accrued expenses of $0.6 million.  This cash decrease was partially offset bydepreciation expense of $0.1 million, a decrease in accounts receivable of $0.4million, an increase in deferred revenue of $0.1 million and a decrease inprepaid expenses and other assets of $0.2 million.  Future fluctuations in inventory balances,accounts receivable and accounts payable will be dependent upon severalfactors, including, but not limited to, quarterly sales, our strategy in buildinginventory in advance of receiving orders from customers, and the accuracy ofour forecasts of product demand and component requirements.

 

Cashused in investing activities in the six months ended June 30, 2005 was$2.4 million, which consisted primarily of the net purchase of short-term investmentsof $2.4 million and net purchases of property and equipment of $0.1 million,partially offset by maturities of short-term investments of $0.1 million,compared to cash used by investing activities of $1.5 million for the sixmonths ended June 30, 2004, which consisted primarily of the net maturityof short-term investments of $1.4 million and net purchases of property andequipment of $0.1 million.

 

Cashprovided by financing activities in the six months ended June 30, 2005 was$2.4 million, consisting of net financing proceeds from a private placement of$2.5 million, partially offset by payment of dividends on preferred stock of$115 thousand, compared to cash provided by financing activities for the sixmonths ended June 30, 2004 of $4.7 million, consisting of net financingproceeds from a private placement of $4.7 million and the exercise of employeestock options of $6 thousand.

 

At June 30, 2005,the Company did not have any material commitments for capital expenditures.

 

During the six months endedJune 30, 2005, the Company funded its operations through financingproceeds raised during the first quarter of 2005 as well as the use of cash,cash equivalents and sales of short-term investments.

 

Basedon our financial projections, we expect that our cash on hand, along with ourshort-term investments, and cash from our operations will be sufficient to fundour operations for the next 12 months. However, our projections are dependent upon our ability to meet ourrevenue and gross profit targets.  Wefunded our operations and met our cash requirements during the six months endedJune 30, 2005 through financing proceeds on preferred stock and the use ofcash, cash equivalents and sales of short-term investments.  Although we believe we have sufficient cashresources to finance our operations and expected capital expenditures for thenext twelve months, based on our internal estimates and our operating plan, thesufficiency of our cash resources may depend to a certain extent on generaleconomic, financial, competitive or other factors beyond our control.  Moreover, despite actions to reduce our costsand improve our profitability, our operating losses and net operating cashoutflows may continue through at least the third quarter of 2005.  As a result, we may not be able toachieve the revenue and gross margin objectives necessary to achieve positivecash flow or profitability or to remain in compliance with Nasdaq’scontinued listing requirement of at least $2.5 million of stockholders’ equitywithout obtaining additional equity financing. We do not currently have any arrangements for financing, and we may notbe able to secure additional debt or equity financing on terms acceptable tous, or at all, at the time when we need such funding.  If our business does not generate sufficientcash flow from operations and sufficient future financings are not available,we may not be able to operate or grow our business, pay our expenses when due,fund our other liquidity needs or maintain our listing on the Nasdaq SmallCapMarket.

 

13

----

 

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 todevelop, either internally or through the licensing, or acquisition of productsfrom third parties.  While we engage fromtime to time in discussions with respect to potential acquisitions, there canbe no assurances that any such acquisitions will be made or that we will beable to successfully integrate any acquired business.  In order to finance such acquisitions andworking capital it may be necessary for us to raise additional funds throughpublic or private financings.  Any equityor debt financings, if available at all, may be on terms, which are notfavorable to us and, in the case of equity financings, may result in dilutionto our stockholders.

 

Off-Balance SheetArrangements.

 

Asof June 30, 2005, we did not have any significant off-balance sheetarrangements, as defined by Item 303(c)(2) ofRegulation S-B.

 

Factors That May AffectFuture Results of Operations 

 

Numerousfactors may affect our business and future results of operations.  These factors include current economic andmarket conditions, the effect of military actions on government and corporatespending on information security products, spending patterns of, andappropriations to, U.S. government departments, technological changes, competitionand market acceptance, acquisitions, product transitions, timing of orders,manufacturing and suppliers, reliance on outsourcing vendors and otherpartners, intellectual property and licenses, third-party products, dependenceon government customers, international operations, intellectual propertyissues, liquidity and cash resources and effects of restructuring plans andcost reductions.  The discussion belowaddresses some of these and other factors. For a more thorough discussion of these and other factors that mayaffect our business and future results, see the discussion under the caption “FactorsThat May Affect Future Results of Operations” in our Annual Report on Form 10-KSBfor the year ended December 31, 2004.

 

***Our cash, cash equivalents, and investments have increasedapproximately $1.2 million in the last six months but have generally declinedsince 2003.  As a result of our expectedcontinuing net cash outflows, we may not have sufficient cash to operate ourbusiness and may not be able to maintain our Nasdaqlisting.***

 

Duringthe six months ended June 30, 2005, our cash, cash equivalents andshort-term investments increased approximately $1.2 million from approximately$2.4 million as of December 31, 2004 to approximately $3.6 million at June 30,2005, primarily as a result of a private placement of our preferred stock andwarrants, that yielded net proceeds of $2.5 million, which we completed on March 28,2005.  As of December 31, 2004, wehad cash, cash equivalents and investments in the amount of approximately $2.4million, down from approximately $2.7 million as of December 31,2003.  Although we believe the proceedswe received in connection with the private placement in March 2005 willprovide us with sufficient cash resources to finance our operations for thenext twelve months, based on our internal estimates and our operating plan, thesufficiency of our cash resources may depend to a certain extent on generaleconomic, financial, competitive or other factors beyond our control. Moreover,despite our actions to reduce costs and improve profitability, our netoperating losses and net operating cash outflows may continue through at leastthe third quarter of 2005.  If our lossescontinue, our stockholders’ equity could fall below $2.5 million in the fourthquarter of 2005.  If this occurs, wewould not be in compliance with the Nasdaq listingrequirements, and we could face delisting. We do not currently have any further arrangements for equity financing,and we may not be able to secure additional debt or equity financing on termsthat are acceptable to us, or at all, at the time when we need thisfinancing.  Therefore, if our businessdoes not generate sufficient cash flow from operations and sufficient financingresources are not available, we may not be able to operate or grow ourbusiness, pay our expenses when due, fund our other liquidity needs or maintainour listing on the Nasdaq SmallCap Market.

 

14

----

 

***If we fail to respond to rapid technological changes in the networksecurity, data protection, regulated information compliance and spywareprevention industries, we may lose customers or our products may becomeobsolete.***

 

Thenetwork security, data protection, regulated information compliance and spywareprevention industries are characterized by frequent product introductions,rapidly changing technology and continued evolution of industry standards.  We must introduce upgrades to our products rapidlyin response to customer needs, such as new computer viruses or other novelexternal attacks on computer networks as well as the adoption privacy and dataprotection laws.  In addition, the natureof the network security, data protection, regulated information compliance andspyware prevention industries requires our products to be compatible andinteroperable with numerous security products, networking products, workstationand personal computer architectures and computer and network operating systemsoffered by various vendors, including our competitors.  As a result, our success depends upon ourability to develop and introduce in a timely manner new products andenhancements to our products that meet changing customer requirements andevolving industry and legal standards. The development of technologicallyadvanced network security, data protection, regulatedinformation compliance and spyware prevention products is a complex anduncertain process requiring high levels of innovation, rapid response andaccurate anticipation of technological and market trends.  We cannot assure you that we will be able toidentify, develop, manufacture, market or support new or enhancedproducts successfully in a timely manner. Further, the introduction of new products or product enhancements by usor our competitors or the adoption of new or amended privacy or data protectionlaws may shorten the life cycle of our existing products or cause our existingproducts to become obsolete.

 

***Although our revenues have increased to $2.9 million for the first sixmonths of 2005 from $2.4 for the same period in 2004, our overall revenues havedeclined from $7.8 million in 2002 to $6.0 million in 2004 in connection with ashift to sales of our newer product lines. If our network intrusion detection,regulated information compliance system, data privacy system and spywareprevention products do not achieve market acceptance, our revenues will suffer.***

 

Overthe past three years, we have transitioned our sales strategy from our lowermargin SecureCom and PDS security appliance products to the development andsales of our higher margin network intrusion detection, regulated informationcompliance system, data privacy protection and spyware preventionproducts.  During this transition, salesof our new products were not enough to counteract the loss in sales associatedwith our older products.  As a result,although our revenues for the six months ended June 30, 2005 increased to$2.9 million from $2.4 million for the same period in 2004, our overall netrevenues have declined from approximately $7.8 million in 2002, toapproximately $6.5 million in 2003 and approximately $6.0 million in 2004.

 

Ournew network security products, regulated information compliance systems, dataprivacy protection systems and spyware prevention products have only been inthe market place for a limited period of time and may have longer sales cyclesthan our previous products.  Althoughresponse to our products has been positive, we have not yet received broadmarket acceptance.  We cannot assure youthat our present or future products will achieve market acceptance on asustained basis.

 

Inorder to achieve market acceptance and achieve future revenue growth, we mustintroduce complementary products, incorporate new technologies into ourexisting product lines and design, develop and successfully commercializehigher performance products in a timely manner. We cannot assure you that we will be able to offer new or complementaryproducts that gain market acceptance quickly enough to avoid decreased revenuesduring current or future product introductions or transitions.

 

***We resemble a developmental stage company and our business strategy maynot be successful.***

 

Fromour founding in 1983 until 2000, we derived substantially all of our revenuefrom the design, manufacture and sale of local area networking equipment.  In order to permit us to focus our resourcessolely on developing and marketing our network security products, we sold ourlocal area networking assets and related networking divisions in a series ofsales from 2000 to 2002.

 

15

----

 

Asa result of these sales, we now depend exclusively on revenues generated fromthe sale of our network security products, which have received limited marketacceptance.  Moreover, we have onlyrecently introduced our regulated compliance and data privacy systems and ourspyware prevention products.  Althoughinitial response to these products has been positive, the market for theseproducts has only begun to emerge and sales of these products may not occur asquickly as we expect.  Consequently, weresemble a developmental stage company and will face the following inherentrisks and uncertainties:

 

•                  the need for our network security products,regulated information compliance systems, data privacy protection systems andspyware prevention products to achieve market acceptance and produce asustainable revenue stream;

 

•                  our ability to manage costs and expenses;

 

•                  our dependence on key personnel;

 

•                  our ability to obtain financing on acceptableterms; and

 

•                  our ability to offer greater value than ourcompetitors.

 

Ourbusiness strategy may not successfully address these risks.  If we fail to recognize significant revenuesfrom the sales of our network security products and regulated informationcompliance systems, our business, financial condition and operating resultswould be materially adversely affected.

 

***We incurred a net loss of $2.0 million for the six months ended June 30,2005 and have an accumulated deficit of $50.7 million as of June 30,2005.  As a result, we must generatesubstantially greater revenues from sales in order to achieve profitability.***

 

Wehave incurred significant operating losses and are uncertain about our futureoperating results.  For the six monthsended June 30, 2005, we incurred a net loss of $2.0 million and had anaccumulated deficit of approximately $50.7 million as of June 30,2005.  We need to generate and sustainsubstantially greater revenues from the sales of our products if we are toachieve profitability.  If we are unableto achieve these greater revenues, our losses will continue indefinitely, andwe may never achieve or sustain profitability or generate positive cash flow.

 

***We face intense competition from both start-up and establishedcompanies that may have significant advantages over us and our products.***

 

Themarket for network security solutions is intensely competitive. There arenumerous companies competing with us in various segments of the data securitymarkets, and their products may have advantages over our products in areas suchas conformity to existing and emerging industry standards, interoperabilitywith networking and other security products, management and securitycapabilities, performance, price, ease of use, scalability, reliability,flexibility, product features and technical support.

 

Ourprinciple competitors in the network intrusion and detection market includeInternet Security Systems, Inc., Cisco Systems, Inc., MicroSoft,Symantec, Inc., Netscreen Technologies, Inc., McAfee, Inc.,Tipping Point Technologies, a division of 3COM Corporation, and NFR Security, Inc.  The market for regulated informationcompliance systems is relatively new. Our competitors in this market include a number of start-up companies thathave entered the market in the last two years. However, as this market develops, we expect increased competition fromboth start-up and established companies. Our current and potential competitors may have one or more of thefollowing significant advantages over us:

 

•               greater financial, technical and marketing resources;

 

•                  better name recognition;

 

•                  more comprehensive security solutions;

 

•                  better or more extensive cooperative relationships;and

 

•                  larger customer base.

 

16

----

 

Althoughwe believe our network security products and regulated information compliancesystems compare favorably to our competitors’ products and create a sustainablebusiness model, we cannot assure you that our products will achieve marketacceptance or that we will be able to compete successfully with our existing ornew competitors.

 

***Military actions may disrupt our business by reducing spending ourproducts, increasing our costs and affecting our international operations.***

 

Wederive a substantial portion of our revenue from sales to United Statesgovernment entities, including sales to various Army and other armed****servicesbases.  As a result, United Statesmilitary actions or other events occurring in response to or in connection withthem, including future terrorist attacks, actual conflicts involving the UnitedStates or its allies or military or trade disruptions could impact ouroperations by:

 

•              reducing or delaying government, armedservice or corporate spending on our products;

 

•              increasing the cost and difficulty inobtaining materials or shipping products; and

 

•               affecting our ability to conduct businessinternationally.

 

Shouldthese events occur, our business, operating results and financial conditioncould be materially and adversely affected.

 

***Our products can have long sales and implementation cycles, which mayresult in us incurring substantial expenses before realizing any associatedrevenues.***

 

Thesale and implementation of our products to large companies and governmententities typically involves a lengthy education process and a significanttechnical evaluation and commitment of capital and other resources.  This process is also subject to the risk ofdelays associated with customers’ internal budgeting and other procedures forapproving capital expenditures, deploying new technologies within theirnetworks and testing and accepting new technologies that affect keyoperations.  As a result, sales andimplementation cycles for our products can be lengthy, and we may expendsignificant time and resources before we receive any revenues from a customeror potential customer.  Our quarterly andannual operating results could be materially harmed if orders forecasted for aspecific customer for a particular period are not realized.

 

***Our failure to realize the expected benefits of our recentrestructuring efforts could adversely affect our operating results.***

 

Duringthe first six months of 2005, we incurred $55 thousand in severance relatedcosts.  Since we began restructuring in2002, we have incurred approximately $1.1 million in restructuring charges,severance, and related expenses. The objective of our restructuring plan was toreduce our cost structure to a sustainable level that is consistent with ourcurrent cash resources and the general economic climate.  We have also implemented other strategicinitiatives to strengthen our operations, such as reductions in our work forceand facilities and aligning our organization around our businessobjectives.  Any further work forcereductions could result in temporary reduced productivity of our remainingemployees.  Additionally, our customersand prospects may delay or forgo purchasing our products due to a perceiveduncertainty caused by our restructuring and other changes.  Failure to achieve the desired results of ourinitiatives could seriously harm our business, results of operations andfinancial condition.

 

***Consolidation in the network security data protection and spywareprevention industries may limit market acceptance of our products.***

 

Severalof our competitors have acquired security companies with complementarytechnologies in the past.  We expectconsolidation in the network security, data protection and spyware preventionindustries to continue in the future.  Theseacquisitions may permit our competitors to accelerate the development andcommercialization of broader product lines and more comprehensive solutionsthan we currently offer.  Acquisitions ofvendors or other companies with which we have a strategic relationship by ourcompetitors may limit our access to commercially significant technologies.  Further, business combinations in the networksecurity industry are creating companies with larger market share, customerbases, sales forces, product offerings and technology and marketing expertise,which may make it more difficult for us to compete.

 

17

----

 

***Sales to government entities accounted for 71.0% of our revenues thesix months ended June 30, 2005 and 53.6% of our revenues for the yearended December 31, 2004.  Sales togovernment customers involve unique risks, which could adversely impact ourrevenues.***

 

Wederived 71.0% of our revenues from sales to various U.S. government entitiesfor the six months ended June 30, 2005, and 53.6% of our revenues fromthese sales for the year ended December 31, 2004.  We expect to continue to derive a substantialportion of our revenues from U.S. government customers in the future.  Sales to the government present risks in additionto those involved in sales to commercial customers, including potentialdisruption due to appropriation and spending patterns and the government’sright to cancel contracts and purchase orders for its convenience.  General political and economic conditions,which we cannot accurately predict, directly and indirectly may affect thequantity and allocation of expenditures by federal departments.  In addition, obtaining government contractsmay involve long purchase and payment cycles, competitive bidding,qualification requirements, delays or changes in funding, budgetaryconstraints, political agendas, extensive specification development and pricenegotiations and milestone requirements. Each government entity also maintains its own rules and regulationswith which we must comply and which can vary significantly amongdepartments.  As a result, cutbacks orre-allocations in the federal budget or losses of government sales due to otherfactors could have a material adverse effect on our revenues and operatingresults.

 

***We derived 11.8% of our revenues from international sales in the sixmonths ended June 30, 2005, and 19.2% of our revenues from these sales forthe year ended December 31, 2004. Our ability to sell our products internationally aresubject to certain risks which could harm our business.***

 

Salesto foreign customers accounted for approximately 19.2% of our revenues for theyear ended December 31, 2004, and 11.8% of our revenues for the six monthsended June 30, 2005.  We expectsales to foreign customers to continue to represent a significant portion ofour revenues in the future.  Ourinternational operations are subject to many inherent risks that may adverselyaffect our business, financial condition and operating results, including:

 

•                  political, social and economic instability;

 

•                  trade restrictions;

 

•                  increases in duty rates and other potentially adversetax consequences;

 

•                  exposure to different legal standards, particularlywith respect to the protection of intellectual property;

 

•                  burdens of complying with a variety of foreign laws;

 

•                  unexpected changes in regulatory requirements;

 

•                  import and export license requirements andrestrictions of the United States and each other country where we operate;

 

•                  fluctuations in currency exchange rates; and

 

•                  changes in local purchasing practices, includingseasonal fluctuations in demand.

 

***Sales through indirect channels accounted for 28.3% of our revenues forthe six months ended June 30, 2005 and 36.9% of our revenue for the yearended December 31, 2004.  Ourrevenues will suffer if we do not expand our sales through, or receive theanticipated benefits from our sales through, indirect sales channels.***

 

Wederived 28.3% of our revenues for the six months ended June 30, 2005, and36.9% of our revenue for the year ended December 31, 2004, from salesthrough indirect sales channels, such as distributors, value added resellers,system integrators, original equipment manufacturers and managed serviceproviders.  We believe we must expand oursales through these indirect channels in order to increase our revenues.  Although we are actively pursuing a strategyto increase the percentage of our revenues generated through these indirectsales channels, we cannot assure you that our products will gain marketacceptance in these indirect sales channels or that sales through theseindirect sales channels will increase our revenues as expected.  Further, many of our competitors are alsotrying to sell their products through these indirect sales channels, whichcould result in lower prices and reduced profit margins for sales of ourproducts.

 

18

----

 

***We must adequately protect our intellectual property in order toprevent loss of valuable proprietary information.***

 

Werely on a combination of patent, copyright, trademark and trade secret laws,confidentiality procedures and non-disclosure agreements to protect ourproprietary technology.  However,unauthorized parties may attempt to copy or reverse engineer aspects of ourproducts or to obtain and use information that we regard as proprietary.  Policing unauthorized use of our products isdifficult, and we cannot be certain that the steps we have taken will preventmisappropriation of our intellectual property. This is particularly true in foreign countries where the laws may notprotect proprietary rights to the same extent as the laws of the United Statesand may not provide us with an effective remedy against unauthorized use.  If our protection of our intellectual propertyproves to be inadequate or unenforceable, others may be able to use ourproprietary developments without compensation to us, resulting in potentialcost advantages to our competitors.

 

***We may incur substantial expenses defending ourselves against claims ofinfringement.***

 

Thereare numerous patents held by many companies relating to the design andmanufacture of network security systems. Although we are not aware of any instances in which our products violatethe intellectual property rights of others or inappropriately use theirtechnology, it is possible that third parties in the future may claim that ourproducts infringe on their intellectual property rights.  Any claim, with or without merit, couldconsume our management’s time, result in costly litigation, cause delays insales or implementations of our products or require us to enter into royalty orlicensing agreements.  Royalty andlicensing agreements, if required and available, may be on terms unacceptableto us or detrimental to our business. Moreover, a successful claim of product infringement against us or ourfailure or inability to license the infringed or similar technology oncommercially reasonable terms could seriously harm our business.

 

***Fluctuations in our quarterly revenues may cause the price of ourcommon stock to decline.***

 

Ouroperating results have varied significantly from quarter to quarter in thepast, and we expect our operating results to vary from quarter to quarter inthe future due to a variety of factors, many of which are outside of ourcontrol.  Although our revenues aresubject to fluctuation, significant portions of our expenses are not variablein the short term, and we cannot reduce them quickly to respond to decreases inrevenues.  Therefore, if revenues are belowour expectations, this shortfall is likely to adversely and disproportionatelyaffect our operating results. Accordingly we may not attain positive operating margins in futurequarters.  Any of these factors couldcause our operating results to be below the expectations of securities analystsand investors, which likely would negatively affect the price of our commonstock.

 

***The price of our common stock has been volatile in the past and maycontinue to be volatile in the future due to factors outside of our control.***

 

Themarket price of our common stock has been highly volatile in the past and maycontinue to be volatile in the future. For example, for the six-month period ending June 30, 2005, themarket price of our common stock on The Nasdaq SmallCapMarket fluctuated between $2.01 and $6.20 per share.  The market price of our common stock mayfluctuate significantly in response to a number of factors, many of which areoutside our control, including:

 

•               variations in our quarterly operating results;

 

•                  changes in estimates of our financialperformance by securities analysts;

 

•                  changes in market valuations of our competitors;

 

•                  announcements by us or our competitors of new products,significant contracts, acquisitions, strategic relationships, joint ventures orcapital commitments;

 

•                  product or design flaws, product recalls or similaroccurrences;

 

•                  additions or departures of key personnel;

 

•                  sales of common stock in the future; and

 

•                  fluctuations in stock market prices and volume, which canbe particularly common among network security and other high technologycompanies.

 

19

----

 

***Our reductions in our work force may make it more difficult for us toattract and retain the personnel necessary to successfully operate ourbusiness.***

 

Werely upon the continued service of a relatively small number of key technical,sales and senior management personnel. Our future success depends on retaining our key employees and ourcontinuing ability to attract, train and retain other highly qualifiedtechnical, sales and managerial personnel. As a result, our employees could resign with little or no priornotice.  We may not be able to attract,assimilate or retain other highly qualified technical, sales and managerialpersonnel in the future, especially given our recent reductions in force.  The loss of any of our key technical, salesand senior management personnel or our inability to attract, train and retainadditional qualified personnel could seriously harm our business.

 

***Certain rights of the holders of our preferred stock may hinder ourability to raise additional financing.***

 

We cannot issueshares of capital stock with rights senior to those of our existing 5%preferred stock or Series 2 5% preferred stock without the approval of atleast a majority of the holders of our 5% preferred stock and all of theholders of our Series 2 5% preferred stock, voting or acting as separateclasses.  We also cannot incur certainindebtedness without the approval of at least a majority of the holders of our5% preferred stock.  In addition, holdersof the Series 2 5% preferred stock who are not executive officers ordirectors have the right to purchase a pro rata portion of certain futureissuances of securities by us.  The combinationof these provisions could hinder or delay our ability to raise additional debtor equity financing.

 

***You will experience substantial dilution upon the conversion orredemption of the shares of preferred stock and exercise of warrants that weissued in recent private placements.***

 

On March 25,2004, we completed a $5,000,000 private placement in connection with which weissued 1,000,000 shares of our 5% Convertible Preferred Stock and warrants toacquire 556,619 shares of our common stock. The conversion price for the preferred stock and the exercise price ofthe warrants is $3.144 per share.  Wealso issued our placement agent a warrant for 64,408 shares of our common stockat an exercise price of $3.144 per share. As of July 25, 2005, there were 389,088 shares of 5% preferredstock, representing 618,776 shares of common stock upon conversion, andwarrants to purchase 556,619 shares of common stock outstanding.

 

In addition, on March 28,2005, we completed a $2,663,000 private placement in connection with which weissued 1,065,200 shares of our Series 2 5% Convertible Preferred Stock andwarrants to acquire 532,600 shares of our common stock.  We also issued two affiliates of ourplacement agent warrants to purchase an aggregate of 60,390 shares of commonstock.  The conversion price for thepreferred stock is $2.50 per share and the exercise price of the warrants is$2.77 per share.  As of July 25,2005, there were 640,000 shares of Series 2 5% preferred stock,representing 640,000 shares of common stock upon conversion, and warrants topurchase 532,600 shares of common stock outstanding.

 

On July 25,2005, we had 6,573,230 shares of common stock outstanding.  As a result, we expect the private placementsto result in a further dilution to holders of our common stock upon conversionof the preferred stock and exercise of the warrants of 2,472,793 shares ofcommon stock, or an approximately 37.6% increase in the number of shares of ourcommon stock outstanding.

 

Further, theoccurrence of certain specified events controlled by the Company may entitleholders of our Series 2 5% preferred stock to require us to redeem theirshares for a number of shares of our common stock equal to the redemption pricedivided by 75% of the ten-day average of the volume weighted average price ofour common stock ending on the day immediately preceding the holder’s electionto redeem.  The redemption price for theshares of Series 2 5% preferred stock equals the sum of (1) thegreater of $3.25 and the volume weighted average price of our common stock onthe trading day immediately preceding the redemption event multiplied by $2.50divided by the conversion price of the Series 2 5% preferred stock then ineffect plus (2) any accrued but unpaid dividends on the Series 2 5%preferred stock plus (3) any unpaid liquidated damages or other amountspayable to the holders of the Series 2 5% preferred stock.  As a result, assuming we have paid allliquidated damages and other amounts to the holders, accrued but unpaiddividends on July 25, 2005 of $13 thousand, a volume weighted averageprice of $3.17, which was the closing price of our common stock on July 25,2005, and our 6,573,230 shares of common stock outstanding on July 25,2005, we would issue approximately 880,336 shares of our common stock if aspecified redemption event occurs and all holders of Series 2 5% preferredstock elected to redeem their shares for common stock.  This would represent an increase ofapproximately 13.4% in the number of shares of our common stock as of July 25,2005.

 

20

----

 

***The conversion of preferred stock or exercise of warrants we issued inour recent private placement may cause the price of our common stock todecline.***

 

The holders of theshares of 5% preferred stock and warrants we issued on March 25, 2004 andthe holders of the shares of Series 2 5% preferred stock and warrants weissued on March 28, 2005, may freely convert their shares of preferredstock and exercise their warrants and sell the underlying shares of commonstock pursuant to effective registration statements we filed the SEC.  As of July 25, 2005, 610,912 shares ofpreferred stock had converted into 971,551 shares of common stock, and 425,000shares of Series 2 5% preferred stock had converted into 425,000 shares ofcommon stock.

 

For the four weeksended on July 25, 2005, the average daily trading volume of our commonstock on The NASDAQ SmallCap Market was 47,174 shares.  Consequently, if holders of preferred stockor warrants elect to convert their remaining shares or exercise their warrantsand sell a material amount of their underlying shares of common stock on theopen market, the increase in selling activity could cause a decline in themarket price of our common stock. Furthermore, these sales, or the potential for these sales, couldencourage short sales, causing additional downward pressure on the market priceof our common stock.

 

***Our acquisition of complementary products or businesses may adverselyaffect our financial condition.***

 

Wehave made acquisitions in the past, and, in the future, we may acquire orinvest in additional companies, business units, product lines or technologiesto accelerate the development of products and sales channels complementary toour existing products and sales channels. Negotiation of potential acquisitions and integration of acquiredproducts, technologies or businesses could divert our management’s time andresources.  Future acquisitions couldcause us to issue equity securities that would dilute your ownership of us,incur debt or contingent liabilities, amortize intangible assets or write offin-process research and development, goodwill and other acquisition-relatedexpenses that could seriously harm our financial condition and operating results.  Further, if we are not able to properlyintegrate acquired products, technologies or businesses with our existingproducts and operations, train, retain and motivate personnel from the acquiredbusiness or combine potentially different corporate cultures, we may notreceive the intended benefits of our acquisitions, which could adversely affectour business, operating results and financial condition.

 

***The payment of accrued dividends on our preferred stock may strain ourcash resources, and our inability to pay these dividends could cause our stockprice to decline or could adversely affect our ability to raise additional financing .***

 

Shares of our 5%convertible preferred stock accrue cash dividends equal to $0.25 per share perannum, payable in arrears on March 31 and September 30 of each year,and shares of our Series 2 5% convertible preferred stock accrue cashdividends equal to $0.125 per share per annum, payable in arrears on the firstbusiness day of March, June, September and December of each year.  The amount of the dividends on our Series 25% preferred stock may increase to $0.45 per share per annum upon theoccurrence of certain event entitling the holders of these shares toredemption.

 

During 2004, wepaid $129 thousand in dividends related to our 5% preferred stock and at June 30,2005, we have dividends accrued of $25 thousand related to our 5% preferredstock and $8 thousand related to our Series 2 5% preferred stock.

 

Delaware lawprovides that we may only pay dividends out of our capital surplus or, if nosurplus is available, out of our net profits for the fiscal year the dividendis declared and/or the preceding fiscal year. We have not had net profits for the last two fiscal years ended December 31,2004.  However, we did have sufficientcapital surplus, defined as the amount by which our net assets exceed ourstated capital, based on par value of our outstanding shares as provided byDelaware law.  Although we are currentlyable to pay accrued dividends on our outstanding shares of preferred stock, wecannot assure you that our net assets will continue to exceed our statedcapital or that we will have net profits in order to pay these dividends in thefuture.  These dividends continue toaccrue on our outstanding shares of preferred stock, regardless of whether weare legally able to pay them.  Theaccrual of these dividends may adversely affect our operating results.  Moreover, the payment of these dividends couldstrain our available cash resources, which could adversely affect our abilityto operate or grow our business.

 

In addition, ourinability to pay dividends could require us to redeem outstanding shares of Series 25% preferred stock in exchange for shares of our common stock issued at a priceequal to 75% of the average of volume weighted average price of our commonstock for the ten days ending on the day immediately preceding an election toredeem.  As a result, the issuance, orpotential issuance, of these additional shares of our common stock could causeour stock price to decline.  Furthermore,our inability to pay these dividends in cash could adversely affect our abilityto raise equity financing in the future if required.

 

21

----

 

***Compliance with export regulations may hinder our sales to foreigncustomers.***

 

Certainof our data security products incorporate encryption and other technology thatmay require clearance and export licenses from the U.S. Department of Commerceunder United States export regulations. Any inability to obtain these clearances or licenses or any foreignregulatory approvals, if required, on a timely basis could delay sales and havea material adverse effect on our operating results.

 

***Provisions of our charter documents and Delaware law may haveanti-takeover effects.***

 

Certainprovisions of our certificate of incorporation and bylaws, such as our abilityto offer “blank check” preferred stock and the inability of our stockholders toact by written consent, could make it more difficult for a third party to acquireus, even if doing so would be beneficial to our stockholders.  We are also subject to the provisions of Section 203of the Delaware General Corporation Law, which restricts certain businesscombinations with interested stockholders and could inhibit a non-negotiatedmerger or other business combination.

 

***Our management and larger stockholders exercise significant controlover our company and may approve or take actions that may be adverse to yourinterests.***

 

Asof July 25, 2005, our executive officers, directors and preferredstockholders beneficially own approximately 26.9% of our voting power.  As a result, these stockholders will be ableto exercise significant control over all matters requiring stockholder approval,including the election of directors and the approval of significant corporatetransactions, which could delay or prevent someone from acquiring or mergingwith us or providing us with additional financing if required.  These stockholders may use their influence toapprove or take actions that may be adverse to your interests.

 

Item 3.                                CONTROLS AND PROCEDURES

 

Wehave carried out an evaluation, under the supervision and the participation ofour management, including our Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of our disclosure controls and procedures as of June 30,2005, pursuant to Rule 13a-15(b) under the Exchange Act.  Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective in ensuring that information required tobe disclosed is recorded, processed, summarized and reported in a timelymanner.

 

Wehave carried out an evaluation, under the supervision and participation of ourmanagement, including our Chief Executive Officer and Chief Financial Officer,of any changes in our internal controls over financial reporting that occurredduring the quarterly period ended June 30, 2005, and our Chief ExecutiveOfficer and Chief Financial Officer have concluded that there was no changeduring the quarterly period ended June 30, 2005 that has materiallyaffected or is reasonably expected to materially affect our internal controlover financial reporting.

 

22

----

 

**PART II – OTHER INFORMATION**

 

Item 1.                                LEGAL PROCEEDINGS

 

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 such legalproceedings will not have a material impact.

 

Item 4.             SUBMISSION OF MATTERSTO A VOTE OF SECURITY HOLDERS

 

The Annual Meetingof Stockholders was held on June 14, 2005, at the Radisson Hotel, DallasNorth in Richardson, Texas.  Thefollowing is a brief description of each matter voted upon by stockholders,including a number of votes cast for, against, or withheld with regard to each matterof nominee.

 

(1)                                  Electionof five (5) directors to serve until the next Annual Meeting ofStockholders and until their respective successors are duly elected andqualified.

 
| ** **             | ** ** | **FOR**   | ** ** | **WITHHELD** | ** ** |
|------------------------|------------|-----------|------------|--------------|------------|
| G. Ward  Paxton        |       | 5,300,376 |       | 89,487       |       |
| T. Joe Head            |       | 6,323,908 |       | 65,955       |       |
| James F.  Gero         |       | 6,305,313 |       | 84,550       |       |
| J. Fred Bucy, Jr. |       | 6,301,138 |       | 88,725       |       |
| Donald M.  Johnston    |       | 5,771,087 |       | 88,423       |       |

 

(2)                                  Ratificationand approval of 2005 Stock Incentive Plan.

 
| **FOR**   | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 3,411,947 |       | 145,891     |       | 41,047      |       |

 

(3)                                  Ratificationand approval for issuance of greater than 1,211,605 shares of Company’s commonstock upon conversion or redemption of the Company’s Series 2 5%Convertible Preferred Common Stock and the exercise of warrants to purchase theCompany’s common stock the Company sold in a private placement on March 28,2005.

 
| **FOR**   | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 2,498,567 |       | 94,196      |       | 38,082      |       |

 

(4)                                  Ratificationand approval for the issuance of shares of Company’s common stock upon theconversion or redemption of shares of the Company’s Series 2 5%Convertible Preferred Stock and warrants purchased by G. Ward Paxton, theCompany’s Chairman, President and Chief Executive Officer and James F. Gero,one of the Company’s directors in the private placement offering on March 28,2005.

 
| **FOR**   | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 2,551,042 |       | 136,247     |       | 38,491      |       |

 

(5)                                  Ratificationand approval of selection by the Board of Directors of KBA Group LLP asindependent auditors of the Registrant for the fiscal year ending December 31,2005.

 
| **FOR**   | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 6,304,861 |       | 42,483      |       | 42.519      |       |

 

23

----

 

Item 6.                                EXHIBITS AND REPORTS ON FORM 8-K

 

(a)                                      The following Exhibits are filed with thisreport form 10-QSB:

 
| 10.1(1) |   | 2005 Stock  Incentive Plan                                                                                                                                                                                      |
|---------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.2(1) |   | Form of  Notice of Grant of Stock Option                                                                                                                                                                   |
| 10.3(1) |   | Form of Stock  Option Agreement                                                                                                                                                                            |
| 10.4(1) |   | Form of  Stock Issuance Agreement                                                                                                                                                                          |
| 10.5(1) |   | Form of  Notice of Grant of Non-Employee Director Automatic Stock Option (Initial  Grant)                                                                                                                  |
| 10.6(1) |   | Form of  Notice of Grant of Non-Employee Director Automatic Stock Option (Annual Grant)                                                                                                                    |
| 10.7(1) |   | Form of  Automatic Stock Option Agreement                                                                                                                                                                  |
| 31.1(2) |   | Certification of Chief Executive Officer  Pursuant to Rule 13a-14(a) of the Exchange Act.                                                                                                             |
| 31.2(2) |   | Certification of Chief Financial Officer  Pursuant to Rule 13a-14(a) of the Exchange Act.                                                                                                             |
| 32.1(2) |   | Certification of Chief Executive Officer  Pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2(2) |   | Certification of Chief Financial Officer  Pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

----

(1)                                 Filed as an Exhibit to theRegistrant’s Current Report on Form 8-K dated June 15, 2005, which Exhibit isincorporated herein by reference.

 

(2)                                 Filed herewith.

 

(b)                                     During the quarter ended June 30, 2005,we filed the following reports on Form 8-K:

 

•                  Report on Form 8-K filed on May 3,2005, announcing the $1.0 million order from the U.S. Army at Fort Hood, TX.

•                  Report on Form 8-K filed on June 15,2005, announcing the approval by our board of directors and stockholders of the2005 Stock Incentive Plan.

 

24

----

 

**S I G N A TU 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: August 12, 2005 | /s/ Michael L. Paxton                                                     |
|                       | Michael L. Paxton                                                         |
|                       | Vice  President, Chief Financial Officer,  Treasurer & Secretary |
|                       | (Principal Financial & Accounting Officer)                       |

 

25

----