Table of Contents

 

 

 

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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| **x**                                                                                                                                                                                                                                               | **QUARTERLY REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                |
| **For the quarterly period ended June 30, 2009**                                                                                                                                                                                               |
|                                                                                                                                                                                                                                                |
| **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**                                                                                                                                                                                                                  |

 

**INTRUSIONINC.**

(Exactname of registrant as specified in its charter)

 

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

 

**1101 East Arapaho Road, Suite 200, Richardson, Texas75081**

(Addressof principal executive offices)

(ZipCode)

 

**(972) 234-6400**

(Registrant’stelephone number, including area code)

 

**Not Applicable**

Formername, former address and former fiscal year, 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 x No o

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter)during the preceding 12 months (or for such shorter period that the registrantwas required to submit and post such files). Yes o No o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See the definitions of “largeaccelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act.

 
| Large accelerated  filer  o          |   | Accelerated filer o          |
|------------------------------------------------|--------|-----------------------------------|
|                                           |   |                              |
| Non-accelerated  filer o                  |   | Smaller reporting  company x |
| (Do not check if a smaller  reporting company) |   |                              |

 

Indicate by check markwhether the Registrant is a shell company (as defined in Rule 12b-2 of theExchange Act):  Yes o No x

 

The number of sharesoutstanding of the Registrant’s Common Stock, $0.01 par value, on July 31,2009 was 11,704,535.

 

 

 

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**INTRUSION INC.**

 

INDEX

 
| **PART I  — FINANCIAL INFORMATION**                                                                               |
|-----------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                        |
| Item  1. Financial Statements                                                                                               |
|                                                                                                                        |
| Unaudited  Condensed Consolidated Balance Sheets as of June 30, 2009 and  December 31, 2008                       |
|                                                                                                                        |
| Unaudited  Condensed Consolidated Statements of Operations for the three and six months  ended June 30, 2009 and  2008 |
|                                                                                                                        |
| Unaudited  Condensed Consolidated Statements of Cash Flows for the six months ended  June 30, 2009 and 2008            |
|                                                                                                                        |
| Notes to Unaudited Condensed Consolidated Financial  Statements                                                             |
|                                                                                                                        |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations                         |
|                                                                                                                        |
| Item 4T. Controls and Procedures                                                                                            |
|                                                                                                                        |
| **PART II  — OTHER INFORMATION**                                                                                  |
|                                                                                                                        |
| Item  1. Legal Proceedings                                                                                                  |
|                                                                                                                        |
| Item  1A. Risk Factors                                                                                                      |
|                                                                                                                        |
| Item 3. Defaults Upon Senior Securities                                                                                     |
|                                                                                                                        |
| Item 4. Submission of Matters to a Vote of Security  Holders                                                                |
|                                                                                                                        |
| Item 6.  Exhibits                                                                                                           |
|                                                                                                                        |
| Signature Page                                                                                                              |

 

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**PART I — FINANCIAL INFORMATION**

 

Item 1. FINANCIAL STATEMENTS

 

**INTRUSION INC. AND SUBSIDIARIES**

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(Inthousands, except par value amounts)

 
| ** **                                                                                                                                 | ** ** | **June ****30,******** 2009** | ** ** | **December ****31,  2008** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|---------------------------------|------------|
| **ASSETS**                                                                                                                                 |       |                                    |       |                            |       |
| Current Assets:                                                                                                                            |       |                                    |       |                            |       |
| Cash and cash equivalents                                                                                                                  |       | $                                       | 136        |                            | $          | 554 |   |
| Accounts receivable                                                                                                                        |       | 289                                     |       | 341                             |       |
| Inventories, net                                                                                                                           |       | 6                                       |       | 20                              |       |
| Prepaid expenses                                                                                                                           |       | 58                                      |       | 56                              |       |
| Total  current assets                                                                                                                      |       | 489                                     |       | 971                             |       |
| Property and equipment, net                                                                                                                |       | 134                                     |       | 169                             |       |
| Other assets                                                                                                                               |       | 39                                      |       | 39                              |       |
| TOTAL ASSETS                                                                                                                               |       | $                                       | 662        |                            | $          | 1,179 |   |
|                                                                                                                                       |       |                                    |       |                            |       |
| **LIABILITIES AND STOCKHOLDERS’ DEFICIT**                                                                                             |       |                                    |       |                            |       |
|                                                                                                                                       |       |                                    |       |                            |       |
| Current Liabilities:                                                                                                                       |       |                                    |       |                            |       |
| Accounts payable and accrued expenses                                                                                                      |       | $                                       | 547        |                            | $          | 538 |   |
| Loan payable to officer                                                                                                                    |       | 835                                     |       | 480                             |       |
| Dividends payable                                                                                                                          |       | 276                                     |       | 187                             |       |
| Deferred revenue                                                                                                                           |       | 416                                     |       | 1,090                           |       |
| Total current liabilities                                                                                                                  |       | 2,074                                   |       | 2,295                           |       |
|                                                                                                                                       |       |                                    |       |                            |       |
| Commitments and contingencies                                                                                                              |       |                                    |       |                            |       |
| Stockholders’ deficit:                                                                                                                |       |                                    |       |                            |       |
| Preferred stock, $0.01 par value:  Authorized shares — 5,000                                                                          |       |                                    |       |                            |       |
| Series 1 shares issued and outstanding  — 220 in 2009 and 260 in 2008 Liquidation preference of $1,212 as of  June 30, 2009 |       | 778                                     |       | 918                             |       |
| Series 2 shares issued and outstanding  — 460 Liquidation preference of $1,241 as of June 30, 2009                          |       | 724                                     |       | 724                             |       |
| Series 3 shares issued and outstanding  — 354 Liquidation preference of $834 as of June 30, 2009                            |       | 504                                     |       | 504                             |       |
| Common stock, $0.01 par value:                                                                                                             |       |                                    |       |                            |       |
| Authorized shares — 80,000                                                                                                            |       |                                    |       |                            |       |
| Issued shares — 11,715 in 2009 and 11,648  in 2008                                                                                    |       |                                    |       |                            |       |
| Outstanding shares — 11,705 in 2009 and  11,638 in 2008                                                                               |       | 117                                     |       | 116                             |       |
| Common stock held in treasury, at cost — 10  shares                                                                                   |       | (362                                    | )          | (362                            | )          |
| Additional paid-in capital                                                                                                                 |       | 55,558                                  |       | 55,443                          |       |
| Accumulated deficit                                                                                                                        |       | (58,552                                 | )          | (58,280                         | )          |
| Accumulated other comprehensive loss                                                                                                       |       | (179                                    | )          | (179                            | )          |
| Total stockholders’ deficit                                                                                                           |       | (1,412                                  | )          | (1,116                          | )          |
| TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT                                                                                           |       | $                                       | 662        |                            | $          | 1,179 |   |

 

Seeaccompanying notes.

 

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

 
| ** **                                                                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended**   | ** ** |
|-------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                          | ** ** | **June 30, 2009** | ** ** | **June 30, 2008** | ** ** | **June 30, 2009** | ** ** | **June 30, 2008** | ** ** |
| Net product revenue                                                                 |       | $                      | 1,217      |                   | $          | 1,132 |   | $ | 1,977 |   | $ | 1,431 |   |
| Net customer support and maintenance  revenue                                       |       | 75                     |       | 151                    |       | 171 |   | 315 |   |
| Total revenue                                                                       |       | 1,292                  |       | 1,283                  |       | 2,148 |   | 1,746 |   |
| Cost of product revenue                                                             |       | 429                    |       | 434                    |       | 701 |   | 608 |   |
| Cost of customer support and maintenance  revenue                                   |       | 4                      |       | 6                      |       | 9 |   | 12 |   |
| Total cost of revenue                                                               |       | 433                    |       | 440                    |       | 710 |   | 620 |   |
|                                                                                |       |                   |       |                   |       |   |   |   |   |
| Gross profit                                                                        |       | 859                    |       | 843                    |       | 1,438 |   | 1,126 |   |
|                                                                                |       |                   |       |                   |       |   |   |   |   |
| Operating expenses:                                                                 |       |                   |       |                   |       |   |   |   |   |
| Sales and marketing                                                                 |       | 270                    |       | 361                    |       | 534 |   | 732 |   |
| Research and development                                                            |       | 251                    |       | 195                    |       | 617 |   | 710 |   |
| General and administrative                                                          |       | 273                    |       | 230                    |       | 532 |   | 496 |   |
|                                                                                |       |                   |       |                   |       |   |   |   |   |
| Operating income (loss)                                                             |       | 65                     |       | 57                     |       | (245 | ) | (812 | ) |
|                                                                                |       |                   |       |                   |       |   |   |   |   |
| Interest expense, net                                                               |       | (15                    | )          | (16                    | )          | (26 | ) | (22 | ) |
|                                                                                |       |                   |       |                   |       |   |   |   |   |
| Income (loss) before income tax provision                                           |       | 50                     |       | 41                     |       | (271 | ) | (834 | ) |
|                                                                                |       |                   |       |                   |       |   |   |   |   |
| Income tax provision                                                                |       | —                 |       | —                 |       | — |   | — |   |
|                                                                                |       |                   |       |                   |       |   |   |   |   |
| Net income (loss)                                                                   |       | $                      | 50         |                   | $          | 41 |   | $ | (271 | ) | $ | (834 | ) |
|                                                                                |       |                   |       |                   |       |   |   |   |   |
| Preferred stock dividends accrued                                                   |       | (39                    | )          | (40                    | )          | (78 | ) | (105 | ) |
| Net income (loss) attributable to common  stockholders                              |       | $                      | 11         |                   | $          | 1 |   | $ | (349 | ) | $ | (939 | ) |
|                                                                                |       |                   |       |                   |       |   |   |   |   |
| Net income (loss) per share attributable to  common stockholders, basic and diluted |       | $                      | 0.00       |                   | $          | 0.00 |   | $ | (0.03 | ) | $ | (0.08 | ) |
|                                                                                |       |                   |       |                   |       |   |   |   |   |
| Weighted average common shares outstanding:                                         |       |                   |       |                   |       |   |   |   |   |
| Basic                                                                               |       | 11,664                 |       | 11,638                 |       | 11,652 |   | 11,638 |   |
| Diluted                                                                             |       | 13,117                 |       | 11,638                 |       | 11,652 |   | 11,638 |   |

 

Seeaccompanying notes.

 

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

 
| ** **                                                                   | ** ** | **Six Months Ended**    | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                   | ** ** | **June 30,  2009** | ** ** | **June 30,  2008** | ** ** |
| Operating Activities:                                                        |       |                    |       |   |   |
| Net loss                                                                     |       | $                       | (271       | ) | $ | (834 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                    |       |   |   |
| Depreciation and amortization                                                |       | 35                      |       | 23 |   |
| Stock-based compensation                                                     |       | 50                      |       | 29 |   |
| Changes in operating assets and  liabilities:                                |       |                    |       |   |   |
| Accounts receivable                                                          |       | 52                      |       | (444 | ) |
| Inventories                                                                  |       | 14                      |       | 64 |   |
| Prepaid expenses and other assets                                            |       | (2                      | )          | 10 |   |
| Accounts payable and accrued expenses                                        |       | 22                      |       | (32 | ) |
| Deferred revenue                                                             |       | (674                    | )          | (46 | ) |
| Net cash used in operating activities                                        |       | (774                    | )          | (1,230 | ) |
| Financing Activities:                                                        |       |                    |       |   |   |
| Net activity under line of credit                                            |       | —                  |       | (100 | ) |
| Borrowings from officer                                                      |       | 355                     |       | 1,180 |   |
| Proceeds from stock options exercised                                        |       | 1                       |       | — |   |
| Net cash provided by financing activities                                    |       | 356                     |       | 1,080 |   |
|                                                                         |       |                    |       |   |   |
| Net decrease in cash and cash equivalents                                    |       | (418                    | )          | (150 | ) |
| Cash and cash equivalents at beginning of  period                            |       | 554                     |       | 362 |   |
| Cash and cash equivalents at end of period                                   |       | $                       | 136        |   | $ | 212 |   |
|                                                                         |       |                    |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON CASH FINANCING  ACTIVITIES:                   |       |                    |       |   |   |
|                                                                         |       |                    |       |   |   |
| Preferred stock dividends accrued                                            |       | $                       | 74         |   | $ | 106 |   |
| Series 1 preferred stock converted to  common stock                     |       | $                       | 140        |   | $ | — |   |

 

Seeaccompanying notes.

 

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**INTRUSION INC. AND SUBSIDIARIES**

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.     Description of Business

 

We develop, market and support a family of entity identification,regulated information compliance, data privacy protection, data leak preventionand network intrusion prevention/detection products.  Our product families include:  TraceCopTM for identitydiscovery and disclosure, Compliance CommanderTM for regulated information compliance, leak protection and dataprivacy protection, and Intrusion SecureNetTM for network intrusion prevention and detection.  Our products help protect critical informationassets by quickly detecting, protecting, analyzing and reporting attacks ormisuse of classified, private and regulated information for government andenterprise networks.

 

Our TraceCop products include:  (1) databasescontaining IP addresses which are continually updated and used in thedetermination of the origination of cyber based attacks or other cyber basedcrimes; (2) analysis software used for the location of cyber based attacksand (3) data collected relative to the location of the crimes.

 

We market and distribute our products through a direct sales force toend-users, distributors and system integrators, managed service providers andvalue-added resellers. Our end-user customers include U.S. federal governmententities, banks, credit unions, other financial institutions, foreigngovernment entities and local government entities, hospitals and otherhealthcare providers, and academic institutions.

 

We were organized in Texas in September 1983 and reincorporated inDelaware in October 1995. For more than 15 years, we provided localarea networking equipment and were known as Optical Data Systems or ODSNetworks. On April 17, 2000, we announced plans to sell, or otherwisedispose of, our networking divisions, which included our Essential Communicationsdivision and our local area networking assets. On June 1, 2000, we changedour name from ODS Networks, Inc. to Intrusion.com, Inc., and ourticker symbol from ODSI to INTZ to reflect our focus on intrusion preventionand detection solutions, along with information compliance and data privacyprotection products. On November 1, 2001, we changed our name fromIntrusion.com, Inc. to Intrusion Inc.

 

Our principal executive offices are located at 1101 East Arapaho Road, Suite 200,Richardson, Texas 75081, and our telephone number is (972) 234-6400.  Our website URL is www.intrusion.com.  References to “we”, “us”, “our” or “Intrusion Inc.”refer to Intrusion Inc. and its subsidiaries.  Compliance CommanderTM, SecureNetTM andTraceCopTM are trademarks of Intrusion Inc.

 

As of June 30, 2009, we had cash and cash equivalents ofapproximately $136,000, down from approximately $554,000 as of December 31,2008 and a working capital deficit totaling $1.58 million.  We used $243,000 of cash in operations in thesecond quarter 2009 and operating cash outflows may continue in 2009 andpossibly beyond.  As of June 30,2009, in addition to cash and cash equivalents of $136,000, we had $177,000 infunding available under our $1.25 million line of credit at Silicon ValleyBank, and $1.4 million funding available from a written commitment toinvest up to $1.5 million from G. Ward Paxton, our Chairman, President andChief Executive Officer (the “CEO”).  Basedon projections of growth in revenue and net income in the coming quarters, andthe borrowings available previously mentioned, we believe that we willhave  sufficient cash resources tofinance our operations and expected capital expenditures for the next twelvemonths.  We expect to fund our operations throughCompany profits, our line of credit, borrowings from the Company’s CEO, andpossibly additional investments of private equity and debt, which, if we areable to obtain, will have the effect of diluting our existing commonstockholders, perhaps significantly.  Anyequity or 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. If our operations do not generate positive cash flow inthe upcoming year, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

2.     Basis of Presentation

 

The accompanying unauditedcondensed consolidated financial statements have been prepared in accordancewith accounting principles generally accepted in the United States for interimfinancial information and with the instructions to Form 10-Q and Item10-01 of Regulation S-X.  Accordingly,they do not include all of the information and footnotes required by accountingprinciples generally accepted in the United States for complete financialstatements.  The December 31, 2008balance 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 ended June 30,2009 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 our annual report on Form 10-K for the yearended December 31, 2008, filed with the U.S. Securities and ExchangeCommission (the

 

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“SEC”) on March 27,2009.

 

The Companycalculates the fair value of its assets and liabilities which qualify asfinancial instruments and includes this additional information in the notes toconsolidated financial statements when the fair value is different than thecarrying value of these financial instruments. The estimated fair value ofaccounts receivable, accounts payable and accrued expenses, and dividendspayable approximate their carrying amounts due to the relatively short maturityof these instruments. The carrying value of loans payable to officer alsoapproximates fair value since these instruments bear market rates of interest.None of these instruments are held for trading purposes.

 

3.     Inventories (In thousands)

 
| ** **                     | ** ** | **June 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|--------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                           |       |                    |       |                        |       |
| Inventories consist of:        |       |                    |       |                        |       |
|                           |       |                    |       |                        |       |
| Finished goods                 |       | $                       | 57         |                        | $          | 67 |   |
| Demonstration systems          |       | 1                       |       | 5                           |       |
| Reserve for obsolete inventory |       | (52                     | )          | (52                         | )          |
| Net inventory                  |       | $                       | 6          |                        | $          | 20 |   |

 

4.     Loan Payable to Officer

 

On January 30, 2008, we enteredinto a revolving promissory note to borrow up to $700,000 from G. WardPaxton, the Company’s Chairman, President and Chief Executive Officer.    Under the terms of the note, the Companymay borrow, repay and reborrow on the loan as needed up to an outstandingprincipal amount of $700,000 at any date. All outstanding principal and accrued but unpaid interest was originallydue on December 31, 2008 but was extended on March 19, 2009 to matureon March 31, 2010.  As of June 30,2009, we had borrowings of $700,000 outstanding from the note with accruedinterest payable of $16,000.  On March 20,2008, we received a written commitment from our Chief Executive Officerto invest up to an additional $1.5 million in the Company until March 2009,should such funding be required by the Company. This commitment to continue to advance additional funds as needed wasextended on November 7, 2008 to mature in March 2010.  As of June 30, 2009, we hadborrowings of $135,000 outstanding under the commitment.  Amountsthe Company borrows under the note and the commitment accrue interest at afloating rate per annum equal to the announced prime rate of Silicon ValleyBank (“SVB”) plus 1% and are unsecured.

 

5.     Line of Credit

 

On March 29, 2006,we entered into a Loan and Security Agreement with Silicon Valley Bank (“SVB”)to establish a $1.0 million line of credit with SVB (the “2006 Credit Line”).  On June 30, 2008, we entered into anAmended and Restated Loan and Security Agreement with SVB to, among otherthings, replace the 2006 Credit Line with a $2.5 million line of credit (the “2008Credit Line”).  On June 28, 2009, weentered into the First Amendment to Amended and Restated Loan and SecurityAgreement (the “Loan Agreement”) with SVB to replace the 2008 Credit Line witha $1.25 million line of credit (the “Current Line of Credit”).  Our obligations under the Loan Agreement aresecured by substantially all of our assets, including all of our intellectualproperty.  In addition, G. Ward Paxton,the Company’s Chief Executive Officer, has established a Guaranty Agreementwith SVB for all outstanding balances under the Current Line of Credit.  Borrowings under the Current Line of Creditare based on advances (each an “Advance”) against certain of our accountsreceivable that are approved by SVB (each an “Eligible Account”).  SVB may make an Advance of up to eightypercent (80%) of each Eligible Account, or such other percentage SVB maydetermine in its sole discretion.  EachAdvance is subject to a finance charge calculated as a daily rate that is basedon a 360-day annual rate of the greater of the prime rate or 5.25%, plus2.0%.  Finance charges are payable at thesame time its related Advance is due. Each Advance is also subject to a monthly collateral handling fee of0.5% of all outstanding Advances, depending on certain qualifying financialfactors specified in the Loan Agreement. The collateral handling fee is payable at the same time its relatedAdvance is due.  Each Advance must berepaid at the earliest of (a) the date that the Eligible Account relatedto the Advance is paid, (b) the date the Eligible Account is no longereligible under the Amended and Restated Loan Agreement, or (c) the date onwhich any “Adjustment” (as defined in the Loan Agreement) is asserted to theEligible Account.  On June 27, 2010,the Loan Agreement terminates and all outstanding Advances, accrued but unpaidfinance charges, outstanding collateral handing fees, and other amounts becomedue under the Amended and Restated Loan Agreement and related documents.  We have certain non-financial and financialcovenants, including a liquidity coverage ratio and a rolling EBITDAcomputation, as defined in the Loan Agreement. We have no borrowings outstanding under the Current Line of Credit as ofJune 30, 2009 and had borrowings available of $177,000.

 

6.     Accounting for Stock-Based Compensation

 

Duringthe three month period ended June 30, 2009 and 2008, the Company granted15,000 stock options to employees and directors in each period.  The Company recognized $33,000 and $24,000,respectively, stock-based compensation expense for the

 

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three month periods ended June 30,2009 and 2008.  During the six monthperiod ended June 30, 2009 and 2008, the Company granted 491,000 and442,000, respectively, stock options to employees and directors.  The Company recognized $50,000 and $29,000,respectively, stock-based compensation expense for the six month period ended June 30,2009 and 2008.

 

Duringthe three month period ended June 30, 2009 and 2008, 3,001and 0,respectively, options were exercised under the 2005 Plan.   During the six month period ended June 30,2009 and 2008, 3,001and 0, respectively, options were exercised under the 2005Plan.

 

Valuation Assumptions

 

The fair values of option awards were estimated at the date of grantusing a Black-Scholes option-pricing model with the following assumptions:

 
| ** **                             | ** ** | **For Three Months Ended  June 30, 2009** | ** ** | **For Three Months Ended  June 30, 2008** | ** ** | **For Six  Months Ended  June 30, 2009** | ** ** | **For Six  Months Ended  June 30, 2008** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------|------------|------------------------------------------------|------------|----------------------------------------------------|------------|-----------------------------------------------|------------|
|                                   |       |                                                |       |                                           |       |                                               |       |                                          |       |
| Weighted average grant date fair value |       | $                                                   | 0.39       |                                           | $          | 0.16                                               |       | $                                             | 0.26       |   | $ | 0.17 |   |
| Weighted average assumptions used:     |       |                                                |       |                                           |       |                                               |       |                                          |       |
| Expected dividend yield                |       | 0.0                                                 | %          | 0.0                                            | %          | 0.0                                                | %          | 0.0                                           | %          |
| Risk-free interest rate                |       | 2.1                                                 | %          | 3.4                                            | %          | 1.9                                                | %          | 2.6                                           | %          |
| Expected volatility                    |       | 177.0                                               | %          | 111.0                                          | %          | 163.5                                              | %          | 107.1                                         | %          |
| Expected life (in years)               |       | 5.0                                                 |       | 5.0                                            |       | 4.89                                               |       | 5.0                                           |       |
|                                        |            |                                                     |            |                                                |            |                                                    |            |                                               |            |  |  |  |  |

 

Expected volatility is based on historical volatility and in part onimplied volatility.  The expected lifeconsiders the contractual term of the option as well as historical exercise andforfeiture behavior.  The risk-freeinterest rate is based on the rates in effect on the grant date for U.S.Treasury instruments with maturities matching the relevant expected term of theaward. Options granted to non-employees are valued using the fair market valueon each measurement date of the option.

 

7.     Preferred Stock

 

During the three month period ended June 30, 2009, 39,696 sharesof our 5% preferred stock were converted into 63,129 shares of our commonstock.  At June 30, 2009 there are220,000 shares of our 5% preferred stock outstanding, convertible into 349,871shares of common stock.

 

8.     Net Loss Per Share

 

Basic net loss per share iscomputed by dividing net loss attributable to common stockholders for theperiod by the weighted average number of common shares outstanding for theperiod.  Diluted net loss per share iscomputed by dividing the net loss attributable to common stockholders by theweighted average number of common shares and dilutive common stock equivalentsoutstanding for the period.  Our commonstock equivalents include all common stock issuable upon conversion ofpreferred stock and the exercise of outstanding options and warrants.  The aggregate number of common stockequivalents excluded from the diluted earnings per share calculation for the threemonth periods ending June 30, 2009 and 2008 are 1,848,486 and 4,227,826,respectively as they are antidilutive. In addition, for the six month periodending June 30, 2009 and 2008, 4,050,118 and 4,227,826 common stockequivalents are not included in the diluted loss per share as they are antidilutive.

 

9.     Concentrations

 

Our operations are concentrated in one area—security software/entityidentification.  Sales to the U.S.Government through direct and indirect channels totaled 94.2% of total revenuesfor the second quarter of 2009 compared to 86.5% of total revenues the secondquarter of 2008.  During the secondquarter of 2009 approximately 94.0% of total revenues are attributable to threegovernment customers compared to approximately 82.3% of total revenuesattributable to two government customers in the second quarter of 2008.  There were no individual commercial customersin the second quarter of 2009 or 2008 that exceeded 10% of total revenues forthat quarter.  Our similar product andservice offerings are not viewed as individual segments, as our managementanalyzes the business as a whole and expenses are not allocated to each productoffering.

 

10.   Commitments and Contingencies

 

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

 

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11.   Dividends Payable

 

During the quarter ended June 30, 2009, we accrued $15,000 individends to the holders of our 5% Preferred Stock, $14,000 in dividends to theholders of our Series 2 5% Preferred Stock and $10,000 in dividends to theholders of our Series 3 5% Preferred Stock.  As of June 30, 2009, we have $276,000 inaccrued and unpaid dividends included in other current liabilities.  Delaware law provides that we may only paydividends out of our capital surplus or, if no surplus is available, out of ournet profits for the fiscal year the dividend is declared and/or the precedingfiscal year.  We have not had net profitsfor the last two fiscal years and did not have sufficient capital surplus,defined as the amount by which our net assets exceed our stated capital, basedon par value of our outstanding shares as provided by Delaware law.  These dividends continue to accrue on all ouroutstanding shares of preferred stock, regardless of whether we are legallyable to pay them.  Because we were unableto pay dividends on our preferred stock, we began accruing an additional latefee penalty of 18% per annum on the unpaid dividends for the Series 2Preferred Stock and Series 3 Preferred Stock.  Total penalties accrued during the quarterended June 30, 2009 were approximately $4,000.  Our CEO, CFO and one member of our Board ofDirectors, who own preferred stock, have waived the late fee penalty so we haverecorded approximately $2,000 as contributed capital during the quarter relatedto these waivers.  In addition to thislate penalty, the holders of our Series 2 Preferred Stock and Series 3Preferred Stock could elect to present us with written notice of our failure topay dividends as scheduled, in which case we would have 45 days to cure such abreach.  In the event that we failed tocure the breach, the holders of these shares of preferred stock would then havethe right to require us to redeem their shares of preferred stock for a cashamount calculated in accordance with their respective certificates ofdesignation.  If we were required toredeem all shares of Series 2 Preferred Stock and Series 3 PreferredStock as of July 31, 2009, the aggregate redemption price we would owewould be $2.2 million.

 

12.   Recent Accounting Pronouncements

 

In May 2009,the FASB issued SFAS No. 165, *Subsequent Events*(“SFAS 165”), which establishes general standards of accounting for, and requiresdisclosure of, events that occur after the balance sheet date but beforefinancial statements are issued or are available to be issued.  TheCompany adopted the provisions of SFAS 165 as of June 30,2009.  The adoption of these provisions did not have a significantimpact on the Company’s financial statements.

 

In June 2009,the FASB issued Statement No. 168, *TheFASB Accounting Standards Codification and the Hierarchy of Generally AcceptedAccounting Principles* (“SFAS 168”).  SFAS 168 will becomethe single source of authoritative nongovernmental U.S. generally acceptedaccounting principles (“GAAP”), superseding existing FASB, American Instituteof Certified Public Accountants (“AICPA”), Emerging Issues Task Force (“EITF”),and related accounting literature.  SFAS 168 reorganizes thethousands of GAAP pronouncements into roughly 90 accounting topics and displaysthem using a consistent structure.  Also included is relevantSecurities and Exchange Commission guidance organized using the same topicalstructure in separate sections.  SFAS 168 will be effective forfinancial statements issued for reporting periods that end after September 15,2009.  This will have an impact on the Company’s financial statementssince all future references to authoritative accounting literature will bereferences in accordance with SFAS 168.

 

13.   Subsequent Events

 

Managementperformed an evaluation of the Company’s activities through August 12th, 2009, andhas concluded that there are no significant subsequent events requiringdisclosure through the date these financial statements were issued.

 

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

 

Forward LookingStatements

 

This Quarterly Report on Form 10-Q,including, without limitation, the section entitled “Management’s Discussionand Analysis of Financial Condition and Results of Operations,” containsforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended and Section 21E of the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”). Such forward-lookingstatements are generally accompanied by words such as “estimate,” “expect,” “believe,”“should,” “would,” “could,” “anticipate,” “may” or other words that conveyuncertainty of future events or outcomes. These statements relate to future events or to our future financialperformance, and involve known and unknown risks, uncertainties and otherfactors that may cause our actual results, levels of activity, performance, orachievements to be materially different from any future results, levels ofactivity, performance or achievements expressed or implied by theseforward-looking statements. Factors that may cause actual results to differmaterially from current expectations, which we describe in more detailelsewhere in this Quarterly Report on Form 10-Q  under the heading “Factors That May AffectFuture Results of Operations,” and in our 2008 Annual Report on Form 10-Kin “Item 1 — Description of Business” include, but are not limited to:

 

·                  insufficient cash to operate ourbusiness and inability to meet our liquidity requirements;

 

·                  loss of revenues due to the failureof our newer products to achieve market acceptance;

 

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·                  our need to continue current revenueslevels in order to sustain profitability;

 

·                  concentration of our revenues fromU.S. government entities and the possibility of loss of one of these customersand the  unique risks associated withgovernment customers;

 

·                  our dependence on sales made throughindirect channels;

 

·                  the challenge of selling our productsinternationally;

 

·                  our dependence on equity or debtfinancing provided primarily by our Chief Executive Officer in order to meetour cash flow requirements;

 

·                  the effect that payment of accrueddividends on our preferred stock has on our cash resources and the substantialdilution upon the conversion or redemption of our preferred stock and exerciseof outstanding warrants;

 

·                  the impact of conversion of preferredstock or exercise of warrants on the price of our common stock;

 

·                  the ability of our preferredstockholders and lenders to hinder additional financing; and

 

·                  the influence that our management andlarger stockholders have over actions taken by the Company.

 

If one or more of theseor other risks or uncertainties materialize, or if our underlying assumptionsprove to be incorrect, actual results may vary significantly from what weprojected. These forward-looking statements and other statements made elsewherein this report are made in reliance on the Private Securities Litigation ReformAct of 1995.  Any forward-looking statementyou read in this Quarterly Report on Form 10-Q or our Annual Report on Form 10-Kreflects our current views with respect to future events and is subject tothese and other risks, uncertainties and assumptions relating to ouroperations, results of operations, growth strategy and liquidity. We assume noobligation to publicly update or revise these forward-looking statements forany reason, or to update the reasons actual results could differ materiallyfrom those anticipated in these forward-looking statements, even if newinformation becomes available in the future. The section below entitled “Factors That May Affect Future Resultsof Operations” sets forth and incorporates by reference certain factors thatcould cause actual future results of the Company to differ materially fromthese statements.

 

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Results of Operations

 

The following table setsforth, for the periods indicated, certain financial data as a percentage of netrevenues. The period-to-period comparison of financial results is notnecessarily indicative of future results.

 
| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended**   | ** ** |
|--------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                             | ** ** | **June 30, 2009** | ** ** | **June 30, 2008** | ** ** | **June 30, 2009** | ** ** | **June 30, 2008** | ** ** |
| Net product revenue                                    |       | 94.2                   | %          | 88.2                   | %          | 92.1 | % | 82.0 | % |
| Net customer support and maintenance  revenue          |       | 5.8                    |       | 11.8                   |       | 7.9 |   | 18.0 |   |
| Total revenue                                          |       | 100.0                  |       | 100.0                  |       | 100.0 |   | 100.0 |   |
| Cost of product revenue                                |       | 33.2                   |       | 33.8                   |       | 32.6 |   | 34.8 |   |
| Cost of customer support and maintenance  revenue      |       | 0.3                    |       | 0.5                    |       | 0.4 |   | 0.7 |   |
| Total cost of revenue                                  |       | 33.5                   |       | 34.3                   |       | 33.0 |   | 35.5 |   |
| Gross profit                                           |       | 66.5                   |       | 65.7                   |       | 67.0 |   | 64.5 |   |
| Operating expenses:                                    |       |                   |       |                   |       |   |   |   |   |
| Sales and marketing                                    |       | 20.9                   |       | 28.2                   |       | 24.9 |   | 41.9 |   |
| Research and development                               |       | 19.5                   |       | 15.2                   |       | 28.7 |   | 40.7 |   |
| General and administrative                             |       | 21.1                   |       | 17.9                   |       | 24.8 |   | 28.4 |   |
|                                                   |       |                   |       |                   |       |   |   |   |   |
| Operating income (loss)                                |       | 5.0                    |       | 4.4                    |       | (11.4 | ) | (46.5 | ) |
|                                                   |       |                   |       |                   |       |   |   |   |   |
| Interest expense                                       |       | (1.1                   | )          | (1.2                   | )          | (1.2 | ) | (1.3 | ) |
| Income (loss) before income tax provision              |       | 3.9                    |       | 3.2                    |       | (12.6 | ) | (47.8 | ) |
|                                                   |       |                   |       |                   |       |   |   |   |   |
| Income tax provision                                   |       | —                 |       | —                 |       | — |   | — |   |
|                                                   |       |                   |       |                   |       |   |   |   |   |
| Net income (loss)                                      |       | 3.9                    | %          | 3.2                    | %          | (12.6 | )% | (47.8 | )% |
| Preferred stock dividends accrued                      |       | (3.0                   | )          | (3.1                   | )          | (3.6 | ) | (6.0 | ) |
|                                                   |       |                   |       |                   |       |   |   |   |   |
| Net income (loss) attributable to common  stockholders |       | 0.9                    | %          | 0.1                    | %          | (16.2 | )% | (53.8 | )% |

 
| ** **          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended**   | ** ** |
|---------------------|------------|------------------------|------------|------------------------|------------|
| ** **          | ** ** | **June 30, 2009** | ** ** | **June 30, 2008** | ** ** | **June 30, 2009** | ** ** | **June 30, 2008** | ** ** |
| Domestic revenues   |       | 99.1                   | %          | 96.6                   | %          | 98.1 | % | 93.4 | % |
| Export revenues to: |       |                   |       |                   |       |   |   |   |   |
| Europe              |       | 0.8                    |       | 3.0                    |       | 1.6 |   | 5.9 |   |
| Canada              |       | —                 |       | 0.1                    |       | — |   | 0.1 |   |
| Asia                |       | —                 |       | 0.2                    |       | 0.1 |   | 0.4 |   |
| Latin America       |       | 0.1                    |       | 0.1                    |       | 0.2 |   | 0.2 |   |
|                |       |                   |       |                   |       |   |   |   |   |
| Net revenues        |       | 100.0                  | %          | 100.0                  | %          | 100.0 | % | 100.0 | % |

 

**NetRevenues**.  Net revenues for the quarter and sixmonths ended June 30, 2009 were $1.3 million and $2.1 million,respectively, compared to $1.3 million and $1.7 million for the same periods in2008.  Product revenues increased $85thousand for the quarter ended June 30,2009, and increased $0.5 million for the six months ended June 30,2009 compared to the same periods in 2008. Customer support and maintenance revenue decreased $76 thousand and $144thousand for the quarter and six months ended June 30, 2009 compared tothe same periods in 2008.  This decreasewas due to the current sales mix with a high concentration of government salesnot requiring a maintenance contract.

 

**Concentrationof Revenues**.  Revenues from sales to various U.S.government entities totaled $1.2 million, or 94.2% of revenues, for the quarterended June 30, 2009 compared to $1.1 million, or 86.5% of revenues, forthe same period in 2008.  Revenues fromsales to various U.S. government entities totaled $2.0 million, or 92.2% ofrevenues, for the six months ended June 30, 2009 compared to $1.4 million,or 79.6% of revenues, for the same period in 2008.    Although we expect our concentration ofrevenues to vary among customers in future periods depending upon the timing ofcertain sales, we anticipate that sales to government customers will continueto account for a significant portion of our revenues in future periods.  Sales to the government present risks inaddition to those involved in sales to commercial customers which couldadversely affect our revenues, including, without limitation, potentialdisruption to appropriation and spending patterns and the government’sreservation of the right to cancel contracts and purchase orders for itsconvenience.  Although we do not believethat a material portion of our revenues with government customers is subject to

 

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renegotiation, a large number of cancelled orrenegotiated government orders could have a material adverse effect on ourfinancial results.  Currently, we are notaware of any proposed cancellation or renegotiation of any of our existingarrangements with government entities and, historically, government entitieshave not cancelled or renegotiated orders which had a material adverse effecton our business.

 

**Gross Profit**.  Gross profitwas $0.9 million or 66.5% of net revenues for the quarter ended June 30,2009, compared to $0.8 million or 65.7% of net revenues for the quarter ended June 30,2008.  Gross profit was $1.4 million or67.0% of net revenues for the six months ended June 30, 2009 compared to$1.1 million or 64.5% of net revenues for the six months ended June 30,2008.   Gross profit on product revenuesfor the quarter and six months ended June 30, trended from 61.6% and57.5%, respectively, in 2008 to 64.7% and 64.6%, respectively, in 2009 mainlydue to an increase in net revenues and/or decreases in fixed costs.  Gross profit on customer support andmaintenance revenues for the quarter and six months ended June 30, trendedfrom 96.1% and 96.4%, respectively, in 2008 to 94.8% and 94.6%, respectively,in 2009.  Gross profit as a percentage of net revenues isimpacted by several factors, including shifts in product mix, changes inchannels of distribution, revenue volume, pricing strategies, and fluctuationsin revenues of integrated third-party products.

 

**Sales and Marketing**.  Sales andmarketing expenses decreased to $0.3 million for the quarter ended June 30,2009, compared to $0.4 million for the quarter ended June 30, 2008. Salesand marketing expenses decreased to $0.5 million for the six months ended June 30,2009, compared to $0.7 million for the six months ended June 30, 2008primarily due to a planned reduction in sales and marketing relatedexpenses.  Sales and marketing expensesmay vary in the future.  However, webelieve that these costs will remain relatively constant through the end of2009, although expenses may be increased relative to increases in revenue.

 

**Research and Development**.  Research anddevelopment expenses increased to $0.3 million for the quarter ended June 30,2009 compared to $0.2 million for the quarter ended June 30, 2008.Research and development expenses decreased to $0.6 million for the six monthsended June 30, 2009, compared to $0.7 million for the six months ended June 30,2008.  Research and developmentcosts are expensed in the period incurred. Research and development expenses fluctuated in the three months and sixmonths ended June 30, 2009, compared to the same periods in 2008 primarilydue to shifts from research and development expenses to cost of sales inrelation to engineering contract jobs. Research and development expenses may vary in the future; however, webelieve that these costs will remain relatively constant through the end of2009, although expenses may be increased relative to increases in revenue.

 

**General and Administrative**.  General andadministrative expenses increased to $0.3 million for the quarter ended June 30,2009 compared to $0.2 million for the quarter ended June 30, 2008.  General and administrative expenses remainedat $0.5 million for the six months ended June 30, 2009, compared to $0.5million for the six months ended June 30, 2008.  It is expectedthat general and administrative expenses will remain relatively constantthroughout the remainder of 2009, although expenses may be increased relativeto increases in revenue.

 

**Interest**.  Interestexpense decreased to $15 thousand for the quarter ended June 30, 2009compared to $16 thousand for the same period in 2008.  Interest expense increased to $26 thousandfor the six months ended June 30, 2009 compared to $22 thousand for thesame period in 2008.  The decrease ininterest income was primarily due to a decrease of cash and short-terminvestment balances when compared to the prior year and an increase in interestexpense related to the line of credit. Net interest income may vary in the future based on our cash flow andrate of return on investments.

 

Liquidity and Capital Resources

 

Our principal source of liquidity at June 30,2009 is approximately $136 thousand of cash and cash equivalents.  At June 30, 2009, we had a workingcapital deficiency of $1.6 million compared to a $1.3 million deficiency at June 30,2008.

 

Cash used in operations forthe six months ended June 30, 2009 was $0.8 million, primarily due to anet loss of $0.3 million, decreases in deferred revenue of $0.7 million and anincrease in prepaid expenses and other assets of $2 thousand.  This cash decrease was partially offset bydepreciation expense of $35 thousand, stock-based compensation expense of $50thousand, a decrease in accounts receivable of $52 thousand, a decrease ininventories of $15 thousand, and an increase accounts payable and accruedexpenses of $22 thousand.  Cash used inoperations for the six months ended June 30, 2008 was $1.2 million,primarily due to a net loss of $0.8 million, an increase in accounts receivableof $444 thousand and decreases in deferred revenue of $46 thousand and accountspayable and accrued expense of $32 thousand. This cash decrease was partially offset by depreciation expense of $23thousand, stock-based compensation expense of $29 thousand, a decrease ininventories of $64 thousand, and a decrease in prepaid expenses and otherassets of $10 thousand.   Futurefluctuations in inventory balances, accounts receivable and accounts payablewill be dependent upon several factors, including, but not limited to,quarterly sales, our strategy in building inventory in advance of receivingorders from customers, and the accuracy of our forecasts of product demand andcomponent requirements.

 

There was no cash used ininvesting activities in the six months ended June 30, 2009 and 2008.

 

Cash provided by financing activities in the sixmonths ended June 30, 2009 was $0.4 million, primarily consisting of theproceeds from a promissory note and commitment by our CEO, G. Ward Paxton, for$0.4 million compared to cash provided by

 

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financing activities in the six months ended June 30,2008 of $1.1 million, primarily consisting of the proceeds from a promissorynote and commitment by our CEO, G. Ward Paxton, for $1.2 million which wasoffset by repayments to the line of credit of $0.1 million.

 

At June 30, 2009,the Company did not have any material commitments for capital expenditures.

 

During the six monthsended June 30, 2009, the Company funded its operations through the use ofcash and cash equivalents, and borrowings of $355 thousand from our CEO, G.Ward Paxton.

 

On March 29, 2006,we entered into a Loan and Security Agreement with Silicon Valley Bank (“SVB”)to establish a $1.0 million line of credit with SVB.  On June 30, 2008, we entered into anAmended and Restated Loan and Security Agreement with SVB to, among otherthings, replace the 2006 Credit Line with a $2.5 million line of credit.  On June 28, 2009, we entered into theFirst Amendment to Amended and Restated Loan and Security Agreement (the “LoanAgreement”) with SVB to replace the 2008 Credit Line with a $1.25 million lineof credit (the “Current Line of Credit”). Our obligations under the Loan Agreement are secured by substantiallyall of our assets, including all of our intellectual property.  In addition, G. Ward Paxton, the Company’sChief Executive Officer, has established a Guaranty Agreement with SVB for alloutstanding balances under the Current Line of Credit.  Borrowings under the Current Line of Creditare based on advances (each, an “Advance”) against certain of our accountsreceivable that are approved by SVB (each an “Eligible Account”).  SVB may make an Advance of up to eightypercent (80%) of each Eligible Account, or such other percentage SVB maydetermine in its sole discretion.  EachAdvance is subject to a finance charge calculated as a daily rate that is basedon a 360-day annual rate of the greater of the prime rate or 5.25%, plus2.0%.  Finance charges are payable at thesame time its related Advance is due. Each Advance is also subject to a monthly collateral handling fee of0.5% of all outstanding Advances, depending on certain qualifying financialfactors specified in the Loan Agreement. The collateral handling fee is payable at the same time its relatedAdvance is due.  Each Advance must berepaid at the earliest of (a) the date that the Eligible Account relatedto the Advance is paid, (b) the date the Eligible Account is no longereligible under the Amended and Restated Loan Agreement, or (c) the date onwhich any “Adjustment” (as defined in the Loan Agreement) is asserted to theEligible Account.  On June 27, 2010,the Loan Agreement terminates and all outstanding Advances, accrued but unpaidfinance charges, outstanding collateral handing fees, and other amounts becomedue under the Amended and Restated Loan Agreement and related documents.  We have certain non-financial and financialcovenants, including a liquidity coverage ratio and a rolling EBITDAcomputation, as defined in the Loan Agreement. We have no borrowings outstanding under the Current Line of Credit as ofJune 30, 2009 and had borrowings available of $177,000.

 

Asof June 30, 2009, we had cash and cash equivalents of approximately$136,000, down from approximately $554,000 as of December 31, 2008 and aworking capital deficit totaling $1.58 million. We used $243,000 of cash in operations in the second quarter 2009 andoperating cash outflows may continue in 2009 and possibly beyond.  As of June 30, 2009, in addition to cashand cash equivalents of $136,000, we had $177 thousand in funding availableunder our $1.25 million line of credit at SVB, and $1.4 million fundingavailable from a written commitment to invest up to $1.5 million from G. Ward Paxton, ourCEO.  Based on projections ofgrowth in revenue and net income in the coming quarters, and the borrowingsavailable previously mentioned, we believe that we will have  sufficient cash resources to finance ouroperations and expected capital expenditures for the next twelve months. We expect to fund our operations through Company profits, our line ofcredit, borrowings from the Company’s CEO, and possibly additional investmentsof private equity and debt, which, if we are able to obtain, will have theeffect of diluting our existing common stockholders, perhapssignificantly.  Any equity or debtfinancings, if available at all, may be on terms which are not favorable to usand, in the case of equity financings, may result in dilution to ourstockholders. If our operations do not generate positive cash flow in theupcoming year, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

We may explore the possible acquisitions ofbusinesses, products and technologies that are complementary to our existingbusiness.  We are continuing to identifyand prioritize additional security technologies, which we may wish to develop,either internally or through the licensing, or acquisition of products fromthird parties.  While we may 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 be ableto 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.

 

Item 4T.                        CONTROLS AND PROCEDURES

 

We maintain “disclosurecontrols and procedures,” as defined in Rule 13a-15(e) under the ExchangeAct, that are designed to ensure that information required to be disclosed byus in reports we file or submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms, and that such information is accumulated and communicated to ourmanagement, including our principal executive officer and principal financialofficer, as appropriate, to allow timely decisions regarding requireddisclosure.  In designing and evaluatingour disclosure controls and procedures, management recognized that disclosurecontrols and procedures, no matter how well conceived and operated, can provideonly reasonable assurance of achieving the desired control objectives, and wenecessarily are required to apply our judgment in evaluating the cost-benefitrelationship of possible disclosure controls and procedures.

 

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Our management, includingour principal executive officer and principal financial officer, evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures as of June 30, 2009 and concluded that the disclosure controlsand procedures were effective.

 

There have not been anychanges in our internal control over financial reporting that occurred duringthe quarter ended June 30, 2009 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**PART II– OTHER INFORMATION**

 

Item 1.                                LEGAL PROCEEDINGS

 

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

 

Item 1A.                 RISKFACTORS

 

**Factors That May Affect Future Results of Operations**

 

Weare providing the following information regarding changes that have occurred topreviously disclosed risk factors from our Annual Report on Form 10-K forthe year ended December 31, 2008. In addition to the other information set forth below and elsewhere inthis report, you should consider the factors discussed under the heading “FactorsThat May Affect Future Results of Operations” in our Form 10-K forthe year ended December 31, 2008. The risks described in our Quarterly Reports on Form 10-Q are notthe only risks facing our Company. Additional risks and uncertainties not currently known to us or that wecurrently deem to be immaterial also may materially adversely affect ourbusiness, financial condition and/or operating results.

 

***Ourcash, cash equivalents, and investments decreased from $554 thousand at December 31,2008 to $136 thousand at June 30, 2009. If net cash outflows continue, we may not have sufficient cash tooperate our business and may not be able to maintain certain liquidity requirements.  Additional debt and equity offerings to fundfuture operations may not be available and, if available, may significantlydilute the value of our currently outstanding common stock.***

 

Asof June 30, 2009, we had cash and cash equivalents of approximately$136,000, down from approximately $554,000 as of December 31, 2008 and aworking capital deficit totaling $1.58 million. We used $243,000 of cash in operations in the second quarter 2009 andoperating cash outflows may continue in 2009 and possibly beyond.  As of June 30, 2009, in addition to cashand cash equivalents of $136,000, we had $177,000 in funding available underour $1.25 million line of credit at Silicon Valley Bank, and $1.4 millionfunding available from a written commitment to invest up to $1.5 million from G. Ward Paxton, ourCEO.  Based on projections ofgrowth in revenue and net income in the coming quarters, and the borrowingsavailable previously mentioned, we believe that we will have  sufficient cash resources to finance ouroperations and expected capital expenditures for the next twelve months. We expect to fund our operations through Company profits, our line ofcredit, borrowings from the Company’s CEO, and possibly additional investmentsof private equity and debt, which, if we are able to obtain, will have theeffect of diluting our existing common stockholders, perhapssignificantly.  Any equity or debtfinancings, if available at all, may be on terms which are not favorable to usand, in the case of equity financings, may result in dilution to ourstockholders. If our operations do not generate positive cash flow in theupcoming year, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

***Wehad a net income of $0.05 million for the quarter ended June 30, 2009, anet loss of $0.3 million for the six months ended June 30, 2009 and havean accumulated deficit of $58.6 million as of June 30, 2009.  To continue profitability, we must continueto generate current or increased revenue levels.***

 

For the quarter ended June 30,2009, we incurred a net income of $0.05 million and had an accumulated deficitof approximately $58.6 million as of June 30, 2009, compared to a netincome of $0.04 million for the quarter ended June 30, 2008 and anaccumulated deficit of approximately $58.3 million as of June 30, 2008. ** **We need to sustaincurrent or greater revenue levels from the sales of our products if we are tosustain profitability.  If we are unableto achieve these revenue levels, losses could happen for the near term andpossibly longer, and we may not sustain profitability or generate positive cashflow from operations.

 

***Ifour newer products do not achieve market acceptance, our revenues may decline.***

 

Our new entityidentification products, regulated information compliance systems and networksecurity products have only been in the market place for a limited period oftime and may have longer sales cycles than our previous products.  Accordingly, we may not achieve themeaningful revenue growth needed to sustain operations.  We can provide no assurances that sales ofour newer 

 

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products will continue togrow or generate sufficient revenues to sustain our business.  If we are unable to recognize revenues due tolonger sales cycles or other problems, our results of operations will beadversely affected, perhaps materially.

 

We have not yet receivedbroad market acceptance for our newer products. We cannot assure you that our present or future products will achievemarket acceptance on a sustained basis. In order to achieve market acceptance and achieve future revenue growth,we must introduce complementary security products, incorporate new technologiesinto our existing 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.

 

***A large percentage of our revenues are received from U.S.government entities, and the loss of one of these customers could reduce ourrevenues and materially harm our business and prospects.***

 

A large percentage of ourrevenues result from sales to U.S. government entities.  If we were to lose one or more of these keyrelationships, our revenues could decline and our business and prospects may bematerially harmed. We expect that even if we are successful in developingrelationships with non-governmental customers, our revenues will continue to beconcentrated among government entities. For the quarter ended June 30,2009, sales to U.S. government entities collectively accounted for 94.2% of ourrevenues, compared to 86.5% of our revenues as of June 30, 2008.  The loss of any of these key relationshipsmay send a negative message to other U.S. government entities ornon-governmental customers concerning our product offering. We cannot assure you that U.S. government entities will be customersof ours in future periods or that we will be able to diversify our customerportfolio to adequately mitigate the risk of loss of any of these customers.

 

***Government customers involve unique risks, which couldadversely impact our revenues.***

 

We expect to continue toderive a substantial portion of our revenues from U.S. government customers inthe future.  Sales to the governmentpresent risks in addition to those involved in sales to commercial customers,including potential disruption due to appropriation and spending patterns,delays in approving a federal budget and the government’s right to cancelcontracts 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.

 

***Weare highly dependent on sales made through indirect channels, the loss of whichwould materially adversely affect our operations.***

 

We derived 80.7% ofrevenue in the second quarter of 2009 through indirect channels of mainlygovernment resellers, compared to 36.3% of our revenues as of June 30,2008.   We must expand our sales through theseindirect channels in order to increase our revenues.  We cannot assure you that our products willgain market acceptance in these indirect sales channels or that sales throughthese indirect sales channels will increase our revenues.  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 our products.

 

***The payment of accrued dividends on our preferred stock maystrain our cash resources.***

 

On March 25,2004, we completed a $5,000,000 private placement pursuant to which we issued1,000,000 shares of our 5% Convertible Preferred Stock (the “Series 1Preferred Stock”) and warrants to acquire 556,619 shares of our commonstock.  The conversion price for the Series 1Preferred Stock and the exercise price of the warrants is $3.144 pershare.  As of July 31, 2009, therewere 220,000 shares of the Series 1 Preferred Stock outstanding,representing approximately 349,870 shares of common stock upon conversion.

 

On March 28,2005, we completed a $2,663,000 private placement pursuant to which we issued1,065,200 shares of our Series 2 5% Convertible Preferred Stock (the “Series 2Preferred Stock”) and warrants to acquire 532,600 shares of our commonstock.  The conversion price for the Series 2Preferred Stock is $2.50 per share and the exercise price of the warrants is$2.77 per share.  As of July 31,2009, there were 460,000 shares of the Series 2 Preferred Stockoutstanding, representing 460,000 shares of common stock upon conversion.

 

OnDecember 2, 2005, we completed a $1,230,843 private placement pursuant towhich we issued 564,607 shares of our Series 3 5% Preferred Stock (the “Series 3Preferred Stock”) and warrants to acquire 282,306 shares of our commonstock.  The preferred shares may beconverted into 564,607 shares of common stock at an initial conversion price of$2.18 per share, and the warrants may be exercised at a price of $0.40 per shareduring the five-year period commencing on June 2, 2006.  As of July 31, 2009, 

 

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therewere 354,056 shares of Series 3 Preferred Stock outstanding, representing354,056 shares of common stock upon conversion.

 

***Wehave been unable to pay scheduled dividends on shares of our preferred stock,and the continued failure to make such payments has resulted in late penaltypayments and could potentially result in additional consequences, some of themmaterial.***

 

During the quarterended June 30, 2009, we accrued $15,000 in dividends to the holders of our5% Preferred Stock, $14,000 in dividends to the holders of our Series 2 5%Preferred Stock and $10,000 in dividends to the holders of our Series 3 5%Preferred Stock.  At June 30, 2009,we have dividends accrued of $112,000 related to our 5% Preferred Stock,$97,000 related to our Series 2 5% Preferred Stock and $67,000 related toour Series 3 5% Preferred Stock. Delaware law provides that we may only pay dividends out of our capitalsurplus or, if no surplus is available, out of our net profits for the fiscalyear the dividend is declared and/or the preceding fiscal year.  We have not had net profits for the last twofiscal years and as of the quarter ended June 30, 2009, did not havesufficient capital surplus, defined as the amount by which our net assetsexceed our stated capital, based on par value of our outstanding shares asprovided by Delaware law.  We cannotassure you that our net assets will exceed our stated capital or that we willhave net profits in order to pay these dividends in the future.  These dividends continue to accrue on all ouroutstanding shares of preferred stock, regardless of whether we are legallyable to pay them.  Because we were unableto pay dividends on our preferred stock, we began accruing an additional latefee penalty of 18% per annum on the unpaid dividends for the Series 2Preferred Stock and Series 3 Preferred Stock.  Our CEO, CFO and outside board member thatare invested in Series 2 and Series 3 Preferred Stock have waived thelate fee penalty.  In addition to thislate penalty, the holders of our Series 2 Preferred Stock and Series 3Preferred Stock could elect to present us with written notice of our failure topay dividends as scheduled, in which case we would have 45 days to cure such abreach.  In the event that we failed tocure the breach, the holders of these shares of preferred stock would then havethe right to require us to redeem their shares of preferred stock for a cashamount calculated in accordance with their respective certificates ofdesignation.  If we were required toredeem all shares of Series 2 Preferred Stock and Series 3 PreferredStock as of July 31, 2009, the aggregate redemption price we would owewould be $2.2 million.

 

***Youwill experience substantial dilution upon the conversion or redemption of theshares of preferred stock and the exercise of warrants that we issued in ourrecent private placements or in the event we raise additional funds through theissuance of new shares of our common stock or securities convertible orexercisable into shares of common stock.***

 

On July 31,2009, we had 11,704,535 shares of common stock outstanding.  Upon conversion of all outstanding shares ofpreferred stock and exercise of the outstanding warrants, we will have13,771,291 shares of common stock outstanding, approximately a 17.7% increasein the number of shares of our common stock outstanding.

 

Further, the occurrenceof certain events could entitle holders of our Series 2 Preferred Stockand Series 3 Preferred Stock to require us to redeem their shares for acertain number of shares of our common stock. Assuming (i) we have paid all liquidated damages and other amountsto the holders, (ii) incurred accrued but unpaid dividends on July 31,2009 of $161,000, (iii) a volume weighted average price of $0.56, whichwas the ten-day volume weighted average closing price of our common stock on July 31,2009, and (iv) our 11,704,535 shares of common stock outstanding on July 31,2009, upon exercise of their redemption right by the holders of the Series 3Preferred Stock and the Series 2 Preferred Stock, we would be obligated toissue approximately 6,331,892 shares of our common stock.  This would represent an increase ofapproximately 54% in the number of shares of our common stock as of July 31,2009.

 

In addition, managementmay issue additional shares of common stock or securities exercisable orconvertible into shares of common stock in order to finance our continuingoperations.  Any future issuances of suchsecurities would have additional dilutive effects on the existing holders ofour Common Stock.

 

***Theconversion of preferred stock or exercise of warrants we issued in the privateplacements may cause the price of our common stock to decline.***

 

The holders of the sharesof our 5% Preferred Stock and warrants we issued in connection with the sale ofour 5% Preferred Stock may freely convert their shares of preferred stock andexercise their warrants and sell the underlying shares of common stock pursuantto Rule 144 of the Securities and Exchange Commission.  As of July 31, 2009, 780,000 shares ofour 5% Preferred Stock had converted into 1,240,456 shares of common stock.

 

The holders of the sharesof Series 2 5% Preferred Stock and warrants we issued in connection withthe sale of our Series 2 Preferred Stock may freely convert their sharesof preferred stock and exercise their warrants and sell the underlying sharesof common stock pursuant to Rule 144 of the Securities and ExchangeCommission.  As of July 31, 2009,605,200 shares of Series 2 Preferred Stock had converted into 605,200shares of common stock.

 

The holders of the sharesof Series 3 5% Preferred Stock and warrants we issued in connection withthe sale of our Series 3 Preferred Stock, may freely convert their sharesof Series 3 Preferred Stock and exercise their warrants and sell theunderlying shares of common stock pursuant to Rule 144 of the Securitiesand Exchange Commission.  As of July 31,2009, 210,551 shares of Series 3 Preferred Stock had converted into210,551 shares of common stock.

 

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For the four weeks endedon July 31, 2009, the average daily trading volume of our common stock onThe OTCBB was 869 shares.  Consequently,if holders of preferred stock or warrants elect to convert their remainingshares or exercise their warrants and sell a material amount of theirunderlying shares of common stock on the open market, the increase in sellingactivity could cause a decline in the market price of our common stock.  Furthermore, these sales, or the potentialfor these sales, could encourage short sales, causing additional downwardpressure on the market price of our common stock.

 

***Certainrights of the holders of our preferred stock and the terms of our securedcredit line may hinder our ability to raise additional financing.***

 

Under the terms ofour preferred stock instruments, we cannot issue shares of capital stock withrights senior to those of our existing 5% Preferred Stock, Series 2 5%Preferred Stock or Series 3 5% Preferred Stock without the approval of atleast a majority of the holders of our 5% Preferred Stock, all of the holdersof our Series 2 5% Preferred Stock, and holders of at least 75% of our Series 35% Preferred Stock voting or acting as separate classes.  We also cannot incur certain indebtednesswithout the approval of at least a majority of the holders of each class of ourPreferred Stock.  Furthermore, the termsof our secured credit line with Silicon Valley Bank include covenants whichrestrict our ability to incur additional debt and pay certain dividends.  The combination of these provisions couldhinder or delay our ability to raise additional debt or equity financing.

 

***Our management and larger stockholders exercise significantcontrol over our company and have the ability to approve or take actions thatmay be adverse to your interests.***

 

As of July 31, 2009,our executive officers, directors and preferred stockholders beneficially ownapproximately 30% of our voting power. As a result, these stockholders will be able to exercise significantcontrol over all matters requiring stockholder approval, including the electionof directors and approval of significant corporate transactions, which coulddelay or prevent someone from acquiring or merging with us.  These stockholders may use their influence toapprove or take actions that may be adverse to your interests.  Further, we may contemplate the possibleissuance of shares of our Common Stock or of securities exercisable orconvertible into shares of our Common Stock in the future to our ChiefExecutive Officer.  Any such issuancewill increase the percentage of stock our Chief Executive Officer and ourmanagement group beneficially holds.

 

Item 3.                                Defaults Upon Senior Securities

 

During the quarterended June 30, 2009, we accrued $15,000 in dividends to the holders of our5% Preferred Stock, $14,000 in dividends to the holders of our Series 2 5%Preferred Stock and $10,000 in dividends to the holders of our Series 3 5%Preferred Stock.  At June 30, 2009,we have dividends accrued of $112,000 related to our 5% Preferred Stock,$97,000 related to our Series 2 5% Preferred Stock and $67,000 related toour Series 3 5% Preferred Stock. Delaware law provides that we may only pay dividends out of our capital surplusor, if no surplus is available, out of our net profits for the fiscal year thedividend is declared and/or the preceding fiscal year.  We have not had net profits for the last twofiscal years and as of the quarter ended June 30, 2009, did not havesufficient capital surplus, defined as the amount by which our net assetsexceed our stated capital, based on par value of our outstanding shares asprovided by Delaware law.  We cannotassure you that our net assets will exceed our stated capital or that we willhave net profits in order to pay these dividends in the future.  These dividends continue to accrue on all ouroutstanding shares of preferred stock, regardless of whether we are legallyable to pay them.  Because we were unableto pay dividends on our preferred stock, we began accruing an additional latefee penalty of 18% per annum on the unpaid dividends for the Series 2Preferred Stock and Series 3 Preferred Stock.  Our CEO, CFO and outside board member thatare invested in Series 2 and Series 3 Preferred Stock have waived thelate fee penalty.  In addition to thislate penalty, the holders of our Series 2 Preferred Stock and Series 3Preferred Stock could elect to present us with written notice of our failure topay dividends as scheduled, in which case we would have 45 days to cure such abreach.  In the event that we failed tocure the breach, the holders of these shares of preferred stock would then havethe right to require us to redeem their shares of preferred stock for a cashamount calculated in accordance with their respective certificates ofdesignation.  If we were required toredeem all shares of Series 2 Preferred Stock and Series 3 PreferredStock as of July 31, 2009, the aggregate redemption price we would owewould be $2.2 million.

 

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Item 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS

 

The Annual Meetingof Stockholders was held on May 21, 2009, 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 eachmatter of nominee.

 

(1)                                  Election of five (5) directors toserve until the next Annual Meeting of Stockholders and until their respectivesuccessors are duly elected and qualified.

 
| ** **             | ** ** | **FOR**    | ** ** | **WITHHELD** | ** ** |
|------------------------|------------|------------|------------|--------------|------------|
| G. Ward Paxton         |       | 10,767,950 |       | 324,962      |       |
| T. Joe Head            |       | 10,769,320 |       | 323,592      |       |
| James F. Gero          |       | 10,787,056 |       | 305,856      |       |
| J. Fred Bucy, Jr. |       | 10,774,693 |       | 318,219      |       |
| Donald M. Johnston     |       | 10,790,726 |       | 302,186      |       |

 

(2)                                  Ratification and approval for theamendment of the 2005 Stock Incentive Plan.

 
| **FOR**   | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 7,579,721 |       | 164,623     |       | 1,662       |       |

 

(3)                                  Ratification and approval of selection bythe Board of Directors of KBA Group LLP as independent auditors of theRegistrant for the fiscal year ending December 31, 2009.

 
| **FOR**    | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|------------|------------|-------------|------------|-------------|------------|
| 11,014,714 |       | 5,610       |       | 72,588      |       |

 

Item 6.                                Exhibits

 

The following Exhibitsare filed with this report form 10-Q:

 
| 31.1 |   | Certification of Chief Executive Officer Pursuant to  Rule 13a-14(a) of the Exchange Act.                                                                                  |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification of Chief Financial Officer Pursuant to  Rule 13a-14(a) of the Exchange Act.                                                                                  |
| 32.1 |   | Certification 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. |

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

 

 
| ** **                 | **INTRUSION INC.**                                                       |
|----------------------------|--------------------------------------------------------------------------|
|                       |                                                                     |
| Date: August 12, 2009 | /s/ G. Ward Paxton                                                       |
|                       | G. Ward Paxton                                                           |
|                       | Chairman, President & Chief Executive  Officer                  |
|                       | (Principal Executive Officer)                                            |
|                       |                                                                     |
|                       |                                                                     |
| Date: August 12, 2009 | /s/ Michael L. Paxton                                                    |
|                       | Michael L. Paxton                                                        |
|                       | Vice President, Chief Financial Officer, Treasurer &  Secretary |
|                       | (Principal Financial & Accounting Officer)                      |

 

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