** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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** **

**FORM 10-QSB**

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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, 2006**                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |       |                                                                                               |
| **OR**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |       |                                                                                               |
| o                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | ** ** | **TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |       |                                                                                               |
| **For the  transition period from                                       to                                       ** |

 

**CommissionFile Number  0-20191**

 

**INTRUSION INC.**

(Exact name ofsmall business issuer as specified in its charter)

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

 

**1101East Arapaho Road, Richardson, Texas 75081**(Address of principal executive offices)(Zip Code)

**(972)234-6400**(Issuer’s telephone number, including area code)

**NotApplicable**Former name, if changed since last report)

* * * * * * * * **

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

Yes xNo o

Indicate by check mark whether the Registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act:  Yes oNo x

The number of shares outstanding of the Registrant’sCommon Stock, $0.01 par value, on August 4, 2006 was 7,046,213.

Transitional Small Business Disclosure Format (checkone):  Yes oNo x

 

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**INTRUSIONINC.**

INDEX

 
| **PART I–FINANCIAL INFORMATION**                                                                                 |
|----------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                       |
| Item 1. Financial Statements                                                                                               |
|                                                                                                                       |
| Unaudited Condensed  Consolidated Balance Sheets as of June 30, 2006 and December 31,  2005                      |
|                                                                                                                       |
| Unaudited  Condensed Consolidated Statements of Operations for the three and six months  ended June 30, 2006 and 2005 |
|                                                                                                                       |
| Unaudited Condensed  Consolidated Statements of Cash Flows for the six months ended June 30,  2006 and 2005           |
|                                                                                                                       |
| Notes to  Unaudited Condensed Consolidated Financial Statements                                                            |
|                                                                                                                       |
| Item  2. Management’s Discussion and Analysis of Financial Condition and Results of  Operations                       |
|                                                                                                                       |
| Item 3. Controls  and Procedures                                                                                           |
|                                                                                                                       |
| **PART II–OTHER  INFORMATION**                                                                                   |
|                                                                                                                       |
| Item 1. Legal  Proceedings                                                                                                 |
|                                                                                                                       |
| Item 4. Submission  of Matters to a Vote of Security Holders                                                               |
|                                                                                                                       |
| Item  6. Exhibits                                                                                                          |
|                                                                                                                       |
| Signature  Page                                                                                                            |

 

2

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**PART I—FINANCIAL INFORMATION**

Item 1. FINANCIALSTATEMENTS

**INTRUSION INC. AND SUBSIDIARIES**

UNAUDITEDCONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except parvalue amounts)

 
| ** **                                                                                                                               | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                               |       |                    |       |                        |       |
| Current Assets:                                                                                                                          |       |                    |       |                        |       |
| Cash and cash  equivalents                                                                                                               |       | $                       | 319        |                        | $          | 2,844 |   |
| Short-term  investments                                                                                                                  |       | —                  |       | 500                         |       |
| Accounts  receivable, less allowance for doubtful accounts of $89 in 2006 and $102 in  2005                                              |       | 838                     |       | 443                         |       |
| Inventories, net                                                                                                                         |       | 324                     |       | 373                         |       |
| Prepaid expenses                                                                                                                         |       | 144                     |       | 191                         |       |
| Total current assets                                                                                                                     |       | 1,625                   |       | 4,351                       |       |
| Property and equipment,  net                                                                                                             |       | 200                     |       | 256                         |       |
| Other assets                                                                                                                             |       | 41                      |       | 41                          |       |
| TOTAL ASSETS                                                                                                                             |       | $                       | 1,866      |                        | $          | 4,648 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                           |       |                    |       |                        |       |
| Current Liabilities:                                                                                                                     |       |                    |       |                        |       |
| Accounts payable  and accrued expenses                                                                                                   |       | $                       | 948        |                        | $          | 1,142 |   |
| Deferred revenue                                                                                                                         |       | 283                     |       | 527                         |       |
| Total current  liabilities                                                                                                               |       | 1,231                   |       | 1,669                       |       |
|                                                                                                                                     |       |                    |       |                        |       |
| Stockholders’ Equity:                                                                                                               |       |                    |       |                        |       |
| Preferred stock,  $0.01 par value: Authorized Shares—5,000                                                                          |       |                    |       |                        |       |
| Series 1  shares issued and outstanding—260 in 2006 and 2005 Liquidation preference of  $1,316 as of June 30, 2006        |       | 918                     |       | 918                         |       |
| Series 2  shares issued and outstanding—460 in 2006 and 500 in 2005 Liquidation  preference of $1,155 as of June 30, 2006 |       | 724                     |       | 787                         |       |
| Series 3  shares issued and outstanding—469 in 2006 and 565 in 2005 Liquidation  preference of $1,026 as of June 30, 2006 |       | 667                     |       | 805                         |       |
| Common stock,  $0.01 par value:                                                                                                          |       |                    |       |                        |       |
| Authorized  shares—80,000                                                                                                           |       |                    |       |                        |       |
| Issued  shares—7,056 in 2006 and 6,919 in 2005                                                                                      |       | 71                      |       | 69                          |       |
| Outstanding  shares—7,046 in 2006 and 6,909 in 2005                                                                                 |       |                    |       |                        |       |
| Common stock  held in treasury, at cost—10 shares                                                                                   |       | (362                    | )          | (362                        | )          |
| Additional  paid-in capital                                                                                                              |       | 53,469                  |       | 52,994                      |       |
| Accumulated  deficit                                                                                                                     |       | (54,673                 | )          | (52,053                     | )          |
| Accumulated  other comprehensive loss                                                                                                    |       | (179                    | )          | (179                        | )          |
| Total stockholders’  equity                                                                                                         |       | 635                     |       | 2,979                       |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                          |       | $                       | 1,866      |                        | $          | 4,648 |   |

 

See accompanyingnotes.

3

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**INTRUSIONINC. AND SUBSIDIARIES**

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts)

 
| ** **                                                                 | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                 | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005**    | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
| Net product  revenue                                                       |       | $                                | 957        |                           | $          | 1,323 |   | $ | 1,375 |   | $ | 2,194 |   |
| Net customer  support and maintenance revenue                              |       | 247                              |       | 386                            |       | 680 |   | 700 |   |
| Total revenue                                                              |       | 1,204                            |       | 1,709                          |       | 2,055 |   | 2,894 |   |
| Cost of product  revenue                                                   |       | 429                              |       | 719                            |       | 686 |   | 1,221 |   |
| Cost of customer  support and maintenance revenue                          |       | 30                               |       | 21                             |       | 160 |   | 46 |   |
| Total cost of  revenue                                                     |       | 459                              |       | 740                            |       | 846 |   | 1,267 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Gross profit                                                               |       | 745                              |       | 969                            |       | 1,209 |   | 1,627 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Operating  expenses:                                                       |       |                             |       |                           |       |   |   |   |   |
| Sales and marketing                                                        |       | 848                              |       | 873                            |       | 1,665 |   | 1,632 |   |
| Research and development                                                   |       | 615                              |       | 703                            |       | 1,407 |   | 1,405 |   |
| General and administrative                                                 |       | 385                              |       | 304                            |       | 733 |   | 532 |   |
| Severance and related costs                                                |       | —                           |       | 55                             |       | — |   | 55 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Operating loss                                                             |       | (1,103                           | )          | (966                           | )          | (2,596 | ) | (1,997 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Other income  (expense), net                                               |       | (53                              | )          | 2                              |       | (65 | ) | 2 |   |
| Interest income,  net                                                      |       | 11                               |       | 29                             |       | 41 |   | 33 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Loss before  income tax provision                                          |       | (1,145                           | )          | (935                           | )          | (2,620 | ) | (1,962 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Income tax  provision                                                      |       | —                           |       | —                         |       | — |   | — |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Net loss                                                                   |       | $                                | (1,145     | )                              | $          | (935 | ) | $ | (2,620 | ) | $ | (1,962 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Preferred stock  dividends accrued                                         |       | (43                              | )          | (56                            | )          | (88 | ) | (85 | ) |
| Beneficial  conversion feature on preferred stock                          |       | —                           |       | —                         |       | — |   | (919 | ) |
| Net loss  attributable to common stockholders                              |       | $                                | (1,188     | )                              | $          | (991 | ) | $ | (2,708 | ) | $ | (2,966 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Net loss per  share attributable to common stockholders, basic and diluted |       | $                                | (0.17      | )                              | $          | (0.16 | ) | $ | (0.39 | ) | $ | (0.49 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Weighted average common  shares outstanding, basic and diluted             |       | 7,046                            |       | 6,182                          |       | 7,014 |   | 6,110 |   |

 

See accompanyingnotes.

4

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**INTRUSION INC. AND SUBSIDIARIES**

UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)

 
| ** **                                                                      | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                      | ** ** | **June 30,  2006**        | ** ** | **June 30,  2005** | ** ** |
| Operating  Activities:                                                          |       |                           |       |   |   |
| Net loss                                                                        |       | $                              | (2,620     | ) | $ | (1,962 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:    |       |                           |       |   |   |
| Depreciation and amortization                                                   |       | 59                             |       | 94 |   |
| Provision for doubtful accounts                                                 |       | (13                            | )          | (177 | ) |
| Stock based compensation                                                        |       | 363                            |       | — |   |
| Changes in  operating assets and liabilities:                                   |       |                           |       |   |   |
| Accounts receivable                                                             |       | (382                           | )          | 917 |   |
| Inventories                                                                     |       | 49                             |       | 110 |   |
| Prepaid expenses and other assets                                               |       | 47                             |       | 159 |   |
| Accounts payable and accrued expenses                                           |       | (176                           | )          | (248 | ) |
| Deferred revenue                                                                |       | (244                           | )          | 116 |   |
| Net cash used in  operating activities                                          |       | (2,917                         | )          | (991 | ) |
| Investing  Activities:                                                          |       |                           |       |   |   |
| Purchases of short-term investments                                             |       | —                         |       | (2,350 | ) |
| Maturities of short-term investments                                            |       | 500                            |       | 75 |   |
| Purchases of property and equipment                                             |       | (3                             | )          | (134 | ) |
| Net cash  provided by (used in) investing activities                            |       | 497                            |       | (2,409 | ) |
| Financing  Activities:                                                          |       |                           |       |   |   |
| Proceeds from the exercise of employee stock options                            |       | 1                              |       | — |   |
| Dividends paid on preferred stock                                               |       | (106                           | )          | (115 | ) |
| Proceeds from the issuance of preferred stock and  warrants, net                |       | —                         |       | 2,490 |   |
| Net cash  provided by (used in) financing activities                            |       | (105                           | )          | 2,375 |   |
|                                                                            |       |                           |       |   |   |
| Effect of  foreign currency translation adjustment on cash and cash equivalents |       | —                         |       | (6 | ) |
|                                                                            |       |                           |       |   |   |
| Net decrease in  cash and cash equivalents                                      |       | (2,525                         | )          | (1,031 | ) |
| Cash and cash  equivalents at beginning of period                               |       | 2,844                          |       | 2,315 |   |
| Cash and cash  equivalents at end of period                                     |       | $                              | 319        |   | $ | 1,284 |   |
|                                                                            |       |                           |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF NON CASH FINANCING ACTIVITIES:                      |       |                           |       |   |   |
|                                                                            |       |                           |       |   |   |
| Fair value of  warrants issued in connection with sale of preferred stock       |       | $                              | —     |   | $ | 815 |   |
| Amortization of  preferred stock beneficial conversion feature                  |       | $                              | —     |   | $ | (919 | ) |
| Preferred stock  dividends accrued but not paid                                 |       | $                              | 88         |   | $ | 85 |   |

 

See accompanyingnotes.

5

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**INTRUSIONINC. AND SUBSIDIARIES**

NOTES TO UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.               Description ofBusiness

We develop, market andsupport a family of regulated information compliance and data privacyprotection products, entity identification systems along with network intrusionprevention and detection systems that address vital security issues facingorganizations with mission critical business applications or housingclassified, confidential, or customer information assets. Our products includeCompliance CommanderTM for regulated information and data privacy protection,TraceCopTM for entity identification and location, SpySnareTM for real-timeinline blocking of spyware and unwanted peer-to-peer applications, andSecureNetTM for network intrusion prevention and detection.

We market and distributeour products through a direct sales force to end-users and distributors and bynumerous domestic and international system integrators, managed serviceproviders and value-added resellers. Our end-user customers include hightechnology, manufacturing, telecommunications, transportation, health care,insurance, government entities, financial institutions, academic institutionsand e-commerce.

We were organized inTexas in September 1983 and reincorporated in Delaware in October 1995.For more than 15 years, we provided local area networking equipment and wereknown as Optical Data Systems or ODS Networks. On June 1, 2000, we changedour name from ODS Networks, Inc. to Intrusion.com, Inc., and ourNasdaq ticker symbol from ODSI to INTZ to reflect our focus on intrusiondetection solutions. On November 1, 2001, we changed our name fromIntrusion.com, Inc. to Intrusion Inc.

Our principal executiveoffices are located at 1101 East Arapaho Road, Richardson, Texas 75081, and ourtelephone number is (972) 234-6400. Our website URL is www.intrusion.com.Information contained in or linked to our website are not a part of this report.References to “we,” “us” and “our” in this report refer to Intrusion Inc. andits subsidiaries.

As of June 30, 2006,we had cash, cash equivalents and short-term investments in the amount ofapproximately $0.3 million, down from approximately $3.3 million as of December 31,2005. The decrease in cash and short-term investments funded our operations forthe first and the second quarter 2006. On March 29, 2006, we established a$1.0 million line of credit with Silicon Valley Bank. Our existing cashresources, line of credit and projections for increased revenues for theremainder of 2006, may not provide sufficient cash resources to finance ouroperations and expected capital expenditures for the next twelve months. It islikely that we may need to seek additional debt or equity financing to fund ouroperations for the next year. The sufficiency of our cash resources depends toa certain extent on general economic, financial, competitive or other factorsbeyond our control. Moreover, despite actions to reduce our costs and improveour profitability, our operating losses and net operating cash outflows maycontinue through at least the third quarter of 2006. We may not be able toachieve the revenue and gross margin objectives necessary to achieve positivecash flow or profitability without obtaining additional equity financing. We donot currently have any arrangements for additional financing and we may not beable to secure additional debt or equity financing on terms acceptable to us,or at all, at the time when we need such funding. Additionally, we may not havesufficient availability under our credit line when additional funds are needed.Furthermore, because our stockholders’ equity of $0.6 million as of June 30,2006 is less than the $2.5 million required by Nasdaq, we currently facedelisting by Nasdaq and must raise additional equity or generate at least $1.9million of net income in order to meet continued listing requirements. Althoughwe are currently exploring a range of alternatives to increase the amount ofour equity, we may not be successful in time to avoid Nasdaq delisting.

2.               Basis ofPresentation

The accompanyingunaudited condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesfor interim financial information and with the instructions to Form 10-QSBand Item 310 of Regulation S-B. Accordingly, they do not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States for complete financial statements. The December 31,2005 balance sheet was derived from audited financial statements, but does notinclude all the disclosures required by accounting principles generallyaccepted in the United States. However, we believe that the disclosures areadequate to make the information presented not misleading. In our opinion, allthe adjustments (consisting of normal recurring adjustments) considerednecessary for fair presentation have been included. The results of operationsfor the three month period ending June 30, 2006 are not necessarily indicativeof the results that may be achieved for the full fiscal year or for any futureperiod. The unaudited condensed consolidated financial statements includedherein should be read in conjunction with the consolidated financial statementsand notes thereto included in the Company’s annual report on Form 10-KSBfor the year ended December 31, 2005.

6

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3.               Inventories (Inthousands)

 
|                          | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Inventories  consist of: |       |                    |       |                        |       |
|                     |       |                    |       |                        |       |
| Finished goods           |       | $                       | 232        |                        | $          | 290 |   |
| Work in progress         |       | 8                       |       | 8                           |       |
| Demonstration  systems   |       | 84                      |       | 75                          |       |
| Net inventory            |       | $                       | 324        |                        | $          | 373 |   |

 

4.               Accounting forStock-Based Compensation

In December 2004,the Financial Accounting Standards Board issued Statement of FinancialAccounting Standards No. 123 (revised 2004), “Share-Based Payment” (SFAS123(R)), which replaces SFAS 123 and supersedes APB Opinion No. 25. SFAS123(R) requires all share-based payments to employees, including grants ofemployee stock options, to be recognized in the financial statements based ontheir fair values. The pro forma disclosures previously permitted under SFAS123 no longer will be an alternative to financial statement recognition.

Prior to January 1,2006, we accounted for employee stock-based compensation in accordance with APB25 and followed the disclosure requirements in accordance with SFAS 148. Nocompensation cost was recorded for stock options, as all options granted underthe plans have an exercise price equal (at minimum) to the market value of theunderlying common stock on the date of grant.

Weadopted SFAS 123(R) on January 1, 2006 using the modified prospectiveapplication method described in the statement. Results for prior periods havenot been restated. Stock-based compensation expense recognized during the periodis based on the value of the portion of stock-based payment awards that isultimately expected to vest. Stock-based compensation expense recognized in thecondensed consolidated statement of operations during the first quarter of 2006included compensation expense for stock-based payment awards granted prior to,but not yet vested, as of December 31, 2005 based on the grant date fairvalue estimated in accordance with the pro forma provisions of SFAS 148 andcompensation expense for the stock-based payment awards granted subsequent to December 31,2005, based on the grant date fair value estimated in accordance with SFAS123(R). As stock-based compensation expense recognized in the statement ofincome for the first quarter of 2006 is based on awards ultimately expected tovest, it has been reduced for estimated forfeitures. SFAS 123(R) requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates. In thepro forma information required under SFAS 148 for the periods prior to 2006, weaccounted for forfeitures as they occurred.

Byadopting SFAS 123(R) we will record substantial non-cash stockcompensation expenses. The adoption of SFAS 123(R) is not expected to havea significant effect on our financial condition or cash flows but is expectedto have a significant, adverse effect on our results of operations.

At June 30,2006, we had three stock-based compensation plans, which are described below.These plans were developed to retain and attract key employees and directors.

In1995, we adopted our 1995 Stock Option Plan (the “1995 Plan”), which providesfor the issuance of up to 400,000 shares of common stock upon exercise ofoptions granted pursuant to the 1995 Plan. On April 26, 2001, ourstockholders increased the overall number of shares available for issuancepursuant to the plan to 825,000 shares of common stock. The 1995 Plan providesfor the issuance of both non-qualified and incentive stock options to our employees,officers, and employee-directors. The 1995 Plan expired by its terms on March 21,2005 and no options were available for future issuance after the expiration. AtJune 30, 2006, 67,365 employee options have been exercised and employeeoptions to purchase a total of 517,380 shares of common stock areoutstanding. A total of 2,290,295 options have been granted pursuant tothe 1995 Plan, of which, 1,705,550 have been cancelled.

In 1995, we also adoptedthe 1995 Non-Employee Director Stock Option Plan (the “1995 Non-EmployeeDirector Plan”). The 1995 Non-Employee Director Plan provided for the issuanceof non-qualified stock options to non-employee directors. The 1995 Non-EmployeeDirector Plan was amended in April 2002 to increase the number of sharesavailable for issuance to 65,000 from 40,000 shares. The 1995 Non-EmployeeDirector Plan expired by its terms on March 21, 2005 and no options wereavailable for future issuance after the expiration. No options have beenexercised under the 1995 Non-Employee Director Plan. Non-employee options topurchase a total of 32,500 shares of common stock are outstanding at June 30,2006. A total of 62,500 options have been granted to directors pursuant tothe 1995 Non-Employee Director Plan, of which, 30,000 have been cancelled.

7

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On March 17,2005, the Board approved the 2005 Stock Incentive Plan (the “2005 Plan”), whichwas approved by the stockholders on June 14, 2005. The 2005 Plan serves asa replacement for the 1995 Non-Employee Director Plan and the 1995 Option Planwhich expired by their terms on March 21, 2005. The approval of the 2005Plan had no effect on the 1995 Plans or any options granted pursuant to eitherplan. All options will continue with their existing terms and will be subjectto the 1995 Non-Employee Director Plan or the 1995 Plan, as applicable. Further,the Company will not be able to re-issue any option which is cancelled orterminated under the 1995 Non-Employee Director Plan or the 1995 Option Plan. The2005 Plan provides for the issuance of up to 750,000 shares of common stockupon exercise of options granted pursuant to the 2005 Plan. The 2005 Planconsists of three (3) separate equity incentive programs: theDiscretionary Option Grant Program; the Stock Issuance Program; and theAutomatic Option Grant Program for non-employee Board members. Officers andemployees, non-employee Board members and independent contractors are eligibleto participate in the Discretionary Option Grant and Stock Issuance Programs. Participationin the Automatic Option Grant Program is limited to non-employee members of theBoard. Each non-employee Board member will receive an option grant for 10,000shares of Common Stock upon initial election or appointment to the Board,provided that individual has not previously been employed by the Company in thepreceding six (6) months. In addition, on the date of each annualstockholders meeting, each Board member will automatically be granted an optionto purchase 5,000 shares of Common Stock, provided he or she has served as anon-employee Board member for at least six (6) months. At June 30,2006, no 2005 plan options have been exercised and employee and non-employeeBoard member options to purchase a total of 327,000 shares of common stockare outstanding. A total of 348,000 options have been granted under the 2005Plan, of which 21,000 have been cancelled and options for 423,000 sharesremain available for future grant. No shares have been issued pursuant to theStock Issuance Program.

TheCompensation Committee of our Board of Directors determines for all employeeoptions, the term of each option, option exercise price within limits set forthin the plans, number of shares for which each option is granted and the rate atwhich each option is exercisable (generally ratably over one, three or fiveyears from grant date). However, the exercise price of any incentive stockoption may not be less than the fair market value of the shares on the dategranted (or less than 110% of the fair market value in the case of optioneesholding more than 10% of our voting stock of the Company), and the term cannotexceed ten years (five years for incentive stock options granted to holders ofmore than 10% of our voting stock).

Effect of Adopting SFAS No. 123(R)

The following is theeffect of adopting SFAS No. 123(R) as of January 1, 2006 for thethree and six months ended June 30, 2006 (in thousands, except per sharedata).
|                                                        | ** ** | **For Three Months  Ended  June 30, 2006** | ** ** | **For Six Months  Ended  June 30, 2006** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| Stock-option  compensation expense recognized          |       |                                                           |       |                                                         |       |
| (for stock options only):                              |       |                                                           |       |                                                         |       |
| Cost of revenue                                        |       | $                                                              | 22         |                                                         | $          | 46 |   |
| Research and development                               |       | 36                                                             |       | 79                                                           |       |
| Sales and marketing                                    |       | 56                                                             |       | 125                                                          |       |
| General and administrative                             |       | 51                                                             |       | 113                                                          |       |
| Effect on net  loss                                    |       | $                                                              | 165        |                                                         | $          | 363 |   |
| Effect on basic and  diluted earnings per common share |       | $                                                              | (0.02      | )                                                            | $          | (0.05 | ) |

 

ValuationAssumptions

Thefair values of option awards were estimated at the date of grant using aBlack-Scholes option-pricing model with the following assumptions:

 
| ** **                              | ** ** | **For Three Months Ended  June 30, 2006** | ** ** | **For Three Months Ended  June 30, 2005** | ** ** | **For Six Months   Ended  June 30, 2006** | ** ** | **For Six Months   Ended  June 30, 2005** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
|                                    |       |                                                               |       |                                                               |       |                                                               |       |                                                               |       |
| Weighted average grant  date fair value |       | $                                                                  | 0.50       |                                                               | $          | 2.33                                                               |       | $                                                                  | 1.03       |   | $ | 2.35 |   |
| Weighted average  assumptions used:     |       |                                                               |       |                                                               |       |                                                               |       |                                                               |       |
| Expected  dividend yield                |       | 0.0                                                                | %          | 0.0                                                                | %          | 0.0                                                                | %          | 0.0                                                                | %          |
| Risk-free  interest rate                |       | 5.1                                                                | %          | 3.7                                                                | %          | 4.6                                                                | %          | 3.9                                                                | %          |
| Expected  volatility                    |       | 101.0                                                              | %          | 111.0                                                              | %          | 98.6                                                               | %          | 113.1                                                              | %          |
| Expected life (in  years)               |       | 5.0                                                                |       | 4.1                                                                |       | 5.0                                                                |       | 4.4                                                                |       |
|                                         |            |                                                                    |            |                                                                    |            |                                                                    |            |                                                                    |            |  |  |  |  |

 

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TheBlack-Scholes option valuation model was developed for use in estimating thefair value of traded options that have no vesting restrictions and are fullytransferable. In addition, option valuation models require the input of highlysubjective assumptions including the expected stock price volatility. Becauseour employee stock options have characteristics significantly different fromthose of traded options, and because changes in the subjective inputassumptions can materially affect the fair value estimate, in management’sopinion, the existing models do not necessarily provide a reliable singlemeasure of the fair value of its employee stock options.

Expectedvolatility is based on historical volatility and in part on implied volatility.The expected term considers the contractual term of the option as well ashistorical exercise and forfeiture behavior. The risk-free interest rate isbased on the rates in effect on the grant date for U.S. Treasury instrumentswith maturities matching the relevant expected term of the award.

Stock IncentivePlan Activity

Stockoption activity under the Company’s various long-term incentive and directorcompensation plans during the six months ended June 30, 2006, were asfollows:

|                                        | ** ** | **Number of  Options  (in thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|----------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------|------------|
| Outstanding at  December 31, 2005 |       | 891                                              |       | $                                      | 5.48       |   |
| Granted                                |       | 48                                               |       | 1.37                                   |       |
| Exercised                              |       | (1                                               | )          | 0.76                                   |       |
| Forfeited                              |       | (44                                              | )          | 2.71                                   |       |
| Expired                                |       | (17                                              | )          | 11.81                                  |       |
|                                   |       |                                             |       |                                   |       |
| Outstanding at  June 30, 2006     |       | 877                                              |       | $                                      | 5.27       |   |

 

Stock Options Outstandingand Exercisable

Summarizedinformation about outstanding stock options as of June 30, 2006, that arefully vested and those that are expected to vest in the future as well as stockoptions that are fully vested and currently exercisable, are as follows:

 

| As of June 30, 2006      | ** ** | **Outstanding Stock  Options (Fully Vested  and Expected to Vest)*** | ** ** | **Options that are  Exercisable** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                   | ** ** | ** **                                                                                         | ** ** | ** **                                  | ** ** |
| Number of  outstanding options               |       | 877                                                                                                |       | 690                                         |       |
| Weighted average  remaining contractual life |       | 7.73                                                                                               |       | 7.41                                        |       |
| Weighted average  exercise price per share   |       | $                                                                                                  | 5.27       |                                        | $          | 6.03 |   |
| Intrinsic value                              |       | $                                                                                                  | 0          |                                        | $          | 0 |   |

----

* Includes effectsof expected forfeitures

 

Theoptions detailed in the table above have a $0 intrinsic value as the fairmarket value on June 30, 2006 is less than the exercise prices of all ofthe options vested and expected to vest. As of June 30, 2006, the totalunrecognized compensation cost related to non-vested options not yet recognizedin the statement of operations totaled approximately $159 thousand and theweighted period over which these awards are expected to be recognized was 1.25years.

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Pro Forma Presentation for Periods Prior to theAdoption of SFAS 123(R)

Under the modifiedprospective application method, results for prior periods have not beenrestated to reflect the effects of implementing SFAS No. 123(R). Thefollowing pro forma information was reported, as required by SFAS No. 148,“Accounting for Stock-Based Compensation—Transition and Disclosure” for thequarter and six months ended June 30, 2005.
|                                                                                                  | ** ** | **Quarter  Ended  June 30,  2005** | ** ** | **Six  Months  June 30,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|--------------------------------------|------------|
| Net loss  attributable to common stockholders                                                    |       | $                                       | (991       | )                                    | $          | (2,966 | ) |
| Deduct: Total  stock-based compensation determined under fair value-based method for all  awards |       | (175                                    | )          | (306                                 | )          |
| Pro forma net  loss attributable to common stockholders                                          |       | $                                       | (1,166     | )                                    | $          | (3,272 | ) |
| Net loss per  share attributable to common stockholders:                                         |       |                                    |       |                                 |       |
| (basic and diluted)                                                                              |       |                                    |       |                                 |       |
| as reported                                                                                      |       | $                                       | (0.16      | )                                    | $          | (0.49 | ) |
| pro forma                                                                                        |       | $                                       | (0.19      | )                                    | $          | (0.54 | ) |
| Weighted-average  shares used in computation:                                                    |       |                                    |       |                                 |       |
| Basic and  diluted                                                                               |       | 6,182                                   |       | 6,110                                |       |

 

5.               Net Loss Per Share

Basic net loss per shareis computed 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 is computed by dividing the net lossattributable to common stockholders by the weighted average number of commonshares and common stock equivalents outstanding for the period. Our commonstock equivalents include all common stock issuable upon conversion ofpreferred stock and the exercise of outstanding options and warrants. Theaggregate number of common stock equivalents excluded from the loss per sharecalculation for the three and six month periods ended June 30, 2006 and2005 are 3,742,472 and 3,471,285, respectively. Our common stock equivalentsare not included in the diluted loss per share for the six month periods ended June 30,2006 and 2005, as they are antidilutive.

6.               Commitments andContingencies

We are subject to legalproceedings and claims that arise in the ordinary course of business. We do notbelieve that the outcome of those matters will have a material adverse affecton our consolidated financial position, operating results or cash flows. However,there can be no assurance such legal proceedings will not have a materialimpact**.**

7.               Preferred Stock andCommon Stock

During the six monthsended June 30, 2006, 40,000 shares of our Series 2 5% preferred stockwere converted into 40,000 shares of common stock and 95,872 shares of Series 35% preferred stock were converted into 95,872 shares of common stock. At June 30,2006, there are 259,696 shares of 5% preferred stock outstanding, 460,000shares of Series 2 5% preferred stock outstanding and 468,735 shares of Series 35% preferred stock outstanding. In addition, an employee exercised stockoptions to purchase 834 shares of common stock during the six months ended June 30,2006.

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

This report containsforward-looking statements, within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934, that involve risks and uncertainties, such as statements concerning: thedifficulties in forecasting future sales caused by current economic and marketconditions, the effect of military actions on government and corporate spendingon information security products, spending patterns of, and appropriations to,U.S. government departments, the impact of our cost reduction programs and ourrefocused product line, the difficulties and uncertainties in successfullydeveloping and introducing new products, market acceptance of our products, theimpact of sustained losses on our ability to successfully operate and grow ourbusiness, our stock price and our ongoing Nasdaq eligibility, the highlycompetitive market for our products, the effects of sales and implementationcycles for our new products on our quarterly results, difficulties inaccurately estimating market growth, the consolidation of the informationsecurity industry, the impact of changing economic conditions, businessconditions in the information security industry, our ability to manageacquisitions effectively, our ability to manage discontinued operations effectively,the impact of market peers and their products as well as risks concerningfuture technology and others identified in our Annual Report on Form 10-KSBand other Securities and Exchange Commission filings. Such forward-lookingstatements are generally accompanied by words such as “plan,” “estimate,” “expect,”“believe,” “should,” “would,” “could,” “anticipate,” “may” or other words thatconvey uncertainty of future events or outcomes. These forward-lookingstatements and other statements made elsewhere in this report are made inreliance on the Private Securities Litigation Reform Act of 1995. Thesection below entitled “Factors That May Affect Future Results ofOperations” sets forth and incorporates by reference certain factors that couldcause actual future results of the Company to differ materially from thesestatements.

Critical Accounting Policies and Estimates

Management’s discussionand analysis of financial condition and results of operations are based uponour unaudited condensed consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States. The preparation of these financial statements requires us tomake estimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities. On an on-going basis, we evaluate our estimates, includingthose related to product returns, bad debts, inventories, income taxes,warranty obligations, restructuring, maintenance contracts and contingencies. Webase our estimates on historical experience and on various other assumptionsthat we believe are reasonable under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. Actual resultsmay differ from these estimates under different assumptions or conditions.

We believe the followingcritical accounting policies affect our more significant judgments andestimates used in the preparation of our unaudited condensed consolidatedfinancial statements.

*RevenueRecognition*

Wegenerally recognize product revenue upon shipment of product. We accrue forestimated warranty costs and sales returns at the time of shipment based on ourexperience. Revenue from maintenance contracts is deferred and recognized overthe contractual period the services are performed, generally one year. There isa risk that technical issues on new products could result in unexpectedwarranty costs and returns. However, as we migrate to more of a software-basedbusiness model, the warranty costs should continue to decline. To the extentthat they do decline, our warranty reserve from current sales will decrease. Tothe extent that our warranty costs exceed our expectations, we will increaseour warranty reserve to compensate for the additional expense expected to beincurred. We review these estimates periodically and determine the appropriatereserve percentage. However, to date, warranty costs and sales returns have notbeen material. Historically, our estimates for these items have not differedmaterially from actual results. Significant or subjective estimates associatedwith our revenue recognition policy include our estimate of warranty cost andsales returns.

Werecognize software revenue from the licensing of our software products inaccordance with Statement of Position (“SOP”) No. 97-2 “SoftwareRevenue Recognition”, SOP 98-9 “Modification of 97-2, Software RevenueRecognition, with respect to certain transactions” and Staff AccountingBulletin (“SAB”) No. 104, “Revenue Recognition” whereby revenue from thelicensing of our products is not recognized until all four of the followingcriteria have been met: (1) execution of a written agreement; (2) deliveryof the product has occurred; (3) the fee is fixed and determinable; and (4) collectibilityis probable. Bundled hardware and perpetual software product sales arerecognized at time of delivery, as our licenses are not sold on a subscriptionbasis. In the case of multiple product and service sales, we perform a VendorSpecific Objective Evidence analysis to appropriately determine the amount ofrevenue derived from each deliverable. If our license strategy changes and webegin to offer licenses on a subscription basis, we would perform this analysisin a similar manner. Under these circumstances, the revenue related to thelicense would be recognized ratably over the subscription period. Market valuesare easily obtained for all of our product offerings, as we have historicalsales information on our product offerings. We defer and recognize maintenanceand support revenue over the term of the contract period, which is generallyone year.

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

Wegenerally recognize service revenue upon delivery of the contracted service. Servicerevenue, primarily including maintenance, training and installation, arerecognized upon delivery of the service and typically are unrelated to productsales. These services are not essential to the functionality of the deliveredproduct. To date, training and installation revenue has not been material.

*Allowancefor Doubtful Accounts and Returns*

Wemaintain allowances for doubtful accounts for estimated losses resulting fromthe inability of our customers to make required payments. Our receivables areuncollaterized and we expect to continue this policy in the future. If thefinancial condition of our customers were to deteriorate, resulting in animpairment of their ability to make payments, additional allowances may berequired. Historically, our estimates for sales returns and doubtful accountshave not differed materially from actual results.

*Inventory*

We write down ourinventory for estimated obsolescence or unmarketable inventory equal to thedifference between the cost of inventory and the estimated market value basedupon assumptions about future demand and market conditions. If actual marketconditions are less favorable than those projected by management, additionalinventory write-downs may be required. Historically, our estimates forinventory obsolescence have not differed materially from actual results.

*Stock-based Compensation*

Beginning on January 1,2006, we began accounting for stock options under the provisions of FinancialAccounting Standards No. 123 (revised 2004), “Share-Based Payment” (FAS123(R)), which requires the recognition of the fair value of stock-basedcompensation. Under the fair value recognition provisions for FAS 123(R),stock-based compensation cost is estimated at the grant date based on the fairvalue of the awards expected to vest and recognized as expense ratably over therequisite service period of the award. We have used the Black-Scholes valuationmodel, to estimate fair value of our stock-based awards which requires variousjudgmental assumptions including estimating stock price volatility, forfeiturerates, and expected life. Our computation of expected volatility is based on acombination of historical and market-based implied volatility. In addition, weconsider many factors when estimating expected forfeitures and expected life,including types of awards, employee class, and historical experience. If any ofthe assumptions used in the Black-Scholes model change significantly,stock-based compensation expense may differ materially in the future from thatrecorded in the current period.

We adopted FAS 123(R) usingthe modified prospective method which requires the application of theaccounting standard as of January 1, 2006. In accordance with the modifiedprospective method, the consolidated financial statements for prior periodshave not been restated to reflect, and do not include, the impact of FAS123(R).

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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, 2006**      | ** ** | **June 30, 2005**    | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
| Net product  revenue                              |       | 79.5                             | %          | 77.4                           | %          | 66.9 | % | 75.8 | % |
| Net customer  support and maintenance revenue     |       | 20.5                             |       | 22.6                           |       | 33.1 |   | 24.2 |   |
| Total revenue                                     |       | 100.0                            |       | 100.0                          |       | 100.0 |   | 100.0 |   |
| Cost of product  revenue                          |       | 35.6                             |       | 42.1                           |       | 33.4 |   | 42.2 |   |
| Cost of customer  support and maintenance revenue |       | 2.5                              |       | 1.2                            |       | 7.8 |   | 1.6 |   |
| Total cost of  revenue                            |       | 38.1                             |       | 43.3                           |       | 41.2 |   | 43.8 |   |
| Gross profit                                      |       | 61.9                             |       | 56.7                           |       | 58.8 |   | 56.2 |   |
| Operating  expenses:                              |       |                             |       |                           |       |   |   |   |   |
| Sales and marketing                               |       | 70.4                             |       | 51.1                           |       | 81.0 |   | 56.4 |   |
| Research and development                          |       | 51.1                             |       | 41.1                           |       | 68.5 |   | 48.5 |   |
| General and administrative                        |       | 32.0                             |       | 17.8                           |       | 35.7 |   | 18.4 |   |
| Severance and related costs                       |       | —                           |       | 3.2                            |       | — |   | 1.9 |   |
| Operating loss                                    |       | (91.6                            | )          | (56.5                          | )          | (126.4 | ) | (69.0 | ) |
| Other income  (expense), net                      |       | (4.4                             | )          | 0.1                            |       | (3.2 | ) | 0.0 |   |
| Interest income,  net                             |       | 0.9                              |       | 1.7                            |       | 2.0 |   | 1.2 |   |
| Loss before  income tax provision                 |       | (95.10                           | )          | (54.7                          | )          | (127.6 | ) | (67.8 | ) |
| Income tax  provision                             |       | —                           |       | —                         |       | — |   | — |   |
| Net loss                                          |       | (95.1                            | )%         | (54.7                          | )%         | (127.6 | )% | (67.8 | )% |
| Preferred stock  dividends accrued                |       | (3.6                             | )          | (3.3                           | )          | (4.3 | ) | (2.9 | ) |
| Beneficial  conversion feature on preferred stock |       | —                           |       | —                         |       | — | ) | (31.8 | ) |
| Net loss attributable  to common stockholders     |       | (98.7                            | )%         | (58.0                          | )%         | (131.9 | )% | (102.5 | )% |

 
|                      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **           | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005**    | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
| Domestic  revenues   |       | 86.6                             | %          | 89.7                           | %          | 86.3 | % | 88.2 | % |
| Export revenues  to: |       |                             |       |                           |       |   |   |   |   |
| Europe               |       | 12.6                             |       | 7.4                            |       | 10.6 |   | 7.6 |   |
| Canada               |       | 0.3                              |       | 1.0                            |       | 1.6 |   | 0.6 |   |
| Asia                 |       | 0.4                              |       | 1.8                            |       | 1.3 |   | 3.5 |   |
| Latin America        |       | 0.1                              |       | 0.1                            |       | 0.2 |   | 0.1 |   |
| Net revenues         |       | 100.0                            | %          | 100.0                          | %          | 100.0 | % | 100.0 | % |

 

**Net Revenues**. Netrevenues for the quarter and six months ended June 30, 2006 were $1.2million and $2.1 million, respectively, compared to $1.7 million and $2.9million for the same periods in 2005, primarily because projected sales did notmeet our expectations as we continued our strategic move to concentrate on ourintrusion prevention/detection, entity identification and regulated informationcompliance and data privacy products. Product revenues decreased $0.4 millionand $0.8 million, respectively, for the quarter and six months ended June 30,2006 compared to the same periods in 2005. Customer support and maintenancerevenue decreased $0.1 million for the quarter and remained consistent for thesix months ended June 30, 2006 compared to the same periods in 2005.

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**Concentrationof Revenues**. Revenues from sales to various U.S. governmententities totaled $0.9 million, or 72.4% of revenues, for the quarter ended June 30,2006 compared to $1.3 million, or 76.7% of revenues, for the same period in2005. Revenues from sales to various U.S. government entities totaled $1.4million, or 70.0% of revenues, for the six months ended June 30, 2006compared to $2.1 million, or 71.0% of revenues, for the same period in 2005. Although,we expect our concentration of revenues to vary among customers in futurequarters depending upon the timing of certain sales, we anticipate that salesto government customers will continue to account for a significant portion ofour revenues in future quarters. Sales to the government present risks inaddition to those involved in sales to commercial customers which couldadversely affect our revenues, including potential disruption to appropriationand spending patterns and the government’s reservation of the right to cancelcontracts and purchase orders for its convenience. Although we do not believethat the cancellation of any particular order would have a material adverseeffect on our financial results or that any of our revenues with governmentcustomers are subject to renegotiation, a large number of cancelled orrenegotiated government orders could possibly have a material adverse effect onour financial results. Currently, we are not aware of any proposed cancellationor renegotiation of any of our existing arrangements with government entitiesand, historically, government entities have not cancelled or renegotiatedorders which had a material adverse effect on our business.

**GrossProfit**. Gross profit was $0.7 million or 61.9% of netrevenues for the quarter ended June 30, 2006, compared to $1.0 million or56.7% of net revenues for the quarter ended June 30, 2005. Gross profitwas $1.2 million or 58.8% of net revenues for the six months ended June 30,2006, compared to $1.6 million or 56.2% of net revenues for the six monthsended June 30, 2005. Gross profit margins as a percentage of net revenuesincreased from the same period in the prior year due to a favorable shift inproduct mix. Gross profit on product revenues for the quarter and six monthsended June 30, increased from 45.6% and 44.3%, respectively, in 2005 to55.2% and 50.1%, respectively, in 2006 due to the transition to our moreprofitable software-based products. Gross profit on customer support andmaintenance revenues for the quarter and six months ended June 30,decreased from 94.7% and 93.4%, respectively, in 2005 to 87.9% and 76.4%,respectively, in 2006, as more costs associated with maintenance contracts wereincurred during the quarter.

Gross profit as apercentage of net revenues is impacted by several factors, including shifts inproduct mix, changes in channels of distribution, revenue volume, fluctuationsin third-party assembly costs, pricing strategies, and fluctuations in revenuesof integrated third-party products.

**Salesand Marketing**. Sales and marketing expenses decreased to $0.8million for the quarter ended June 30, 2006, compared to $0.9 million forthe quarter ended June 30, 2005. Sales and marketing expenses remainedrelatively constant at $1.7 million for the six months ended June 30,2006, compared to $1.6 million for the six months ended June 30, 2005. Salesand marketing expenses may vary as a percentage of net sales in the future. However,we believe that these costs will trend downward through the end of the year dueto reductions in personnel and discretionary sales and marketing expenditures.

**Researchand Development**. Research and development expenses decreasedto $0.6 million for the quarter ended June 30, 2006 compared to $0.7million for the quarter ended June 30, 2005. Research and developmentexpenses remained relatively constant at $1.4 million for the six months ended June 30,2006, compared to $1.4 million for the six months ended June 30, 2005.Research and development costs are expensed in the period incurred. Researchand development expenses may vary as a percentage of net sales in the future;however, we believe that these costs will trend downward through the end of theyear as some engineering expenses will move to cost of sales on developmentcontracts.

**Generaland Administrative**. General and administrative expensesincreased to $0.4 million for the quarter ended June 30, 2006 compared to$0.3 million for the quarter ended June 30, 2005. General andadministrative expenses increased to $0.7 million for the six months ended June 30,2006, compared to $0.5 million for the six months ended June 30, 2005. Thisincrease was primarily due to stock-based compensation expense totaling $363thousand recognized in 2006 under SFAS123(R). It is expected that general andadministrative expenses will trend slightly downward through the end of theyear because of personnel reductions and other cost cutting efforts. Generaland administrative expense may vary as a percentage of net sales in the future.

**Interest**.Net interest income decreased to $11 thousand for the quarter ended June 30,2006 compared to $29 thousand for the same period in 2005. Net interest incomeincreased to $41 thousand for the six months ended June 30, 2006 comparedto $33 thousand for the same period in 2005. Net interest income may vary in thefuture based on our cash flow and rate of return on investments.

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Liquidity and Capital Resources

Our principal source ofliquidity at June 30, 2006 is approximately $0.3 million of cash and cashequivalents. At June 30, 2006 working capital was $0.4 million compared to$2.9 million at June 30, 2005.

Cash used in operationsfor the six months ended June 30, 2006 was $2.9 million, primarily due toa net loss of $2.6 million, a decrease in accounts payable and accrued expensesof $0.2 million, a reduction in deferred revenue of $0.2 million, an increasein accounts receivable of $0.4 million and a reduction in the provision fordoubtful accounts of $13 thousand. This cash decrease was partially offset bystock-based compensation of $0.4 million, depreciation expense of $59 thousand,a decrease in inventories of $49 thousand and a decrease in prepaid expensesand other assets of $47 thousand. Cash used in operations for the six monthsended June 30, 2005 was $1.0 million, primarily due to an operating loss of$2.0 million, a decrease in accounts payable and accrued expenses of $0.2million and a decrease in the provision for doubtful accounts of $0.2 million. Thiscash usage was partially offset by depreciation and amortization of $0.1million, a decrease in accounts receivable of $0.9 million, an increase indeferred revenue of $0.1 million and a decrease in prepaid expenses and otherassets of $0.2 million. Future fluctuations in inventory balances, accountsreceivable and accounts payable will be dependent upon several factors,including, but not limited to, quarterly sales, our strategy in buildinginventory in advance of receiving orders from customers, and the accuracy ofour forecasts of product demand and component requirements.

Cash provided by investingactivities in the six months ended June 30, 2006 was $3 thousand of netpurchases of property and equipment offset by maturities of short-terminvestments of $0.5 million, compared to cash used in investing activities of$2.4 million for the six months ended June 30, 2005, which consistedprimarily of the net purchases of short-term investments of $2.4 million andnet purchases of property and equipment of $0.1 million partially offset bymaturities of short-term investments of $0.1 million.

Cash used in financingactivities in the six months ended June 30, 2006 was $0.1 million,primarily consisting of the payment of dividends on preferred stock, comparedto cash provided by financing activities in the six months ended June 30,2005 was $2.4 million, consisting of net financing proceeds from a privateplacement of $2.5 million, partially offset by payment of dividends onpreferred stock of $115 thousand.

At June 30, 2006, the Company did not have any materialcommitments for capital expenditures.

During the three months ended June 30, 2006, the Company fundedits operations through the use of cash and cash equivalents.

As of June 30, 2006,we had cash, cash equivalents and short-term investments in the amount ofapproximately $0.3 million, down from approximately $3.3 million as of December 31,2005. We funded our operations and met our cash requirements during the threemonths ended June 30, 2006 through the use of cash and cash equivalents. OnMarch 29, 2006, we established a $1.0 million line of credit with SiliconValley Bank. Our existing cash resources, line of credit and projections forincreased revenues for the remainder of 2006, may not provide sufficient cashresources to finance our operations and expected capital expenditures for thenext twelve months. It is likely that we may need to seek additional debt orequity financing to fund our operations for the next year. The sufficiency ofour cash resources depend to a certain extent on general economic, financial,competitive or other factors beyond our control. Moreover, despite actions toreduce our costs and improve our profitability, our operating losses and netoperating cash outflows may continue through at least the third quarter of 2006.We may not be able to achieve the revenue and gross margin objectives necessaryto achieve positive cash flow or profitability without obtaining additionalequity financing. We do not currently have any arrangements for additionalfinancing and we may not be able to secure additional debt or equity financingon terms acceptable to us, or at all, at the time when we need such funding. Additionally,we may not have sufficient availability under our credit line when additionalfunds are needed. Furthermore, because our stockholders’ equity of $0.6 millionas of June 30, 2006 is less than the $2.5 million required by Nasdaq, wecurrently face delisting from The Nasdaq Capital Market and must raiseadditional equity or generate at least $1.9 million of net income in order tomeet continued listing requirements. If our business does not generatesufficient cash flow from operations and sufficient future financings are notavailable, we may not be able to operate or grow our business, pay our expenseswhen due, fund our other liquidity needs or maintain our listing on The NasdaqCapital Market. Moreover, any financing raised by us may restrict our businessactivities for future capital raising efforts or cause dilution to our currentstockholders.

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We may explore thepossible acquisitions of businesses, products and technologies that arecomplementary to our existing business. We are continuing to identify andprioritize 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 from time to time in discussions withrespect to potential acquisitions, there can be no assurances that any suchacquisitions will be made or that we will be able to successfully integrate anyacquired business. In order to finance such acquisitions and working capital itmay be necessary for us to raise additional funds through public or privatefinancings. Any equity or debt financings, if available at all, may be onterms, which are not favorable to us and, in the case of equity financings, mayresult in dilution to our stockholders.

Off-Balance Sheet Arrangements.

As of June 30, 2006,we did not have any significant off-balance sheet arrangements, as defined byItem 303(c)(2) of Regulation S-B.

Factors That May Affect Future Results ofOperations 

Numerous factors mayaffect our business and future results of operations. These factors includecurrent economic and market conditions, the effect of military actions ongovernment and corporate spending on information security products, spendingpatterns of, and appropriations to, U.S. government departments, technologicalchanges, competition and market acceptance, acquisitions, product transitions,timing of orders, manufacturing and suppliers, reliance on outsourcing vendorsand other partners, intellectual property and licenses, third-party products,dependence on government customers, international operations, intellectualproperty issues, liquidity and cash resources and effects of restructuringplans and cost reductions. The discussion below addresses some of these andother factors. For a more thorough discussion of these and other factors thatmay affect our business and future results, see the discussion under thecaption “Factors That May Affect Future Results of Operations” in ourAnnual Report on Form 10-KSB for the year ended December 31, 2005.

***Ourcash, cash equivalents, and investments decreased from $3.3 million at December 31,2005 to $0.3 million at June 30, 2006 due to results of operations. If ournet cash outflows continue, we may not have sufficient cash to operate ourbusiness and may not be able to maintain our Nasdaq listing.***

As of June 30, 2006,we had cash, cash equivalents and investments in the amount of approximately$0.3 million, down from approximately $3.3 million as of December 31, 2005.Our existing cash resources, line of credit and projections for increasedrevenues for the remainder of 2006, may not provide sufficient cash resourcesto finance our operations and expected capital expenditures for the next twelvemonths. It is likely that we may need to seek additional debt or equityfinancing to fund our operations for the next year. The sufficiency of our cashresources depend to a certain extent on general economic, financial,competitive or other factors beyond our control. Moreover, despite actions toreduce our costs and improve our profitability, our operating losses and netoperating cash outflows may continue through at least the third quarter of 2006.As a result, we may not be able to achieve the revenue and gross marginobjectives necessary to achieve positive cash flow or profitability withoutobtaining additional equity financing. We do not currently have anyarrangements for additional financing and we may not be able to secure additionaldebt or equity financing on terms acceptable to us, or at all, at the time whenwe need such funding. If our business does not generate sufficient cash flowfrom operations and sufficient financing resources are not available, we maynot be able to operate or grow our business, pay our expenses when due or fundour other liquidity needs. We may not have sufficient availability under ourcredit line when we need additional funds. Furthermore, we may not be able tosecure additional debt or equity financing on terms that are acceptable to us,or at all, on a timely basis. Therefore, if our business does not generatesufficient cash flow from operations and sufficient financing resources are notavailable, we may not be able to operate or grow our business, pay our expenseswhen due or fund our other liquidity needs.

***Our stock is subject todelisting from the Nasdaq Capital Market which could adversely effect the priceand liquidity of our shares.***

The Nasdaq Capital Marketmaintains certain minimum requirements to maintain the Nasdaq listing of ourcommon stock. In particular, Nasdaq Marketplace Rule 4320(c)(2)(B) requiresus to have at least one of (1) $2,500,000 in stockholders’ equity, (2) $35,000,000market value of listed securities or (3) $500,000  of net income from continuing operations forthe most recently completed fiscal year or two of the three most recentlycompleted fiscal years. As of June 30, 2006, our stockholders’ equity wasapproximately $635,000, and as of August 1, 2006, the market value of ourcommon stock was approximately $2,889,000 based on 7,046,213 shares outstandingand a closing price of $0.41 per share. In addition, we have reported netlosses from continuing operations in each of the last three most recentlycompleted fiscal years. On June 14, 2006, Nasdaq notified us we failed tomeet the minimum stockholders’ equity requirements. Although we presented aplan for compliance to Nasdaq, on June 1, 2006, Nasdaq informed us thatthey plan to delist our stock based on the minimum equity deficiency. On August 3,2006, we appealed Nasdaq’s determination and we presented our appeal to theNasdaq Listing Qualifications Panel. We are currently awaiting a decision fromNasdaq, but we cannot assure you that they will grant our appeal or, if theydo, that we will be able to comply with any conditions to our continuedlisting.

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In addition, NasdaqMarketplace Rule 4310(c)(4) require the minimum bid price of ourcommon stock to be at least $1.00 per share. On June 26, 2006, Nasdaqnotified us that our common stock had not maintained the required minimum bidper share for more than 30 consecutive trading days. In accordance withMarketplace Rule 4310(c)(8)(D), we have 180 calendar days, or until December 26,2006, to regain compliance with this requirement.

Although we are currentlyexploring a range of alternatives to increase the amount of our cash, we maynot be able to complete an alternative transaction on acceptable terms, if atall, and may not be able to regain compliance with the minimum stockholdersequity requirements. Further, the price of our stock is subject to a number offactors outside of our control and we may not be able to regain compliance withthe minimum bid price requirements. Therefore, Nasdaq may seek to delist ourshares of common stock from The Nasdaq Capital Market. In that event, ourcommon stock likely would trade in a less efficient market such as the OTCBulletin Board or in the “pink sheets” maintained by the National QuotationBureau, Inc. Furthermore, our common stock may become subject to the “pennystock” rules adopted by the SEC which impose additional sales pricerequirements on broker dealers who sell our shares. Consequently, the delistingof our common stock may adversely impact our stock price, the liquidity of ourcommon stock and our general business reputation.

***If we fail torespond to rapid technological changes in the network security, dataprotection, regulated information compliance, entity identification and spywareprevention industries, we may lose customers or our products may becomeobsolete.***

The network security,data protection, regulated information compliance, entity identification andspyware prevention industries are characterized by frequent productintroductions, rapidly changing technology and continued evolution of industrystandards. We must introduce upgrades to our products rapidly in response tocustomer needs, such as new computer viruses or other novel external attacks oncomputer networks as well as the adoption privacy and data protection laws. Inaddition, the nature of the network security, data protection, regulatedinformation compliance, entity identification and spyware prevention industriesrequires our products to be compatible and interoperable with numerous securityproducts, networking products, workstation and personal computer architecturesand computer and network operating systems offered by various vendors,including our competitors. As a result, our success depends upon our ability todevelop and introduce in a timely manner new products and enhancements to ourproducts that meet changing customer requirements and evolving industry andlegal standards. The development of technologically advanced network security,data protection, regulated information compliance, entity identification andspyware prevention products is a complex and uncertain process requiring highlevels of innovation, rapid response and accurate anticipation of technologicaland market trends. We cannot assure you that we will be able to identify, develop,manufacture, market or support new or enhanced products successfully in atimely manner. Further, the introduction of new products or productenhancements by us or our competitors or the adoption of new or amended privacyor data protection laws may shorten the life cycle of our existing products orcause our existing products to become obsolete.

***Ourrevenues have decreased to $2.1 million for the first six months of 2006 from$2.9 million for the same period in 2005 and have generally decreased since2003 in connection with a shift to sales of our newer product lines. If ournetwork intrusion detection, regulated information compliance, spywareprevention and entity identification products do not achieve market acceptance,our revenues will suffer.***

We have continuedto transition our sales strategy from our lower margin SecureCom and PDSsecurity appliance products to the development and sales of our higher marginnetwork intrusion detection/prevention, regulated information compliance,entity identification and spyware products. During this transition, sales ofour new products were not enough to counteract the loss in sales associatedwith our older products. As a result, our net revenues remained relativelyconstant at approximately $6.0 million in 2004 and 2005 but have declined inthe first half of 2006 compared to the same period in 2005 due to a longer thanexpected sales cycle.

Our new network securityproducts, regulated information compliance systems, entity identification andspyware products have only been in the market place for a limited period oftime and may have longer sales cycles than our previous products. Althoughresponse to our products has been positive, we have not yet received broadmarket acceptance. We cannot assure you that our present or future productswill achieve market acceptance on a sustained basis.

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In order toachieve market acceptance and achieve future revenue growth, we must introducecomplementary security products, incorporate new technologies into our existingproduct lines and design, develop and successfully commercialize higherperformance products in a timely manner. We cannot assure you that we will beable to offer new or complementary products that gain market acceptance quicklyenough to avoid decreased revenues during current or future productintroductions or transitions.

***We resemble adevelopmental stage company and our business strategy may not be successful.***

From our founding in 1983until 2000, we derived substantially all of our revenue from the design,manufacture and sale of local area networking equipment. In order to permit usto focus our resources solely on developing and marketing our network securityproducts, we sold our local area networking assets and related networkingdivisions in a series of sales from 2000 to 2002.

As a result of thesesales, we now depend exclusively on revenues generated from the sale of ournetwork security products, which have received limited market acceptance. Moreover,we have only recently introduced our regulated compliance and data privacysystems and our spyware prevention and entity identification products. Althoughinitial response to these products has been positive, the market for theseproducts has only begun to emerge and sales of these products may not occur asquickly as we expect. Consequently, we resemble a developmental stage companyand will face the following inherent risks and uncertainties:

·                  the need for ournetwork security products, regulated information compliance systems, dataprivacy protection systems, entity identification products and spywareprevention products to achieve market acceptance and produce a sustainablerevenue stream;

·                  our ability tomanage costs and expenses;

·                  our dependenceon key personnel;

·                  our ability toobtain financing on acceptable terms; and

·                  our ability tooffer greater value than our competitors.

Our business strategy maynot successfully address these risks. If we fail to recognize significantrevenues from the sales of our network security products and regulatedinformation compliance systems, our business, financial condition and operatingresults would be materially adversely affected.

***We incurred a netloss of $2.6 million for the six months ended June 30, 2006 and have anaccumulated deficit of $54.7 million as of June 30, 2006. As a result, wemust generate substantially greater revenues from sales in order to achieveprofitability.***

We have incurredsignificant operating losses and are uncertain about our future operatingresults. For the six months ended June 30, 2006, we incurred a net loss of$2.6 million and had an accumulated deficit of approximately $54.7 million asof June 30, 2006. We need to generate and sustain substantially greaterrevenues from the sales of our products if we are to achieve profitability. Ifwe are unable to achieve these greater revenues, our losses will continueindefinitely, and we may never achieve or sustain profitability or generatepositive cash flow.

***We face intensecompetition from both start-up and established companies that may havesignificant advantages over us and our products.***

The market for networksecurity solutions is intensely competitive. There are numerous companiescompeting with us in various segments of the data security markets, and theirproducts may have advantages over our products in areas such as conformity toexisting and emerging industry standards, interoperability with networking andother security products, management and security capabilities, performance,price, ease of use, scalability, reliability, flexibility, product features andtechnical support.

Our principal competitorsin the network intrusion prevention and detection market include InternetSecurity Systems, Inc., Cisco Systems, Inc., Symantec, Inc.,Network Associates, Inc., Tipping Point Technologies, a division of 3ComCorporation, and NFR Security, Inc. Our competitors in the regulatedinformation compliance market include Vontu, Port Authority, Vericept,Reconnex, Tablus and a small number of start-up companies that entered the spacewithin the last two years. Regarding the spyware prevention market, wecurrently directly and indirectly compete with a number of host-based spywaredetection systems, such as Ad-Aware, Spybot S&D and Spy Sweeper and someinline proxy solutions such as Blue Coat Systems, Inc. Our current andpotential competitors may have one or more of the following significantadvantages over us:

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·                  greaterfinancial, technical and marketing resources;

·                  better namerecognition;

·                  morecomprehensive security solutions;

·                  better or moreextensive cooperative relationships; and

·                  larger customerbase.

Although we believe ourproducts compare favorably to our competitors’ products and create asustainable business model, we cannot assure you that our products will achievemarket acceptance or that we will be able to compete successfully with ourexisting or new competitors.

***Military actionsmay disrupt our business by reducing spending for our products, increasing ourcosts and affecting our international operations.***

We derive a substantialportion of our revenue from sales to United States government entities,including sales to various Army andother armed****services bases.As a result, United States military actions or other events occurring inresponse to or in connection with them, including future terrorist attacks,actual conflicts involving the United States or its allies or military or tradedisruptions could impact our operations by:

·                  reducing ordelaying government, armed service or corporate spending on our products;

·                  increasing thecost and difficulty in obtaining materials or shipping products; and

·                  affecting ourability to conduct business internationally.

Should these eventsoccur, our business, operating results and financial condition could bematerially and adversely affected.

***Our products canhave long sales and implementation cycles, which may result in us incurringsubstantial expenses before realizing any associated revenues.***

The sale andimplementation of our products to large companies and government entitiestypically involves a lengthy education process and a significant technicalevaluation and commitment of capital and other resources. This process is alsosubject to the risk of delays associated with customers’ internal budgeting andother procedures for approving capital expenditures, deploying new technologieswithin their networks and testing and accepting new technologies that affectkey operations. As a result, sales and implementation cycles for our productscan be lengthy, and we may expend significant time and resources before wereceive any revenues from a customer or potential customer. Our quarterly andannual operating results could be materially harmed if orders forecasted for aspecific customer for a particular period are not realized.

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

Since we beganrestructuring in 2002, we have incurred approximately $1.1 million inrestructuring charges, severance, and related expenses. The objective of ourrestructuring plan was to reduce our cost structure to a sustainable level thatis consistent with our current cash resources and the general economic climate.We have also implemented other strategic initiatives to strengthen ouroperations, such as reductions in our work force and facilities and aligningour organization around our business objectives. Any further work forcereductions could result in temporary reduced productivity of our remainingemployees. Additionally, our customers and prospects may delay or forgopurchasing our products due to a perceived uncertainty caused by ourrestructuring and other changes. Failure to achieve the desired results of ourinitiatives could seriously harm our business, results of operations andfinancial condition.

***Consolidation in the network security industry may limitmarket acceptance of our products.***

Several of ourcompetitors have acquired security companies with complementary technologies inthe past. We expect consolidation in the network security industry to continuein the future. These acquisitions may permit our competitors to accelerate thedevelopment and commercialization of broader product lines and morecomprehensive solutions than we currently offer. Acquisitions of vendors orother companies with which we have a strategic relationship by our competitorsmay limit our access to commercially significant technologies. Further,business combinations in the network security industry are creating companieswith larger market shares, customer bases, sales forces, product offerings andtechnology and marketing expertise, which may make it more difficult for us tocompete.

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***Sales to government entities accounted for 70.0% of ourrevenues for the six months ended June 30, 2006 and 70.7% of our revenuesfor the year ended December 31, 2005. Sales to government customersinvolve unique risks, which could adversely impact our revenues.***

We derived 70.0% of ourrevenues from sales to various U.S. government entities for the six monthsended June 30, 2006, and 70.7% of our revenues from these sales for theyear ended December 31, 2005. We expect to continue to derive asubstantial portion of our revenues from U.S. government customers in thefuture. Sales to the government present risks in addition to those involved insales to commercial customers, including potential disruption due toappropriation and spending patterns and the government’s right to cancelcontracts and purchase orders for its convenience. General political and economicconditions, which we cannot accurately predict, may affect the quantity andallocation of expenditures by federal departments. In addition, obtaininggovernment contracts may involve long purchase and payment cycles, competitivebidding, qualification requirements, delays or changes in funding, budgetaryconstraints, political agendas, extensive specification development and pricenegotiations and milestone requirements. Each government entity also maintainsits own rules and regulations with which we must comply and which can varysignificantly among departments. As a result, cutbacks or re-allocations in thefederal budget or losses of government sales due to other factors could have amaterial adverse effect on our revenues and operating results.

***We derived 13.7% ofour revenues from international sales in the six months ended June 30,2006, and 10.7% of our revenues from these sales for the year ended December 31,2005. Our ability to sell our products internationally is subject to certainrisks which could harm our business.***

Sales to foreigncustomers accounted for approximately 10.7% of our revenues for the year ended December 31,2005, and 13.7% of our revenues for the six months ended June 30, 2006. Weexpect sales to foreign customers to continue to represent a significantportion of our revenues in the future. Our international operations are subjectto many inherent risks that may adversely affect our business, financialcondition and operating results, including:

·                  political,social and economic instability;

·                  traderestrictions;

·                  increases induty rates and other potentially adverse tax consequences;

·                  exposure todifferent legal standards, particularly with respect to the protection ofintellectual property;

·                  burdens ofcomplying with a variety of foreign laws;

·                  unexpectedchanges in regulatory requirements;

·                  import andexport license requirements and restrictions of the United States and eachother country where we operate;

·                  fluctuations incurrency exchange rates; and

·                  changes in localpurchasing practices, including seasonal fluctuations in demand.

***Sales throughindirect channels accounted for 10.0% of our revenues for the six months ended June 30,2006 and 36.2% of our revenue for the year ended December 31, 2005. Ourrevenues will suffer if we do not expand our sales through, or receive theanticipated benefits from our sales through, indirect sales channels.***

We derived 10.0% of ourrevenues for the six months ended June 30, 2006, and 36.2% of our revenuefor the year ended December 31, 2005, from sales through indirect saleschannels, such as distributors, value added resellers, system integrators,original equipment manufacturers and managed service providers. We believe wemust expand our sales through these indirect channels in order to increase ourrevenues. Although we are actively pursuing a strategy to increase thepercentage of our revenues generated through these indirect sales channels, wecannot assure you that our products will gain market acceptance in theseindirect sales channels or that sales through these indirect sales channelswill increase our revenues as expected. Further, many of our competitors arealso trying to sell their products through these indirect sales channels, whichcould result in lower prices and reduced profit margins for sales of ourproducts.

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***We must adequatelyprotect our intellectual property in order to prevent loss of valuableproprietary information.***

We rely on a combinationof patent, copyright, trademark and trade secret laws, confidentiality proceduresand non-disclosure agreements to protect our proprietary technology. However,unauthorized parties may attempt to copy or reverse engineer aspects of ourproducts or to obtain and use information that we regard as proprietary. Policingunauthorized use of our products is difficult, and we cannot be certain thatthe steps we have taken will prevent misappropriation of our intellectualproperty. This is particularly true in foreign countries where the laws may notprotect proprietary rights to the same extent as the laws of the United Statesand may not provide us with an effective remedy against unauthorized use. Ifour protection of our intellectual property proves to be inadequate orunenforceable, others may be able to use our proprietary developments withoutcompensation to us, resulting in potential cost advantages to our competitors.

***We may incursubstantial expenses defending ourselves against claims of infringement.***

There are numerouspatents held by many companies relating to the design and manufacture ofnetwork security systems. Although we are not aware of any instances in whichour products violate the intellectual property rights of others orinappropriately use their technology, it is possible that third parties in thefuture may claim that our products infringe on their intellectual propertyrights. Any claim, with or without merit, could consume our management’s time,result in costly litigation, cause delays in sales or implementations of ourproducts or require us to enter into royalty or licensing agreements. Royaltyand licensing agreements, if required and available, may be on termsunacceptable to us or detrimental to our business. Moreover, a successful claimof product infringement against us or our failure or inability to license theinfringed or similar technology on commercially reasonable terms couldseriously harm our business.

***Fluctuations in ourquarterly revenues may cause the price of our common stock to decline.***

Our operating resultshave varied significantly from quarter to quarter in the past, and we expectour operating results to vary from quarter to quarter in the future due to avariety of factors, many of which are outside of our control. Although ourrevenues are subject to fluctuation, significant portions of our expenses arenot variable in the short term, and we cannot reduce them quickly to respond todecreases in revenues. Therefore, if revenues are below our expectations, thisshortfall is likely to adversely and disproportionately affect our operatingresults. Accordingly we may not attain positive operating margins in futurequarters. Any of these factors could cause our operating results to be belowthe expectations of securities analysts and investors, which likely wouldnegatively affect the price of our common stock.

***The price of ourcommon stock has been volatile in the past and may continue to be volatile inthe future due to factors outside of our control.***

The market price of ourcommon stock has been highly volatile in the past and may continue to bevolatile in the future. For example, for the six-month period ending June 30,2006, the market price of our common stock on The Nasdaq Capital Marketfluctuated between $0.40 and $2.87 per share. The market price of our commonstock may fluctuate significantly in response to a number of factors, many ofwhich are outside our control, including:

·                  variations inour quarterly operating results;

·                  changes inestimates of our financial performance by securities analysts;

·                  changes inmarket valuations of our competitors;

·                  announcements byus or our competitors of new products, significant contracts, acquisitions,strategic relationships, joint ventures or capital commitments;

·                  product ordesign flaws, product recalls or similar occurrences;

·                  additions or departuresof key personnel;

·                  sales of commonstock in the future; and

·                  fluctuations instock market prices and volume, which can be particularly common among networksecurity and other high technology companies.

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***Our reductions inour work force may make it more difficult for us to attract and retain thepersonnel necessary to successfully operate our business.***

We rely upon thecontinued service of a relatively small number of key technical, sales andsenior management personnel. Our future success depends on retaining our keyemployees and our continuing ability to attract, train and retain other highlyqualified technical, sales and managerial personnel. As a result, our employeescould resign with little or no prior notice. We may not be able to attract, assimilateor retain other highly qualified technical, sales and managerial personnel inthe future, especially given our recent reductions in force. The loss of any ofour key technical, sales and senior management personnel or our inability toattract, train and retain additional qualified personnel could seriously harmour business.

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

We cannot issueshares of capital stock with rights senior to those of our existing 5%preferred stock, Series 2 5% preferred stock or Series 3 5% preferredstock without the approval of at least a majority of the holders of our 5%preferred stock, all of the holders of our Series 2 5% preferred stock,and holders of at least 75% of our Series 3 5% preferred stock voting oracting as separate classes. We also cannot incur certain indebtedness withoutthe approval of at least a majority of the holders of our 5% preferred stock. Inaddition, holders of the Series 3 5% preferred stock who are not executiveofficers or directors have the right to purchase a pro rata portion of certainfuture issuances of securities by us. Furthermore, the terms of our securedcredit line with Silicon Valley Bank include covenants which restrict ourability to incur additional debt and pay certain dividends. The combination ofthese provisions could hinder or delay our ability to raise additional debt orequity financing.

***You will experiencesubstantial dilution upon the conversion or redemption of the shares ofpreferred stock and exercise of warrants that we issued in recent privateplacements.***

On March 25,2004, we completed a $5,000,000 private placement in connection with which weissued 1,000,000 shares of our 5% Convertible Preferred Stock and warrants toacquire 556,619 shares of our common stock. The conversion price for thepreferred stock and the exercise price of the warrants is $3.144 per share. Wealso issued our placement agent a warrant for 64,408 shares of our common stockat an exercise price of $3.144 per share. As of August 1, 2006, there were259,696 shares of 5% preferred stock, representing approximately 413,003 sharesof common stock upon conversion, and warrants to purchase 621,027 shares ofcommon stock outstanding.

In addition, on March 28,2005, we completed a $2,663,000 private placement in connection with which weissued 1,065,200 shares of our Series 2 5% Convertible Preferred Stock andwarrants to acquire 532,600 shares of our common stock. We also issued twoaffiliates of our placement agent warrants to purchase an aggregate of 60,390shares of common stock. The conversion price for the preferred stock is $2.50per share and the exercise price of the warrants is $2.77 per share. As of August 1,2006, there were 460,000 shares of Series 2 5% preferred stock,representing 460,000 shares of common stock upon conversion, and warrants topurchase 592,990 shares of common stock outstanding.

Finally, on December 2,2005, we completed a $1,230,843 private placement in connection with which weissued 564,607 shares of our Series 3 5% preferred stock and warrants toacquire 282,306 shares of our common stock. We also issued two affiliates ofour placement agent warrants to purchase an aggregate of 27,531 shares ofcommon stock. The conversion price of the preferred stock is $2.18 per shareand the exercise price of the warrants is $2.58 per share. As of August 1,2006, there were 468,735 shares of Series 3 5% preferred stock,representing 468,735 shares of common stock upon conversion, and warrants topurchase 309,837 shares of common stock outstanding.

On August 1, 2006,we had 7,046,213 shares of common stock outstanding. We expect the privateplacements discussed above to result in a further dilution to holders of ourcommon stock upon conversion of the preferred stock and exercise of thewarrants of 2,865,592 shares of common stock, or an approximately 40.7%increase in the number of shares of our common stock outstanding.

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Further, the occurrenceof certain events entitle holders of our Series 3 5% preferred stock torequire us to redeem their shares for a number of shares of our common stockequal to the redemption price divided by 75% of the ten-day average of thevolume weighted average price of our common stock ending on the day immediatelypreceding the holder’s election to redeem, subject to a floor of $0.87 pershare. Holders of our Series 2 5% preferred stock have similar redemptionrights without a floor. The redemption price for the shares of Series 3 5%preferred stock equals the sum of (1) the greater of $2.834 and the volumeweighted average price of our common stock on the trading day immediatelypreceding the redemption event multiplied by $2.18 divided by the conversionprice of the Series 3 5% preferred stock then in effect plus (2) anyaccrued but unpaid dividends on the Series 3 5% preferred stock plus (3) anyunpaid liquidated damages or other amounts payable to the holders of the Series 35% preferred stock. The redemption price for the shares of Series 2 5%preferred stock equals the sum of (1) the greater of $3.25 and the volumeweighted average price of our common stock on the trading day immediatelypreceding the redemption event multiplied by $2.50 divided by the conversionprice of the Series 2 5% preferred stock then in effect plus (2) anyaccrued but unpaid dividends on the Series 2 5% preferred stock plus (3) anyunpaid liquidated damages or other amounts payable to the holders of the Series 25% preferred stock. As a result, assuming we have paid all liquidated damagesand other amounts to the holders, accrued but unpaid dividends on July 28,2006 of $17,256, a volume weighted average price of $0.41, which was theten-day volume weighted average closing price of our common stock on July 28,2006, and our 7,046,213 shares of common stock outstanding on July 28,2006, we would issue approximately 9,137,599 shares of our common stock if aspecified redemption event occurs and all holders of Series 3 5% preferredstock and Series 2 5% preferred stock elected to redeem their shares forcommon stock. This would represent an increase of approximately 129.7% in thenumber of shares of our common stock as of July 28, 2006.

***The conversion ofpreferred stock or exercise of warrants we issued in our recent privateplacement may cause the price of our common stock to decline.***

The holders of theshares of our 5% preferred stock and warrants we issued on March 25, 2004,may freely convert their shares of preferred stock and exercise their warrantsand sell the underlying shares of common stock pursuant to an effectiveregistration statement we filed on August 6, 2004. As of August 1,2006, 740,304 shares of preferred stock had converted into 1,177,327 shares ofcommon stock.

The holders of theshares of Series 2 5% preferred stock and warrants we issued on March 28,2005, may freely convert their shares of preferred stock and exercise theirwarrants and sell the underlying shares of common stock pursuant to aneffective registration statement we filed on May 5, 2005. As of August 1,2006, 605,200 shares of Series 2 5% preferred stock had converted into605,200 shares of common stock.

The holders of theshares of Series 3 5% preferred stock and warrants we issued on December 2,2005, may freely convert their shares of preferred stock and exercise theirwarrants and sell the underlying shares of common stock pursuant to aneffective registration statement we filed on January 5, 2006. As of August 1,2006, 95,872 shares of Series 3 5% preferred stock had converted into95,872 shares of common stock.

For the four weeksended on July 28, 2006, the average daily trading volume of our commonstock on The Nasdaq Capital Market was 31,021 shares. Consequently, if holdersof preferred stock or warrants elect to convert their remaining shares orexercise their warrants and sell a material amount of their underlying sharesof common stock on the open market, the increase in selling activity couldcause a decline in the market price of our common stock. Furthermore, thesesales, or the potential for these sales, could encourage short sales, causingadditional downward pressure on the market price of our common stock.

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

Shares of our 5%preferred stock accrue cash dividends equal to $0.25 per share per annum,payable in arrears on March 31 and September 30 of each year, sharesof our Series 2 5% preferred stock accrue cash dividends equal to $0.125per share per annum, payable in arrears on the first business day of March,June, September and December of each year and shares of our Series 35% preferred stock accrue cash dividends equal to $0.109 per share per annum,payable in arrears on the first business day of March, June, September andDecember of each year. The amount of the dividends on our Series 2 5%preferred stock may increase to $0.45 per share per annum and the amount of thedividends on our Series 3 5% preferred stock may increase to $0.3294 pershare per annum upon the occurrence of certain event entitling the holders ofthese shares to redemption.

During 2005, we paid $123thousand in dividends related to our 5% convertible preferred stock and $63thousand in dividends related to our Series 2 5% preferred stock. At June 30,2006, we had $16,187 dividends accrued related to our 5% preferred stock,$4,726 related to our Series 2 5% preferred stock and $4,199 related toour Series 3 5% preferred stock.

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Delaware lawprovides that we may only pay dividends out of our capital surplus or, if nosurplus is available, out of our net profits for the fiscal year the dividendis declared and/or the preceding fiscal year. We have not had net profits forthe last two fiscal years ended as of December 31, 2005. However, we didhave sufficient 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. Although we are currently able to pay accrueddividends on our outstanding shares of preferred stock, we cannot assure youthat our net assets will continue to exceed our stated capital or that we willhave net profits in order to pay these dividends in the future. These dividendscontinue to accrue on our outstanding shares of preferred stock, regardless ofwhether we are legally able to pay them. The accrual of these dividends mayadversely affect our operating results. Moreover, the payment of thesedividends could strain our available cash resources, which could adversely affectour ability to operate or grow our business.

In addition, ourinability to pay dividends could require us to redeem outstanding shares of Series 25% preferred stock and Series 3 5% preferred stock for shares of ourcommon stock issued at a price equal to 75% of the average of the volumeweighted average price of our common stock for the ten days ending on the dayimmediately preceding an election to redeem, subject, in the case of the Series 35% preferred stock, to a floor of $0.87. As a result, the issuance, orpotential issuance, of these additional shares of common stock could cause ourstock price to decline. Furthermore, our inability to pay dividends couldadversely affect our ability to raise equity financing in the future ifrequired.

***Our acquisition ofcomplementary products or businesses may adversely affect our financialcondition.***

We have made acquisitionsin the past, and, in the future, we may acquire or invest in additionalcompanies, business units, product lines or technologies to accelerate thedevelopment of products and sales channels complementary to our existingproducts and sales channels. Negotiation of potential acquisitions andintegration of acquired products, technologies or businesses could divert ourmanagement’s time and resources. Future acquisitions could cause us to issueequity securities that would dilute your ownership of us, incur debt orcontingent liabilities, amortize intangible assets or write off in-processresearch and development, goodwill and other acquisition-related expenses thatcould seriously harm our financial condition and operating results. Further, ifwe are not able to properly integrate acquired products, technologies orbusinesses with our existing products and operations, train, retain and motivatepersonnel from the acquired business or combine potentially different corporatecultures, we may not receive the intended benefits of our acquisitions, whichcould adversely affect our business, operating results and financial condition.

***Compliance withexport regulations may hinder our sales to foreign customers.***

Certain of our datasecurity products incorporate encryption and other technology that may requireclearance and export licenses from the U.S. Department of Commerce under UnitedStates export regulations. Any inability to obtain these clearances or licensesor any foreign regulatory approvals, if required, on a timely basis could delaysales and have a material adverse effect on our operating results.

***Provisions of ourcharter documents and Delaware law may have anti-takeover effects.***

Certain provisions of ourcertificate of incorporation and bylaws, such as our ability to offer “blankcheck” preferred stock and the inability of our common stockholders to act bywritten consent, could make it more difficult for a third party to acquire us,even if doing so would be beneficial to our stockholders. We are also subjectto the provisions of Section 203 of the Delaware General Corporation Law,which restricts certain business combinations with interested stockholders andcould inhibit a non-negotiated merger or other business combination.

***Our management andpreferred stockholders exercise significant control over our company and mayapprove or take actions that may be adverse to your interests.***

As of August 1,2006, our executive officers, directors and preferred stockholders beneficiallyown approximately 23.5% of our voting power. As a result, these stockholderswill be able to exercise significant control over all matters requiringstockholder approval, including the election of directors and the approval ofsignificant corporate transactions, which could delay or prevent someone fromacquiring or merging with us or providing us with additional financing ifrequired. These stockholders may use their influence to approve or take actionsthat may be adverse to your interests.

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Item 3.                                CONTROLSAND PROCEDURES

We have carried out anevaluation, under the supervision and the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures as of March 31,2006, pursuant to Rule 13a-15(b) under the Exchange Act. Basedupon that evaluation, our Chief Executive Officer and Chief Financial Officerconcluded that our disclosure controls and procedures are effective in ensuringthat information required to be disclosed is recorded, processed, summarizedand reported in a timely manner.

We have carried out anevaluation, under the supervision and participation of our management,including our Chief Executive Officer and Chief Financial Officer, of anychanges in our internal controls over financial reporting that occurred duringthe quarterly period ended June 30, 2006, and our Chief Executive Officerand Chief Financial Officer have concluded that there was no change during thequarterly period ended June 30, 2006 that has materially affected or isreasonably expected to materially affect our internal control over financialreporting.

**PART II–OTHER INFORMATION**

Item 1.                                LEGALPROCEEDINGS

We are subject to legalproceedings and claims that arise in the ordinary course of business. We do notbelieve that the outcome of those matters will have a material adverse affecton our consolidated financial position, operating results or cash flows. However,there can be no assurance such legal proceedings will not have a materialimpact.

Item 4.    SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

The Annual Meeting of Stockholders was held on June 13, 2006, atthe Radisson Hotel, Dallas North in Richardson, Texas. The following is a briefdescription of each matter voted upon by stockholders, including a number ofvotes cast for, against, or withheld with regard to each matter of nominee.

(1)                                  Electionof five (5) directors to serve until the next Annual Meeting ofStockholders and until their respective successors are duly elected andqualified.
|                         | ** ** | **FOR**   | ** ** | **WITHHELD** | ** ** |
|-------------------------|------------|-----------|------------|--------------|------------|
| G. Ward Paxton          |       | 7,029,934 |       | 152,691      |       |
| T. Joe Head             |       | 7,061,681 |       | 120,944      |       |
| James F. Gero           |       | 7,062,719 |       | 119,906      |       |
| J. Fred  Bucy, Jr. |       | 7,061,731 |       | 120,894      |       |
| Donald M. Johnston      |       | 7,059,006 |       | 123,619      |       |

(2)                                  Ratificationand approval for issuance of shares of the Company’s common stock sufficient tofully provide for the conversion or redemption of the Company’s Series 35% Convertible Preferred Common Stock and the exercise of warrants to purchasethe Company’s common stock the Company sold in a private placement on December 2,2005.
| FOR       | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 3,752,085 |       | 182,172     |       | 291,924     |       |

(3)                                  Ratificationand approval for the issuance of shares of Company’s common stock upon theconversion or redemption of shares of the Company’s Series 3 5%Convertible Preferred Stock and warrants purchased by G. Ward Paxton, theCompany’s Chairman, President and Chief Executive Officer and James F. Gero,one of the Company’s directors in the private placement offering on December 2,2005.
| FOR       | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 3,185,140 |       | 185,702     |       | 300,299     |       |

(4)                                  Ratificationand approval of selection by the Board of Directors of KBA Group LLP asindependent auditors of the Registrant for the fiscal year ending December 31,2006.
| FOR       | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 7,105,597 |       | 64,002      |       | 13,025      |       |

 

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Item 6.                                EXHIBITS

The following Exhibits are filed with this report form10-QSB:
| 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 of Chief Executive Officer Pursuant to  Rule 13a-14(b) of the Exchange Act and 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
| 32.2 |   | Certification of Chief Financial Officer Pursuant to  Rule 13a-14(b) of the Exchange Act and 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

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

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.
|                            | ** ** | **INTRUSION INC.**                                                       |
|----------------------------|------------|--------------------------------------------------------------------------|
|                       |       |                                                                     |
| Date: August 11, 2006 |       | /s/ G. Ward Paxton                                                       |   |
|                       |       | G. Ward Paxton                                                           |
|                       |       | Chairman, President & Chief Executive  Officer                  |
|                       |       | (Principal Executive Officer)                                            |
|                       |       |                                                                     |
|                       |       |                                                                     |
| Date: August 11, 2006 |       | /s/ Michael L. Paxton                                                    |   |
|                       |       | Michael L. Paxton                                                        |
|                       |       | Vice President, Chief Financial Officer,  Treasurer & Secretary |
|                       |       | (Principal Financial & Accounting Officer)                      |

 

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