**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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| **ý**                                                                                                                                                                                                                                                                                                                  | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                        |                                                                                          |
| **For  the quarterly period ended June 30, 2003**                                                                                                                                                                                                                                                                      |
|                                                                                                                                                                                                                                                                                                                        |                                                                                          |
| **OR**                                                                                                                                                                                                                                                                                                                      |
|                                                                                                                                                                                                                                                                                                                        |                                                                                          |
| **o**                                                                                                                                                                                                                                                                                                                       | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                                                                        |                                                                                          |
| **For  the transition period from                         to                       ** |
|                                                                                                                                                                                                                                                                                                                        |                                                                                          |
| **Commission File Number 0-20191**                                                                                                                                                                                                                                                                                          |

 

**INTRUSIONINC.**

(Exactname of Registrant as specified in its charter)

 

| **Delaware**                                                     |   | **75-1911917**                         |
|------------------------------------------------------------------|--------|----------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |   | (I.R.S.  Employer  Identification No.) |
|                                                             |   |                                   |
| **1101  East Arapaho Road, Richardson, Texas 75081**             |
| (Address  of principal executive offices)  (Zip Code)            |
|                                                             |   |                                   |
| **(972)  234-6400**                                              |
| (Registrant’s  telephone number, including area code)       |
|                                                             |   |                                   |
| **Not  Applicable**                                              |
| Former  name, if changed since last report)                      |

 

* * * * * * * * * *

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days:

Yes  ý  No  o

 

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

 

The number ofshares outstanding of the Registrant’s Common Stock, $0.01 par value, onAugust 13, 2003 was 20,649,425.

 

 

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**INTRUSIONINC.**

 

INDEX

 
| **PART I - FINANCIAL  INFORMATION**                                                                                                   |
|---------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                  |
| Item 1.  Financial Statements                                                                                                    |
|                                                                                                                                  |
| Condensed  Consolidated Balance Sheets as of June 30, 2003 and December 31,  2002                                           |
|                                                                                                                                  |
| Condensed  Consolidated Statements of Operations for the three months and six months  ended June 30, 2003 and June 30, 2002 |
|                                                                                                                                  |
| Condensed  Consolidated Statements of Cash Flows for the six months ended June 30,  2003 and June 30, 2002                  |
|                                                                                                                                  |
| Notes  to Condensed Consolidated Financial Statements                                                                                 |
|                                                                                                                                  |
| Item 2.   Management’s Discussion and Analysis of Financial Condition and  Results of Operations                            |
|                                                                                                                                  |
| Item 3.   Quantitative and Qualitative Disclosures About Market Risk                                                             |
|                                                                                                                                  |
| Item 4.   Controls and Procedures                                                                                                |
|                                                                                                                                  |
| **PART II - OTHER INFORMATION**                                                                                                       |
|                                                                                                                                  |
| Item  1.  Legal Proceedings                                                                                                      |
|                                                                                                                                  |
| Item  4.  Submission of Matters to a Vote of  Security Holders                                                                   |
|                                                                                                                                  |
| Item 6.  Exhibits and Reports on Form 8-K                                                                                        |
|                                                                                                                                  |
| Signature Page                                                                                                                        |

 

2

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**PART I - FINANCIAL INFORMATION**

** **

Item 1.  FINANCIAL STATEMENTS

 

**INTRUSION INC. AND SUBSIDIARIES**

CONDENSEDCONSOLIDATED BALANCE SHEETS

(In thousands, except par value amounts)

 
|                                                                                                                                                                                 |   | **June 30,  2003** |   | **Dec 31,  2002** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|--------|-------------------|--------|
|                                                                                                                                                                                 |   | **(Unaudited)**         |   | **(Audited)**     |   |
| **ASSETS**                                                                                                                                                                           |   |                    |   |              |   |
| Current Assets:                                                                                                                                                                      |   |                    |   |              |   |
| Cash and cash equivalents                                                                                                                                                            |   | $                       | 1,030  |              | $      | 2,898 |   |
| Short-term investments                                                                                                                                                               |   | 5,050                   |   | 7,825             |   |
| Accounts receivable, less allowance for doubtful  accounts $644 in 2003 and $934 in 2002                                                                                             |   | 961                     |   | 2,363             |   |
| Inventories, net                                                                                                                                                                     |   | 1,556                   |   | 1,411             |   |
| Other assets                                                                                                                                                                         |   | 341                     |   | 759               |   |
| Total current assets                                                                                                                                                                 |   | 8,938                   |   | 15,256            |   |
| Property and equipment, net                                                                                                                                                          |   | 832                     |   | 1,597             |   |
| Other assets                                                                                                                                                                         |   | 81                      |   | 86                |   |
| TOTAL ASSETS                                                                                                                                                                         |   | $                       | 9,851  |              | $      | 16,939 |   |
|                                                                                                                                                                                 |   |                    |   |              |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                       |   |                    |   |              |   |
|                                                                                                                                                                                 |   |                    |   |              |   |
| Current Liabilities:                                                                                                                                                                 |   |                    |   |              |   |
| Accounts payable and accrued expenses                                                                                                                                                |   | $                       | 2,033  |              | $      | 2,905 |   |
| Deferred revenue                                                                                                                                                                     |   | 1,148                   |   | 1,650             |   |
| Total current liabilities                                                                                                                                                            |   | 3,181                   |   | 4,555             |   |
| Stockholders’ Equity:                                                                                                                                                           |   |                    |   |              |   |
| Preferred stock, $.01 par value, authorized shares –  5,000, no shares issued and outstanding                                                                                   |   | —                  |   | —            |   |
| Common stock, $.01 par value, authorized shares –  80,000, Issued shares – 20,688 in 2003 and 20,686 in 2002, Outstanding shares  – 20,648 in 2003 and 20,646 in 2002 |   | 207                     |   | 207               |   |
| Common stock held in treasury, at cost – 40 shares                                                                                                                              |   | (362                    | )      | (362              | )      |
| Additional paid-in capital                                                                                                                                                           |   | 47,371                  |   | 47,371            |   |
| Accumulated deficit                                                                                                                                                                  |   | (40,318                 | )      | (34,604           | )      |
| Accumulated other comprehensive loss                                                                                                                                                 |   | (228                    | )      | (228              | )      |
| Total stockholders’ equity                                                                                                                                                      |   | 6,670                   |   | 12,384            |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                      |   | $                       | 9,851  |              | $      | 16,939 |   |

 

Seeaccompanying notes.

 

3

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**INTRUSION INC. AND SUBSIDIARIES**

CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS

(Inthousands, except per share amounts)

(Unaudited)

 
|                                                           |   | **Three  Months Ended** |   | **Six Months  Ended**   |   |
|----------------------------------------------------------------|--------|-------------------------|--------|-------------------------|--------|
|                                                           |   | **June 30,  2003** |   | **June 30,  2002** |   | **June 30,  2003** |   | **June 30,  2002** |   |
| Net sales                                                      |   | $                       | 1,483  |                    | $      | 1,465 |   | $ | 2,959 |   | $ | 3,979 |   |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Cost of sales                                                  |   | 1,091                   |   | 1,142                   |   | 2,095 |   | 2,851 |   |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Gross profit                                                   |   | 392                     |   | 323                     |   | 864 |   | 1,128 |   |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Operating expenses:                                            |   |                    |   |                    |   |   |   |   |   |
| Sales and marketing                                            |   | 1,923                   |   | 3,197                   |   | 3,786 |   | 7,099 |   |
| Research and development                                       |   | 901                     |   | 1,485                   |   | 1,824 |   | 3,364 |   |
| General and administrative                                     |   | 446                     |   | 615                     |   | 848 |   | 1,323 |   |
| Amortization of intangibles                                    |   | —                  |   | 199                     |   | — |   | 399 |   |
| Severance costs                                                |   | 118                     |   | 200                     |   | 244 |   | 200 |   |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Operating loss                                                 |   | (2,996                  | )      | (5,373                  | )      | (5,838 | ) | (11,257 | ) |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Other income                                                   |   | 10                      |   | —                  |   | 10 |   | — |   |
| Interest income, net                                           |   | 53                      |   | 108                     |   | 114 |   | 198 |   |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Loss before income tax provision                               |   | (2,933                  | )      | (5,265                  | )      | (5,714 | ) | (11,059 | ) |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Income tax benefit                                             |   | —                  |   | 608                     |   | — |   | 608 |   |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Loss from continuing operations                                |   | (2,933                  | )      | (4,657                  | )      | (5,714 | ) | (10,451 | ) |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Gain from discontinued operations, net of taxes                |   | —                  |   | —                  |   | — |   | 401 |   |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Net loss                                                       |   | $                       | (2,933 | )                       | $      | (4,657 | ) | $ | (5,714 | ) | $ | (10,050 | ) |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Basic and diluted loss per share, continuing  operations       |   | $                       | (0.14  | )                       | $      | (0.23 | ) | $ | (0.28 | ) | $ | (0.51 | ) |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Basic and diluted loss per share                               |   | $                       | (0.14  | )                       | $      | (0.23 | ) | $ | (0.28 | ) | $ | (0.49 | ) |
|                                                           |   |                    |   |                    |   |   |   |   |   |
| Weighted average common shares outstanding, basic  and diluted |   | 20,648                  |   | 20,643                  |   | 20,648 |   | 20,638 |   |

 

Seeaccompanying notes.

 

4

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**INTRUSION INC. AND SUBSIDIARIES**

CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS

(Inthousands)

(Unaudited)

 
|                                                                                                                         |   | **Six Months  Ended**   |   |
|------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|--------|
|                                                                                                                         |   | **June 30,  2003** |   | **June 30,  2002** |   |
| Operating Activities:                                                                                                        |   |                    |   |   |   |
| Loss from continuing operations                                                                                              |   | $                       | (5,714 | ) | $ | (10,451 | ) |
| Adjustments to reconcile loss from  continuingoperations to net cash used in operating activities of continuing  operations: |   |                    |   |   |   |
| Depreciation and amortization                                                                                                |   | 850                     |   | 1,450 |   |
| Provision for doubtful accounts                                                                                              |   | (290                    | )      | (75 | ) |
| Changes in operating assets and liabilities:                                                                                 |   |                    |   |   |   |
| Accounts receivable                                                                                                          |   | 1,692                   |   | 1,972 |   |
| Income taxes receivable                                                                                                      |   | —                  |   | 2,779 |   |
| Inventories                                                                                                                  |   | (145                    | )      | 1,601 |   |
| Other assets                                                                                                                 |   | 423                     |   | (755 | ) |
| Accounts payable and accrued expenses                                                                                        |   | (872                    | )      | (1,645 | ) |
| Deferred revenue                                                                                                             |   | (502                    | )      | (206 | ) |
| Net cash used in operating activities of  continuingoperations                                                               |   | (4,558                  | )      | (5,330 | ) |
| Investing Activities:                                                                                                        |   |                    |   |   |   |
| Purchases of short-term investments                                                                                          |   | (2,150                  | )      | (9,125 | ) |
| Maturities of short-term investments                                                                                         |   | 4,925                   |   | 7,002 |   |
| Net purchases of property and equipment                                                                                      |   | (85                     | )      | (37 | ) |
| Net cash provided by (used in) investing activities  ofcontinuing operations                                                 |   | 2,690                   |   | (2,160 | ) |
| Financing Activities:                                                                                                        |   |                    |   |   |   |
| Exercise of warrants and employee stock options                                                                              |   | —                  |   | 50 |   |
| Issuance of shares in employee stock purchase plan                                                                           |   | —                  |   | 1 |   |
| Other                                                                                                                        |   | —                  |   | (21 | ) |
| Net cash provided by financing activities  ofcontinuing operations                                                           |   | —                  |   | 30 |   |
| Net cash provided by discontinued operations                                                                                 |   | —                  |   | 485 |   |
| Effect of foreign currency translation adjustmentson  cash and cash equivalents                                              |   | —                  |   | (3 | ) |
| Net decrease in cash and cash equivalents                                                                                    |   | (1,868                  | )      | (6,978 | ) |
| Cash and cash equivalents at beginning of period                                                                             |   | 2,898                   |   | 15,783 |   |
| Cash and cash equivalents at end of period                                                                                   |   | $                       | 1,030  |   | $ | 8,805 |   |

 

Seeaccompanying notes.

 

5

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**INTRUSION INC. AND SUBSIDIARIES**

NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

1.               Descriptionof Business

 

We develop, marketand support network intrusion detection systems (IDS) and VPN/firewallappliances that address vital security issues facing enterprise and governmententities that rely on their networks for daily operations.

 

Our IntrusionSecureNet network intrusion detection system provides users a broad andaccurate detection technology, simple deployment options and a highly intuitivemanagement interface. The SecureNet Sensor can be deployed on 10, 100, 250Mb/sand Gigabit networks as either an all-inclusive Hardware-Appliance or usingIntrusion’s Software-Appliance CD, which can turn certain standard networkservers into IDS Sensors. Both Hardware-Appliances and Software-Appliances takeadvantage of the Intrusion SecureNet WBI Sensor web-browser managementinterface that can be accessed from anywhere in the enterprise. Centralizedevent monitoring and system management is done with the Intrusion SecureNetProvider, three-tier centralized management system.

 

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

 

We organized inTexas in September 1983 and reincorporated in Delaware inOctober 1995.  For more than 15years, we provided local area networking equipment and were known as OpticalData Systems or ODS Networks.  OnApril 17, 2000, we announced plans to sell, or otherwise dispose of, ournetworking divisions, which included our Essential Communications Division(“Essential”) and our local area networking assets.  This plan was completed during March 2002.  We have accounted for these businesses asdiscontinued operations.  OnJune 1, 2000, we changed our name from ODS Networks, Inc. toIntrusion.com, Inc., and our NASDAQ ticker symbol from ODSI to INTZ to reflectour focus on intrusion detection solutions. On November 1, 2001, we changed our name from Intrusion.com, Inc.to Intrusion Inc.

 

Our principalexecutive offices are located at 1101 East Arapaho Road, Richardson, Texas75081, and our telephone number is (972) 234-6400.  Our website URL is www.intrusion.com.  References to “we”, “us”, “our” or “Intrusion Inc.” refer toIntrusion Inc. and its subsidiaries.

 

2.               Basisof Presentation

 

The accompanyingunaudited condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesfor interim financial information and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States forcomplete financial statements.  TheDecember 31, 2002 balance sheet was derived from audited financialstatements, but does not include all the disclosures required by accountingprinciples generally accepted in the United States.  However, we believe that the disclosures are adequate to make theinformation presented not misleading. In our opinion, all

 

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the adjustments (consisting of normal recurringadjustments) considered necessary for fair presentation have beenincluded.  The results of operations forthe three and six month periods ending June 30, 2003 are not necessarilyindicative of the results that may be achieved for the full fiscal year or forany future period.  The condensedconsolidated financial statements included herein should be read in conjunctionwith the consolidated financial statements and notes thereto included in theCompany’s annual report on Form 10-K for the year ended December 31, 2002.

 

At June 30,2003, the Company had approximately $6.1 million of unrestricted cash, cashequivalents and short-term investments,down from approximately $10.7 million as of December 31, 2002.  The Company funded its operations and metcash requirements during the quarter by selling a portion of short-terminvestments.  The sale of short-terminvestments resulted in a higher cash balance at quarter end when compared tothe previous quarter.  Although webelieve that we have sufficient cash resources to finance our operations andexpected capital expenditures for the next twelve months based on our internal estimatesand our operating plan, the sufficiency of our cash resources may depend to acertain extent on general economic, financial, competitive or other factorsbeyond our control.  This plan isbenefited by further cost reduction actions that are scheduled to take place inthe third quarter this year.  TheCompany plans to allocate resources to markets and opportunities that offerhigher margin and larger sales dollars. Despite actions to reduce our costs and improve our profitability, weexpect our operating losses and net operating cash outflows to continue through2003.  As a result, we may not be ableto achieve the revenue and gross margin objectives necessary to achievepositive cash flow or profitability without obtaining additionalfinancing.  However, there is noassurance that financing will be available on acceptable terms or in a timelymanner, if at all.  If our business doesnot generate sufficient cash flow from operations and sufficient future financingsare not available, we may not be able to operate or grow our business, pay ourexpenses when due or fund our other liquidity needs.

 

The consolidatedfinancial statements do not include any adjustments that might result from theoutcome of any of the uncertainties discussed above.

 

3.               RecentAccounting Pronouncements

 

In December 2002, the FASBissued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition andDisclosure” (“SFAS 148”).  SFAS 148amends FASB Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS123”), to provide alternative methods of transition to SFAS 123’s fair valuemethod of accounting for stock-based employee compensation.

 

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

 

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

 

4.               Foreign Currency Translation

 

OnJanuary 1, 2003, the Company elected to change the functional currency ofits foreign operations to the United States dollar. This change in functionalcurrency is supported by the fact that all foreign operations are fundedmonthly in United States dollars and the majority of revenue contracts aredenominated in United States dollars. Under United States dollar functional currency, the financial statementsof foreign locations are remeasured from the recording currency to the UnitedStates dollar. The resulting remeasurement adjustment is recorded as foreignexchange gain or loss in the statement of operations. There is no translationadjustment to the separate component of stockholders’ equity or adjustment tocomprehensive income. The effect of the change in functional currency had nomaterial impact on results of operations. The accumulation of prior years’translation adjustments remains on the balance sheet as a separate component ofstockholders’ equity until part, or all, of the respective entities aredisposed. During 2002, the financial statements were prepared using the localcurrency as the functional currency. All balance sheet accounts of foreignsubsidiaries were translated at the current exchange rate as of the end of theaccounting period. The resulting translation adjustment was previously recordedas a separate component of stockholders’ equity. Income statement items arepreviously translated at average currency exchange rates.

 

5.               Inventories(In thousands)

 
| **Inventories consist of:** |   | **June 30,  2003** |   | **December 31,  2002** |   |
|-----------------------------|--------|-------------------------|--------|-----------------------------|--------|
|                        |   |                    |   |                        |   |
| Raw materials               |   | $                       | — |                        | $      | 70 |   |
| Finished goods              |   | 1,467                   |   | 1,157                       |   |
| Demonstration systems       |   | 89                      |   | 184                         |   |
| Net inventory               |   | $                       | 1,556  |                        | $      | 1,411 |   |

 

6.               Accountingfor Stock-Based Compensation

 

We account for employee stock-basedcompensation under APB 25.  Thefollowing table summarizes relevant information as to the reported resultsunder our intrinsic value method of accounting for stock awards, withsupplemental information as if the fair value recognition provision of SFAS 123had been applied for the quarters ended June 30, 2003 and June 30,2002 and the six months ended June 30, 2003 and June 30, 2002 (inthousands, except per share data):

 

8

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|                                                                                                   |   | **Quarter  Ended********June 30,  2003** |   | **Quarter********Ended********June 30,  2002** |   | **Six********Months********June 30,  2003** |   | **Six********Months********June 30,  2002** |   |
|--------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------|--------|-----------------------------------------------------|--------|--------------------------------------------------|--------|--------------------------------------------------|--------|
|                                                                                                   |   |                                          |   |                                                |   |                                             |   |                                             |   |
| Net loss, as  reported                                                                                 |   | $                                             | (2,933 | )                                                   | $      | (4,657                                           | )      | $                                                | (5,714 | ) | $ | (10,050 | ) |
| Add (Deduct):  Total stock-based compensation determined under fair value-based method for  all awards |   | 4_                                            |   | 16                                                  |   | 336                                              |   | (437                                             | )      |
| Pro forma net  loss                                                                                    |   | $                                             | (2,929 | )                                                   | $      | (4,641                                           | )      | $                                                | (5,378 | ) | $ | (10,487 | ) |
|                                                                                                   |   |                                          |   |                                                |   |                                             |   |                                             |   |   |   |   |   |
| Net loss per  share:                                                                                   |   |                                          |   |                                                |   |                                             |   |                                             |   |
| Basic, as  reported                                                                                    |   | $                                             | (0.14  | )                                                   | $      | (0.23                                            | )      | $                                                | (0.28  | ) | $ | (0.49 | ) |
| Basic, pro forma                                                                                       |   | $                                             | (0.14  | )                                                   | $      | (0.22                                            | )      | $                                                | (0.26  | ) | $ | (0.51 | ) |
| Diluted, as  reported                                                                                  |   | $                                             | (0.14  | )                                                   | $      | (0.23                                            | )      | $                                                | (0.28  | ) | $ | (0.49 | ) |
| Diluted, pro  forma                                                                                    |   | $                                             | (0.14  | )                                                   | $      | (0.22                                            | )      | $                                                | (0.26  | ) | $ | (0.51 | ) |
| Weighted-average  shares used in computation:                                                          |   |                                          |   |                                                |   |                                             |   |                                             |   |
| Basic and diluted                                                                                      |   | 20,648                                        |   | 20,643                                              |   | 20,648                                           |   | 20,638                                           |   |

 

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

 

7.               Net Loss Per Share

 

We report twoseparate earnings per share (“EPS”) numbers, basic EPS and diluted EPS.  Basic net loss per share is computed bydividing net loss for the period by the weighted average number of commonshares outstanding for the period. Diluted net loss per share is computed by dividing the net loss by theweighted average number of common shares and common stock equivalentsoutstanding for the period.  Our commonstock equivalents are not included in the diluted loss per share for the threeand six-month periods ended June 30, 2003 and 2002, as they are antidilutive.  Such options are excluded due to incurring anet loss per share in the applicable period.

 

8.               DiscontinuedOperations

 

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

 

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

 

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fourth quarter of 2002 for less than $0.3 millionresulted in additional gain on sale of $0.1 million.

 

The followingrepresents a summary of gains and losses from discontinued operations (Inthousands):

 
|                                |   | **Six Months Ended  June 30, 2002** |   |
|-------------------------------------|--------|------------------------------------------|--------|
| Net sales                           |   | $                                        | 727    |   |
| Cost of sales                       |   | 323                                      |   |
| Gross profit                        |   | 404                                      |   |
|                                |   |                                     |   |
| Operating expenses                  |   | 502                                      |   |
| Operating loss                      |   | (98                                      | )      |
|                                |   |                                     |   |
| Gain on sale                        |   | 499                                      |   |
| Income before income taxes          |   | 401                                      |   |
|                                |   |                                     |   |
| Income tax benefit                  |   | —                                   |   |
|                                |   |                                     |   |
| Income from discontinued operations |   | $                                        | 401    |   |

 

9.               Commitmentsand Contingencies

 

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

 

On March 22,2002, Morgan Newton Company, L.P. (“Morgan Newton”) filed suit against us inDallas County District Court, Case No. DV02-02339-C, alleging claims for breachof contract, promissory estoppel, and fraud. The claims arise out of an alleged oral representation to Morgan Newtonconcerning a request for quotation for the purchase of a large amount of MorganNewton’s products.  Morgan Newton hasnot specified the amount of damages it is seeking in the lawsuit, but it ispossible that Morgan Newton may be seeking damages in excess of $2.0million.  In addition to actual damages,Morgan Newton is also seeking attorney’s fees and punitive damages.  We believe Morgan Newton’s claims arewithout merit and intend to vigorously defend this lawsuit, generally denyingall claims and asserting certain affirmative defenses.  As of this time, discovery is substantiallyunderway, and trial has been scheduled for October 2003.  Due to the uncertainty of the ultimateresult of this suit, we have not recorded a liability related to the suit at June 30,2003 or December 31, 2002.

 

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

 

This reportcontains forward-looking statements, within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of 1934,that involve risks and uncertainties, such as statements concerning: the difficulties in forecastingfuture sales caused by current economic and market conditions, the effect ofmilitary actions on government and corporate spending on information securityproducts, the impact of our cost reduction programs and our refocused productline, the difficulties and

 

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uncertainties insuccessfully developing and introducing new products, our ability to continueto meet operating expenses through current cash flow or additional financings,the continuance and strength of our relationship with Check Point, the highlycompetitive market for our products, difficulties in accurately estimatingmarket growth, the consolidation of the information security industry, theimpact of changing economic conditions, business conditions in the informationsecurity industry, our ability to manage acquisitions effectively, our abilityto manage discontinued operations effectively, the impact of market peers andtheir products as well as risks concerning future technology and othersidentified in our Annual Report on Form 10-K and other Securities and ExchangeCommission filings.  Such forward-lookingstatements are generally accompanied by words such as “plan,” “estimate,”“expect,” “believe,” “should,” “would,” “could,” “anticipate,” “may” or otherwords that convey uncertainty of future events or outcomes.  These forward-looking statements and otherstatements made elsewhere in this report are made in reliance on the PrivateSecurities Litigation Reform Act of 1995. The section below entitled “Factors That May Affect Future Resultsof Operations” sets forth and incorporates by reference certain factors thatcould cause actual future results of the company to differ materially fromthese statements.

 

Overview

 

We develop, marketand support network intrusion detection systems and VPN/firewall appliancesthat address vital security issues facing enterprise and government entitiesthat rely on their networks for daily operations.

 

Our IntrusionSecureNet network IDS provides users a broad and accurate detection technology,simple deployment options and a highly intuitive management interface. TheSecureNet Sensor can be deployed on 10, 100, 250Mb/s and Gigabit networks aseither an all-inclusive Hardware-Appliance or using Intrusion’sSoftware-Appliance CD, which can turn certain standard network servers into IDSSensors. Both Hardware-Appliances and Software-Appliances take advantage of theIntrusion SecureNet WBI Sensor web-browser management interface that can beaccessed from anywhere in the enterprise. Centralized event monitoring andsystem management is done with the Intrusion SecureNet Provider, three-tiercentralized management system.

 

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

 

We organized inTexas in September 1983 and reincorporated in Delaware inOctober 1995.  For more than 15years, we provided local area networking equipment and were known as OpticalData Systems or ODS Networks.  OnApril 17, 2000, we announced plans to sell, or otherwise dispose of, ournetworking divisions, which include Essential and our local area networkingassets.  In accordance with these plans,we have accounted for these businesses as discontinued operations.  On June 1, 2000, we changed our namefrom ODS Networks, Inc. to Intrusion.com, Inc., and our NASDAQ ticker symbolfrom ODSI to INTZ to reflect our focus on intrusion detection solutions.  On November 1, 2001, we changed ourname from Intrusion.com, Inc. to Intrusion Inc.

 

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Our principalexecutive offices are located at 1101 East Arapaho Road, Richardson, Texas75081, and our telephone number is (972) 234-6400.  Our website URL is www.intrusion.com.  References to “we”, “us”, “our” or “Intrusion Inc.” refer toIntrusion Inc. and its subsidiaries.

 

CriticalAccounting Policies and Estimates

 

Management’s discussion and analysisof financial condition and results of operations are based upon our condensedconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States.  The preparation of these financialstatements requires us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues and expenses, and related disclosureof contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those relatedto product returns, bad debts, inventories, warranty obligations, restructuring,maintenance contracts and contingencies. We base our estimates on historical experience and on various otherassumptions that are believed to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from othersources.  Actual results may differ fromthese estimates under different assumptions or conditions.

 

We believe the following criticalaccounting policies affect our more significant judgments and estimates used inthe preparation of our condensed consolidated financial statements.

 

*Revenue Recognition*

 

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

 

We recognizesoftware revenue from the licensing of our software products in accordance withStatement of Position (“SOP”) No. 97-2 “Software Revenue Recognition” and SOP98-9 “Modification of 97-2, Software Revenue Recognition, with respect tocertain transactions” whereby revenue from the licensing of our products is notrecognized until all four of the following conditions have been met: i)execution of a written purchase order, license agreement or contract; ii)shipment of the product has occurred; iii) the license fee is fixed anddeterminable; and iv) collectibility is probable.  The Company defers and recognizes maintenance and support revenueover the term of the contract period, which is generally one year.

 

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

 

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related to the sale at the time of shipment to thedistributor.  The deferred revenue inthe accompanying financial statements is offset by deferred cost of sales.

 

*Allowance for Doubtful Accountsand Returns*

 

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

 

*Inventory*

 

We write down our inventory forestimated obsolescence or unmarketable inventory equal to the differencebetween the cost of inventory and the estimated market value based uponassumptions about future demand and market conditions. If actual marketconditions are less favorable than those projected by management, additionalinventory write-downs may be required.

 

Results of Operations

 

The followingtable sets forth, for the periods indicated, certain financial data as apercentage of net sales. The period-to-period comparison of financial resultsis not necessarily indicative of future results.

 
|                                           |   | **Three  Months Ended** |   | **Six Months  Ended**   |   |
|------------------------------------------------|--------|-------------------------|--------|-------------------------|--------|
|                                           |   | **June 30,  2003** |   | **June 30,  2002** |   | **June 30,  2003** |   | **June 30,  2002** |   |
| Net sales                                      |   | 100.0                   | %      | 100.0                   | %      | 100.0 | % | 100.0 | % |
| Cost of sales                                  |   | 73.6                    |   | 78.0                    |   | 70.8  |   | 71.7 |   |
| Gross profit                                   |   | 26.4                    |   | 22.0                    |   | 29.2 |   | 28.3 |   |
| Operating expenses:                            |   |                    |   |                    |   |   |   |   |   |
| Sales and marketing                            |   | 129.7                   |   | 218.2                   |   | 127.9 |   | 178.4 |   |
| Research and development                       |   | 60.8                    |   | 101.4                   |   | 61.6 |   | 84.5 |   |
| General and administrative                     |   | 30.1                    |   | 42.0                    |   | 28.7 |   | 33.2 |   |
| Amortization of intangibles                    |   | —                  |   | 13.6                    |   | — |   | 10.0 |   |
| Severance costs                                |   | 8.0                     |   | 13.7                    |   | 8.2 |   | 5.0 |   |
| Operating loss                                 |   | (202.2                  | )      | (366.9                  | )      | (197.2 | ) | (282.8 | ) |
|                                           |   |                    |   |                    |   |   |   |   |   |
| Other income                                   |   | 0.7                     |   | —                  |   | 0.3 |   | — |   |
| Interest income, net                           |   | 3.6                     |   | 7.4                     |   | 3.9 |   | 5.0 |   |
| Loss before income tax provision               |   | (197.9                  | )      | (359.5                  | )      | (193.0 | ) | (277.8 | ) |
|                                           |   |                    |   |                    |   |   |   |   |   |
| Income tax benefit                             |   | —                  |   | 41.5                    |   | — |   | 15.3 |   |
|                                           |   |                    |   |                    |   |   |   |   |   |
| Loss from continuing operations                |   | —                  |   | (318.0                  | )      | — |   | (262.5 | ) |
| Gain from discontinuedoperations, net of taxes |   | —                  |   | 0.0                     |   | — |   | 10.1 |   |
|                                           |   |                    |   |                    |   |   |   |   |   |
| Net loss                                       |   | (197.9                  | )      | (318.0                  | )      | (193.0 | ) | (252.4 | ) |

 

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|             |   | **Three  Months Ended**       |   | **Six Months  Ended**   |   |
|------------------|--------|-------------------------------|--------|-------------------------|--------|
|             |   | **June 30,********2003** |   | **June 30,  2002** |   | **June 30,  2003** |   | **June 30,  2002** |   |
| Domestic sales   |   | 66.6                          | %      | 66.1                    | %      | 57.6 | % | 68.9 | % |
| Export sales to: |   |                          |   |                    |   |   |   |   |   |
| Europe           |   | 24.6                          |   | 10.8                    |   | 30.9 |   | 8.6 |   |
| Canada           |   | 1.9                           |   | 10.4                    |   | 0.6 |   | 6.9 |   |
| Asia             |   | 6.6                           |   | 12.2                    |   | 10.8 |   | 15.4 |   |
| Latin America    |   | 0.3                           |   | 0.5                     |   | 0.1 |   | 0.2 |   |
|             |   |                          |   |                    |   |   |   |   |   |
| Net sales        |   | 100.0                         | %      | 100.0                   | %      | 100.0 | % | 100.0 | % |

 

**NetSales**.  Net sales forthe quarter and six months ended June 30, 2003 were $1.5 million and $3.0million, respectively, compared to $1.5 million and $4.0 million, respectively,for the same periods of 2002.  Salesfrom our first generation security products continued to decrease and our salesof SecureNet network intrusion detection products and PDS security applianceproducts increased.  The world-wideeconomic slow down, combined with the military operations in Iraq andelsewhere, negatively impacted our government and non-government sales.

 

**ExportSales**.  Export salesfor the quarter and six months ended June 30, 2003 were $0.5 million and $1.3million respectively, compared to $0.5 million and $1.2 million, respectively,for the same period of 2002.  Sales fromour SecureNet Pro intrusion detection product family, PDS security appliancefamily and other security product lines accounted for this slight increase.

 

**Concentrationof Sales**.  There wereno significant concentrations of sales (i.e. greater than 10%) during thesecond quarter or first six months of 2002 or 2003. We expect the lack of aconcentration of sales to continue as we sell to various customers, and theconcentration mix may vary depending upon the timing of certain sales.

 

**GrossProfit**.  Gross profitwas $0.4 million or 26.4% of net sales for the quarter ended June 30,2003, compared to $0.3 million or 22.0% of net sales for the quarter endedJune 30, 2002. For the six months ended June 30, 2002, gross profitdecreased to $0.9 million or 29.2% of net sales compared to $1.1 million or28.3% of net sales for the same period in the prior year. Gross profit marginsas a percentage of net sales were up for the quarter and six months endedJune 30, 2003 primarily because of the change in product mix from lowermargin hardware products to higher margin intrusion detection products.

 

Gross profit in2003 was negatively impacted by the write off of prepaid licenses for productsthat are no longer sold by Intrusion. The amortization of these prepaid licenses was accelerated during 2003due to the termination of the underlying agreement on June 30, 2003.  The accelerated amortization related tothese prepaid licenses for the three-month and six-month periods endedJune 30, 2003 was $0.3 million and $0.4 million, respectively.  This accelerated amortization negativelyimpacted gross profit for the three-month and six-month periods ended June 30,2003 by 17.1% and 14.7%, respectively. The prepaid licenses related to this agreement have been fully amortizedat June 30, 2003.

 

Gross profit as apercentage of net sales is impacted by several factors, including shifts inproduct mix, changes in channels of distribution, sales

 

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volume, fluctuations in manufacturing costs, pricingstrategies, and fluctuations in sales of integrated third-party products.

 

**Salesand Marketing**.  Salesand marketing expenses decreased to $1.9 million for the quarter endedJune 30, 2003, compared to $3.2 million for the quarter endedJune 30, 2002. Sales and marketing expenses decreased to $3.8 million forthe six months ended June 30, 2003 compared to $7.1 million for the sameperiod of 2002. Sales and marketing expenses decreased in the quarter and sixmonths ended June 30, 2003, compared to the same periods of 2002,primarily due to the reorganization of our sales and marketing departments andother cost reduction initiatives.  Weexpect sales and marketing expenses to continue to decline in the third quarterof 2003, in comparison to the second quarter of 2003 as we continue our costreduction initiatives.  Sales andmarketing expenses may vary as a percentage of net sales in the future.

 

**Researchand Development**. Research and development expenses decreased to $0.9 million for thequarter ended June 30, 2003, compared to $1.5 million for the quarterended June 30, 2002. Research and development costs for the six monthsended June 30, 2003 decreased to $1.8 million compared to $3.4 million forthe same period in 2002. Research and development costs are expensed in theperiod incurred.  Research anddevelopment expenses decreased in the quarter and six months ended June 30,2003, compared to the same periods in 2002 as we reduced the research anddevelopment workforce and focused more of our development efforts on our coresecurity products, SecureNet Pro and PDS security appliances, while reducingefforts on our other security products. Research and development expenses mayvary as a percentage of net sales in the future.

 

**Generaland Administrative**. General and administrative expenses decreased to $0.4 million for thequarter ended June 30, 2003, compared to $0.6 million for the quarterended June 30, 2002. General and administrative expensed decreased to $0.8million for the six months ending June 30, 2003, compared to $1.3 millionfor the six months ending June 30, 2002. General and administrative expensesdecreased in the quarter and six months ending June 30, 2003 compared tothe same periods of 2002, primarily due to restructuring activities in 2002 andother cost reduction initiatives.  It isexpected that general and administrative expenses will remain relatively constantthroughout the remainder of the year. General and administrative expense may vary as a percentage of net salesin the future.

 

**Amortization**.  Amortization expenses ceased atDecember 31, 2002 due to the impairment charge taken duringDecember 2002 to write down the balance of all intangible assets to zero.

 

**SeveranceCosts. **Severancecosts of $0.1 million for the three-month period ended June 30, 2003 and$0.2 million for the six-month period ended June 30, 2003 consists ofseverance expense as a result of additional reductions in force.  There were severance charges for thethree-month and six-month period ended June 30, 2002 of $0.2 million and$0.2 million, respectively.

 

**Interest**.  Net interest income remained relativelyconstant at $0.1 million for the quarter ended June 30, 2003, compared to$0.1 million for the same period in 2002. Net interest income decreased to $0.1 million for the six months endedJune 30, 2003, compared to $0.2 million for the six months endedJune 30, 2002. The net interest income decreases were primarily due to thereduced overall cash balances resulting from operating losses.  Net interest

 

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income may vary in the future based on our cash flowand rate of return on investments.

 

Liquidity and CapitalResources

 

Our principalsource of liquidity at June 30, 2003 is approximately $1.0 million of cashand cash equivalents and $5.1 million of short-term investments.  As of June 30, 2003 working capital was$5.8 million compared to $17.4 million as of June 30, 2002.

 

Cash used incontinuing operations for the six months ended June 30, 2003 was $4.6million, primarily due to an operating loss from continuing operations of $5.7million, the provision for doubtful accounts and an increase in inventories, aswell as decreases in accounts payable and accrued expenses and deferredrevenue, which are offset by depreciation expense and decreases in accountsreceivable and other assets, compared to cash used in operations of $5.3 millionfor the six months ended June 30, 2002, primarily due to an operating lossfrom continuing operations of $10.5 million, an increase in other assets anddecreases in accounts payable and accrued expenses and deferred revenue, whichare offset by a decrease in income taxes receivable, accounts receivable andinventories.  Future fluctuations ininventory balances, accounts receivable and accounts payable will be dependentupon several factors, including, but not limited to, quarterly sales, ourstrategy in building inventory in advance of receiving orders from customers,and the accuracy of our forecasts of product demand and component requirements.

 

Cash provided byinvesting activities in the six months ended June 30, 2003 was $2.7million, which consisted primarily of purchases and maturities of short-terminvestments, compared to cash used in investing activities of $2.2 million forthe six months ended June 30, 2002, which also consisted primarily ofpurchases and maturities of short-term investments.

 

Cash provided byfinancing activities in the six months ended June 30, 2003 was $0.5thousand, as there were two thousand shares issued through the employee stockpurchase plan during the period, compared to $30.0 thousand during the sixmonths ended June 30, 2002, which was primarily the result of the exerciseof employee stock options.

 

At June 30,2003, the Company did not have any material commitments for capitalexpenditures.

 

During the sixmonths ended June 30, 2003, the Company funded its operations through theuse of cash and cash equivalents.

 

Based on theCompany’s financial projections, the Company expects that cash on hand, alongwith short-term investments, and cash from its operations will be sufficient tofund operations for the next 12 months. However, that plan is dependent upon decreases in operatingexpenses.  The Company funded its operations and met cash requirements during thequarter by selling a portion of short-term investments.  The sale of short-term investments resultedin a higher cash balance at quarter end when compared to the previousquarter.  Although we believe that wehave sufficient cash resources to finance our operations and expected capitalexpenditures for the next twelve months based on our internal estimates and ouroperating plan, the sufficiency of our cash resources may depend to a certainextent on general economic, financial, competitive or other factors beyond ourcontrol.  This plan is benefited byfurther cost reduction actions that are scheduled to take place in the thirdquarter this year.  The

 

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Company plans to allocateresources to markets and opportunities that offer higher margin and largersales dollars.  Despite actions toreduce our costs and improve our profitability, we expect our operating lossesand net operating cash outflows to continue through 2003.  As a result, we may not be able to achievethe revenue and gross margin objectives necessary to achieve positive cash flowor profitability without obtaining additional financing.  However, there is no assurance thatfinancing will be available on acceptable terms or in a timely manner, if atall.  If our business does not generatesufficient cash flow from operations and sufficient future financings are notavailable, we may not be able to operate or grow our business, pay our expenseswhen due or fund our other liquidity needs.

 

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

 

Factors ThatMay Affect Future Results of Operations 

 

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

 

**Sufficiencyof Cash Flow.**  At June 30, 2003, the Companyhad approximately $6.1 million of unrestricted cash, cash equivalents andshort-term investments, down fromapproximately $10.7 million as of December 31, 2002.  The Company funded its operations and metcash requirements during the quarter by selling a portion of short-terminvestments.  The sale of short-terminvestments resulted in a higher cash balance at quarter end when compared tothe previous quarter.  Although webelieve that we have sufficient cash resources to finance our operations andexpected capital expenditures for the next twelve months based on our internalestimates and our operating plan, the sufficiency of our cash resources maydepend to a certain extent on general economic, financial, competitive or otherfactors beyond our control.  This planis benefited by further cost reduction actions that are scheduled to take placein the third quarter this year.  TheCompany plans to allocate resources to markets and opportunities that offerhigher margin and larger sales dollars. Despite actions to reduce our costs and improve our profitability, weexpect our

 

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operating losses and netoperating cash outflows to continue through 2003.  As a result, we may not be able to achieve the revenue and grossmargin objectives necessary to achieve positive cash flow or profitability withoutobtaining additional financing.  However,there is no assurance that financing will be available on acceptable terms orin a timely manner, if at all.  If ourbusiness does not generate sufficient cash flow from operations and sufficientfuture financings are not available, we may not be able to operate or grow ourbusiness, pay our expenses when due or fund our other liquidity needs.

 

**Technological Changes.**  The market for our products is characterizedby frequent product introductions, rapidly changing technology and continuedevolution of new industry standards. The market for security products requires our products to be compatibleand interoperable with products and architectures offered by various vendors,including other security products, networking products, workstation and personalcomputer architectures and computer and network operating systems.  Our success will depend to a substantialdegree upon our ability to develop and introduce in a timely manner newproducts and enhancements to our existing products that meet changing customerrequirements and evolving industry standards. The development of technologically advanced products is a complex anduncertain process requiring high levels of innovation as well as the accurateanticipation of technological and market trends.  There can be no assurance that we will be able to identify,develop, manufacture, market and support new or enhanced products successfullyin a timely manner.  Further, we or ourcompetitors may introduce new products or product enhancements that shorten thelife cycle of or make obsolete our existing product lines, any of which couldhave a material adverse effect on our business, operating results and financialcondition.

 

**MarketAcceptance.**  We arepursuing a strategy to increase the percentage of our revenue generated throughindirect sales channels including distributors, value added resellers, systemintegrators, original equipment manufacturers and managed serviceproviders.  There can be no assurancethat our products will gain market acceptance in these indirect saleschannels.  Further, competition amongsecurity companies to sell products through these indirect sales channels couldresult in significant price competition and reduced profit margins.

 

We are alsopursuing a strategy to further differentiate our product line by introducingcomplementary security products and incorporating new technologies into ourexisting product line.  There can be noassurance that we will successfully introduce these products or that suchproducts will gain market acceptance. We anticipate competition from networking companies, network securitycompanies and others in each of our product lines.  We anticipate that profit margins will vary among our productlines and that product mix fluctuations could have an adverse effect on ouroverall profit margins.

 

**Acquisitions.**Some of our competitors have acquired several security companies withcomplementary technologies, and we anticipate that such acquisitions willcontinue in the future.  Theseacquisitions may permit such competitors to accelerate the development andcommercialization of broader product lines and more comprehensive solutionsthan we currently offer.  In the past,we have relied upon a combination of internal product development andpartnerships with other security vendors to provide competitive solutions tocustomers.  Certain of the recent andfuture acquisitions by our competitors may have the effect of limiting ouraccess to commercially significant technologies.  Further, the business combinations and acquisitions in thesecurity industry are creating companies with larger market shares, customerbases, sales forces,

 

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product offerings and technology and marketingexpertise.  There can be no assurance thatwe will be able to compete successfully in such an environment.

 

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

 

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

 

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

 

All of the materials used in our products are purchased under contractsor purchase orders with third parties. While we believe that many of the materials used in the production ofour products are generally readily available from a variety of sources, certaincomponents such as microprocessors and mother boards are available from one ora limited number of suppliers.  The leadtimes for delivery of components vary significantly and can exceed twelve weeksfor certain components.  If we shouldfail to forecast our requirements accurately for components, we may experienceexcess inventory or shortages of certain components that could have an adverseeffect on our business and operating results. Further, any interruption in the supply of any of these components, orthe inability to procure these components from alternative sources atacceptable prices within a reasonable time, could have an adverse effect on ourbusiness and operating results.

 

**Intellectual Property and Licenses.** There are many patents held by companies, which relate to the design andmanufacture of network security

 

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systems.  Holders of those could assert potentialclaims of infringement.  We could incursubstantial costs in defending our company and our customers against any suchclaim regardless of the merits of such claims. In the event of a successful claim of infringement, we may be requiredto obtain one or more licenses from third parties.  There can be no assurance that we could obtain the necessarylicenses on reasonable terms.

 

**Dependenceon Check Point Technologies**.  A percentage of our sales arerepresented by our PDS family of security appliances, which are integrated withCheck Point Software Technologies’ market-leading virtual private network andfirewall security software.  We expectthe percentage of sales represented by these products to decrease in thefuture.  Although we are a certified appliancepartner of Check Point and our PDS products have received certification fromCheck Point, we have no long-term agreement or exclusive relationship withCheck Point.  As a result, the loss orsignificant change in our relationship with Check Point, the failure of futurePDS products to receive Check Point certification, the business failure ofCheck Point or its acquisition by or of one of our competitors, and the loss ofmarket share of Check Point or market acceptance of its products could each havea material adverse effect on our business, financial condition and results ofoperations.

 

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

 

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

 

**Impact of Government Customers.******** $0.2 million or 13.6% and $0.3 million or 10.0% of revenue in thequarter and six months ended June 30, 2003, respectively, was derived fromsales to the U.S. government, either directly by Intrusion or through systemintegrators and other resellers compared to $0.1 million or 8.1% and $0.5million or 12.0% of revenue for the same periods in 2002.  $0.2 million or 7.5% of revenue in thesix-month period ended June 30, 2003 was derived from sales to all U.K.government entities compared to $0.0 million or 0.0% of revenue for the sameperiod ended June 30, 2002.  Weexpect sales to the U.S. and foreign governments to represent a significantportion of our revenue in future periods. Sales to the government present risks in addition to those involved insales to commercial customers, including potential disruptions due to appropriationand spending patterns and the government’s reservation of the right to cancelcontracts and purchase orders for its convenience.

 

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

 

•                  reducing government or corporatespending on network security products;

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

•                  affecting our ability to conductbusiness internationally.

 

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

 

**Restructuring and CostReductions. **Weimplemented a restructuring plan in April 2002 and are adopting additionalcost-cutting initiatives.  The objectiveof these plans is to reduce our cost structure to a sustainable level that isconsistent with the current macroeconomic environment and our cash flowprojections.  We have also implementedother strategic initiatives designed to strengthen our operations.  These plans involved, among other things,reductions in our workforce and facilities, aligning our organization aroundour business objectives, realignment of our sales force and changes in oursales management.  The workforcereductions, which continued into 2003, could result in temporary reducedproductivity of our remaining employees. Additionally, our customers and prospects may delay or forgo purchasingour products due to a perceived uncertainty caused by the restructuring andother changes.  Failure to achieve thedesired results of our initiatives could seriously harm our business, resultsof operations and financial condition.

 

**Potential Nasdaq Delisting**.  The Nasdaq Stock Market maintains certainminimum requirements to maintain the listing for our common stock.  These requirements include a minimum bidprice for our common stock of $1.00.  Wereceived a notice of noncompliance from Nasdaq on August 12, 2002.  In order to take advantage of additionalgrace periods for compliance, we transferred the listing of our common stockfrom the Nasdaq National Market to the Nasdaq SmallCap Market, effectiveDecember 4, 2002.  Although weexpect to continue to have the opportunity to regain compliance for listing onthe Nasdaq National Market, if the minimum bid price of our common stock is notat least $1.00 for at least 10 consecutive trading days on or prior toNovember 5, 2003, Nasdaq may seek to delist our common stock from theNasdaq SmallCap Market.  We cannotassure you that we will be able to meet the minimum bid price requirement priorto the deadline in order to maintain our listing on the Nasdaq SmallCap Marketor that we will be able to maintain compliance with Nasdaq’s other continuedlisting requirements.

 

If we are unableto regain compliance with the minimum bid price requirement or fail to complywith other Nasdaq continued listing requirements, our common stock likely wouldtrade in a less efficient market, such as the OTC Bulletin Board or in the“pink sheets” maintained by the National Quotation Bureau, Inc.  Because these alternatives generally areconsidered to be less efficient markets, our stock price, the liquidity of ourcommon stock and our general business reputation may be adversely impacted.

 

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**General.**  Sales of our productsfluctuate, from time to time, based on numerous factors, including customers’capital spending levels and general economic conditions.  While certain industry analysts believe thatthere is a significant market for network security products, there can be noassurance as to the rate or extent of the growth of such market or thepotential adoption of alternative technologies.  Currently, capital spending for information technology products,including security products is being adversely affected by uncertain economicconditions and world events such as current military conflicts in Iraq andelsewhere.  Future declines in networksecurity product sales as a result of general economic conditions, adoption ofalternative technologies or any other reason could have a material adverseeffect on our business, operating results and financial condition.

 

Due to the factors noted above and in “Management’s Discussionand Analysis of Financial Condition and Results of Operations”, our futureearnings and common stock price may be subject to significant volatility,particularly on a quarterly basis.  Pastfinancial performance should not be considered a reliable indicator of futureperformance and investors should not use historical trends to anticipate resultsor trends in future periods.  Anyshortfall in revenue and earnings from the levels anticipated by securitiesanalysts could have an immediate and significant effect on the trading price ofour common stock in any given period. Also, we participate in a highly dynamic industry, which often resultsin volatility of our common stock price.

 

Item3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

**ForeignExchange**.  Revenueoriginating outside the U.S. in the quarters ended June 30, 2003, 2002 and2001 was 33.4%, 33.9% and 38.2% of total revenues, respectively. Revenueoriginating outside the U.S. in the six months ended June 30, 2003, 2002and 2001 was 42.4%, 31.1% and 29.1% of total revenues, respectively.  International sales are made mostly from ourforeign sales subsidiaries in the local countries and are typically denominatedin U.S. dollars.  These subsidiariesincur most of their expenses in the local currency.

 

Our internationalbusiness is subject to risks typical of an international business, including,but not limited to: differing economic conditions, changes in politicalclimate, differing tax structures, other regulations and restrictions andforeign exchange rate volatility. Accordingly, our future results could be materially adversely affectedby changes in these or other factors. The effect of foreign exchange rate fluctuations on us in 2003, 2002 and2001 was not material.

 

*Foreign Currency Translation –* On January 1, 2003, the Company elected to change thefunctional currency of its foreign operations to the United States dollar. Thischange in functional currency is supported by the fact that all foreignoperations are funded monthly in United States dollars and the majority of arevenue contracts are denominated in United States dollars.  Under United States dollar functionalcurrency, the financial statements of foreign locations are remeasured from therecording currency to the United States dollar. The resulting remeasurementadjustment is recorded as foreign exchange gain or loss in the statement ofoperations. There is no translation adjustment to the separate component ofstockholders’ equity or adjustment to comprehensive income. The effect of thechange in functional currency had no material impact on results of operations.The accumulation of prior years’ translation adjustments remains on the balancesheet as a separate component of stockholders’ equity until part, or all, ofthe respective entities are

 

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disposed. During 2002, thefinancial statements were prepared using the local currency as the functionalcurrency. All balance sheet accounts of foreign subsidiaries were translated atthe current exchange rate as of the end of the accounting period. The resultingtranslation adjustment was recorded as a separate component of stockholders’equity. Income statement items are translated at average currency exchangerates.

 

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

 

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

 

Investments infixed rate interest earning instruments carry a degree of interest raterisk.  Fixed rate securities may havetheir fair market value adversely impacted due to a rise in interestrates.  Due in part to these factors,our future investment income may fall short of expectations due to changes ininterest rates or we may suffer losses in principal if forced to sellsecurities, which have seen a decline in market value due to changes ininterest rates.  Our investmentsecurities are held for purposes other than trading.  The weighted-average of the stated coupon interest rate oninvestment securities at June 30, 2003 was 6.71%.  Due to the amortization of premiums anddiscounts paid, the actual rate of return will vary from the weighted-averageof the stated coupon interest rate.  Thefair value of investments held at June 30, 2003 approximated amortizedcost.

 

Item 4.                                                             CONTROLS AND PROCEDURES

 

(a)                                  Evaluation of disclosure controlsand procedures.  Within 90 days prior to the filing of thisQuarterly Report on Form 10-Q, we carried out an evaluation, under thesupervision and the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, of the design and operation ofthese disclosure controls and procedures pursuant to Exchange Act of Rule13a-14.  Based upon that evaluation, ourChief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures are effective in timely alerting them tomaterial information relating to the Company (including our consolidatedsubsidiaries) required to be included in our periodic SEC filings.

 

(b)                                 Changes in internal controls. There were no significant changes in internal controls or other factorsthat could significantly affect our internal controls subsequent to the date ofour evaluation.

 

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**PART II - OTHER INFORMATION**

 

Item 1.                                                             LEGAL PROCEEDINGS

 

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

 

On March 22,2002, Morgan Newton Company, L.P. (“Morgan Newton”) filed suit against us inDallas County District Court, Case No. DV02-02339-C, alleging claims for breachof contract, promissory estoppel, and fraud. The claims arise out of an alleged oral representation to Morgan Newtonconcerning a request for quotation for the purchase of a large amount of MorganNewton’s products.  Morgan Newton hasnot specified the amount of damages it is seeking in the lawsuit, but it ispossible that Morgan Newton may be seeking damages in excess of $2.0million.  In addition to actual damages,Morgan Newton is also seeking attorney’s fees and punitive damages.  We believe Morgan Newton’s claims arewithout merit and intend to vigorously defend this lawsuit, generally denyingall claims and asserting certain affirmative defenses.  As of this time, discovery is substantiallyunderway, and trial has been scheduled for October 2003.  Due to the uncertainty of the ultimateresult of this suit, we have not recorded a liability related to the suit at June 30,2003.

 

Item 4.                                                             SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS

 

The Annual Meeting of Stockholders was held on April 24,2003, at the Radisson Hotel, Dallas North in Richardson, Texas.  The following is a brief description of eachmatter voted upon by stockholders, including a number of votes cast for,against, or withheld with regard to each matter of nominee.

 

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

 
|               |   | **FOR**    |   | **WITHHELD** |   |
|--------------------|--------|------------|--------|--------------|--------|
| G. Ward Paxton     |   | 19,431,882 |   | 244,896      |   |
| T. Joe Head        |   | 19,438,582 |   | 238,196      |   |
| James P. Buchanan  |   | 19,566,282 |   | 110,496      |   |
| J. Fred Bucy, Jr.  |   | 19,566,932 |   | 109,846      |   |
| Donald M. Johnston |   | 19,565,932 |   | 109,846      |   |

 

(2)                                  Ratification and approval ofselection by the Board of Directors of KBA Group LLP as independent auditors ofthe Registrant for the fiscal year ending December 31, 2003.

 
| **FOR**    |   | **AGAINST** |   | **ABSTAIN** |   |
|------------|--------|-------------|--------|-------------|--------|
| 19,568,679 |   | 47,513      |   | 60,586      |   |

 

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Item 6.                                                             EXHIBITS AND REPORTS ON FORM 8-K

 

During the quarterended June 30, 2003, we filed the following reports on Form 8-K:

 

•                  None

 

The following Exhibitsare attached:

 

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

 

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

 

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

 

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

 

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

 

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 13,  2003 |                                            | /s/  Michael L. Paxton |
|                        | Michael L. Paxton                               |
|                        | Vice President, Chief  Financial Officer,       |
|                        | Treasurer &  Secretary                      |
|                        | (Principal Financial  & Accounting Officer) |
|                             |                                                 |  |

 

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