**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM10-Q**

 

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| **ý**                                                                                                                                                                                                                                            | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                  |
| **For the quarterly period ended September 30, 2004**                                                                                                                                                                                            |
|                                                                                                                                                                                                                                                  |
| **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**

(Addressof principal executive offices)

(ZipCode)

 

**(972) 234-6400**

(Registrant’stelephone number, including area code)

 

**Not Applicable**

Formername, 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 thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 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 of sharesoutstanding of the Registrant’s Common Stock, $0.01 par value, onNovember 5, 2004 was 5,166,312.

 

 

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**INTRUSION INC.**

 

INDEX

 
| **PART I – FINANCIAL  INFORMATION**                                                                                |   |
|-------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                    |   |
| Item 1.  Financial Statements                                                                                      |   |
|                                                                                                                    |   |
| Condensed  Consolidated Balance Sheets as of September 30, 2004 and  December 31, 2003                        |   |
|                                                                                                                    |   |
| Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2004 and 2003. |   |
|                                                                                                                    |   |
| Condensed  Consolidated Statements of Cash Flows for the nine months ended  September 30, 2004 and 2003            |   |
|                                                                                                                    |   |
| Notes  to Condensed Consolidated Financial Statements                                                                   |   |
|                                                                                                                    |   |
| Item 2.   Management’s Discussion and Analysis of Financial Condition and  Results of Operations              |   |
|                                                                                                                    |   |
| Item 3.   Quantitative and Qualitative Disclosures About Market Risk                                               |   |
|                                                                                                                    |   |
| Item 4.   Controls and Procedures                                                                                  |   |
|                                                                                                                    |   |
| **PART II – OTHER INFORMATION**                                                                                    |   |
|                                                                                                                    |   |
| Item 1.   Legal Proceedings                                                                                        |   |
|                                                                                                                    |   |
| Item 6.   Exhibits and Reports on Form 8-K                                                                         |   |
|                                                                                                                    |   |
| Signature Page                                                                                                          |   |

 

2

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**PART I –FINANCIAL INFORMATION**

 

Item 1. FINANCIAL STATEMENTS

 

**INTRUSION INC. AND SUBSIDIARIES**

CONDENSED CONSOLIDATEDBALANCE SHEETS

(Inthousands, except par value amounts)

 
| ** **                                                                                                                                                                       | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                       | ** ** | **(Unaudited)**              | ** ** | **(Audited)**               | ** ** |
| **ASSETS**                                                                                                                                                                       |       |                         |       |                        |       |
| Current Assets:                                                                                                                                                                  |       |                         |       |                        |       |
| Cash and cash equivalents                                                                                                                                                        |       | $                            | 1,806      |                        | $          | 974 |   |
| Short-term investments                                                                                                                                                           |       | 1,770                        |       | 1,705                       |       |
| Accounts receivable, less allowance for  doubtful accounts of $467 in 2004 and $574 in 2003                                                                                      |       | 1,050                        |       | 972                         |       |
| Inventories, net                                                                                                                                                                 |       | 1,136                        |       | 1,286                       |       |
| Other assets                                                                                                                                                                     |       | 199                          |       | 449                         |       |
| Total current  assets                                                                                                                                                            |       | 5,961                        |       | 5,386                       |       |
| Property and equipment, net                                                                                                                                                      |       | 259                          |       | 297                         |       |
| Other assets                                                                                                                                                                     |       | 77                           |       | 77                          |       |
| TOTAL ASSETS                                                                                                                                                                     |       | $                            | 6,297      |                        | $          | 5,760 |   |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                   |       |                         |       |                        |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| Current Liabilities:                                                                                                                                                             |       |                         |       |                        |       |
| Accounts payable and accrued expenses                                                                                                                                            |       | $                            | 1,756      |                        | $          | 2,188 |   |
| Deferred revenue                                                                                                                                                                 |       | 895                          |       | 788                         |       |
| Total current liabilities                                                                                                                                                        |       | 2,651                        |       | 2,976                       |       |
| Stockholders’ Equity:                                                                                                                                                       |       |                         |       |                        |       |
| Preferred stock, $.01 par value, authorized  shares – 5,000; 1,000 shares issued and outstanding, liquidation preference  $5,000                                            |       | 3,534                        |       | —                      |       |
| Common stock, $.01 par value, authorized shares  – 80,000; issued shares – 5,176 in 2004 and 5,173 in 2003; outstanding shares  – 5,166 in 2004 and 5,163 in 2003 |       | 52                           |       | 52                          |       |
| Common stock held in treasury, at cost – 10  shares                                                                                                                         |       | (362                         | )          | (362                        | )          |
| Additional paid-in capital                                                                                                                                                       |       | 48,594                       |       | 47,526                      |       |
| Accumulated deficit                                                                                                                                                              |       | (47,944                      | )          | (44,204                     | )          |
| Accumulated other comprehensive loss                                                                                                                                             |       | (228                         | )          | (228                        | )          |
| Total stockholders’ equity                                                                                                                                                  |       | 3,646                        |       | 2,784                       |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                  |       | $                            | 6,297      |                        | $          | 5,760 |   |

 

Seeaccompanying notes.

 

3

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**INTRUSION INC. AND SUBSIDIARIES**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS(In thousands, except per share amounts)(Unaudited)

 
| ** **                                                                  | ** ** | **Three Months Ended**       | ** ** | **Nine Months Ended**        | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                                  | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
| Net product revenue                                                         |       | $                            | 1,213      |                         | $          | 1,045 |   | $ | 2,762 |   | $ | 2,704 |   |
| Net customer support and maintenance  revenue                               |       | 464                          |       | 511                          |       | 1,285 |   | 1,811 |   |
| Total revenue                                                               |       | 1,677                        |       | 1,556                        |       | 4,047 |   | 4,515 |   |
| Cost of product revenue                                                     |       | 726                          |       | 743                          |       | 1,705 |   | 2,309 |   |
| Cost of customer support and maintenance  revenue                           |       | 117                          |       | 152                          |       | 351 |   | 682 |   |
| Total cost of revenue                                                       |       | 843                          |       | 895                          |       | 2,056 |   | 2,991 |   |
|                                                                        |       |                         |       |                         |       |   |   |   |   |
| Gross profit                                                                |       | 834                          |       | 661                          |       | 1,991 |   | 1,524 |   |
|                                                                        |       |                         |       |                         |       |   |   |   |   |
| Operating expenses:                                                         |       |                         |       |                         |       |   |   |   |   |
| Sales and marketing                                                         |       | 894                          |       | 1,313                        |       | 2,867 |   | 5,099 |   |
| Research and development                                                    |       | 613                          |       | 860                          |       | 1,947 |   | 2,684 |   |
| General and administrative                                                  |       | 304                          |       | 374                          |       | 884 |   | 1,222 |   |
| Litigation settlement                                                       |       | —                       |       | 450                          |       | — |   | 450 |   |
| Severance costs                                                             |       | 5                            |       | 119                          |       | 134 |   | 363 |   |
|                                                                        |       |                         |       |                         |       |   |   |   |   |
| Operating loss                                                              |       | (982                         | )          | (2,455                       | )          | (3,841 | ) | (8,294 | ) |
|                                                                        |       |                         |       |                         |       |   |   |   |   |
| Other income                                                                |       | 26                           |       | —                       |       | 67 |   | 10 |   |
| Interest income, net                                                        |       | 9                            |       | 43                           |       | 34 |   | 156 |   |
|                                                                        |       |                         |       |                         |       |   |   |   |   |
| Loss before income tax provision                                            |       | (947                         | )          | (2,412                       | )          | (3,740 | ) | (8,128 | ) |
|                                                                        |       |                         |       |                         |       |   |   |   |   |
| Income tax provision                                                        |       | —                       |       | —                       |       | — |   | — |   |
|                                                                        |       |                         |       |                         |       |   |   |   |   |
| Net loss                                                                    |       | $                            | (947       | )                            | $          | (2,412 | ) | $ | (3,740 | ) | $ | (8,128 | ) |
|                                                                        |       |                         |       |                         |       |   |   |   |   |
| Preferred stock dividends accrued                                           |       | (67                          | )          | —                       |       | (129 | ) | — |   |
| Beneficial conversion feature on preferred  stock                           |       | —                       |       | —                       |       | (938 | ) | — |   |
| Net loss attributable to common stockholders                                |       | $                            | (1,014     | )                            | $          | (2,412 | ) | $ | (4,807 | ) | $ | (8,128 | ) |
|                                                                        |       |                         |       |                         |       |   |   |   |   |
| Net loss per share attributable to common  stockholders (basic and diluted) |       | $                            | (0.20      | )                            | $          | (0.47 | ) | $ | (0.93 | ) | $ | (1.57 | ) |
|                                                                        |       |                         |       |                         |       |   |   |   |   |
| Weighted average common shares outstanding,  basic and diluted              |       | 5,166                        |       | 5,163                        |       | 5,166 |   | 5,163 |   |

 

Seeaccompanying notes.

 

4

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**INTRUSION INC. AND SUBSIDIARIES**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS(In thousands)(Unaudited)

 
| ** **                                                                   | ** ** | **Nine Months Ended**        | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                   | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
| Operating Activities:                                                        |       |                         |       |   |   |
| Net loss                                                                     |       | $                            | (3,740     | ) | $ | (8,128 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                         |       |   |   |
| Depreciation and amortization                                                |       | 164                          |       | 1,182 |   |
| Provision for doubtful accounts                                              |       | (108                         | )          | (314 | ) |
| Changes in operating assets and  liabilities:                                |       |                         |       |   |   |
| Accounts receivable                                                          |       | 30                           |       | 1,853 |   |
| Inventories                                                                  |       | 150                          |       | (78 | ) |
| Other assets                                                                 |       | 250                          |       | 405 |   |
| Accounts payable and accrued expenses                                        |       | (561                         | )          | (168 | ) |
| Deferred revenue                                                             |       | 107                          |       | (757 | ) |
| Net cash used in operating activities                                        |       | (3,708                       | )          | (6,005 | ) |
| Investing Activities:                                                        |       |                         |       |   |   |
| Purchases of short-term investments                                          |       | (3,100                       | )          | (3,450 | ) |
| Maturities of short-term investments                                         |       | 3,035                        |       | 8,325 |   |
| Net purchases of property and equipment                                      |       | (126                         | )          | (78 | ) |
| Net cash (used in) provided by investing  activities                         |       | (191                         | )          | 4,797 |   |
| Financing Activities:                                                        |       |                         |       |   |   |
| Proceeds from the exercise of employee  stock options                        |       | 6                            |       | — |   |
| Proceeds from the issuance of preferred  stock and warrants, net             |       | 4,725                        |       | 1 |   |
| Net cash provided by financing activities                                    |       | 4,731                        |       | 1 |   |
|                                                                         |       |                         |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                        |       | 832                          |       | (1,207 | ) |
| Cash and cash equivalents at beginning of  period                            |       | 974                          |       | 2,898 |   |
| Cash and cash equivalents at end of period                                   |       | $                            | 1,806      |   | $ | 1,691 |   |
|                                                                         |       |                         |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON CASH  FINANCING ACTIVITIES:                   |       |                         |       |   |   |
|                                                                         |       |                         |       |   |   |
| Fair value of warrants issued in connection  with sale of preferred stock    |       | $                            | 1,191      |   | $ | — |   |
| Amortization of preferred stock beneficial  conversion feature               |       | $                            | 938        |   | $ | — |   |
| Preferred stock dividend accrued                                             |       | $                            | 129        |   | $ | — |   |

 

Seeaccompanying notes.

 

5

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**INTRUSION INC. AND SUBSIDIARIES**

NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

1.     Description of Business

 

We develop, market and supporta family of network intrusion prevention and detection systems and regulatedinformation compliance systems that address vital security issues facingorganizations with mission critical business applications or housingclassified, confidential, or customer information assets.  We currently provide network security andregulated information compliance solutions with our Compliance CommanderTM forregulated information and data privacy protection, SpySnareTM for real-timeinline blocking of spyware and unwanted peer-to-peer applications andSecureNetTM for network intrusion prevention and detection.

 

We market and distribute ourproducts through a direct sales force to end-users and distributors and bynumerous domestic and international system integrators, managed serviceproviders and value-added resellers.  Ourend-user customers include high technology, manufacturing, telecommunications,retail, transportation, health care, insurance, entertainment, utilities andenergy companies, government entities, financial institutions, and academicinstitutions.

 

We were organized in Texasin 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 andour local area networking assets.  Inaccordance with these plans, we have accounted for these businesses asdiscontinued operations.  On June 1,2000, we changed our name from ODS Networks, Inc. to Intrusion.com, Inc., andour NASDAQ ticker symbol from ODSI to INTZ to reflect our focus on intrusion detectionsolutions.  On November 1, 2001, wechanged our name from Intrusion.com, Inc. to Intrusion Inc.

 

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

 

As of September 30,2004, we had cash, cash equivalents and short-term investments in the amount ofapproximately $3.6 million, up from approximately $2.7 million as ofDecember 31, 2003.  Although webelieve 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.  Moreover,despite actions to reduce our costs and improve our profitability, we expectour operating losses and net operating cash outflows to continue through2004.  As a result, we may not be able toachieve the revenue and gross margin objectives necessary to achieve positive cashflow or profitability or to remain in compliance with Nasdaq’s continuedlisting requirement of at least $2.5 million of stockholders’ equity withoutobtaining additional financing.  We donot currently have any arrangements for financing and we may not be able tosecure additional debt or equity financing on terms acceptable to us, or atall, at the time when we need such funding. If our business does not generate sufficient cash flow from operationsand sufficient future financings are not available, we may not be able tooperate or grow our business, pay our expenses when due, fund our otherliquidity needs or maintain our listing on the Nasdaq SmallCap Market.

 

2.     Basis of Presentation

 

The accompanying unauditedcondensed consolidated financial statements have been prepared in accordancewith accounting principles generally accepted in the United States for interimfinancial information and with the instructions to Form 10-Q 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, 2003 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 areadequate to make the information presented not misleading.  In our opinion, all the adjustments(consisting of normal recurring adjustments) considered necessary for fairpresentation have been included.  Theresults of operations for the nine months ending September 30, 2004 arenot necessarily indicative of the results that may be achieved for the fullfiscal year or for any future period. The condensed consolidated financial statements included herein shouldbe read in conjunction with the consolidated financial statements and notesthereto included in the Company’s annual report on Form 10-K for the year endedDecember 31, 2003.

 

6

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3.     Inventories (In thousands)

 
| ** **              | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------------|------------|------------------------------|------------|-----------------------------|------------|
|                    |       |                         |       |                        |       |
| Inventories consist of: |       |                         |       |                        |       |
|                    |       |                         |       |                        |       |
| Finished goods          |       | $                            | 870        |                        | $          | 851 |   |
| Work in progress        |       | 49                           |       | 261                         |       |
| Demonstration systems   |       | 217                          |       | 174                         |       |
| Net inventory           |       | $                            | 1,136      |                        | $          | 1,286 |   |

 

4.     Accounting for Stock-Based Compensation

 

We account for employeestock-based compensation under APB 25. The following table summarizes relevant information as to the reportedresults under our intrinsic value method of accounting for stock awards, withsupplemental information as if the fair value recognition provision of SFAS 123as amended by SFAS 148 had been applied for the quarters and nine months endedSeptember 30, 2004 and September 30, 2003 (in thousands, except pershare data).  All stock information inthis report reflects a four-for-one (4:1) reverse stock split completed onMarch 29, 2004:

 
| ** **                                                                                            | ** ** | **Quarter  Ended  September 30,  2004** | ** ** | **Quarter  Ended  September 30,  2003** | ** ** | **Nine  Months  September 30,  2004** | ** ** | **Nine  Months  September 30,  2003** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|
|                                                                                                  |       |                                         |       |                                         |       |                                       |       |                                       |       |
| Net loss attributable to common  stockholders                                                         |       | $                                            | (1,014     | )                                            | $          | (2,412                                     | )          | $                                          | (4,807     | ) | $ | (8,128 | ) |
| Add (Deduct): Total stock-based  compensation determined under fair value-based method for all awards |       | (44                                          | )          | (3                                           | )          | (164                                       | )          | 331                                        |       |
| Pro forma net loss attributable to common  stockholders                                               |       | $                                            | (1,058     | )                                            | $          | (2,415                                     | )          | $                                          | (4,971     | ) | $ | (7,797 | ) |
| Net loss per share attributable to common  stockholders:                                              |       |                                         |       |                                         |       |                                       |       |                                       |       |
| as reported (basic and  diluted)                                                                      |       | $                                            | (0.20      | )                                            | $          | (0.47                                      | )          | $                                          | (0.93      | ) | $ | (1.57 | ) |
| pro forma (basic and diluted)                                                                         |       | $                                            | (0.20      | )                                            | $          | (0.47                                      | )          | $                                          | (0.96      | ) | $ | (1.51 | ) |
| Weighted-average shares used in  computation:                                                         |       |                                         |       |                                         |       |                                       |       |                                       |       |
| Basic and diluted                                                                                     |       | 5,166                                        |       | 5,163                                        |       | 5,166                                      |       | 5,163                                      |       |

 

As required, the pro formadisclosures above include options granted since January 1, 1995.  Consequently, the effects of applying SFAS123 and SFAS 148 for providing pro forma disclosures may not be representativeof the effects on reported operating results for future years until all optionsoutstanding 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.

 

5.     Net Loss Per Share

 

We report two separateearnings per share (“EPS”) numbers, basic EPS and diluted EPS.  Basic net loss per share is computed bydividing net loss attributable to common stockholders for the period by theweighted average number of common shares outstanding for the period.  Diluted net loss per share is computed bydividing the net loss attributable to common stockholders by the weightedaverage number of common shares and common stock equivalents outstanding forthe period.  Our common stock equivalentsinclude all common stock issuable upon conversion of convertible preferredstock and the exercise of outstanding options and warrants.  The aggregate number of common stockequivalents excluded from the loss per share calculation for the three andnine-month periods ended September 30, 2004 and 2003 are 2,607,197 and364,279, respectively.  Our common stockequivalents are not included in the diluted loss per share for the three andnine-month periods ended September 30, 2004 and 2003, as they areantidilutive.

 

7

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6.     Commitments and Contingencies

 

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

 

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

 

This report containsforward-looking statements, within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934, that involve risks and uncertainties, such as statements concerning: thedifficulties in forecasting future sales caused by current economic and marketconditions, the effect of military actions on government and corporate spendingon information security products, spending patterns of, and appropriations to,U.S. government departments, the impact of our cost reduction programs and ourrefocused product line, the difficulties and uncertainties in successfullydeveloping and introducing new products, market acceptance of our products, theimpact of sustained losses on our ability to successfully operate and grow ourbusiness, our stock price and our ongoing Nasdaq eligibility, the highlycompetitive market for our products, the effects of sales and implementationcycles for our new products on our quarterly results, difficulties inaccurately estimating market growth, the consolidation of the informationsecurity industry, the impact of changing economic conditions, businessconditions in the information security industry, our ability to manageacquisitions effectively, our ability to manage discontinued operationseffectively, the impact of market peers and their products as well as risksconcerning future technology and others identified in our Annual Report on Form10-K, as amended, and other Securities and Exchange Commission filings.  Such forward-looking statements are generallyaccompanied by words such as “plan,” “estimate,” “expect,” “believe,” “should,”“would,” “could,” “anticipate,” “may” or other words that convey uncertainty offuture events or outcomes.  Theseforward-looking statements and other statements made elsewhere in this reportare made in reliance on the Private Securities Litigation Reform Act of1995.  The section below entitled “FactorsThat May Affect Future Results of Operations” sets forth and incorporates byreference certain factors that could cause actual future results of the companyto differ materially from these statements.

 

Critical Accounting Policiesand Estimates

 

Management’s discussion andanalysis of financial condition and results of operations are based upon ourcondensed consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the UnitedStates.  The preparation of thesefinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingent assets and liabilities.  On an on-going basis, we evaluate ourestimates, including those related to product returns, bad debts, inventories,income taxes, warranty obligations, restructuring, maintenance contracts andcontingencies.  We base our estimates onhistorical experience and on various other assumptions that are believed to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.

 

We believe the followingcritical accounting policies affect our more significant judgments andestimates used in the preparation of our condensed consolidated financialstatements.

 

*RevenueRecognition*

 

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

 

8

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We recognize softwarerevenue from the licensing of our software products in accordance withStatement of Position (“SOP”) No. 97-2 “Software Revenue Recognition”, SOP 98-9“Modification of 97-2, Software Revenue Recognition, with respect to certaintransactions” and Staff Accounting Bulletin (“SAB”) No. 104, “RevenueRecognition” whereby revenue from the licensing of our products is notrecognized until all four of the following have been met: i) execution of awritten agreement; ii) delivery of the product has occurred; iii) the fee isfixed and determinable; and iv) collectibility is probable. Bundled hardwareand perpetual software product sales are recognized at time of delivery, as ourlicenses are not sold on a subscription basis. In the case of multiple product and service sales, we perform a VendorSpecific Objective Evidence analysis to appropriately determine the amount ofrevenue derived from each deliverable. If our license strategy changes and we begin to offer licenses on asubscription basis, we would perform this analysis in a similar manner.  Under these circumstances, the revenuerelated to the license would be recognized ratably over the subscriptionperiod.  Market values are easily obtainedfor all of our product offerings, as we have historical sales information onour product offerings.  We defer andrecognize maintenance and support revenue over the term of the contract period,which is generally one year.

 

We have signed distributionagreements with distributors in the United States, Europe and Asia. In general,these relationships are non-exclusive. Distributors typically maintain aninventory of our products. Under these agreements, we provide certainprotection to the distributors for their inventory of our products for pricereductions as well as products that are slow moving or have been discontinuedby us.  Historically, returns from ourdistributors and charges related to price reductions on inventory held bydistributors have not been material. Recognition of sales to distributors and related gross profits aredeferred until the distributors resell the merchandise. 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 related to the sale at the time of shipment tothe distributor. Revenue, offset by deferred cost of sales, is included indeferred revenue in the accompanying financial statements.  Since the net balance in deferred revenuerepresents the sales price less the cost of the product maintained by thedistributors, the deferred costs of these products are included in ourobsolescence and slow-moving analysis and are written down according to theircurrent value.  This transaction,effectively recognizes expense for the write-down, if any, and increases thenet liability in the deferred revenue account.

 

We generally recognizeservice revenue upon delivery of the contracted service.  Service revenue, primarily includingmaintenance, training and installation are recognized upon delivery of theservice and typically are unrelated to product sales.  These services are not essential to thefunctionality of the delivered product. To date, training and installation revenue has not been material.

 

*Allowancefor Doubtful Accounts and Returns*

 

Trade accounts receivableare stated at the amount we expect to collect. We maintain allowances for doubtful accounts for estimated lossesresulting from the inability of our customers to make required payments.  Management considers the following factorswhen determining the collectibility of specific customer accounts:  customer credit-worthiness, past transactionhistory with the customer, current economic industry trends, and changes incustomer payment terms.  If the financialcondition of our customers were to deteriorate, adversely affecting theirability to make payments, additional allowances would be required.  Based on management’s assessment, we providefor estimated uncollectible amounts through a charge to earnings and a creditto a valuation allowance.  Balances thatremain outstanding after we have used reasonable collection efforts are writtenoff through a charge to the valuation allowance and a credit to accountsreceivable.  Historically, our estimatesfor sales returns and doubtful accounts have not materially differed fromactual results.

 

*Inventory*

 

We write down our inventoryfor estimated 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. Historically, our estimates for inventory obsolescence have not differedmaterially from actual results.

 

9

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Results of Operations

 

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

 
| ** **                                        | ** ** | **Three Months Ended**       | ** ** | **Nine Months Ended**        | ** ** |
|---------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                        | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
| Net product revenue                               |       | 72.3                         | %          | 67.2                         | %          | 68.2 | % | 59.9 | % |
| Net customer support and maintenance  revenue     |       | 27.7                         |       | 32.8                         |       | 31.8 |   | 40.1 |   |
| Total revenue                                     |       | 100.0                        |       | 100.0                        |       | 100.0 |   | 100.0 |   |
| Cost of product revenue                           |       | 43.3                         |       | 47.7                         |       | 42.1 |   | 51.1 |   |
| Cost of customer support and maintenance  revenue |       | 7.0                          |       | 9.8                          |       | 8.7 |   | 15.1 |   |
| Total cost of revenue                             |       | 50.3                         |       | 57.5                         |       | 50.8 |   | 66.2 |   |
| Gross profit                                      |       | 49.7                         |       | 42.5                         |       | 49.2 |   | 33.8 |   |
| Operating expenses:                               |       |                         |       |                         |       |   |   |   |   |
| Sales and marketing                               |       | 53.3                         |       | 84.4                         |       | 70.9 |   | 113.0 |   |
| Research and development                          |       | 36.6                         |       | 55.3                         |       | 48.1 |   | 59.4 |   |
| General and administrative                        |       | 18.1                         |       | 24.0                         |       | 21.8 |   | 27.1 |   |
| Litigation settlement                             |       | —                       |       | 28.9                         |       | — |   | 10.0 |   |
| Severance costs                                   |       | 0.3                          |       | 7.7                          |       | 3.3 |   | 8.0 |   |
| Operating loss                                    |       | (58.6                        | )          | (157.8                       | )          | (94.9 | ) | (183.7 | ) |
|                                              |       |                         |       |                         |       |   |   |   |   |
| Other income                                      |       | 1.6                          |       | —                       |       | 1.7 |   | 0.2 |   |
| Interest income, net                              |       | 0.5                          |       | 2.7                          |       | 0.8 |   | 3.5 |   |
| Loss before income tax provision                  |       | (56.5                        | )          | (155.1                       | )          | (92.4 | ) | (180.0 | ) |
|                                              |       |                         |       |                         |       |   |   |   |   |
| Income tax provision                              |       | —                       |       | —                       |       | — |   | — |   |
|                                              |       |                         |       |                         |       |   |   |   |   |
| Net loss                                          |       | (56.5                        | )%         | (155.1                       | )%         | (92.4 | )% | (180.0 | )% |
| Preferred stock dividends accrued                 |       | (4.0                         | )          | —                       |       | (3.2 | ) | — |   |
| Beneficial conversion feature on preferred  stock |       | —                       |       | —                       |       | (23.2 | ) | — |   |
|                                              |       |                         |       |                         |       |   |   |   |   |
| Net loss attributable to common  stockholders     |       | (60.5                        | )%         | (155.1                       | )%         | (118.8 | )% | (180.0 | )% |

 
| ** **          | ** ** | **Three Months Ended**       | ** ** | **Nine Months Ended**        | ** ** |
|---------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **          | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
| Domestic revenues   |       | 84.5                         | %          | 76.8                         | %          | 78.2 | % | 64.2 | % |
| Export revenues to: |       |                         |       |                         |       |   |   |   |   |
| Europe              |       | 8.8                          |       | 16.9                         |       | 13.3 |   | 26.1 |   |
| Canada              |       | 2.1                          |       | 0.6                          |       | 4.1 |   | 0.6 |   |
| Asia                |       | 4.4                          |       | 5.6                          |       | 4.1 |   | 9.0 |   |
| Latin America       |       | 0.2                          |       | 0.1                          |       | 0.3 |   | 0.1 |   |
|                |       |                         |       |                         |       |   |   |   |   |
| Net revenues        |       | 100.0                        | %          | 100.0                        | %          | 100.0 | % | 100.0 | % |

 

10

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**NetRevenues**.  Net revenues for the quarter and nine monthsended September 30, 2004 were $1.7 million and $4.0 million, respectively,compared to $1.6 million and $4.5 million for the same periods in 2003.  Product revenues increased $0.2 million and$0.1 million for the quarter and nine months ended September 30, 2004compared to the same periods in 2003. Customer support and maintenance revenue remained constant for thequarter ended September 2004 compared to the same period in 2003 and decreased$0.5 million for the nine months ended September 30, 2004 compared to thesame period in 2003.  Total revenues(including maintenance and support) for the quarter and nine months endedSeptember 30, 2004 from our SecureNet product line increased to $1.4million and $3.6 million from $1.0 million and $2.9 million for the sameperiods in 2003, but were offset by a continued decline in sales of ourhardware-based products in connection with our continuing shift in businessfocus towards sales of higher-margin software-based products such as SecureNet.  Our first generation product sales, includingPDS and SecureCom decreased for the quarter and nine months endedSeptember 30, 2004 to $0.3 million and $0.4 million from $0.5 million and$1.6 million from the same periods in 2003. In addition to our shift in business focus, continued sluggish economicconditions and delayed customer orders contributed to the decline in revenues.

 

**ExportRevenues**.  Export revenues for the quarter and ninemonths ended September 30, 2004 decreased to $0.3 million and $0.9 millionfrom $0.4 million and $1.6 million compared to the same periods in 2003 asrevenues from our PDS security appliance family decreased and we focused moreof our resources domestically.

 

**Concentrationof Revenues**.  Revenues from sales to various U.S. governmententities totaled $0.9 million, or 56.4% of revenues, for the quarter endedSeptember 30, 2004 compared to $0.3 million, or 19.1% of revenues, for thesame period in 2003.  Although, we expectour concentration of revenues to vary among customers in future quartersdepending upon the timing of certain sales, we anticipate that sales togovernment customers will continue to account for a significant portion of ourrevenues in future quarters.

 

**GrossProfit**.  Gross profit was $0.8 million or 49.7% of netrevenues for the quarter ended September 30, 2004, compared to $0.7million or 42.5% of net revenues for the quarter ended September 30, 2003.Gross profit was $2.0 million or 49.2% of net revenues for the nine monthsended September 30, 2004, compared to $1.5 million or 33.8% of netrevenues for the nine months ended September 30, 2003. Gross profitmargins as a percentage of net revenues increased from the same period in theprior year due to a continued shift in product mix, which resulted in an increaseas a percentage of revenues of our higher margin SecureNet product line.  Gross profit on product revenues for thequarters ended September 30, increased from 28.9% in 2003 to 40.1% in 2004due to the transition to our higher margin software-based products.  Gross profit on customer support andmaintenance revenues for the quarters ended September 30, increasedfrom 70.3% in 2003 to 74.8% in 2004, as less repair costs were incurred duringthe 2004 quarter in conjunction with our transition to software-based products.

 

Gross profit as a percentageof net revenues is impacted by several factors, including shifts in productmix, changes in channels of distribution, revenue volume, fluctuations inthird-party assembly costs, pricing strategies, and fluctuations in revenues ofintegrated third-party products.

 

**Sales andMarketing**.  Sales and marketing expenses decreased to$0.9 million for the quarter ended September 30, 2004, compared to $1.3million for the quarter ended September 30, 2003. Sales and marketingexpenses decreased to $2.9 million for the nine months ended September 30,2004, compared to $5.1 million for the nine months ended September 30,2003. This cost reduction was primarily due to the reorganization of our salesand marketing departments, including a reduction in headcount, and other costreduction initiatives.  We expect tocontinue to realize the impact of our cost reduction initiatives throughout2004.  Sales and marketing expenses mayvary as a percentage of net sales in the future.  However, we believe that these costs willremain relatively constant through the end of the year.

 

**Researchand Development**.  Research and development expenses decreasedto $0.6 million for the quarter ended September 30, 2004, compared to $0.9million for the quarter ended September 30, 2003. Research and developmentexpenses decreased to $1.9 million for the nine months ended September 30,2004, compared to $2.7 million for the nine months ended September 30,2003. Research and development costs are expensed in the period incurred.  Research and development expenses decreasedin the quarter and nine months ended September 30, 2004, compared to thesame periods in 2003 as a portion of our engineers were engaged on revenuegenerating projects during the periods and their associated costs wererecognized as direct product costs related to those projects.  Research and development expenses may vary asa percentage of net sales in the future.

 

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**General andAdministrative**.  General and administrative expenses decreasedto $0.3 million for the quarter ended September 30, 2004, compared to $0.4million for the quarter ended September 30, 2003.  General and administrative expenses decreasedto $0.9 million for the nine months ended September 30, 2004, compared to$1.2 million for the nine months ended September 30, 2003.  This decrease was primarily due to therestructuring done in 2003, including a reduction in headcount, and other costreduction initiatives.  It is expectedthat general and administrative expenses will remain relatively constantthroughout the remainder of the year, as no further headcount reductions areanticipated.  General and administrativeexpense may vary as a percentage of net sales in the future.

 

**LitigationSettlement. **Litigationsettlement charges relate to the litigation settlement agreement betweenIntrusion and Morgan Newton as discussed in previous filings.  Charges of $0.5 million, which were paid inOctober 2003, were recognized and accrued during the quarter ended September30, 2003.  This settlement concludes allobligations related to this litigation settlement.  There were no litigation settlement charges forthe quarter or nine-month period ended September 30, 2004.

 

**SeveranceCosts. **Severance costs decreased to $5 thousand and$134 thousand for the quarter and nine-month periods ended September 30,2004, compared to $119 thousand and $363 thousand for the quarter and ninemonths ended September 30, 2003. Severance costs during the quarter and nine-month periods endedSeptember 30, 2004 consisted primarily of severance payments made duringthe periods as a result of reductions in force. All severance obligations were paid prior to September 30, 2004,and we were not receiving further benefit from these individuals afterSeptember 30, 2004.  Severance costsfor the quarter and nine-month periods ended September 30, 2003 consistedof reductions in force made during those periods.

 

**OtherIncome**.  Other income increased to $26 thousand forthe quarter ended September 30, 2004 compared to $0.0 thousand for the sameperiod in 2003.  Other income increasedto $67 thousand for the nine months ended September 30, 2004 compared to $10thousand for the same period in 2003. The increase was mainly due to collection of accounts receivable thatwere previously written off and gain on sale of fully depreciated assets.

 

**Interest**.  Netinterest income decreased to $9 thousand for the quarter endedSeptember 30, 2004 compared to $43 thousand for the same period in2003.  Net interest income decreased to$34 thousand for the nine months ended September 30, 2004 compared to $156thousand for the same period in 2003. The decrease in interest income was primarily due to the decrease inoverall cash and short-term investment balances over the prior year.  Net interest income may vary in the futurebased on our cash flow and rate of return on investments.

 

Liquidity and CapitalResources

 

Our principal source ofliquidity at September 30, 2004 is approximately $1.8 million of cash andcash equivalents and $1.8 million of short-term investments.  As of September 30, 2004 working capitalwas $3.3 million compared to $3.7 million as of September 30, 2003.

 

Cash used in operations forthe nine months ended September 30, 2004 was $3.7 million, primarily dueto an operating loss of $3.7 million, a decrease in accounts payable andaccrued expenses of $0.6 million and a decrease in the provision for doubtfulaccounts of $0.1 million.  This cashusage was partially offset by depreciation and amortization of $0.2 million, adecrease in inventories of $0.2 million, an increase in deferred revenue of$0.1 million and a decrease in other assets of $0.3 million.  Cash used in operations of $6.0 million forthe nine months ended September 30, 2003, was primarily due to anoperating loss of $8.1 million.  Thiscash usage was partially offset by depreciation expense of $1.2 million, adecrease in the provision for doubtful accounts of $0.3 million and decreasesin accounts receivable of $1.9 million and other assets of $0.4 million, offsetby an increase in inventories of $0.1 million, a decrease in accounts payableand accrued liabilities of $0.2 million and a decrease in deferred revenue of$0.8 million.  Future fluctuations ininventory balances, accounts receivable and accounts payable will be dependentupon several factors, including quarterly sales, our strategy in buildinginventory in advance of receiving orders from customers, and the accuracy ofour forecasts of product demand and component requirements.  In addition, during the fourth quarter of2004, we will be required to pay cash dividends on the preferred stock totaling$129 thousand.  These dividends areaccrued at September 30, 2004 and were paid on October 1, 2004.

 

Cash used in investingactivities in the nine months ended September 30, 2004 was $0.2 million,which consisted primarily of the net purchase of short-term investments of $0.1million and net purchases of property and equipment of $0.1 million, comparedto cash provided by investing activities of $4.8 million for the nine monthsended September 30, 2003, which consisted primarily of the maturity ofshort-term investments of $8.3 million, partially offset by purchases ofshort-term investment of $3.5 million and net purchases of property andequipment of $0.1 million.

 

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Cash provided by financingactivities in the nine months ended September 30, 2004 was $4.7 million,consisting of net financing proceeds from a private placement of $4.7 millionand the exercise of employee stock options of $6 thousand.

 

At September 30, 2004,the Company did not have any material commitments for capital expenditures.

 

During the nine months endedSeptember 30, 2004, the Company funded its operations through financingproceeds raised during the first quarter of 2004.

 

Based on our financialprojections, we expect that our cash on hand, along with our short-terminvestments, and cash from our operations will be sufficient to fund ouroperations for the next 12 months. However, our projections are dependent upon our ability to meet ourrevenue and gross profit targets.  Wefunded our operations and met our cash requirements during the quarter byselling a portion of our short-term investments.  Although we believe we have sufficient cashresources to finance our operations and expected capital expenditures for thenext twelve months, based on our internal estimates and our operating plan, thesufficiency of our cash resources may depend to a certain extent on generaleconomic, financial, competitive or other factors beyond our control.  Moreover, despite actions to reduce our costsand improve our profitability, we expect our operating losses and net operatingcash outflows to continue through 2004. As a result, we may not be able to achieve the revenue and grossmargin objectives necessary to achieve positive cash flow or profitability orto remain in compliance with Nasdaq’s continued listing requirement of at least$2.5 million of stockholders’ equity without obtaining additionalfinancing.  We do not currently have anyarrangements for financing, and we may not be able to secure additional debt orequity financing on terms acceptable to us, or at all, at the time when we needsuch funding.  If our business does notgenerate sufficient cash flow from operations and sufficient future financingsare not available, we may not be able to operate or grow our business, pay ourexpenses when due, fund our other liquidity needs or maintain our listing onthe Nasdaq SmallCap Market.

 

We intend to explore thepossible acquisitions of businesses, products and technologies that arecomplementary to our existing business. We are continuing to identify and prioritize additional security technologies,which we may wish to develop, either internally or through the licensing, oracquisition of products from third parties. While we engage from time to time in discussions with respect topotential acquisitions, there can be no assurances that any such acquisitionswill be made or that we will be able to successfully integrate any acquiredbusiness.  In order to finance suchacquisitions and working capital it may be necessary for us to raise additionalfunds through public or private financings. Any equity or debt financings, if available at all, may be on terms,which are not favorable to us and, in the case of equity financings, may resultin dilution to our stockholders.

 

Factors That May AffectFuture Results of Operations 

 

Numerous factors may affectour business and future results of operations. These factors include current economic and market conditions, the effectof military actions on government and corporate spending on informationsecurity products, spending patterns of, and appropriations to, U.S. governmentdepartments, technological changes, competition and market acceptance,acquisitions, product transitions, timing of orders, manufacturing andsuppliers, reliance on outsourcing vendors and other partners, intellectualproperty and licenses, third-party products, dependence on governmentcustomers, international operations, intellectual property issues, liquidityand cash resources and effects of restructuring plans and cost reductions.  The discussion below addresses some of these andother factors.  For a more thoroughdiscussion of these and other factors that may affect our business and futureresults, see the discussion under the caption “Factors That May Affect FutureResults of Operations” in our Annual Report on Form 10-K for the year endedDecember 31, 2003.

 

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***Our cash, cash equivalents, and investments have increasedapproximately $0.9 million in the last nine months but have generally declinedsince 2003.  As a result of our expectedcontinuing net cash outflows, we may not have sufficient cash to operate ourbusiness or and may not be able to maintain our Nasdaq listing.***

 

During the nine months endedSeptember 30, 2004, our cash, cash equivalents and short-term investments increasedapproximately $0.9 million from approximately $2.7 million as ofDecember 31, 2003 to approximately $3.6 million at September 30, 2004,primarily as a result of a private placement of our preferred stock andwarrants totaling $4.7 million we completed on March 25, 2004.  As of December 31, 2003, we had cash,cash equivalents and investments in the amount of approximately $2.7 million,down from approximately $10.7 million as of December 31, 2002.  Although we believe the proceeds we receivedin connection with the private placement will provide us with sufficient cashresources to finance our operations for the next twelve months, based on ourinternal estimates and our operating plan, the sufficiency of our cashresources may depend to a certain extent on general economic, financial,competitive or other factors beyond our control. Moreover, despite our actionsto reduce costs and improve profitability, we expect our net operatinglosses and net operating cash outflows to continue through 2004.  If our losses continue, our stockholders’equity could fall below $2.5 million in the fourth quarter of 2004.  If this occurs, we would not be in compliancewith the Nasdaq listing requirements, and we could face delisting.  We do not currently have any furtherarrangements for financing, and we may not be able to secure additional debt orequity financing on terms that are acceptable to us, or at all, at the timewhen we need this financing.  Therefore,if our business does not generate sufficient cash flow from operations andsufficient financing resources are not available, we may not be able to operateor grow our business, pay our expenses when due, fund our other liquidity needsor maintain our listing on the Nasdaq SmallCap Market.

 

***If we fail to respond to rapid technological changes in the networksecurity industry, we may lose customers or our products may become obsolete.***

 

The network securityindustry is characterized by frequent product introductions, rapidly changingtechnology and continued evolution of new industry standards.  We must also introduce upgrades to ourproducts rapidly in response to customer needs such as new computer viruses orother novel external attacks on computer networks.  In addition, the nature of the networksecurity industry requires our products to be compatible and interoperable withnumerous security products, networking products, workstation and personalcomputer architectures and computer and network operating systems offered byvarious vendors, including our competitors. As a result, our success depends upon our ability to develop andintroduce in a timely manner new products and enhancements to our existingproducts that meet changing customer requirements and evolving industrystandards. The development of technologically advanced network securityproducts is a complex and uncertain process requiring high levels ofinnovation, rapid response and accurate anticipation of technological andmarket trends.  We cannot assure you thatwe will be able to identify, develop, manufacture, market or support new or enhancedproducts successfully in a timely manner. Further, we or our competitors may introduce new products or productenhancements that shorten the life cycle of our existing products or cause ourexisting products to become obsolete.

 

***Our revenues have declined from $16.7 million in 2001 to $6.5 millionin 2003 and to $4.0 million for the nine months ended September 30, 2004from $4.5 in the same period in 2003 in connection with a shift to sales of ournewer product lines. If our network intrusion detection and regulatedinformation compliance system products do not achieve market acceptance, ourrevenues will suffer.***

 

Over the past three years,we have transitioned our sales strategy from our lower margin SecureCom and PDSsecurity appliance products to the development and sales of our higher marginSecureNet network intrusion detection products. During this transition, sales of our new products were not enough tocounteract the loss in sales associated with our older products.  As a result, our net revenues have declinedfrom approximately $16.7 million in 2001, to approximately $7.8 million in 2002and approximately $6.5 million in 2003. In addition, our revenues for the first nine months of 2004 are $4.0million as compared to $4.5 million for the same period in 2003.

 

Our new network securityproducts and regulated information compliance systems have only been in themarket place for a limited period of time and may have longer sales cycles thanour previous products.  Although responseto our products has been positive, we have not yet received broad marketacceptance.  We cannot assure you thatour present or future products will achieve market acceptance on a sustainedbasis.

 

In order to achieve marketacceptance and achieve future revenue growth, we must introduce complementarysecurity products, incorporate new technologies into our existing product linesand design, develop and successfully commercialize higher performance productsin a timely manner.  We cannot assure youthat we will be able to offer new or complementary products that gain marketacceptance quickly enough to avoid decreased revenues during current or futureproduct introductions or transitions.

 

14

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

 

From our founding in 1983until 2000, we derived substantially all of our revenue from the design,manufacture and sale of local area networking equipment.  In order to permit us to focus our resourcessolely on developing and marketing our network security products, onApril 17, 2000, we announced our plans to sell our local area networkingassets and related networking divisions.

 

As a result of these sales,we now depend exclusively on revenues generated from the sale of our networksecurity products, which have received limited market acceptance.  Moreover, we have only recently introducedour regulated compliance and data privacy systems and our spyware preventionproducts.  Although initial response tothese products has been positive, the market for these products has only begunto emerge and sales of these products may not occur as quickly as we expect.  Consequently, we resemble a developmentalstage company and will face the following inherent risks and uncertainties:

 

•                  the need for our network security productsand regulated information compliance systems to achieve market acceptance andproduce a sustainable revenue stream;

 

•                  our ability to manage costs and expenses;

 

•                  our dependence on key personnel;

 

•                  our ability to obtain financing on acceptableterms; and

 

•                  our ability to offer greater value than ourcompetitors.

 

Our business strategy maynot successfully address these risks.  Ifwe fail to recognize significant revenues from the sales of our networksecurity products and regulated information compliance systems, our business,financial condition and operating results would be materially adverselyaffected.

 

***We incurred a net loss of $3.7 million for the nine months endedSeptember 30, 2004 and have an accumulated deficit of $47.9 million as ofSeptember 30, 2004.  As a result, wemust generate substantially greater revenues from sales in order to achieveprofitability.***

 

We have incurred significantoperating losses and are uncertain about our future operating results.  For the nine months ended September 30,2004, we incurred a net loss of $3.7 million and had an accumulated deficit ofapproximately $47.9 million as of September 30, 2004.  In addition, our revenues have declined from$16.7 million in 2001, to $7.8 million in 2002, and $6.5 million in 2003.  We need to generate and sustain substantiallygreater revenues from the sales of our products if we are to achieveprofitability.  If we are unable toachieve these greater revenues, our losses will continue indefinitely, and wemay never achieve or sustain profitability or generate positive cash flow.

 

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

 

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

 

Our principle competitors inthe network intrusion and detection market include Internet Security Systems,Inc., Cisco Systems, Inc., Symantec, Inc., Netscreen Technologies, Inc.,McAfee, Inc., Tipping Point Technologies Inc. and NFR Security, Inc.  The market for regulated informationcompliance systems is relatively new. Our competitors in this market include a number of start-up companiesthat have entered the market in the last two years.  However, as this market develops, we expectincreased competition from both start-up and established companies.  Our current and potential competitors mayhave one or more of the following significant advantages over us:

 

15

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•     greaterfinancial, technical and marketing resources;

 

•      bettername recognition;

 

•      morecomprehensive security solutions;

 

•      betteror more extensive cooperative relationships; and

 

•      largercustomer base.

 

Although we believe ournetwork security products and regulated information compliance systems comparefavorably to our competitors’ products and create a sustainable business model,we cannot assure you that our products will achieve market acceptance or thatwe will be able to compete successfully with our existing or new competitors.

 

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

 

United States militaryactions or other events occurring in response to or in connection with them,including future terrorist attacks, actual conflicts involving the UnitedStates or its allies or military or trade disruptions could impact ouroperations by:

 

•     reducingor delaying government or corporate spending on network security products;

 

•     increasingthe cost and difficulty in obtaining materials or shipping products; and

 

•     affectingour ability to conduct business internationally.

 

Should these events occur,our business, operating results and financial condition could be materially andadversely affected.

 

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

 

The sale and implementationof our products to large companies and government entities typically involves alengthy education process and a significant technical evaluation and commitmentof capital and other resources.  Thisprocess is also subject to the risk of delays associated with customers’internal budgeting and other procedures for approving capital expenditures,deploying new technologies within their networks and testing and accepting newtechnologies that affect key operations. As a result, sales and implementation cycles for our products can belengthy, and we may expend significant time and resources before we receive anyrevenues from a customer or potential customer. Our quarterly and annual operating results could be materially harmed iforders forecasted for a specific customer for a particular period are notrealized.

 

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

 

During the first nine monthsof 2004, we continued a restructuring plan and cost reduction efforts, whichresulted in $0.1 million in severance costs. Since we began restructuring in 2002, we have incurred approximately$0.9 million in restructuring charges, severance, and related expenses. Theobjective of our restructuring plan was to reduce our cost structure to asustainable level that is consistent with our current cash resources and thegeneral economic climate.  We have alsoimplemented other strategic initiatives to strengthen our operations, such asreductions in our work force and facilities and aligning our organizationaround our business objectives.  Anyfurther work force reductions could result in temporary reduced productivity ofour remaining employees.  Additionally,our customers and prospects may delay or forgo purchasing our products due to aperceived uncertainty caused by our restructuring and other changes.  Failure to achieve the desired results of ourinitiatives could seriously harm our business, results of operations andfinancial condition.

 

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***Consolidation in the network security industry may limit marketacceptance of our products.***

 

Several of our competitorshave acquired security companies with complementary technologies in the past,and we expect consolidation in the network security industry to continue in thefuture.  These acquisitions may permitour competitors to accelerate the development and commercialization of broaderproduct lines and more comprehensive solutions than we currently offer.  Acquisitions of vendors or other companieswith which we have a strategic relationship by our competitors may limit ouraccess to commercially significant technologies.  Further, business combinations in the networksecurity industry are creating companies with larger market share, customerbases, sales forces, product offerings and technology and marketing expertise,which may make it more difficult for us to compete.

 

***Sales to government entities accounted for 45.9% of our revenues thenine months ended September 30, 2004 and 17% of our revenues for the yearended December 31, 2003.  Sales togovernment customers involve unique risks, which could adversely impact ourrevenues.***

 

We derived 45.9% of ourrevenues from sales to various U.S. government entities for the nine monthsended September 30, 2004, and 17.0% of our revenues from these sales forthe year ended December 31, 2003. We expect to continue to derive a substantial portion of our revenuesfrom U.S. government customers in the future. Sales to the government present risks in addition to those involved insales to commercial customers, including potential disruption due toappropriation and spending patterns and the government’s right to cancelcontracts and purchase orders for its convenience.  General political and economic conditions,which we cannot accurately predict, directly and indirectly may affect thequantity and allocation of expenditures by federal departments.  In addition, obtaining government contractsmay involve long purchase and payment cycles, competitive bidding,qualification requirements, delays or changes in funding, budgetaryconstraints, political agendas, extensive specification development and pricenegotiations and milestone requirements. Each government entity also maintains its own rules and regulations withwhich we must comply and which can vary significantly among departments.  As a result, cutbacks or re-allocations inthe federal budget or losses of government sales due to other factors couldhave a material adverse effect on our revenues and operating results.

 

***We derived 21.8% of our revenues from international sales in the ninemonths ended September 30, 2004, and 31.4% of our revenues from thesesales for the year ended December 31, 2003.  Our ability to sell our productsinternationally are subject to certain risks which could harm our business.***

 

Sales to foreign customersaccounted for approximately 31.4% of our revenues for the year endedDecember 31, 2003, and 21.8% of our revenues for the nine months endedSeptember 30, 2004.  Although exportsales decreased for the quarter and nine month periods ended September 30,2004 when compared to the same periods in 2003, we expect sales to foreigncustomers to continue to represent a significant portion of our revenues in thefuture.  Our international operations aresubject to many inherent risks that may adversely affect our business,financial condition and operating results, including:

 

•      political,social and economic instability;

 

•      traderestrictions;

 

•      increasesin duty rates and other potentially adverse tax consequences;

 

•      exposureto different legal standards, particularly with respect to the protection ofintellectual property;

 

•      burdensof complying with a variety of foreign laws;

 

•      unexpectedchanges in regulatory requirements;

 

•      importand export license requirements and restrictions of the United States and eachother country where we operate;

 

•      fluctuationsin currency exchange rates; and

 

•      changesin local purchasing practices, including seasonal fluctuations in demand.

 

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***Sales through indirect channels accounted for 32.1% of our revenues forthe nine months ended September 30, 2004 and 57% of our revenue for theyear ended December 31, 2003.  Ourrevenues will suffer if we do not expand our sales through, or receive theanticipated benefits from our sales through, indirect sales channels.***

 

We derived 32.1% of ourrevenues for the nine months ended September 30, 2004, and 57% of ourrevenue for the year ended December 31, 2003 from sales through indirectsales channels, such as distributors, value added resellers, systemintegrators, original equipment manufacturers and managed serviceproviders.  We believe we must expand oursales through these indirect channels in order to increase our revenues.  Although we are actively pursuing a strategyto increase the percentage of our revenues generated through these indirectsales channels, we cannot assure you that our products will gain marketacceptance in these indirect sales channels or that sales through theseindirect sales channels will increase our revenues as expected.  Further, many of our competitors are alsotrying to sell their products through these indirect sales channels, which couldresult in lower prices and reduced profit margins for sales of our products.

 

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

 

We rely on a combination ofpatent, copyright, trademark and trade secret laws, confidentiality proceduresand non-disclosure agreements to protect our proprietary technology.  However, unauthorized parties may attempt tocopy or reverse engineer aspects of our products or to obtain and useinformation that we regard as proprietary. Policing unauthorized use of our products is difficult, and we cannot becertain that the steps we have taken will prevent misappropriation of ourintellectual property.  This isparticularly true in foreign countries where the laws may not protectproprietary rights to the same extent as the laws of the United States and maynot provide us with an effective remedy against unauthorized use.  If our protection of our intellectualproperty proves to be inadequate or unenforceable, others may be able to useour proprietary developments without compensation to us, resulting in potentialcost advantages to our competitors.

 

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

 

There are numerous patentsheld by many companies relating to the design and manufacture of networksecurity systems.  Although we are notaware of any instances in which our products violate the intellectual propertyrights of others or inappropriately use their technology, it is possible thatthird parties in the future may claim that our products infringe on theirintellectual property rights.  Any claim,with or without merit, could consume our management’s time, result in costlylitigation, cause delays in sales or implementations of our products or requireus to enter into royalty or licensing agreements.  Royalty and licensing agreements, if requiredand available, may be on terms unacceptable to us or detrimental to ourbusiness.  Moreover, a successful claimof product infringement against us or our failure or inability to license theinfringed or similar technology on commercially reasonable terms couldseriously harm our business.

 

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

 

Our operating results havevaried significantly from quarter to quarter in the past, and we expect ouroperating results to vary from quarter to quarter in the future due to avariety of factors, many of which are outside of our control.  Although our revenues are subject tofluctuation, significant portions of our expenses are not variable in the shortterm, and we cannot reduce them quickly to respond to decreases inrevenues.  Therefore, if revenues arebelow our expectations, this shortfall is likely to adversely anddisproportionately affect our operating results.  Accordingly we may not attain positiveoperating margins in future quarters. Any of these factors could cause our operating results to be below theexpectations of securities analysts and investors, which likely wouldnegatively affect the price of our common stock.

 

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

 

The market price of ourcommon stock has been highly volatile in the past and may continue to bevolatile in the future.  For example, forthe nine-month period ending September 30, 2004, the market price of our commonstock on The Nasdaq SmallCap Market fluctuated between $0.86 and $4.40 per share.  The market price of our common stock mayfluctuate significantly in response to a number of factors, many of which areoutside our control, including:

 

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•     variationsin our quarterly operating results;

 

•      changesin estimates of our financial performance by securities analysts;

 

•      changesin market valuations of our competitors;

 

•      announcementsby us or our competitors of new products, significant contracts, acquisitions,strategic relationships, joint ventures or capital commitments;

 

•      productor design flaws, product recalls or similar occurrences;

 

•      additionsor departures of key personnel;

 

•      salesof common stock in the future; and

 

•      fluctuationsin stock market prices and volume, which can be particularly common amongnetwork security and other high technology companies.

 

***Our recent reductions in our work force may make it more difficult forus to attract and retain the personnel necessary to successfully operate ourbusiness.***

 

We rely upon the continuedservice of a relatively small number of key technical, sales and seniormanagement personnel.  Our future successdepends on retaining our key employees and our continuing ability to attract,train and retain other highly qualified technical, sales and managerialpersonnel.  We have employment agreementswith relatively few**of our keytechnical, sales and senior management personnel.  As a result, our employees could resign withlittle or no prior notice.  We may not beable to attract, assimilate or retain other highly qualified technical, salesand managerial personnel in the future, especially given our recent reductionsin force.  The loss of any of our keytechnical, sales and senior management personnel or our inability to attract,train and retain additional qualified personnel could seriously harm ourbusiness.

 

***Certain rights of the holders of 5% convertible preferred stock mayhinder our ability to raise additional financing.***

 

We cannot issue shares ofcapital stock with rights senior to those of our existing preferred or incurcertain indebtedness without the approval of at least a majority of the holdersof our 5% convertible preferred stock. In addition, holders of the preferred stock who are not executiveofficers or directors have the right to purchase a pro rata portion of certainfuture issuances of securities by us. The combination of these provisions could hinder or delay our ability toraise additional debt or equity financing.

 

***You will experience substantial dilution upon the conversion of theshares of preferred stock and exercise of warrants that we issued in a privateplacement.***

 

On March 25, 2004, wecompleted a $5,000,000 private placement in connection with which we issued1,000,000 shares of our 5% Convertible Preferred Stock and warrants to acquire556,619 shares of our common stock.  Theconversion price for the preferred stock and the exercise price of the warrantsis $3.144 per share.  We also issued ourplacement agent a warrant for 64,408 shares of our common stock at an exerciseprice of $3.144 per share.  As a result,we expect the private placement to result in dilution to holders of our commonstock upon conversion of the preferred stock and exercise of the warrants of2,211,358 shares of common stock, or an approximately 43% increase in thenumber of shares of our common stock outstanding.

 

***The conversion of preferred stock or exercise of warrants we issued inthe private placement may cause the price of our common stock to decline.***

 

Generally, the holders ofpreferred stock and warrants we issued in the private placement are able tofreely convert their shares of preferred stock and exercise their warrants andsell their underlying shares of common stock. For the four weeks ended on October 1, 2004, the average daily tradingvolume of our common stock on The Nasdaq SmallCap Market was 11,919shares.  Consequently, if holders ofpreferred stock or warrants elect to convert their shares or exercise theirwarrants and sell a material amount of their underlying shares of common stockon the open market, the increase in selling activity could cause a decline inthe market price of our common stock. Furthermore, these sales, or the potential for these sales, couldencourage short sales, causing additional downward pressure on the market priceof our common stock.

 

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***The percentage of our revenues attributable to sales of PDS productsintegrated with software of Check Point Software Technologies decreased from29.1% in 2002 to 16.7% in 2003 and to 12.2% for the first nine months of2004.  Because sales of our newerproducts may not offset the reduced sales of our PDS products, a change in ourrelationship with Check Point could have a negative effect on our operatingresults.***

 

Our PDS family of securityappliances, which are integrated with Check Point Software Technologies’market-leading VPN-1®/FireWall-1® software, represented 12.2% of our revenuesfor the nine months ended September 30, 2004, and 16.7% of our revenuesfor the year ended December 31, 2003. These percentages are down from 24.4% of our revenues for the ninemonths ended September 30, 2003, and 29.1% of our revenues for the yearended December 31, 2002.  We expectthe percentage of our sales attributable to our PDS products to decline in thefuture; however, our reliance on newer product sales may not replace theanticipated decline in revenue from sales of our PDS products.  Although we are a certified appliance partnerof Check Point and our PDS products have received Check Point certification, wehave no long-term agreement or exclusive relationship with Check Point.  As a result, the loss or significant changein our relationship with Check Point, the failure of our PDS products tomaintain or receive Check Point certification, the business failure of CheckPoint or its acquisition by or of one of our competitors and the loss of marketshare of Check Point or market acceptance of its products could each have amaterial adverse effect on our business, financial condition and results ofoperations.

 

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

 

We have made acquisitions inthe past, and, in the future, we may acquire or invest in additional companies,business units, product lines or technologies to accelerate the development ofproducts and sales channels complementary to our existing products and saleschannels.  Negotiation of potentialacquisitions and integration of acquired products, technologies or businessescould divert our management’s time and resources.  Future acquisitions could cause us to issueequity securities that would dilute your ownership of us, incur debt orcontingent liabilities, amortize intangible assets or write off in-process researchand development, goodwill and other acquisition-related expenses that couldseriously harm our financial condition and operating results.  Further, if we are not able to properlyintegrate acquired products, technologies or businesses with our existingproducts and operations, train, retain and motivate personnel from the acquiredbusiness or combine potentially different corporate cultures, we may notreceive the intended benefits of our acquisitions, which could adversely affectour business, operating results and financial condition.

 

***The payment of accrued dividends on our 5% convertible preferred stockmay strain our cash resources.***

 

Shares of our 5% convertiblepreferred stock accrue cash dividends equal to $0.25 per share per annum.  These dividends are payable in arrears onMarch 31 and September 30 of each year, commencing onSeptember 30, 2004.  On October 1,2004, we made the first dividend payments totaling $129 thousand.  Delaware law provides that we may only paydividends out of our capital surplus or, if no surplus is available, out of ournet profits for the fiscal year the dividend is declared and/or the precedingfiscal year.  We have not had net profitsfor the last two fiscal years, and as of September 30, 2004 our capital surplus,defined as the amount by which our net assets exceed our stated capital, wasapproximately $2.8 million.  Therefore,we have only limited resources to pay these dividends in future periods.  In addition, the payment of these dividendscould strain our available cash resources, which could adversely affect ourability to operate or grow our business.

 

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

 

Certain of our data securityproducts incorporate encryption and other technology that may require clearanceand export licenses from the U.S. Department of Commerce under United Statesexport regulations.  Any inability toobtain these clearances or licenses or any foreign regulatory approvals, ifrequired, on a timely basis could delay sales and have a material adverse effecton our operating results.

 

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

 

Certain provisions of ourcertificate of incorporation and bylaws, such as our ability to offer “blankcheck” preferred stock and the inability of our stockholders to act by writtenconsent, could make it more difficult for a third party to acquire us, even ifdoing so would be beneficial to our stockholders.  We are also subject to the provisions ofSection 203 of the Delaware General Corporation Law, which restrictscertain business combinations with interested stockholders and could inhibit anon-negotiated merger or other business combination.

 

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

 

As of September 30,2004, our executive officers, directors and 5% stockholders beneficially ownapproximately 38.5% of our voting power. As a result, these stockholders will be able to exercise significantcontrol over all matters requiring stockholder approval, including the electionof directors and approval of significant corporate transactions, which coulddelay or prevent someone from acquiring or merging with us.  These stockholders may use their influence toapprove or take actions that may be adverse to your interests.

 

Item 3.           QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

**ForeignExchange**.  Revenue originating outside the U.S. in thequarters ended September 30, 2004 and 2003 was 15.5% and 23.2 % of totalrevenues, respectively. Revenue originating outside the U.S. in the nine monthsended September 30, 2004 and 2003 was 21.8% and 35.8% of total revenues,respectively. International sales are typically denominated in U.S.dollars.  Our foreign sales subsidiariesincur most of their expenses in the local currency.

 

Our international businessis subject to risks typical of an international business, including, but notlimited to: differing economic conditions, changes in political climate,differing tax structures, other regulations and restrictions and foreignexchange rate volatility.  Accordingly,our future results could be materially adversely affected by changes in theseor other factors.  The effect of foreignexchange rate fluctuations on us in 2004 and 2003 was not material.

 

On January 1, 2003, theCompany elected to change the functional currency of its foreign operations tothe United States dollar. This change in functional currency is supported bythe fact that all foreign operations are funded monthly in United Statesdollars and the majority of a revenue contracts are denominated in UnitedStates dollars.  Under United Statesdollar functional currency, the financial statements of foreign locations areremeasured from the recording currency to the United States dollar. Theresulting remeasurement adjustment is recorded as foreign exchange gain or lossin the statement of operations. There is no translation adjustment to theseparate component of stockholders’ equity or adjustment to comprehensiveincome. The effect of the change in functional currency had no material impacton results of operations. The accumulation of prior years’ translationadjustments remains on the balance sheet as a separate component ofstockholders’ equity until part, or all, of the respective entities aredisposed.

 

**InterestRates**. We invest ourcash in a variety of financial instruments, including bank time deposits, fixedrate obligations of corporations, municipalities, and state and nationalgovernmental entities.  These investmentsare denominated 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 on ourinvestments is carried in “Interest income, net”.  We account for our investment instruments inaccordance with SFAS No. 115, “Accounting for Certain Investments in Debt andEquity Securities”.  All of the cash equivalentsand short-term investments are treated as available-for-sale under SFAS 115.

 

Investments in fixed rateinterest earning instruments carry a degree of interest rate risk.  Fixed rate securities may have their fairmarket value adversely impacted due to a rise in interest rates.  Due in part to these factors, our futureinvestment income may fall short of expectations due to changes in interestrates or we may suffer losses in principal if forced to sell securities, whichhave seen a decline in market value due to changes in interest rates.  Our investment securities are held forpurposes other than trading.  Theweighted-average of the stated coupon interest rate on investment securities atSeptember 30, 2004 was 6.0%.  Due tothe amortization of premiums and discounts paid, the actual rate of return willvary from the weighted-average of the stated coupon interest rate.  The fair value of investments held atSeptember 30, 2004 approximated amortized cost.

 

Item 4.           CONTROLS ANDPROCEDURES

 

We have carried out anevaluation, under the supervision and the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures as ofSeptember 30, 2004, pursuant to Rule 13a-15(b) under the ExchangeAct.  Based upon that evaluation, ourChief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures are effective in ensuring that informationrequired to be disclosed is recorded, processed, summarized and reported in atimely manner.

 

We have carried out anevaluation, under the supervision and participation of our management,including our Chief Executive Officer and Chief Financial Officer, of anychanges in our internal controls over financial reporting that occurred duringthe quarterly period ended September 30, 2004, and our Chief ExecutiveOfficer and Chief Financial Officer have concluded that there was no changeduring the quarterly period ended September 30, 2004 that has materiallyaffected or is reasonably expected to materially affect our internal controlover financial reporting.

 

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**PART II –OTHER INFORMATION**

 

Item 1.           LEGAL PROCEEDINGS

 

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

 

Item 6.           EXHIBITS AND REPORTSON FORM 8-K

 

(a)             The following Exhibits are filedwith this report form 10-Q:

 
| 10.1 |   | Waiver of Liquidated  Damages dated as of July 23, 2004, by and among Intrusion, G. Ward Paxton and  James F. Gero.                                                                                    |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1 |   | Certification of Chief  Executive Officer Pursuant to Rule 13a-14(a) of the Exchange Act.                                                                                                              |
| 31.2 |   | Certification of Chief  Financial Officer Pursuant to Rule 13a-14(a) of the Exchange Act.                                                                                                              |
| 32.1 |   | Certification of Chief  Executive Officer Pursuant to Rule 13a-14(b) of the Exchange Act and 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
| 32.2 |   | Certification of Chief  Financial Officer Pursuant to Rule 13a-14(b) of the Exchange Act and 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

(b)            During the quarter endedSeptember 30, 2004, we did not file any reports on Form 8-K.

 

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

 

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the Registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 

 
| ** **              | **INTRUSION INC.**                                                   |
|-------------------------|----------------------------------------------------------------------|
|                    |                                                                 |
|                    |                                                                 |
| Date: November 12, 2004 | /s/  Michael L. Paxton                                               |   |
|                    | Michael  L. Paxton                                                   |
|                    | Vice President, Chief  Financial Officer,  Treasurer & Secretary |
|                    | (Principal  Financial & Accounting Officer)                      |

 

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