**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

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**FORM 10-K**

 

**(Mark One)**

| **ý**                                                                                                                                                    |   | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  [FEE REQUIRED]**        |
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|                                                                                                                                                          |   |                                                                                                             |
| **FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003**                                                                                                               |
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| **OR**                                                                                                                                                        |
|                                                                                                                                                          |   |                                                                                                             |
| **o**                                                                                                                                                         |   | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  [NO FEE REQUIRED]** |
|                                                                                                                                                          |   |                                                                                                             |
| **For the transition period  from          to          ** |

 

**COMMISSION FILE NUMBER 0-20191**

 

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**IntrusionInc.**

(Exact name of registrant as specified in itscharter)

 

| **DELAWARE**                                                    |   | **75-1911917**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |   |                                  |
| **1101 EAST ARAPAHO ROAD  RICHARDSON, TEXAS**                   |   | **75081**                             |
| (Address of principal executive offices)                        |   | (Zip Code)                            |

 

Registrant’s telephone number, including areacode: **(972) 234-6400**

 

Securities registered pursuant toSection 12(b) of the Act:

**None**

** **

Securities registered pursuant toSection 12(g) of the Act:

**Common Stock, $0.01 par value**

(Title of class)

 

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Indicate by check mark whether the Registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the Registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past90 days. Yes ý  No o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not becontained, to the best of the Registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of thisForm 10-K or any amendment to this Form 10-K. o

 

Indicate by check mark whether the Registrant is an accelerated filer(as defined in Exchange Act Rule 12-b2): Yes oNo ý

 

State the aggregate market value of the voting and non-voting equityheld by non-affiliates computed by reference to the price at which the commonequity was last sold, or the average bid and asked price of such common equity,as of the last business day of the Registrants’ most recently completed secondfiscal quarter: $10,381,910. As of February 27, 2004, 20,652,425 shares ofthe Registrant’s Common Stock were outstanding.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portions of the Registrant’s definitive Proxy Statement filed inconnection with the Registrant’s 2003 Annual Meeting of Stockholders areincorporated by reference into Part III of this Form 10-K.

** **

 

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**INTRUSION INC.**

**INDEX**

 
| **PART I**   |                                                                                                                |   |
|--------------|---------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.      | Business                                                                                                            |   |
| Item 2.      | Properties                                                                                                          |   |
| Item 3.      | Legal  Proceedings                                                                                                  |   |
| Item 4.      | Submission  of Matters to a Vote of Security Holders                                                                |   |
| **PART II**  |                                                                                                                |   |
| Item 5.      | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities |   |
| Item 6.      | Selected  Financial Data                                                                                            |   |
| Item 7.      | Management’s  Discussion and Analysis of Financial Condition And Results of Operations                         |   |
| Item  7A.    | Quantitative  and Qualitative Disclosures About Market Risk                                                         |   |
| Item 8.      | Financial  Statements and Supplementary Data                                                                        |   |
| Item 9.      | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure                               |   |
| Item  9A.    | Controls  and Procedures                                                                                            |   |
| **PART III** |                                                                                                                |   |
| Item  10.    | Directors  and Executive Officers of Intrusion Inc.                                                                 |   |
| Item  11.    | Executive  Compensation                                                                                             |   |
| Item  12.    | Security  Ownership of Certain Beneficial Owners and Management                                                     |   |
| Item  13.    | Certain  Relationships and Related Transactions                                                                     |   |
| Item  14.    | Principal  Accountant Fees and Services                                                                             |   |
| **PART IV**  |                                                                                                                |   |
| Item  15.    | Exhibits,  Financial Statement Schedules, and Reports on Form 8-K                                              |   |
| Signatures   |                                                                                                                |   |

 

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**PARTI**

 

**Item 1**.    Business.

 

In addition to the historical information contained herein, thediscussion in this Form 10-K contains certain forward-lookingstatements, within the meaning of Section 27A of the Securities Act of1933 and Section 21E of the Securities Exchange Act of 1934, that involverisks and uncertainties, such as statements concerning: growth and anticipatedoperating results, developments in our markets and strategic focus; newproducts and product enhancements; potential acquisitions and the integrationof acquired businesses, products and technologies; strategic relationships andfuture economic and business conditions. The cautionary statements made in thisForm 10-K should be read as being applicable to all relatedforward-looking statements whenever they appear in this Form 10-K. Ouractual results could differ materially from the results discussed in theforward-looking statements. Factors that could cause or contribute to suchdifferences include, but are not limited to, those discussed under the sectioncaptioned “Factors That May Affect Future Results of Operations” in Item 1 ofthis Form 10-K as well as those cautionary statements and other factorsset forth elsewhere herein.

 

**General**

 

We develop, market and support a family of network intrusion preventionand detection systems and regulated information compliance systems that addressvital security issues facing organizations with mission critical businessapplications or housing classified, confidential, or customer informationassets. We currently provide network security and regulated informationcompliance solutions under our SecureNet family of hardware and software solutions.

 

We market and distribute our products through a direct sales force toend-users, distributors and by numerous domestic and international systemintegrators, managed service providers and value-added resellers. Our end-usercustomers include high technology, manufacturing, telecommunications, retail,transportation, health care, insurance, entertainment, utilities and energycompanies, government agencies, financial institutions, and academicinstitutions.

 

We were organized in Texas in September 1983 and reincorporated inDelaware in October 1995. For more than 15 years, we provided localarea networking equipment and were known as Optical Data Systems or ODSNetworks. On April 17, 2000, we announced plans to sell, or otherwisedispose of, our networking divisions, which included our EssentialCommunications division (“Essential”) and our 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 ODSNetworks, Inc. to Intrusion.com, Inc., and our NASDAQ ticker symbolfrom ODSI to INTZ to reflect our focus on intrusion detection solutions. OnNovember 1, 2001, we changed our name from Intrusion.com, Inc. toIntrusion Inc.

 

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

 

**Recent Developments**

 

On March 25, 2004, we completed a $5.0 million private placement of 5%Convertible Preferred Stock and warrants. In the private placement, the company sold 1,000,000 shares of preferredstock at a price of $5.00 per share, which convert into 6,361,323 shares ofcommon stock at an initial conversion price of $0.786 per share, and warrantsto purchase 2,226,459 shares of common stock at an exercise price of $0.786 pershare.  In connection with the closingof this private placement, we issued warrants to purchase 257,633 shares of ourcommon stock at an exercise price of $0.786 per share to our financial advisorfor the private placement.

 

On March 18, 2004, at a special meeting, our stockholders approved anamendment to our certificate of incorporation to effect a four-for-one (4:1)reverse stock split of our common stock. The reverse stock split will become effective on March 29, 2004.  All outstanding share numbers and relatedcommon stock numbers, such as earnings per share and outstanding options,included in this report are set forth on a pre-split basis.

 

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**Industry Background**

 

In the last decade, network security has changed from being atechnology deployed only by the government and the most sophisticated or mostparanoid of companies, to technology employed by all sizes of business and amandatory component of all mission critical systems. This change has come aboutwith the permeation of the Internet as a business enabler. Today, email,instant messengers, World Wide Web access, web sites, web-based applicationsand e-commerce are integral components of communications and operations forbusiness and government.

 

Although the Internet has many business advantages, its openness and accessibilitymakes it a potential threat to the networks and systems that are attached toit. Computer hackers, curious or disgruntled employees, competitors andinnocent mistakes may compromise or destroy information assets or disrupt thenormal operations and brand equity of the enterprise.

 

Enterprises are adopting a variety of security solutions to meet thechallenge posed by external and internal threats. To be effective,organizations require enterprise-wide information risk management solutionsthat are broadly deployed and centrally managed. Organizations seek systemswith the optimum combination of best-of-breed capabilities and total cost ofownership. Securing the enterprise network requires two key elements:

 

•                                          Control:the ability to affect network traffic including access to the network or partsthereof in order to enforce a security policy.

 

•                                          Visibility:the ability to see and understand the nature of the network and the traffic onthe network, which assists in decision making as well as crafting and constantimprovement of a security policy.

 

We focus on providing these two primary ingredients of network securitywithin a single device for overall network security and for the protection ofspecific classified, confidential or customer information assets.

 

*Network Intrusion Prevention and DetectionSystems*

 

Network Intrusion Prevention & Detection Systems (NIP&DS)analyze network traffic for attacks and can block threats from entering thenetwork. They examine individual packets within the data stream to identifythreats from authorized users, back-door attacks and hackers who have thwartedthe firewall to exploit network connections, cause system outages and accessinformation assets. NIP&DS provide insight into the nature and character ofthe network that can be used to:

 

•                                          Identifythreats in real time and block or terminate offending communications or simplyalert administrators so that human intervention can protect the network;

 

•                                          Increasethe value and efficacy of the control systems like firewalls and routers withevidence of the efficacy of those systems; and

 

•                                          Providedecision support for the altering of the enterprise security policy and networkmanagement.

 

*Regulated Information Compliance Systems*

 

Regulated Information Compliance Systems(RICS) build upon NIP&DS with the added capability to more deeply analyzetraffic searching for classified, confidential or customer information assets.Working under the same management and monitoring umbrella of NIP&DS, RICSaddress data confidentiality, security and integrity issues facing industriessubject to the Health Portability and Accountability Act of 1996 (HIPAA),Gramm, Leach, Bliley Act (GLBA), Sarbanes-Oxley, California Senate Bill 1386(CA SB 1386) and others. These laws affect a broad range of bothprivate and public entities, including those that maintain information that canpersonally identify a customer or patient and those that house both classifiedand unclassified information.  Penaltiesfor non-compliance include fines, lawsuits, and business process reviews.

 

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**Our Solution and Products**

 

Intrusion Inc. addresses the challenges of ensuring theconfidentiality, security and integrity of electronic information assets bydeveloping, marketing and supporting a family of NIP&DS and RICS fordeployment by public and private enterprises, to include remote and branchoffices, and for managed security service providers. We believe implementingadequate perimeter defenses and monitoring network traffic to“trust-but-verify” are critical elements for the protection of informationassets and integrity.

 

**Our SecureNet Network Systems**

 

The Intrusion SecureNet System has two primary components, Sensors andthe Management System.

 

Sensors are devices or software components that are connected to thenetwork and monitor the traffic searching for matches to signatures as evidenceof an external network attack or malicious use that could threaten informationassets. Signatures are patterns, anomalies and traffic flows that match knownattacks or indicate suspicious activities. When the Sensor matches traffic to asignature it will send an event to the Management System.

 

The Management System controls the Sensors and displays events producedby the Sensors.  Management is used forboth configuration of the system and providing highly productive monitoring ofthe events produced by the system. Management is typically three-tier, whereSensors report to a centralized management system that has multiple analystsviewing the data. Management can also be a standalone system for small- andmedium-businesses where configuration and monitoring are all done directly fromthe Sensor.

 

We have simplified deployment, management and monitoring to reduce thetotal cost of ownership for an easy to set up and manage enterprise system. Toreduce barriers and provide complete enterprise integration, the IntrusionSecureNet system provides more customization and event flow options forhigh-end deployments.

 

Our SecureNet system is “plug-and-protect” and can be connected to anynetwork without interfering with the network operations by using the IntrusionSecureNet passive and inline taps.

 

*Intrusion SecureNet NIP&DS Products*

 

We believe a primary advantage of the SecureNet NIP&DSis that with a single license purchase, the consumer may choose to deploy thesystem for intrusion prevention or intrusion detection, providing a superiorlevel of flexibility and simple migration from passive detection to activeprevention without additional licensing cost.

 

Network Intrusion Prevention Systems (NIPS) — Provide networkmonitoring and analysis functionality like an IDS, with the added ability toblock malicious network traffic. IPS actively regulates inbound and outboundtraffic based on specific users access while controlling what they can do withthat access on a granular, per-conversation basis.

 

Network Intrusion Detection Systems (NIDS) — Provide detection ofspecific exploit and misuse patterns in the traffic that the firewall allows.  IDS detect known exploits and misusepatterns, suspicious activities and anomalous traffic or behavior within bothinbound and outbound traffic. This added visibility provides a checkingmechanism for the efficacy of the firewall’s rule base.

 

Intrusion SecureNet network NIP&DS provide user customizable,protocol decode detection technology for up to Gigabit networks. WhileIntrusion SecureNet Sensors are in the top-tier of the market for detection andthroughput technology, we believe one of the primary benefits provided by ourNIP&DS products is to reduce the total cost of ownership to our customers.

 

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The SecureNet NIP&DS product family provides intuitive and powerfuldata mining and configuration. Intrusion SecureNet Provider is the three-tierenterprise management and monitoring system. SecureNet Provider is forenterprise deployments with no license limitations placed on architecture,freeing the enterprise to build the management system required. SecureNetProvider follows the workflow of the security analyst with a highly productiveenvironment for response, research, resolution and decision support. TheSecureNet Provider suite includes applications for event monitoring, policycreation and tuning and centralized software deployment — making up thecomplete suite of tools required to manage and monitor a SecureNet System fromfive sensors to more than 100.

 

Our SecureNet Sensors have their own web browser interface foreffortless configuration. SecureNet Sensors also deliver complete, stand-aloneNIP&DS for the small and medium business with local management andmonitoring. This allows customers to use their standard web browser to access afull power; full-features network NIP&DS, without additional hardware orsoftware.

 

Our SecureNet NIP&DS Sensors are available as Software-Appliancesand Hardware-Appliances with performance and pricing appropriate for networksranging from 10Mb/s to Gigabit with a Common Criteria EAL2 certified Gigabitappliance.  The following is a list ofour IPS and IDS products

 

•                                          IntrusionSecureNet 7000 Software-Appliance products for networks up to 1000Mb/s.  Seamlessly turns leading servers andworkstations into SecureNet Sensors.

 

•                                          IntrusionSecureNet CC 7345 rack mount Hardware-Appliance, highly redundant, gigabitSensor with Common Criteria EAL2 certification—specifically for governmentdeployments.

 

•                                          IntrusionSecureNet 7145 rack mount, gigabit Hardware-Appliance available with either acopper- or a fiber-monitoring interface.

 

•                                          IntrusionSecureNet 5500 Software-Appliance for networks up to 250Mb/s. Seamlessly turnsleading servers and workstations into SecureNet Sensors.

 

•                                          IntrusionSecureNet 5545 rack mount 250Mb/s Hardware-Appliance for server rooms anddatacenters.

 

•                                          IntrusionSecureNet 5000 Software-Appliance for networks up to 100Mb/s. Seamlessly turnsleading servers and workstations into SecureNet Sensors.

 

•                                          IntrusionSecureNet 5445 rack mount and 2445 desktop 100Mb/s Hardware-Appliances fornetwork deployments and remote and branch offices.

 

•                                          IntrusionSecureNet 2000 Software-Appliance for networks up to 10Mb/s. Seamlessly turnsleading servers and workstations into SecureNet Sensors.

 

•                                          IntrusionSecureNet 2245 Hardware-Appliance for remote and branch offices with throughputup to 10Mb/s at about the price of a laptop.

 

*Intrusion SecureNet RICS Products*

 

RICS provide protection against the loss and misuse of regulated,classified and commercially sensitive data. Loss of information assets that contain customer data has spawned amultitude of federal and state legislation to set a standard of care, use andprotection for customer information. Better known laws that regulate customer information include HIPAA,Gramm-Leach-Bliley Act and its UK equivalent Privacy Act of 1998, andCalifornia SB 1386.  Penalties fornon-compliance include fines, lawsuits, imposed processes and enforced businesslimitations. Any enterprise that falls within the scope of these laws is now workingunder a timeline to demonstrate compliance. In addition, both government and commercial institutions are becomingincreasingly concerned about the misuse and loss of classified or commerciallysensitive data, and are seeking proactive solutions to deal with these issues.

 

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The Intrusion SecureNet RICS products leverage the same Management andSensor components of the SecureNet NIP&DS products. Our SecureNet RICSsolutions are currently designed to address the security and confidentiality issuesin the following industries and customers:

 

•                                          Departmentof defense to help prevent the leakage of classified information,

 

•                                          Healthcare companies (including health care providers, insurance companies andmedical equipment manufacturers) who are working to comply with HIPAA, and

 

•                                          Financialinstitutions and e-commerce enterprises working to comply with the customerconfidentiality provisions of GLBA and CA SB 1386.

 

The Intrusion SecureNet RICS products leverage the same Management andSensor components of the SecureNet IDS AND IPS products. The SecureNet RICS isdesigned to address the [privacy, confidentiality and information security]concerns of the department of defense, health care vertical (including healthcare providers, insurance companies and medical equipment manufacturers),financial institutions and e-commerce.

 

SecureNet RICS solutions provide accuracy through our Dynamic DataDictionary (D3) technology, which securely connects directly to a databasehousing the confidential, classified, or regulated information. The RICS staysup to date with the database to match network traffic to the information thatis resident in the database. This provides an automated accurate mechanism toidentify leaks and misuse of information assets.

 

The Intrusion SecureNet LPS, leak prevention system targets public andprivate enterprises with confidential and classified information. The firstrelease specifically targets the U.S. department of defense and protectingagainst “spillage”, when classified information leaks to unclassified networks.

 

**Third-Party Products**

 

We believe that it is beneficial to work with third parties withcomplementary technologies to provide integrated solutions to our customers. Asthere is rapid technological advancement and significant consolidation in thenetwork security industry, there can be no assurance that we will have accessto all of the third-party products that may be desirable or for the termdesirable to offer fully integrated solutions to our customers.

 

**Customer Services**

 

In addition to offering our network security products, we also offer awide range of services, including design and configuration, project planning,training, installation and maintenance.

 

**Product Development**

 

The network security industry is characterized by rapidly changingtechnology, standards, economy and customer demands. We believe that our futuresuccess depends in large part upon the timely enhancement of existing productsas well as the development of technologically advanced new products that meetindustry standards, perform successfully and simplify the user’s tasks so thatthey can do more with less resources, all to achieve market acceptance. We arecurrently marketing next-generation network NIP&DS products and RICSproducts and are developing products to meet emerging market requirements andare continuously engaged in testing to ensure that our products interoperatewith other manufacturers’ products, which comply with industry standards.

 

During 2003, 2002 and 2001, our research and development expenditureswere $3.5 million $6.1 million, and $12.5 million, respectively. All ofour expenditures for hardware and software research and development costs havebeen expensed as incurred. At December 31, 2003, we had 15 employeesengaged in research and product development.

 

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**Manufacturing and Supplies**

 

Our operational strategy relies on the outsourcing of manufacturingcomponents, assembly and certain other operations to reduce fixed costs and toprovide flexibility in meeting market demand.

 

Our internal manufacturing operations consist primarily of replicationof software on CDs, packaging, testing and quality control of finished units.Materials used in our manufacturing processes include semiconductors such asmicroprocessors, memory chips and application specific integrated circuits(“ASICs”), printed circuit boards, power supplies and enclosures.

 

Our external manufacturing operations consists primarily of hardwareassembly and configuration and the loading of the appropriate software.

 

**Intellectual Property and Licenses**

 

Our success and our ability to compete are dependent, in part, upon ourproprietary technology. While we have applied for certain patents, we currentlyrely on a combination of contractual rights, trade secrets and copyright lawsto establish and protect our proprietary rights in our products. We have alsoentered into non-disclosure agreements with our suppliers, resellers andcertain customers to limit access to and disclosure of proprietary information.There can be no assurance that the steps taken by us to protect ourintellectual property will be adequate to prevent misappropriation of ourtechnology or that our competitors will not independently develop technologiesthat are substantially equivalent or superior to our technology.

 

We have entered into software and product license agreements withvarious suppliers. These license agreements provide us with additional softwareand hardware components that add value to our security products. These licenseagreements do not provide proprietary rights that are unique or exclusive to usand are generally available to other parties on the same or similar terms andconditions, subject to payment of applicable license fees and royalties.

 

**Sales, Marketing and Customers**

 

***Field Sales Force.***  Our direct sales organization focuses onmajor account sales, channel partners including distributors, Value AddedResellers (“VARs”) and integrators; promotes our products to current and potentialcustomers; and monitors evolving customer requirements. The field sales andtechnical support force provides training and technical support to ourresellers and end users and assists our customers to design secure datanetworking solutions.

 

We currently conduct sales and marketing efforts from our principaloffice in Richardson (Dallas), Texas and through foreign sales offices locatedin the following countries: England, France and Malaysia.  In addition, we have sales personnel, salesengineers or sales representatives located in Los Angeles, Eastern Europe andSpain.

 

***Distributors.***  We have signed distribution agreements withdistributors in the United States, Europe and Asia. In general, theserelationships are non-exclusive. Distributors typically maintain an inventoryof our products. Under these agreements, we provide certain protection to thedistributors for their inventory of our products for price reductions as wellas products that are slow moving or have been discontinued. Recognition of salesto distributors and related gross profits are deferred until the distributorsresell the merchandise. However, since we have legally sold the inventory tothe distributor and we no longer have care, custody or control over theinventory, we recognize the trade accounts receivable and reduce inventoryrelated to the sale at the time of shipment to the distributor.

 

***Resellers.***  Domestic and international systemintegrators and VARs (collectively, “resellers”) sell our products as stand-alonesolutions to end users and integrate our products with products sold by othervendors into network security systems that are sold to end users. Our fieldsales force and technical support organization provide support to theseresellers. Our agreements with resellers are non-exclusive, and our resellersgenerally sell other products that may compete with our products. Resellers mayplace higher priority on products of other suppliers who are larger than andhave more name recognition than us, and there can be no assurance thatresellers will continue to sell and support our products.

 

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***Foreign Sales.***  We believe that rapidly evolvinginternational markets are important sources of future net sales. Our exportsales are currently being made through a direct sales force supplemented byinternational resellers in Europe, Asia and Canada.  Export sales accounted for approximately 31.4%, 33.4% and 36.4%of net sales in 2003, 2002 and 2001, respectively. See “Management’s Discussionand Analysis of Financial Condition and Results of Operations” included in thisreport for a geographic breakdown of our product revenue in 2003, 2002 and2001. Sales to foreign customers and resellers generally have been made inUnited States dollars.

 

***Marketing.***  We have implemented several methods tomarket our products, including public relations and placed articles, regularparticipation in and presenting during trade shows and seminars, advertisementin trade journals, telemarketing, distribution of sales literature and productspecifications and ongoing communication with our resellers and installed baseof end-user customers.

 

***Customers.***  Our end-user customers includemanufacturing, high technology, telecommunications, retail, transportation, healthcare, insurance, entertainment, utilities and energy companies, governmentagencies, financial institutions and academic institutions. Sales to certaincustomers and groups of customers can be impacted by seasonal capitalexpenditure approval cycles, and sales to customers within certain geographicregions can be subject to seasonal fluctuations in demand.

 

Although we sell our products to many customers, through variousdistribution channels, no one customer or reseller accounted for 10% or more ofour net sales in any of the past three fiscal years.

 

However, in 2003, 17.0% of our revenue was derived from the sales to avariety of U.S. government entities through system integrators andresellers.  The loss of sales to thevarious U.S. government agencies could have a material adverse effect on ourbusiness and operating results if not replaced.  No other customer accounted for 10% or more of our net sales in2003, 2002 or 2001, respectively.

 

***Backlog.***  We believe that only a small portion of ourorder backlog is non-cancelable and that the dollar amount associated with thenon-cancelable portion is immaterial. We purchase inventory based upon ourforecast of customer demand and maintain inventories of sub-assemblies andfinished products in advance of receiving firm orders from customers. Ordersare generally fulfilled within two days to two weeks following receipt of anorder. Due to the generally short cycle between order and shipment andoccasional customer-initiated changes in delivery schedules or cancellation oforders that are made without significant penalty, we do not believe that ourbacklog as of any particular date is indicative of future net sales.

 

***Customer Support,Service and Warranty.***  We service, repair and provide technical support for ourproducts. Our field sales and technical support force works closely withresellers and end-user customers on-site and by telephone to assist with pre-and post-sales support services such as network security design, systeminstallation and technical consulting. By working closely with our customers,our employees increase their understanding of end-user requirements and provideinput to the product development process.

 

We warrant all of our products against defects in materials andworkmanship for periods ranging from 90 days to 12 months. Before andafter expiration of the product warranty period, we offer both on-site andfactory-based support, parts replacement and repair services. Extendedwarranty services are separately invoiced on a time and materials basis orunder an annual maintenance contract.

 

**Competition**

 

The market for network security solutions is intensely competitive andsubject to frequent product introductions with new technologies, improved priceand performance characteristics. Industry suppliers compete in areas such asconformity to existing and emerging industry standards, interoperability withnetworking and other security products, management and security capabilities,performance, price, ease of use, scalability, reliability, flexibility, productfeatures and technical support. We believe that our approach focusing on thenetwork perimeters with market leading network intrusion detection technologythat reduces the total cost of ownership compared to the competition provides uswith an advantage with large organizations with complex security requirements.

 

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There are numerous companies competing in various segments of the datasecurity markets. Our principle competitors in the network intrusion preventionand detection market include Internet Security Systems, Inc., CiscoSystems, Inc., Symantec, Inc., Netscreen Technologies, Inc., NetworkAssociates, Inc., Tipping Point Technologies Inc., and NFR Security, Inc.  Our competitors in the regulated informationcompliance market include a small number of start up companies that entered thespace within the last two-years. Several of our competitors have substantiallygreater financial, technical, sales and marketing resources, better namerecognition and a larger customer base than we do. In addition, many of ourcompetitors may provide a more comprehensive networking and security solutionthan we currently offer. Even if we do introduce advanced products, which meetevolving customer requirements in a timely manner, there can be no assurancethat our new products will gain market acceptance.

 

Certain companies in the network security industry have expanded theirproduct lines or technologies in recent years as a result of acquisitions.Further, more companies have developed products which conform to existing andemerging industry standards and have sought to compete on the basis of price.We anticipate increased competition from large networking equipment vendors,which are expanding their capabilities in the network security market. Inaddition, we anticipate increased competition from private “start-up” companiesthat have developed or are developing advanced security products. Increasedcompetition in the security industry could result in significant pricecompetition, reduced profit margins or loss of market share, any of which couldhave a material adverse effect on our business, operating results and financialcondition. There can be no assurance that we will be able to compete successfullyin the future with current or new competitors.

 

**Employees**

 

As of December 31, 2003, we employed a total of 44 persons,including 17 in sales, marketing and technical support, 3 in manufacturing andoperations, 15 in research and product development and 9 in administration andfinance.

 

None of our employees are represented by a labororganization, and we are not a party to any collective bargaining agreement. Wehave not experienced any work stoppages and consider our relations with ouremployees to be good.

 

Competition in the recruiting of personnel in the networking and datasecurity industry is intense. We believe that our future success will depend inpart on our continued ability to hire, motivate and retain qualifiedmanagement, sales and marketing, and technical personnel. To date, we have notexperienced significant difficulties in attracting or retaining qualifiedemployees.

 

**Factors That May Affect Future Results ofOperations**

 

In addition to the other information in this Form 10-K, the followingfactors should be considered in evaluating Intrusion Inc. and ourbusiness.  This report may includevarious non-GAAP financial measures (as defined by SEC Regulation G), includingour cash used in operations excluding costs associated with a litigationsettlement and severance charges.  Ourmanagement believes these measures provide useful information to investorsabout our financial condition and results of operations for the periodpresented by eliminating the affects of one-time and other transactions thatcan distort underlying operational results in order to provide greatercomparability of our financial performance on a year-to-year basis. The mostdirectly comparable GAAP financial measures and reconciliation of thedifference between GAAP and non-GAAP financial measures can be found in thetest of this report and our consolidated financial statements included in thisreport.

 

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***Sufficiency of CashFlow.***  Asof December 31, 2003, we had cash, cash equivalents and investments in theamount of approximately $2.7 million, down from approximately $10.7 million asof December 31, 2002.  However,throughout 2003, we reduced expenses. As a result, our cash used in operations, net of the litigation settlementand severance charges, for the fourth quarter was approximately $1.4million.  Including litigationsettlement and severance charges, our cash used in operation in the fourthquarter of 2003 was $1.9 million.  OnMarch 25, 2004, we closed a $5.0 million private placement of 5% ConvertiblePreferred Stock and warrants.  With thisadditional financing, we believe that we have sufficient cash resources tofinance our operations and expected capital expenditures for the next twelvemonths.  The sufficiency of our cashresources may depend to a certain extent on general economic, financial,competitive or other factors beyond our control.  Moreover, despite actions to reduce our cost and improve ourprofitability, we expect our operating losses and net operating cash outflowsto continue through at least the first half of 2004.  We do not currently have any further arrangements for financing,and we may not be able to secure additional debt or equity financing on termsthat are acceptable to us, or at all, at the time when we need suchfunding.  If our business does notgenerate sufficient cash flow from operations and sufficient financings are notavailable, we may not be able to operate or grow our business, pay our expenseswhen due or fund our other liquidity needs.

 

***TechnologicalChanges.*** The market for our products is characterized by frequent productintroductions, rapidly changing technology and continued evolution of newindustry standards. The market for security products requires our products tobe compatible and interoperable with products and architectures offered byvarious vendors, including other security products, networking products,workstation and personal computer architectures and computer and networkoperating systems. Our success will depend to a substantial degree upon ourability to develop and introduce in a timely manner new products andenhancements to our existing products that meet changing customer requirementsand evolving industry standards. The development of technologically advancedproducts is a complex and uncertain process requiring high levels of innovationas well as the accurate anticipation of technological and market trends. Therecan be no assurance that we will be able to identify, develop, manufacture,market and support new or enhanced products successfully in a timely manner.Further, we or our competitors may introduce new products or productenhancements that shorten the life cycle of or obsolete our existing productlines, any of which could have a material adverse effect on our business,operating results and financial condition.

 

***Market Acceptance.***  We are pursuing a strategy to increase thepercentage of our revenue generated through indirect sales channels includingdistributors, VARs, system integrators, original equipment manufacturers andmanaged service providers. There can be no assurance that our products willgain market acceptance in these indirect sales channels. Further, competitionamong security companies to sell products through these indirect sales channelscould result in significant price competition and reduced profit margins.

 

We are also pursuing a strategy to further differentiate our productline by introducing complementary security products and incorporating newtechnologies into our existing product line. There can be no assurance that wewill successfully introduce these products or that such products will gainmarket acceptance. We anticipate competition from networking companies, networksecurity companies and others in each of our product lines. We anticipate thatprofit margins will vary among our product lines and that product mixfluctuations could have an adverse effect on our overall profit margins.

 

***Acquisitions.***  Some of our competitors have acquiredseveral security companies with complementary technologies, and we anticipatethat such acquisitions will continue in the future. These acquisitions maypermit such competitors to accelerate the development and commercialization ofbroader product lines and more comprehensive solutions than we currently offer.In the past, we have relied upon a combination of internal product developmentand partnerships with other security vendors to provide competitive solutionsto customers. Certain of the recent and future acquisitions by our competitorsmay have the effect of limiting our access to commercially significanttechnologies. Further, the business combinations and acquisitions in thesecurity industry are creating companies with larger market shares, customerbases, sales forces, product offerings and technology and marketing expertise.There can be no assurance that we will be able to compete successfully in suchan environment.

 

11

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We have made acquisitions in the past, and we may, in the future,acquire or invest in additional companies, business units, product lines, ortechnologies to accelerate the development of products and sales channelscomplementary to our existing products and sales channels. Acquisitions involvenumerous risks, including: difficulties in assimilation of operations,technologies, and products of the acquired companies; risks of entering marketsin which we have no or limited direct prior experience and where competitors insuch markets have stronger market positions; the potential loss of keyemployees of the acquired company; and the diversion of our attention fromnormal daily operation of our business. There can be no assurance that anyother acquisition or investment will be consummated or that such acquisition orinvestment will be realized.

 

***Product Transitions.***  Once current security products have been inthe market place for a period of time and begin to be replaced by higherperformance products (whether of our design or a competitor’s design), we expectthe net sales of such products to decrease. In order to achieve revenue growthin the future, we will be required to design, develop and successfullycommercialize higher performance products in a timely manner. There can be noassurance that we will be able to introduce new products and gain marketacceptance quickly enough to avoid adverse revenue transition patterns duringcurrent or future product transitions. Nor can there be any assurance that wewill be able to respond effectively to technological changes or new productannouncements by competitors, which could render portions of our inventoryobsolete.

 

***Manufacturing andSuppliers.*** Our operational strategy relies on outsourcing of product assembly andcertain other operations. There can be no assurance that we will effectivelymanage our third-party contractors or that these contractors will meetour future requirements for timely delivery of products of sufficient qualityand quantity. Further, we intend to introduce a number of new products and productenhancements in 2004 that will require that we rapidly achieve volumeproduction of those new products by coordinating our efforts with those of oursuppliers and contractors. The inability of the third-party contractorsto provide us with adequate supplies of high-quality products could cause adelay in our ability to fulfill orders and could have an adverse effect on ourbusiness, operating results and financial condition.

 

All of the materials used in our products are purchased under contractsor purchase orders with third parties. While we believe that many of thematerials used in the production of our products are generally readilyavailable from a variety of sources, certain components such as microprocessorsand motherboards are available from one or a limited number of suppliers. Thelead times for delivery of components vary significantly and can exceed twelveweeks for certain components. If we should fail to forecast our requirementsaccurately for components, we may experience excess inventory or shortages ofcertain components that could have an adverse effect on our business andoperating results. Further, any interruption in the supply of any of thesecomponents, or the inability to procure these components from alternativesources at acceptable prices within a reasonable time, could have an adverseeffect on our business and operating results.

 

***IntellectualProperty and Licenses.***  There are many patents held by companies, which relate to thedesign and manufacture of network security systems. The holders of thosepatents could assert potential claims of infringement. We could incursubstantial costs in defending our company and our customers against any suchclaim regardless of the merits of such claims. In the event of a successful claimof infringement, we may be required to obtain one or more licenses from thirdparties.  There can be no assurance thatwe could obtain the necessary licenses on reasonable terms.

 

***Dependence on CheckPoint Technologies.***  Our PDS family of security appliances, which are integrated withCheck Point Software Technologies’ VPN-1®/FireWall-1® software, represents16.7% of our 2003 sales, which is down from 29.1% of our sales in 2002. Weexpect that the percentage of PDS family sales will continue to decrease as wemove away from the Check Point Software Technologies solutions.  Our long-term plans are for a continueddecline in revenue from the PDS family of products.  Our reliance on newer product sales may not replace theanticipated decline in revenue of the PDS family product sales.  Although we are a certified appliancepartner of Check Point and our PDS products have received certification fromCheck Point, we have no long-term agreement or exclusive relationship withCheck Point.  As a result, the loss orsignificant change in our relationship with Check Point, the failure of futurePDS products to receive Check Point certification, the business failure ofCheck Point or its acquisition by or of one of our competitors, and the loss ofmarket share of Check Point or market acceptance of its products could eachhave a material adverse effect on our business, financial condition and resultsof operations.

 

12

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***Third-PartyProducts.*** We believe that it is beneficial to work with third parties withcomplementary technologies to broaden the appeal of our security products.These alliances allow us to provide integrated solutions to our customers bycombining our developed technology with third-party products. As there israpid technological advancement and significant consolidation in the networksecurity industry, there can be no assurance that we will have access to all ofthe third-party products that may be desirable or for the term desirableto offer fully integrated solutions to our customers.

 

***Dependence on KeyCustomers.*** In the past, a relatively small number of customers have accounted for asignificant portion of our revenue. Although no single customer currentlyaccounts for more than 10% of our revenue, we expect to continue to derive asubstantial portion of our net revenue from sales to U.S. government agencies,large system integrators and managed service providers. We continuously facecompetition from Internet Security Systems, Cisco, Enterasys, NFR, IBM, HewlettPackard and others for U.S. government security projects and corporate securityinstallations. Any reduction or delay in sales of our products to thesecustomers could have a material adverse effect on our operating results.

 

***International Operations.***  Foreign sales accounted for approximately31.4% of our revenue in 2003, and we expect sales to foreign customers tocontinue to represent a significant portion of our revenues in the future.  Our international operations may be affectedby changes in demand resulting from fluctuations in currency exchange rates andlocal purchasing practices, including seasonal fluctuations in demand, as wellas by risks such as increases in duty rates, difficulties in distribution,regulatory approvals and other constraints upon international trade. Our salesto foreign customers are subject to export regulations. In particular, certainsales of our data security products require clearance and export licenses fromthe U.S. Department of Commerce under these regulations. Any inability toobtain such clearances or any required foreign regulatory approvals on a timelybasis could have a material adverse effect on our operating results.

 

***Impact of GovernmentCustomers.*** For the fiscal year ended December 31 2003, 17.0% of our revenue wasderived from sales to various U.S. government entities, either directly by usor through system integrators and other resellers, compared to 20% for thefiscal year ended December 31, 2002, and 2.6% of our revenue for 2003 wasderived from sales to foreign government entities as compared to 0.4% for 2002.Sales to the government present risks in addition to those involved in sales tocommercial customers, including potential disruption due to appropriation andspending patterns and the government’s reservation of the right to cancelcontracts and purchase order for its convenience.

 

***Effects of MilitaryActions.*** United States military actions or other events occurring in response orin connection to them, including future terrorist attacks against United Statestargets, actual conflicts involving the United States or its allies or militaryor trade disruptions could impact our operations, including by:

 

•                                          Reducinggovernment 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 such events occur, our business, operating results and financialcondition could be materially and adversely affected.

 

***Restructuring andCost Reductions.*** We continued with our restructuring plan in 2003, which resulted in$0.5 million in severance charges. The objective of our restructuring planwas to reduce our cost structure to a sustainable level that is consistent withthe current macroeconomic environment. We also implemented other strategicinitiatives designed to strengthen our operations. These plans involved, amongother things, reductions in our workforce and facilities, aligning ourorganization around our business objectives, realignment of our research anddevelopment team, our sales force and changes in our sales management.  Any further workforce reductions couldresult in temporary reduced productivity of our remaining employees.  Additionally, our customers and prospectsmay delay or forgo purchasing our products due to a perceived uncertaintycaused by the restructuring and other changes. Failure to achieve the desiredresults of our initiatives could seriously harm our business, results of operationsand financial condition.

 

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***Potential NasdaqDelisting.*** On August 12, 2002, Nasdaq notified the Company that the Company’sCommon Stock had not maintained the required minimum bid price per share for continuedinclusion on The Nasdaq National Market and was granted a 90-day extensionuntil November 11, 2002 to regain compliance.  The Company failed to remedy the deficiency and, on November 4,2002, filed an application to transfer the listing of its Common Stock from TheNasdaq National Market to The Nasdaq SmallCap Market.  The Company’s Common Stock began trading on The Nasdaq SmallCapMarket on December 4, 2002.  In accordancewith Nasdaq rules, the Company was granted the remainder of a 180-day graceperiod afforded to Nasdaq SmallCap issuers, which expired on February 10,2003.  At that time, the Company wasgranted an additional 180-day grace period to remedy the bid price deficiencywhich expired on August 7, 2003, after which, Nasdaq granted the Company afinal 90-day extension through November 5, 2003 to regain compliance.  On November 6, 2003, the Company received adelisting notice from Nasdaq stating that the Company’s Common Stock would bedelisted at the close of business on November 17, 2003 because the Company hadnot regained compliance with the minimum $1.00 bid price per share requirement.

 

On November 13, 2003, the Company appealed Nasdaq’s delistingdetermination and presented its appeal on December 18, 2003 to a NasdaqListing Qualifications Panel.  OnJanuary 16, 2004, the Listing Qualifications Panel determined that theCompany had presented a definitive plan for compliance with continued listingrequirements and continued the listing of the Company’s Common Stock as aconditional listing (which added the letter “C” to the end of its tradingsymbol) pursuant to a series of exceptions: (1) seeking stockholder approval in a public filing with the Securitiesand Exchange Commission (the “***SEC***”) and Nasdaq for a reverse split to satisfy the$1.00 minimum bid price requirement; (2) demonstrating a closing bid priceof at least $1.00 per share by April 2, 2004 and maintaining the same fora minimum of ten consecutive trading days thereafter; (3) on or beforeMarch  30, 2004, filing its annual report on Form 10-K with the SEC andNasdaq evidencing stockholders’ equity of at least $2.5 million; and (4) on orbefore May 15, 2004, filing its quarterly report on Form 10-Q for thequarter ending March 31, 2004 with the SEC and Nasdaq evidencing stockholders’equity of at least $2.5 million.

 

In order to regain compliance with the Nasdaq minimum bid pricerequirement, at a special meeting on March 18, 2004, our stockholders approveda four-for-one (4:1) reverse split of our common stock, which will becomeeffective on March 29, 2004.  However,there can be no assurance that the reverse stock split will have the desiredconsequences.  Specifically, there canbe no assurance that, before the effectiveness of the reverse stock split, themarket price of our common stock will not decrease to a price requiring a ratiogreater than four-for-one (4:1) or that, after the reverse stock split, themarket price of our common stock will increase by a multiple equal to the ratioof the reverse stock split or result in the sustained increase in the marketprice which is required to regain and maintain compliance with the continuedlisting requirements of The Nasdaq SmallCap Market.  In particular in order to comply with the conditions oncompliance imposed by the Nasdaq Listing Qualifications Panel, our common stockmust have a closing bid price of at least $1.00 per share by April 2, 2004and maintain the same for a minimum of ten consecutive trading daysthereafter.  Nasdaq may also requirethat the Company’s Common Stock maintain a bid price of a least $1.00 for aperiod longer than ten days in order to evidence the Company’s ability toachieve long-term compliance with the minimum bid price requirement.

 

Moreover, Nasdaq has broad authority to determine compliance andcontinued listing on the Nasdaq SmallCap Market.  Therefore, even we are able to satisfy the minimum bid pricerequirement, there can be no assurance that we will be able to remain incompliance with all of Nasdaq’s continued listing requirements in thefuture.  If we are unable to regaincompliance with the minimum bid price requirement or fail to comply with otherNasdaq continued listing requirements, our common stock likely would trade in aless efficient market, such as the OTC Bulletin Board or in the “pink sheets”maintained by the National Quotation Bureau, Inc.  Because these alternatives generally areconsidered to be less efficient markets, our stock price, the liquidity of ourcommon stock and our general business reputation may be adversely impacted.

 

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***Reverse Stock Split***.  As a result of our pending reverse stocksplit, the total market capitalization of our common stock after the reversestock split may be lower than the total market capitalization before theproposed reverse stock split.  In thefuture, if a price of a share of our common stock declines after the reversestock split, this will have a detrimental impact on our market capitalization, themarket value of the our public float and the value of shares of our commonstock. Furthermore, if the market price of a share of our common stockdecreases after the reverse stock split, the percentage decline as an absolutenumber and as a percentage of our overall market capitalization may be greaterthan what would have occurred in the absence of the reverse stock split.

 

***Private Placement.***  On March 25, 2004, we completed a $5.0million private placement of 5% Convertible Preferred Stock and warrants.  In the private placement, the company sold1,000,000 shares of preferred stock at a price of $5.00 per share, whichconvert into 6,361,323 shares of common stock at an initial conversion price of$0.786 per share, and warrants to purchase 2,226,459 shares of common stock atan exercise price of $0.786 per share. In connection with the closing of this private placement, we issuedwarrants to purchase 257,633 shares of our common stock at an exercise price of$0.786 per share to our financial advisor for the private placement.  As a result, the private placement isexpected to result in dilution upon conversion of the preferred stock andexercise of the warrants of 8,845,415 shares of common stock or an approximate42.8% increase in the number of shares of common stock currently outstanding.

 

In addition, we have agreed to register the sale of the shares of ourcommon stock underlying the preferred stock and warrants.  Upon the effectiveness of registrationstatement covering these shares, the holders of the preferred stock andwarrants will be able to freely convert their preferred stock and exercisetheir warrants and sell their shares of common stock.  For the four weeks ended on March 19, 2004, the average weeklytrading volume of our common stock on the Nasdaq SmallCap Market was 486,100shares.  As a result, if holders ofpreferred stock and warrants elect to convert their shares and exercise theirwarrants and sell a material amount of their shares of common stock on the openmarket, the increase selling activity could cause a decline in the market priceof our common stock.  These sales, orthe potential for these sales, could encourage short sales, causing additionaldownward pressure on the market price of our common stock.

 

***General.***  Sales of our products fluctuate, from timeto time, based on numerous factors, including customers’ capital spendinglevels and general economic conditions. While certain industry analysts believethat there is a significant market for network security products, there can beno assurance as to the rate or extent of the growth of such market or thepotential adoption of alternative technologies. Future declines in networksecurity product sales as a result of general economic conditions; adoption ofalternative technologies or any other reason could have a material adverseeffect on our business, operating results and financial condition.

 

Due to the factors noted above and in “Management’s Discussion andAnalysis of Financial Condition and Results of Operations”, our future earningsand common stock price may be subject to significant volatility, particularlyon a quarterly basis. Past financial performance should not be considered areliable indicator of future performance and investors should not usehistorical trends to anticipate results or trends in future periods. Anyshortfall in revenue and earnings from the levels anticipated by securitiesanalysts could have an immediate and significant effect on the trading price ofour common stock in any given period. Also, we participate in a highly dynamicindustry, which often results in volatility of our common stock price.

 

**Item 2**.    Properties.

 

Our headquarters are located in a two-story building in Richardson,Texas, with an aggregate of approximately 95,000 square feet of floor space.This facility includes our corporate administration, operations, marketing,research and development, sales and technical support personnel. We occupy thisfacility under a lease, the base term of which expires in February 2005,with two seven-year options to extend the lease term, subject to compliancewith certain conditions.

 

Subsequent to December 31, 2003, we successfully renegotiated our leaseagreement for our headquarters in Richardson, Texas, which decreased the amountof square feet we lease and extended the lease term for an additional fiveyears.  According to the new leaseagreement, our Richardson, Texas headquarters will be located in the samebuilding.  However, we will leaseapproximately 30,000 square feet of floor space and the term of our lease willexpire in February 2010.

 

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Personnel of Essential were located in a 15,120 square foot leasedproperty in Albuquerque, New Mexico. The lease was scheduled to expire inFebruary 2009. In March 2002, we sold the assets of Essential (seeDiscontinued Operations). A condition of the sale was to give Essentialpersonnel 60 days to exit the facility. Included in the total$0.4 million gain on the sale of Essential in March 2002 was a$0.3 million reserve to terminate the lease, which is the equivalent of2 years’ lease and maintenance of the facility. Successful termination ofthe Essential lease for less than $0.3 million resulted in a$0.1 million gain on disposition during the fourth quarter of 2002, for atotal gain on Discontinued Operations for 2002 of $0.5 million.

 

Approximately one-half of our security software research anddevelopment staff is located in a 6,464 square foot leased property in SanDiego, California.  This lease wasrenewed in August 2002 and will expire in August of 2004.  Research and development personnel occupythis facility.

 

In addition, we lease small amounts of office space for sales andtechnical support personnel domestically and internationally in England,France, Germany and Malaysia. We believe that the existing facilities atDecember 31, 2003 will be adequate to meet our requirements through2004.  See Note 6 of Notes toConsolidated Financial Statements for additional information regarding ourobligations under leases.

 

**Item 3**.    Legal Proceedings.

 

We are subject to legal proceedings and claims that arise in theordinary course of business.  We do notbelieve that any claims exist where the outcome of such matters would have amaterial adverse affect on our consolidated financial position, operatingresults or cash flows.  However, therecan be no assurance such legal proceedings will not have a material impact onfuture results.

 

**Item 4**.    Submission of Matters to a Vote of SecurityHolders.

 

There were no matters submitted to a vote of our security holdersduring the fourth quarter of 2003.

 

**PARTII**

 

**Item 5**.    Market for Intrusion’s Common Equity,Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

Prior to December 4, 2002, our common stock traded on The NasdaqNational Market.  Since that time ourcommon stock has traded on the Nasdaq SmallCap Market, where it is currentlylisted under the symbol “INTZC”, subject to the conditional listing parametersexplained in Factors That May Affect Future Results of Operations.  As of February 10, 2004, there wereapproximately 213 registered holders of record of the common stock. Thefollowing table sets forth, for the periods indicated, the high and low pershare intra-day sales prices for the common stock, as reported by The NasdaqStock Market.

 
|           |   | **2003** |   | **2002** |   |
|----------------|--------|----------|--------|----------|--------|
|           |   | **High** |   | **Low**  |   | **High** |   | **Low** |   |
|           |   |     |   |     |   |   |   |   |   |
| First Quarter  |   | $        | 0.50   |     | $      | 0.15 |   | $ | 2.15 |   | $ | 1.20 |   |
| Second Quarter |   | 1.15     |   | 0.12     |   | 1.85 |   | 0.76 |   |
| Third Quarter  |   | 1.20     |   | 0.56     |   | 1.12 |   | 0.01 |   |
| Fourth Quarter |   | 1.38     |   | 0.49     |   | 0.69 |   | 0.24 |   |
|                |        |          |        |          |        |  |  |  |  |  |  |  |  |

 

We have not declared or paid cash dividends on our capital stock in ourtwo most recent fiscal years. We currently retain any earnings for use in ourbusiness and do not anticipate paying any cash dividends on our common stock inthe foreseeable future. Future dividends on common stock, if any, will bedetermined by our Board of Directors. However, our 5% Convertible Preferred Stock accrues cash dividends equalto $0.25 per share per annum.  Thesedividends are payable in arrears, on March 31 and September 30 of each year,commencing on September 30, 2004.

 

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All stock option plans under which our Common Stock is reserved forissuance have previously been approved by our shareholders. The following tableprovides summary information as of December 31, 2003 for all of our stockoption plans (in thousands, except per share data). See Note 10 to ourconsolidated financial statements for additional discussion.

 
|                                                        |   | **Number of  Shares of  Common Stock to be  Issued upon Exercise  of Outstanding  Options** |   | **Weighted  Average Exercise Price  of Outstanding Options, Excludes  Warrants Rights** |   | **No. of  Shares of  Common Stock  Remaining Available  for Future Issuance** |   |
|-------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------|--------|
|                                                        |   |                                                                                        |   |                                                                                    |   |                                                                          |   |
| Equity compensation plans approved by  security holders     |   | 1,496                                                                                       | (1)    | $                                                                                       | 3.77   |                                                                          | 1,852  | (2) |
| Equity compensation plans not approved by  security holders |   | —                                                                                      |   | —                                                                                  |   | —                                                                        |   |
| Total                                                       |   | 1,496                                                                                       |   | 3.77                                                                                    |   | 1,852                                                                         |   |
|                                                             |        |                                                                                             |        |                                                                                         |        |                                                                               |        |  |

 

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(1)          Included in the outstanding options are1,278,945 from the 1995 Plan, 30,700 from the 1987 Plan, 178,000 from the 1995Non-Employee Director Plan and 8,000 from previous director grants prior to1995 Non-Employee Director Plan.

(2)          Does not include Employee Stock PurchasePlan. At December 31, 2003, 319,626 shares were available for futureissuance under this plan.

 

**Item 6****.    SelectedFinancial Data.**

 

The following selected consolidated financial data should be read inconjunction with “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” in Item 7 of this Form 10-K and theconsolidated financial statements and notes thereto included in Item 15 of thisForm 10-K. Continuing operations consisted of our information securitybusiness, which began operations in 1998. Discontinued operations are composedof our local area networking divisions, which were discontinued inApril 2000 and Essential, which was discontinued in March 2001.

 

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**Statement of Operations Data:**

*(In thousands, except per share data)*

 
|                                                        |   | **Year Ended  December 31,** |   |
|-------------------------------------------------------------|--------|------------------------------|--------|
|                                                        |   | **2003**                     |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
| Revenue                                                     |   | 6,478                        |   | $ | 7,834 |   | $ | 16,685 |   | $ | 23,210 |   | $ | 7,963 |   |
| Cost of Revenue                                             |   | 3,988                        |   | 6,147 | (5) | 13,490 |   | 19,009 |   | 3,877 |   |
| Gross profit                                                |   | 2,490                        |   | 1,687 |   | 3,195 |   | 4,201 |   | 4,086 |   |
| Operating expenses:                                         |   |                         |   |   |   |   |   |   |   |   |   |
| Sales and marketing                                         |   | 6,230                        |   | 11,789 |   | 23,550 |   | 27,740 |   | 12,236 |   |
| Research and development                                    |   | 3,498                        |   | 6,088 |   | 12,549 |   | 13,073 |   | 8,171 |   |
| In-process research and development                         |   | —                       |   | — |   | — |   | — |   | — |   |
| General and administrative                                  |   | 1,632                        |   | 2,576 |   | 4,481 |   | 5,865 |   | 2,466 |   |
| Amortization of intangibles                                 |   | —                       |   | 798 |   | 1,233 |   | 975 |   | 547 |   |
| Impairment of intangibles                                   |   | —                       |   | 3,009 | (4) | — |   | — |   | — |   |
| Litigation Settlement                                       |   | 450                          | (6)    | — |   | — |   | — |   | — |   |
| Severance costs                                             |   | 472                          |   | 200 |   | 4,673 | (2) | — |   | — |   |
| Operating loss                                              |   | (9,792                       | )      | (22,773 | ) | (43,291 | ) | (43,452 | ) | (19,334 | ) |
| Interest income, net                                        |   | 182                          |   | 351 |   | 1,687 |   | 3,301 |   | 1,104 |   |
| Other income (expense)                                      |   | 10                           |   | (7 | ) | 112 |   | 66,335 | (1) | — |   |
| Income (loss) from continuing operations  before income tax |   | (9,600                       | )      | (22,429 | ) | (41,492 | ) | 26,184 |   | (18,230 | ) |
| Income tax provision (benefit)                              |   | —                       |   | (608 | ) | (1,877 | ) | 1,999 |   | — |   |
| Income (loss) from continuing operations                    |   | (9,600                       | )      | (21,821 | ) | (39,615 | ) | 24,185 |   | (18,230 | ) |
| Income (loss) from discontinued operations,  net of tax     |   | —                       |   | 544 | (3) | (6,165 | ) | (974 | ) | 6,190 |   |
| Net income (loss)                                           |   | (9,600                       | )      | (21,277 | ) | $ | (45,780 | ) | $ | 23,211 |   | $ | (12,040 | ) |
|                                                        |   |                         |   |   |   |   |   |   |   |   |   |
| Basic earnings (loss) per share, continuing  operations     |   | (0.46                        | )      | (1.06 | ) | $ | (1.93 | ) | $ | 1.23 |   | $ | (0.98 | ) |
|                                                        |   |                         |   |   |   |   |   |   |   |   |   |
| Diluted earnings (loss) per share,  continuing operations   |   | (0.46                        | )      | (1.06 | ) | $ | (1.93 | ) | $ | 1.18 |   | $ | (0.98 | ) |
|                                                        |   |                         |   |   |   |   |   |   |   |   |   |
| Basic earnings (loss) per share                             |   | (0.46                        | )      | (1.03 | ) | $ | (2.23 | ) | $ | 1.18 |   | $ | (0.65 | ) |
|                                                        |   |                         |   |   |   |   |   |   |   |   |   |
| Dilutive earnings (loss) per share                          |   | (0.46                        | )      | (1.03 | ) | $ | (2.23 | ) | $ | 1.13 |   | $ | (0.65 | ) |
|                                                        |   |                         |   |   |   |   |   |   |   |   |   |
| Weighted average shares outstanding                         |   |                         |   |   |   |   |   |   |   |   |   |
| — Basic                                                |   | 20,649                       |   | 20,640 |   | 20,565 |   | 19,624 |   | 18,565 |   |
|                                                        |   |                         |   |   |   |   |   |   |   |   |   |
| — Diluted                                              |   | 20,649                       |   | 20,640 |   | 20,565 |   | 20,478 |   | 18,565 |   |
|                                                             |        |                              |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Balance Sheet Data:**

 
|                            |   | **2003** |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|---------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
| Working capital                 |   | 2,410    |   | $        | 10,701 |     | $      | 25,240   |   | $        | 52,514 |   | $ | 66,578 |   |
| Total assets                    |   | 5,760    |   | 16,939   |   | 42,295   |   | 92,414   |   | 120,502  |   |
| Total liabilities               |   | 2,976    |   | 4,555    |   | 8,797    |   | 13,627   |   | 38,925   |   |
| Total stockholders’ equity |   | 2,784    |   | 12,384   |   | 33,498   |   | 78,787   |   | 81,577   |   |
|                                 |        |          |        |          |        |          |        |          |        |          |        |  |  |  |  |

 

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(1)                                 Other income for theyear ending December 31, 2000 is comprised primarily of a$66.4 million pre-tax gain realized on the sale of AlteonWebSystems, Inc. common stock.

(2)                                 Restructuring costsfor the year ending December 31, 2001 include the impairment of certainintangible assets associated with obsolete product lines and severance andlease termination costs for restructuring activities.

(3)                                 Gain on discontinuedoperations in 2002 relates to the original gain on sale of $0.5 millionalong with $0.1 million gain related to the successful early terminationof the Essential lease for less than the associated provided reserve.

(4)                                 Impairment chargetaken in December 2002 to write off all intangible assets related to theMimestar acquisition.

 

18

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(5)                                 Includes a$1.0 million charge to write off SecureCom inventory no longer expected tobe sold.

(6)                                 Results from thesettlement of Morgan Newton lawsuit mediated during 2003.

 

See “Management’s Discussion and Analysis of Financial Condition andResults of Operations” and the Notes to the Consolidated Financial Statements.

 

**Item 7****.    Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

 

**“Safe Harbor” Statement under the PrivateLitigation Reform Act of 1995**

 

This Annual Report, other than historical information, may includeforward-looking statements, including statements with respect tofinancial results, product introductions, market demand, sales channels,industry trends, sufficiency of cash resources and certain other matters. Thesestatements are made under the “safe harbor” provisions of the PrivateSecurities Litigation Reform Act of 1995 and involve risks and uncertaintieswhich could cause actual results to differ materially from those in the forward-lookingstatements, including those discussed in the section entitled “Factors That MayAffect Future Results of Operations” in Item 1 and elsewhere in this AnnualReport on Form 10-K and other filings with the Securities and ExchangeCommission.

 

This report may include various non-GAAP financial measures (as definedby SEC Regulation G), including our cash used in operations excluding costsassociated with a litigation settlement and severance charges.  Our management believes these measuresprovide useful information to investors about our financial condition andresults of operations for the period presented by eliminating the affects ofone-time and other transactions that can distort underlying operational resultsin order to provide greater comparability of our financial performance on ayear-to-year basis. The most directly comparable GAAP financial measures andreconciliation of the difference between GAAP and non-GAAP financial measurescan be found in the test of this report and our consolidated financialstatements included in this report.

 

**Overview**

 

We develop, market and support a family of network intrusion preventionand detection systems and regulated information compliance systems that addressvital security issues facing organizations with mission critical businessapplications or housing classified, confidential, or customer informationassets. We currently provide network security and regulated informationcompliance solutions under our SecureNet family of hardware and softwaresolutions.  On June 1, 2000, wechanged our name from ODS Networks, Inc. to Intrusion.com Inc. andour NASDAQ ticker symbol from ODSI to INTZ to reflect our focus on intrusiondetection solutions. On November 1, 2001, we changed our name fromIntrusion.com, Inc. to Intrusion Inc. During the second quarter of2000, we announced our plan to sell, or otherwise dispose of, our networkingdivisions, which included our Essential Communications division and our localarea networking assets, and began accounting for these networking divisions asdiscontinued operations.

 

**Critical Accounting Policies and Estimates**

 

Management’s discussion and analysis of financial condition and resultsof operations are based upon our consolidated financial statements, which havebeen prepared in accordance with accounting principles generally accepted inthe United States. The preparation of these financial statements requires us tomake estimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities. On an on-going basis, we evaluate our estimates, includingthose related to product returns, bad debts, inventories, intangible assets,income taxes, warranty obligations, restructuring, maintenance contracts andcontingencies. We base our estimates on historical experience and on variousother assumptions that are believed to be reasonable under the circumstances,the results of which form the basis for making judgments about the carryingvalues of assets and liabilities that are not readily apparent from othersources. Actual results may differ from these estimates under differentassumptions or conditions.

 

We believe the following critical accounting policies affect our moresignificant judgments and estimates used in the preparation of our consolidatedfinancial statements.

 

19

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*Revenue Recognition*

 

We generally recognize product revenue upon shipment of product. Weaccrue for estimated warranty costs, sales returns and other allowances at thetime of shipment based on our experience. Revenue from maintenance contracts isdeferred and recognized over the contractual period the services are performed.To date, warranty costs and sales returns have not been material. There is arisk that technical issues on new products could result in unexpected warrantycosts and returns.

 

We recognize software revenue from the licensing of our softwareproducts in accordance with Statement of Position (“SOP”) No. 97-2 “SoftwareRevenue Recognition”, SOP 98-9 “Modification of 97-2, Software RevenueRecognition, with respect to certain transactions” and Staff AccountingBulletin (“SAB”) No. 104, “Revenue Recognition” whereby revenue from thelicensing of our products is not recognized until all four of the followinghave been met: i) execution of a written purchase order, license agreementor contract; ii) shipment of the product has occurred; iii) thelicense fee is fixed and determinable; and iv) collectibility is probable.We defer and recognize maintenance and support revenue over the term of thecontract period, which is generally one year.

 

We have signed distribution agreements with distributors in the UnitedStates, Europe and Asia. In general, these relationships are non-exclusive.Distributors typically maintain an inventory of our products. Under theseagreements, we provide certain protection to the distributors for theirinventory of our products for price reductions as well as products that areslow moving or have been discontinued by us. Recognition of sales todistributors and related gross profits are deferred until the distributorsresell the merchandise. However, since we have legally sold the inventory tothe distributor and we no longer have care, custody or control over theinventory, we recognize the trade accounts receivable and reduce inventoryrelated to the sale at the time of shipment to the distributor. Revenue, offsetby deferred cost of sales, is included in deferred revenue in the accompanyingfinancial statements.

 

*Goodwill and Other Intangible Assets*

 

Effective January 1, 2002, we adopted the provisions of Statementof Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and OtherIntangible Assets” (“SFAS 142”), which requires companies to ceaseamortizing goodwill and certain intangible assets with indefinite useful lives.Instead, SFAS 142 requires that goodwill and intangible assets deemed tohave indefinite useful lives be reviewed for impairment upon adoption ofSFAS 142, annually thereafter, and upon the occurrence of any event thatindicates potential impairments.

 

In accordance with SFAS 142, we discontinued recording goodwillamortization effective January 1, 2002.

 

SFAS 142 prescribes a two-phase process for impairment testing ofgoodwill. The first phase screens for potential impairment, while the secondphase (if necessary) measures the impairment. Goodwill is potentially impairedif the net book value of a reporting unit exceeds its estimated fair value. Wehave determined that we have one reporting unit. This methodology differs fromthe Company’s previous policy, as permitted under accounting standards existingat that time, of using undiscounted cash flows on an enterprise-wide basis todetermine if goodwill is recoverable.

 

The Company elected to perform its annual impairment review during thefourth quarter of each year, commencing in the fourth quarter of 2002. Inconnection with our annual impairment review, we determined that the value ofgoodwill was impaired. At the time of our impairment review, the remaininggoodwill of $0.4 million was associated with the MimeStar purchasetransaction. Based on the decline in the market value of the Company asindicated by the decline in its stock price over the last year, it was determinedthat the goodwill carrying value should be zero at December 31, 2002.Therefore, an impairment charge of $0.4 million was recorded and isincluded in impairment of intangibles in the accompanying consolidatedstatement of operations.

 

20

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*Long-Lived Assets*

 

Effective January 1, 2002, we adopted the provisions of SFASNo. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”(“SFAS 144”), which supersedes SFAS No. 121, “Accounting for the Impairmentof Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,”(“SFAS 121”) and accounting and reporting provisions of AccountingPrinciples Bulletin Opinion 30, “Reporting the Results of Operations,” for adisposal of a segment. The primary objective of SFAS 144 is to develop oneaccounting model based on the framework established in SFAS 121 forlong-lived assets to be disposed of and significantly changes the criteria thatwould have to be met to classify an asset as held for sale. SFAS 144 alsorequires expected future operating losses from discontinued operations to bedisplayed in the period(s) in which the losses are incurred, rather than as ofthe measurement date. Our adoption of SFAS 144 had no effect on theCompany’s financial position or results of operations.

 

We review long-lived assets, other than goodwill, for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. Conditions that would necessitate animpairment assessment include material adverse changes in operations,significant adverse differences in actual results in comparison with initialvaluation forecasts prepared at the time of acquisition, a decision to abandonacquired products, services or technologies, or other significant adversechanges that would indicate the carrying amount of the recorded asset might notbe recoverable. Recoverability of assets held and used is measured by acomparison of the carrying amount of an asset to undiscounted pre tax futurenet cash flows expected to be generated by that asset. An impairment loss isrecognized for the amount by which the carrying amount of the assets exceedsthe fair value of the assets. Long-lived assets held for sale are reported atthe lower of cost or fair value less costs to sell.

 

As a result of the write-off of goodwill during the fourth quarter of2002, we determined that a triggering event indicating potential impairment ofthe associated intangibles had occurred. At December 31, 2002, the remainingintangibles of $2.6 million principally included purchased softwareassociated with our acquisition of MimeStar, Inc.. We determined that theundiscounted pre tax cash flows associated with this software was not likely toexceed the remaining carrying values. Due to technological changes that hadtaken place with respect to the core software code acquired, it was determinedthat the carrying value should be zero at December 31, 2002. Therefore, animpairment charge of $2.6 million was recorded and is included inimpairment of intangibles in the accompanying consolidated statement ofoperations.

 

*Allowance for Doubtful Accounts and Returns*

 

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

 

*Inventory*

 

We write down our inventory for estimated obsolescence or unmarketableinventory equal to the difference between the cost of inventory and theestimated market value based upon assumptions about future demand and marketconditions. If actual market conditions are less favorable than those projectedby management, additional inventory write-downs may be required.

 

21

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**Results of Operations**

 

The following tables set forth, for the periods indicated, certainfinancial data as a percentage of net revenue.

 
|                                                    |   | **Year Ended  December 31,** |   |
|---------------------------------------------------------|--------|------------------------------|--------|
|                                                    |   | **2003**                     |   | **2002** |   | **2001** |   |
|                                                    |   |                         |   |   |   |   |   |
| Net revenue                                             |   | 100.0                        | %      | 100.0 | % | 100.0 | % |
| Cost of revenue                                         |   | 61.6                         |   | 78.5 |   | 80.9 |   |
| Gross profit                                            |   | 38.4                         |   | 21.5 |   | 19.1 |   |
| Operating expenses:                                     |   |                         |   |   |   |   |   |
| Sales and marketing                                     |   | 96.2                         |   | 150.5 |   | 141.1 |   |
| Research and development                                |   | 54.0                         |   | 77.7 |   | 75.2 |   |
| General and administrative                              |   | 25.2                         |   | 32.9 |   | 26.9 |   |
| Amortization of intangibles                             |   | —                       |   | 10.2 |   | 7.4 |   |
| Impairment of intangibles                               |   | —                       |   | 38.4 |   | — |   |
| Litigation Settlement                                   |   | 6.9                          |   | — |   | — |   |
| Severance costs                                         |   | 7.3                          |   | 2.6 |   | 28.0 |   |
| Operating loss                                          |   | (151.2                       | )      | (290.7 | ) | (259.5 | ) |
| Interest income, net                                    |   | 2.8                          |   | 4.5 |   | 10.1 |   |
| Other income (expense)                                  |   | 0.2                          |   | (0.1 | ) | 0.7 |   |
| Loss from continuing operations before  income tax      |   | (148.2                       | )      | (286.3 | ) | (248.7 | ) |
| Income tax benefit                                      |   | —                       |   | (7.8 | ) | (11.2 | ) |
| Loss from continuing operations                         |   | (148.2                       | )      | (278.5 | ) | (237.4 | ) |
| Income (loss) from discontinued operations,  net of tax |   | —                       |   | 6.9 |   | (36.9 | ) |
| Net loss                                                |   | (148.2                       | )      | (271.6 | ) | (274.4 | ) |

 

 
|               |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------|--------|----------|--------|----------|--------|----------|--------|
|               |   |     |   |     |   |     |   |
| Domestic revenue   |   | 68.6     | %      | 66.6     | %      | 63.6     | %      |
| Export revenue to: |   |     |   |     |   |     |   |
| Europe             |   | 23.0     |   | 14.5     |   | 25.4     |   |
| Canada             |   | 0.9      |   | 4.0      |   | 4.0      |   |
| Asia               |   | 7.4      |   | 14.6     |   | 6.3      |   |
| Latin America      |   | 0.1      |   | 0.3      |   | 0.7      |   |
| Net revenue        |   | 100.0    | %      | 100.0    | %      | 100.0    | %      |

 

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**2003 compared with 2002**

 

***NetRevenue***

 

Net revenue decreased 17.3% to $6.5 million in 2003 from$7.8 million in 2002. The decrease in net revenue is primarily due to ourshift in focus to higher margin NIP&DS products, the decline in sales ofour SecureCom and other products, coupled with a longer sales cycle related toour newer products. In addition, worldwide economic conditions in 2003negatively impacted our sales of SecureNet network intrusion detection productsand PDS security appliance products.

 

Export sales in 2003 decreased to $2.0 million, or 31.4% of netsales, compared to $2.6 million, or 33.4% of net revenue in 2002 primarilydue to a continued economic decline and decrease in international technologyspending.

 

***Gross Profit***

 

Gross profit increased 47.6% to $2.5 million in 2003 from $1.7 millionin 2002. As a percentage of net revenue, gross profit increased to 38.4% for2003 from 21.5% in 2002. This increase is primarily associated with a moreprofitable product mix in 2003.

 

Gross profit as a percentage of net revenue is impacted by severalfactors, including shifts in product mix, changes in channels of distribution,sales volume, fluctuations in manufacturing costs, pricing strategies, andfluctuations in sales of integrated third-party products.

 

***Salesand Marketing***

 

Sales and marketing expenses decreased 47.2% to $6.2 million in2003 from $11.8 million in 2002 as we restructured our sales force,including headcount reductions, to respond to the decline in sales. As apercentage of net revenue, sales and marketing expenses decreased to 96.2% in2003 from 150.5% in 2002. We expect sales and marketing expenses to decrease in2004 compared to 2003 as we recognize the full benefit from restructuringactions taken throughout 2002, 2003 and early 2004. We also expect sales andmarketing expenses, as a percentage of net revenue, to decrease in 2004compared to 2003.

 

***Researchand Development***

 

Research and development expenses decreased 42.5% to $3.5 million,or 54.0% of net revenue, in 2003 compared to $6.1 million, or 77.7% of netrevenue, in 2002 as we reduced headcount in our engineering department torespond to the decline in sales and eliminated engineering efforts with regardsto our SecureCom product family. Our research and development costs areexpensed in the period in which they are incurred. We expect research anddevelopment expenses to decrease in 2004 compared to 2003 as we recognize thefull benefit from restructuring actions taken throughout 2002 and 2003.  We expect research and development, as apercentage of net revenue, also to decrease in 2004 compared to 2003.

 

***Generaland Administrative***

 

General and administrative expenses, excluding amortization,impairment, severance and litigation settlement expenses, decreased 36.6% to$1.6 million in 2003 from $2.6 million in 2002 as we reducedheadcount in our support functions to reduce costs.  As a percentage of net revenue, general and administrativeexpenses decreased to 25.2% in 2003 from 32.9% in 2002.  We also expect general and administrationexpenses to decrease in 2004 compared to 2003 as we recognize the full benefitof restructuring actions taken throughout 2002 and 2003.

 

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***Amortizationand Impairment of Intangibles***

 

Due to the impairment charge taken during 2002 to write all intangibleassets down to zero at December 31, 2002, no amortization expense or impairmentwas recognized during 2003. Amortization of intangibles was $0.8 million in 2002 prior to theadoption of SFAS No. 142, whereby goodwill was not amortized throughoutthe year. We took an impairment charge during December 2002 to write allintangible assets related to our acquisition of MimeStar, Inc. down to zero asa result of our annual SFAS 142 goodwill impairment test and otherimpairment reviews conducted during the fourth quarter of 2002. The totalcharge for the write-down was $3.0 million. Total amortization and chargesfor impairment was $3.8 million for 2002.

 

***LitigationSettlement***

 

During the third quarter of 2003, Intrusion settled a pending lawsuitwith Morgan Newton.  As a result of thesettlement, Intrusion paid $0.5 million during the fourth quarter of 2003 tofully satisfy this claim.  There is noother litigation pending against Intrusion. There was no litigation settlement charge in 2002.

 

***Severance Costs***

 

In connection with our continued shift to our new intrusion detectionand security appliance product lines during 2003, and as such, we streamlinedoperations and activities that are not aligned with these core markets andstrategies. We recorded severance charges of $0.5 million for severance asa result of reductions in force.  Allseverance obligations related to the 2003 charge were paid prior toDecember 31, 2003 and we were not receiving any benefits from thosesevered individuals after December 31, 2003.

 

Pursuant to the restructuring action discussed above and those taken in2002, we reduced operating expenses, excluding severance charges, litigationsettlement charges, impairment charges and amortization, 26.2% from$3.2 million in the first quarter of 2003 to $2.4 million in thefourth quarter of 2003. Comparing first quarter 2003 to fourth quarter 2003operating expense categories, sales and marketing reduced 39.3% from$1.9 million to $1.1 million; research and development reduced 11.8%from $0.9 million to $0.8 million and general and administrativeremained constant at $0.4 million per quarter throughout the year.

 

***InterestIncome, Net***

 

Net interest income decreased 48.1% to $0.2 million in 2003 from$0.4 million in 2002 primarily due to a decrease in average cash andinterest- bearing investment balances and lower interest rates. We do notexpect net interest income to decrease in 2004 compared to 2003 as we expectour average cash and interest-bearing investment balances to increase in2004 when compared to 2002, related to our private placement in the firstquarter of 2004 and an expected increase in revenue in 2004.  However, we do expect interest rates toremain low, resulting in a lower return on investment. Net interest income willvary in the future based on our cash flow and rate of return on investments.

 

***IncomeTaxes***

 

Our effective income tax rate was 0% in 2003 as a valuation allowancehas been recorded for the entire amount of the net deferred tax asset due touncertainty of realization.  Oureffective income tax rate was an income tax benefit of 2.9% in 2002.  We have fully utilized our net operatingloss carryback.

 

24

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**2002 compared with 2001**

 

***NetRevenue***

 

Net revenue decreased 53.0% to $7.8 million in 2002 from$16.7 million in 2001. The decrease in net revenue is primarily due to thedecline in sales of SecureCom and other products, which are approachingend-of-life, coupled with a longer sales cycle related to our newer products.In addition, worldwide economic conditions in 2002 negatively impacted oursales of SecureNet network intrusion detection products and PDS securityappliance products.

 

Export revenue in 2003 decreased to $2.6 million, or 33.4% of netrevenue, compared to $6.1 million, or 36.4% of net revenue in 2002primarily due to a continued economic decline and decrease in technologyspending.

 

***Gross Profit***

 

Gross profit decreased 47.2% to $1.7 million in 2002 from$3.2 million in 2001. As a percentage of net revenue, gross profitincreased to 21.5% for 2002 from 19.1% in 2001. This increase is primarilyassociated with a more profitable product mix in 2002.

 

Cost of revenue in 2002 includes a $1.0 million fourth quarterwrite-off of SecureCom inventory as demand has shifted to our new intrusiondetection and security appliance product lines. Absent of this write-off, grossprofit would have been $2.7 million or 33.8% as a percentage of netrevenue.

 

Gross profit as a percentage of net revenue is impacted by severalfactors, including shifts in product mix, changes in channels of distribution,sales volume, fluctuations in manufacturing costs, pricing strategies, andfluctuations in sales of integrated third-party products.

 

***Salesand Marketing***

 

Sales and marketing expenses decreased 50.0% to $11.8 million in2002 from $23.6 million in 2001 as we restructured our sales force,including headcount reductions, to respond to the decline in sales. As apercentage of net revenue, sales and marketing expenses increased to 150.5% in2002 from 141.1% in 2001. We expect sales and marketing expenses to decrease in2003 compared to 2002 as we recognize the full benefit from restructuringactions taken throughout 2002 and early 2003. We also expect sales andmarketing expenses, as a percentage of net revenue, to decrease in 2003compared to 2002.

 

***Researchand Development***

 

Research and development expenses decreased 51.5% to $6.1 million,or 77.7% of net revenue, in 2002 compared to $12.5 million, or 75.2% ofnet revenue, in 2001 as we reduced headcount in our engineering department torespond to the decline in sales and eliminated engineering efforts with regardsto our SecureCom product family. Our research and development costs areexpensed in the period in which they are incurred. We expect research anddevelopment expenses to decrease in 2003 compared to 2002 as we recognize thefull benefit from restructuring actions taken throughout 2002 and early in2003. In addition, the lease agreement for our research and development facilityin San Diego, California was renewed in September 2002 at a lower monthlyrate for fewer square feet to accommodate the reduction in our research anddevelopment workforce. We expect research and development, as a percentage ofnet revenue, to decrease in 2003 compared to 2002.

 

25

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***Generaland Administrative***

 

General and administrative expenses, excluding amortization expenses,decreased 42.5% to $2.6 million in 2002 from $4.5 million in 2001 aswe reduced headcount in our support functions to reduce costs. As a percentageof net revenue, general and administrative expenses increased to 32.9% in 2002from 26.9% in 2001. We expect general and administration expenses to decreasein 2003 compared to 2002 as we recognize the full benefit of restructuringactions taken throughout 2002 and early in 2003. In addition to therestructuring impact, amortization expense of $0.8 million incurred in2002 related to the intangible assets that were written off in December 2002will not be incurred in 2003.

 

***Amortizationand Impairment of Intangibles***

 

Amortization of intangibles decreased 35.3% to $0.8 million in2002 from approximately $1.2 million in 2001, due to the adoption of SFASNo. 142 whereby goodwill was not amortized throughout the year. We took animpairment charge during December 2002 to write all intangible assetsrelated to our acquisition of MimeStar, Inc. down to zero as a result of ourannual SFAS 142 goodwill impairment test and other impairment reviewsconducted during the fourth quarter. The total charge for the write-down was$3.0 million. Total amortization and charges for impairment was$3.8 million for 2002.

 

***Restructuring Costs***

 

In connection with our continued shift to our new intrusion detectionand security appliance product lines during 2002, and as such, we streamlinedoperations and activities that are not aligned with these core markets andstrategies. We recorded restructuring charges of $0.2 million forseverance as a result of reductions in force. All severance obligations relatedto the 2002 restructuring charge were paid prior to December 31, 2002 andwe were not receiving any benefits from those severed individuals afterDecember 31, 2002.

 

Pursuant to the restructuring action discussed above and those taken in2001, we reduced operating expenses, excluding restructuring charges andamortization, 37.3% from $6.5 million in the first quarter of 2002 to$4.1 million in the fourth quarter of 2002. Comparing first quarter 2002to fourth quarter 2002 operating expense categories, sales and marketingreduced 44.1% from $3.9 million to $2.2 million, research anddevelopment reduced 29.4% from $1.9 million to $1.3 million andgeneral and administrative reduced 21.0% from $0.7 million to $0.6 million,respectively.

 

***InterestIncome, Net***

 

Net interest income decreased 79.2% to $0.4 million in 2002 from$1.7 million in 2001 primarily due to a decrease in average cash andinterest- bearing investment balances and lower interest rates. We expectnet interest income to decrease in 2003 compared to 2002 as we expect ouraverage cash and interest-bearing investment balances to decline for 2003when compared to 2002. In addition, we expect interest rates to remain low,resulting in a lower return on investment. Net interest income will vary in thefuture based on our cash flow and rate of return on investments.

 

***IncomeTaxes***

 

Our effective income tax rate was a benefit of 2.9% in 2002 compared toan income tax benefit of 4.8% in 2001. We have fully utilized our net operatingloss carryback.

 

**Liquidity and Capital Resources**

 

Our principal sources of liquidity at December 31, 2003 were$1.0 million of cash and cash equivalents and $1.7 million ofshort-term investments. As of December 31, 2003, we do not holdinvestments with a stated maturity beyond one year. Working capital atDecember 31, 2003 was $2.4 million compared to $10.7 million asof December 31, 2002.

 

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Net cash used in continuing operations in 2003 was $7.9 million,primarily due to an operating loss for the year, a decrease in accounts payableand accrued expenses and deferred revenue, offset by depreciation, anddecreases in accounts receivable and inventories.  Future fluctuations in accounts receivable, inventory balancesand accounts payable will be dependent upon several factors, including but notlimited to quarterly sales, timely collection of accounts receivable, and theaccuracy of our forecasts of product demand and component requirements.

 

During 2003, our cash, cash equivalents and investments declined $8.0million from $10.7 million on December 31, 2002 to $2.7 millionon December 31, 2003. During 2003 we continued to streamline ouroperations to better align our workforce with industry trends.  This realignment caused our operatingexpenses, excluding severance charges, litigation settlement charges,impairment charges and amortization to reduce from $3.2 million in the firstquarter of 2003 to $2.4 million in the fourth quarter of 2003.  Based on our current expectations, theCompany will incur operating losses and further usage of cash resources duringthe first half of 2004.

 

Net cash provided by investing activities in 2003 was$6.0 million, which consisted of the net maturity and sale of$6.1 million of available for sale securities and the net purchase ofproperty and equipment of $0.1million.

 

At December 31, 2003, we did not have any material commitments forcapital expenditures. Operating lease commitments of $1.1 million are detailedbelow. During 2003, we funded our operations through the use of available cash,cash equivalents and investments.

 

As of December 31, 2003, we had cash, cash equivalents and investmentsin the amount of approximately $2.7 million, down from approximately $10.7million as of December 31, 2002. However, throughout 2003, we reduced expenses.  As a result, our cash used in operations, excluding thelitigation settlement and severance charges, in the fourth quarter wasapproximately $1.4 million.  Includinglitigation settlement and severance charges, our cash used in operations in thefourth quarter of 2003 was $1.9 million. On March 25, 2004, we closed a $5.0 million private placement of 5%Convertible Preferred Stock and warrants, the proceeds of which we intend touse for general corporate and working capital purposes.  With this additional financing, we believethat we have sufficient cash resources to finance our operations and expectedcapital expenditures for the next twelve months.  The sufficiency of our cash resources may depend to a certainextent on general economic, financial, competitive or other factors beyond ourcontrol.  Moreover, despite actions toreduce our cost and improve our profitability, we expect our operating lossesand net operating cash outflows to continue through at least the first half of2004.  We do not currently have anyfurther arrangements for financing, and we may not be able to secure additionaldebt or equity financing on terms that are acceptable to us, or at all, at thetime when we need such funding. If our business does not generate sufficientcash flow from operations and sufficient financings are not available, we maynot be able to operate or grow our business, pay our expenses when due or fundour other liquidity needs.

 

We intend to explore the possible acquisitions of businesses, productsand technologies that are complementary to our existing business. We arecontinuing to identify and prioritize additional security technologies, whichwe may wish to develop, either internally or through the licensing oracquisition of products from third parties. While we engage from time to timein discussions with respect to potential acquisitions, there can be noassurances that any such acquisitions will be made or that we will be able tosuccessfully integrate any acquired business. In order to finance suchacquisitions, it may be necessary for us to raise additional funds throughpublic or private financings. Any equity or debt financings, if available atall, may be on terms, which are not favorable to us and, in the case of equityfinancings, may result in dilution to our stockholders.

 

Subsequent to December 31, 2003, we successfully renegotiated our leaseagreement for our headquarters in Richardson, Texas, which decreased the amountof square feet we leased and extended the lease term for an additional fiveyears.  According to the new leaseagreement, our Richardson, Texas headquarters will be located in the samebuilding.  However, we will reduce theamount of space that we lease from approximately 95,000 square feet toapproximately 30,000 square feet of floor space and the term of our new leasewill expire in February 2010.

 

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**Contractual Obligations**

 

The following table compares the information concerning the futurecontractual obligations under our operating leases based on the renegotiatedlease agreement for our headquarters location. We have no other significant contractual obligations at December 31,2003.

 

Future minimum lease payments consisted of the following on December31, 2003 (in thousands):

 
|                |   | **Contractual  Obligations at  December 31, 2003** |   | **Renegotiated  Contractual  Obligations dated back to  December 31, 2003** |   |
|---------------------|--------|----------------------------------------------------|--------|-----------------------------------------------------------------------------|--------|
| 2004                |   | $                                                  | 944    |                                                                        | $      | 563 |   |
| 2005                |   | 197                                                |   | 428                                                                         |   |
| 2006                |   | —                                             |   | 376                                                                         |   |
| 2007                |   | —                                             |   | 378                                                                         |   |
| 2008                |   | —                                             |   | 393                                                                         |   |
| 2009 and thereafter |   | —                                             |   | 477                                                                         |   |
|                |   |                                               |   |                                                                        |   |
|                |   | $                                                  | 1,141  |                                                                        | $      | 2,615 |   |

 

**Off-Balance Sheet Arrangements**

 

As of December 31, 2003, we did not have any significant off-balancesheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K.

 

**Item 7A****. Quantitativeand Qualitative Disclosures About Market Risk.**

 

Foreign Exchange.  Our revenueoriginating outside the U.S. in 2003, 2002 and 2001 was 31.4%, 33.4% and 36.4%of total revenues, respectively. Revenues generated from the European region in 2003, 2002 and 2001 were23.0%, 14.5% and 25.4% of total revenues, respectively.  Revenues generated from the Asia region in2003, 2002 and 2001 were 7.4% 14.6% and 6.3% of total revenues,respectively.  International sales aregenerated primarily from our foreign sales subsidiaries in the local countriesand are typically denominated in U.S. dollars. These subsidiaries incur substantially all of their expenses in thelocal currency.

 

Our international business is subject to risks typical of aninternational business, including differing economic conditions, changes inpolitical climate, differing tax structures, import and export regulations,other regulations and restrictions, and foreign exchange rate volatility. Accordingly,our results could be materially adversely impacted by changes in these or otherfactors. The effect of foreign exchange rate fluctuations on our business in2003, 2002 and 2001 was not material.

 

Interest Rates.  We invest ourcash in a variety of investment grade financial instruments, including banktime deposits, fixed rate obligations of corporations, municipalities, andstate and national governmental entities and agencies.  These investments are denominated in U.S.dollars.  Cash balances in foreigncurrencies overseas are operating balances and are invested in short-term timedeposits of the local operating bank.

 

Interest income on our investments is carried in “Interest income,net”. We account for our investment instruments in accordance with Statement ofFinancial Accounting Standards No. 115, “Accounting for CertainInvestments in Debt and Equity Securities”. All of the cash equivalents and short-term investments are treated asavailable-for-sale under SFAS 115.

 

28

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Investments in fixed rate interest earning instruments carry a degreeof interest rate risk.  Fixed ratesecurities may have their fair market value adversely impacted due to a rise ininterest rates.  Due in part to these factors,our future investment income may fall short of expectations due to changes ininterest rates or we may suffer losses in principal if forced to sellsecurities, which have seen a decline in market value due to changes ininterest rates.  Our investmentsecurities are held for purposes other than trading.  The weighted-average interest rate on investment securitiesat December 31, 2003 was 5.8%. The fair value of investments held atDecember 31, 2003 approximated amortized cost.

 

**Item 8****.    Financial Statementsand Supplementary Data.**

 

The information required by this item is included in Part IV Item15(a)(1 and 2).

 

**Item 9****.    Changes Inand Disagreements with Accountants on Accounting and Financial Disclosure.**

 

OnMarch 11, 2003, we appointed KBA Group LLP to serve as our independentpublic accountants, replacing our former independent public accountantsErnst & Young LLP, effective immediately.  This appointment was ratified by our stockholders at our 2003annual meeting. The decision to change independent auditors was approved by ourBoard of Directors upon the recommendation and approval of our Audit Committee.

 

Ernst &Young LLP’s reports on our consolidated financial statements for the fiscalyears ended December 31, 2002 and 2001 did not contain an adverse opinion ordisclaimer of opinion, nor were they qualified or modified as to uncertainty,audit scope or accounting principles.

 

Duringthe fiscal years ended December 31, 2002 and 2001 and the interim period priorto its dismissal, there were no disagreements with Ernst & Young LLPon any matter of accounting principles or practices, financial statementdisclosure, or auditing scope or procedure which, if not resolved toErnst & Young LLP’s satisfaction, would have caused them to makereference to the subject matter in connection with their reports on ourconsolidated financial statements and supporting schedules for such years; andthere were no reportable events, as listed in Item 304(a)(1)(v) ofRegulation S-K.

 

Weprovided Ernst & Young LLP with a copy of the foregoing disclosures. Acopy of Ernst & Young LLP’s letter, dated March 11, 2003, statingtheir agreement with such statements is attached as Exhibit 16.1 to our CurrentReport on Form 8-K filed with the SEC on March 11, 2003.

 

Duringthe fiscal years ended December 31, 2002 and 2001 and through the date of ourdismissal of Ernst & Young, LLP, we did not consult KBA Group LLP withrespect to the application of accounting principles to a specified transaction,either completed or proposed, or the type of the audit opinion that might berendered on our consolidated financial statements, or any other matters orreportable events listed in Items 304(a)(2)(i) and (ii) ofRegulation S-K.

 

**Item 9A****. Controls andProcedures**

 

We have carried out an evaluation, under the supervision and theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, of the effectiveness of our disclosure controls andprocedures as of December 31, 2003 pursuant to Rule 13a-15(b) under theExchange Act.  Based upon thatevaluation, our Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures are effective in ensuring thatinformation required to be disclosed is recorded, processed, summarized andreported in a timely manner.

 

We have carried out an evaluation, under the supervision andparticipation of our management, including our Chief Executive Officer andChief Financial Officer, of any changes in our internal controls over financialreporting that occurred during the quarterly period ended December 31, 2003,and our Chief Executive Officer and Chief Financial Officer have concluded thatthere was no change during the quarterly period ended December 31, 2003 thathas a materially affected or is reasonably expected to materially affect ourinternal control over financial reporting.

 

29

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**PARTIII**

 

Certain information required by Part III is omitted from thisForm 10-K because we will file a definitive Proxy Statement for our2004 annual meeting of stockholders pursuant to Regulation 14A (the “ProxyStatement”) no later than 120 days after the end of the fiscal yearcovered by this Form 10-K, and certain information to be included thereinis incorporated herein by reference.

 

**Item 10****. Directors and Executive Officers ofIntrusion Inc.**

 

The information required regarding Directors and Executive Officers ofIntrusion Inc. appearing under the captions “Election of Directors”, “Compliance with Section 16 Reporting Requirements” and Executive Officers”contained in the Proxy Statement is incorporated herein by reference.

 

**Item 11****. Executive Compensation.**

 

The information set forth under the caption “Executive Compensation”contained in the Proxy Statement is incorporated herein by reference.

 

**Item 12****. Security Ownership of Certain Beneficial Owners andManagement.**

 

The information set forth under the caption “Security Ownership ofCertain Beneficial Owners and Management” contained in the Proxy Statement isincorporated herein by reference.

 

**Item 13****. CertainRelationships and Related Transactions.**

 

The information set forth under “Certain Transactions with Management”contained in the Proxy Statement is incorporated herein by reference.

 

**Item 14****. Principal Accountant Fees and Services**

 

The information set forth under “Fees Paid to Independent PublicAccountants” contained in the Proxy Statement is incorporated herein byreference.

 

30

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**PARTIV**

 

**Item 15****. Exhibits,Financial Statement Schedules, and Reports on Form 8-K.**

 

(a)           1.    **ConsolidatedFinancial Statements.**

 

The following consolidated financial statements of Intrusion Inc.and subsidiaries, are submitted as a separate section of this report (See F-pages),and are incorporated by reference in Item 8:

 
| Report of Independent Auditors                                                                             |   |
|------------------------------------------------------------------------------------------------------------|--------|
| Consolidated Balance Sheets at December 31, 2003 and 2002                                                  |   |
| Consolidated Statements of Operations for  the years ended December 31, 2003, 2002 and 2001                |   |
| Consolidated Statements of Stockholders’  Equity for the years ended December 31, 2003, 2002 and 2001 |   |
| Consolidated Statements of Cash Flows for  the years ended December 31, 2003, 2002 and 2001.               |   |
| Notes to Consolidated Financial Statements                                                                 |   |

 

2.**             FinancialStatement Schedules.**

 
| *Schedule II—Valuation and Qualifying Accounts* |   |
|------------------------------------------------------|--------|

 

All other schedules are omitted because they are either not required ornot applicable or the required information is shown in the ConsolidatedFinancial Statements or Notes thereto.

 

(b)                                                                                 **Reports on Form 8-K.**

 

During the quarter ended December 31, 2003, we filed the followingreports on Form 8-K:

 

•                  Report onForm 8-K (Item 5) filed on November 7, 2003, announcing Intrusion’sintent to appeal Nasdaq’s delisting notification; and

 

•                  Report onForm 8-K (Item 5) filed on October 27, 2003, announcing the electionof James F. Gero to the board of directors.

 

(c)**                                  Exhibits**

 

The following Exhibits are filed herewith pursuant to Item 601 ofRegulation S-K or incorporated herein by reference to previous filings asnoted:

 

31

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| **Exhibit  Number** |   | **Description of Exhibit**                                                                                                                                                                  |
|---------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|  2.1(5)        |   | Certificate of Ownership and Merger Merging  Intrusion.com, Inc. into Intrusion Inc.                                                                                                        |
|  3.1(5)        |   | Amended and Restated Certificate of  Incorporation of the Registrant.                                                                                                                       |
|  3.2(7)        |   | Certificate of Amendment to Certificate of  Incorporation of Registrant                                                                                                                     |
|  3.3(8)        |   | Certificate of Designation for the  Registrant’s 5% Convertible Preferred Stock                                                                                                        |
|  3.4(4)        |   | Bylaws of the Registrant.                                                                                                                                                                   |
|  4.1(9)        |   | Specimen Common Stock Certificate.                                                                                                                                                          |
|  4.2(8)        |   | Specimen 5% Convertible Preferred Stock  Certificate                                                                                                                                        |
|  4.3(8)        |   | Form of Warrant to Purchase Shares of  Common Stock                                                                                                                                         |
|  4.4(8)        |   | Warrant to Purchase Common Stock dated  March 25, 2004, issued by the Registrant to Black Point Partners                                                                                    |
|  4.5(8)        |   | Registration Rights Agreement dated as of  March 25, 2004, by and among the Registrant and the entities listed on  Schedule A thereto                                                       |
|  4.6(8)        |   | Form of Lock-Up Agreement                                                                                                                                                                   |
| 10.1(1)             |   | 1983 Incentive Stock Option Plan of the  Registrant, as amended.                                                                                                                            |
| 10.2(1)             |   | 1987 Incentive Stock Option Plan of the Registrant,  as amended.                                                                                                                            |
| 10.3(1)             |   | Form of Indemnification Agreement.                                                                                                                                                          |
| 10.4(5)             |   | 1995 Stock Option Plan of the Registrant as  amended April 26, 2001.                                                                                                                        |
| 10.5(2)             |   | 1995 Non-Employee Directors Stock  Option Plan of the Registrant (amended and restated as of January 10, 2002).                                                                             |
| 10.7(9)             |   | Lease Agreement between CalWest Industrial  Holdings Texas, L.P. and Intrusion Inc.                                                                                                         |
| 10.8(8)             |   | Securities Purchase Agreement dated as of  March 25, 2004, by and among the Registrant and the purchasers listed on  Exhibit A thereto.                                                     |
| 10.9(4)             |   | Amended and Restated 401(k) Savings Plan of  the Registrant.                                                                                                                                |
| 10.10(4)            |   | 1997 Employee Stock Purchase Plan of the  Registrant, as amended January 17, 2001.                                                                                                          |
| 10.11(3)            |   | Employment Agreement with Aaron Bawcom  dated February 4, 2003                                                                                                                              |
| 10.12(6)            |   | Intrusion Inc. 401(k) Savings Plan Summary  of Material Modifications.                                                                                                                      |
| 21(5)               |   | List of Subsidiaries of Registrant                                                                                                                                                          |
| 23.1(9)             |   | Consent of Ernst & Young LLP,  Independent Auditors.                                                                                                                                    |
| 23.2(9)             |   | Consent of KBA Group LLP, Independent  Auditors                                                                                                                                             |
| 31.1(9)             |   | Certification of Chief Executive Officer  Pursuant to Rule 13a-14(a) of the Exchange Act.                                                                                                   |
| 31.2(9)             |   | Certification of Chief Financial Officer  Pursuant to Rule 13a-14(a) of the Exchange Act.                                                                                                   |
| 32.1(9)             |   | 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(9)             |   | 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. |

 

32

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----

(1)           Filedas an Exhibit in the Registrant's Registration Statement on Form S-1, asamended (File No. 33-6899), which was declared effective on May 21, 1992, bythe Securities and Exchange Commission, which Exhibit is incorporated herein byreference. 

 

(2)           Filedas an Exhibit to the Registrant's Definitive Proxy Statement on Schedule 14A inconnection with the solicitation of proxies for its 2002 Annual Meeting of Stockholders,which Exhibit is incorporated herein by reference. 

 

(3)           Filedas an Exhibit to the Registrant's Quarterly Report on Form 10-Q for the quarterended March 31, 2003, which Exhibit is incorporated herein by reference.

 

(4)           Filedas an Exhibit to the Registrants' Annual Report on Form 10-K, for the fiscalyear ended December 31, 2000. 

 

(5)           Filedas an Exhibit to the Registrant's Annual Report on Form 10-K for the fiscalyear ended December 31, 2001, which Exhibit is incorporated herein by reference.

 

(6)           Filedas an Exhibit to the Registrant's Quarterly Report on Form 10-Q for the quarterended March 31, 2002, which Exhibit is incorporated herein by reference. 

 

(7)           Filedas an Exhibit to the Registrant’s Definitive Proxy Statement on Schedule 14A inconnection with the solicitation of proxies for its Special Meeting ofStockholders held March 18, 2004, which Exhibit is incorporated herein byreference.

 

(8)           Filedas an Exhibit to the Registrant’s Current Report on Form 8-K dated March 26,2004, which Exhibit is incorporated by reference.

 

(9)           Filedherewith.

 

33

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 
| Dated: March 26, 2004 | INTRUSION INC.(Registrant) |
|----------------------------|---------------------------------|
|                       |                            |
|                       |  By:                       | /s/ G.  Ward Paxton |   |
|                       |                            | G. Ward Paxton |   |
|                       |                            | *Chairman, President, and Chief Executive  Officer* |   |
|                       |                            | *(Principal Executive Officer)* |   |

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theRegistrant and in the capacities and on the dates indicated.

 
| **Signature**           |   | **Title**                                    |   | **Date**       |
|-------------------------|--------|----------------------------------------------|--------|----------------|
|                    |   |                                         |   |           |
|                    |   |                                         |   |           |
| /s/  G. Ward Paxton     |   | Chairman, President,                         |   | March 26, 2004 |
| G. Ward Paxton          |   | Chief Executive Officer, and Director        |   |           |
|                    |   |                                         |   |           |
| /s/ T.  Joe Head        |   | Vice Chairman, Vice President                |   | March 26, 2004 |
| T. Joe Head             |   | and Director                                 |   |           |
|                    |   |                                         |   |           |
|                    |   | Vice President, Chief Financial              |   |           |
| /s/ Michael  L. Paxton  |   | Officer, Treasurer and Secretary             |   | March 26, 2004 |
| Michael L. Paxton       |   | (Principal Financial and Accounting Officer) |   |           |
|                    |   |                                         |   |           |
| /s/  James F. GERO      |   | Director                                     |   | March 26, 2004 |
| James F. Gero           |   |                                         |   |           |
|                    |   |                                         |   |           |
| /s/ J.  Fred Bucy       |   | Director                                     |   | March 26, 2004 |
| J. Fred Bucy            |   |                                         |   |           |
|                    |   |                                         |   |           |
| /s/ Donald  M. Johnston |   | Director                                     |   | March 26, 2004 |
| Donald M. Johnston      |   |                                         |   |           |

 

34

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**ANNUAL REPORT ON FORM 10-K**

**ITEM 15(a)(1)**

**FINANCIAL STATEMENTS**

**YEARS ENDED DECEMBER 31, 2003, 2002 and 2001**

**INTRUSION INC.**

**RICHARDSON, TEXAS**

 

35

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**REPORT OF INDEPENDENT AUDITORS**

 

 

The Board of Directors and Stockholders

Intrusion Inc.

 

We have audited the accompanying consolidated balance sheet of Intrusion Inc.and subsidiaries (the “Company”) as of December 31, 2003, and the relatedconsolidated statements of operations, stockholders’ equity, and cash flows forthe year then ended. Our audit also included the financial statement scheduleappearing under Item 15(a)(2). These financial statements and schedule arethe responsibility of the Company’s management. Our responsibility is toexpress an opinion on these financial statements and schedule based on ouraudit.

 

We conducted our audit in accordance with auditing standards generallyaccepted in the United States. Those standards require that we plan and performthe audit to obtain reasonable assurance about whether the financial statementsare free of material misstatement. An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audit provides areasonable basis for our opinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the consolidated financial position ofIntrusion Inc. and subsidiaries at December 31, 2003, and theconsolidated results of their operations and their cash flows for the year thenended, in conformity with accounting principles generally accepted in theUnited States.  Also, in our opinion,the related financial statement schedule, appearing under Item 15(a)(2) for theyear ended December 31, 2003, when considered in relation to the basicfinancial statements taken as a whole, presents fairly in all material respectsthe information set forth therein.

 

 
| KBA Group LLP                                                                   |
|---------------------------------------------------------------------------------|
| Dallas, Texas                                                                   |
| January 30, 2004, except for Note 13, to which the date is March  25, 2004 |

 

F-1

----

 

**REPORT OF INDEPENDENT AUDITORS**

 

The Board of Directors andStockholders

Intrusion Inc.

 

 

We haveaudited the accompanying consolidated balance sheets of Intrusion Inc. andsubsidiaries (the "Company") as of December 31, 2002 and 2001, andthe related consolidated statements of operations, stockholders' equity, andcash flows for each of the years then ended. Our audits also included thefinancial statement schedule included in the Index at Item 15(a). Thesefinancial statements and schedule are the responsibility of the Company'smanagement. Our responsibility is to express an opinion on these financialstatements and schedule based on our audits. 

 

We conductedour audits in accordance with auditing standards generally accepted in theUnited States. Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for ouropinion. 

 

In ouropinion, the financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of Intrusion Inc. andsubsidiaries at December 31, 2002 and 2001, and the consolidated results oftheir operations and their cash flows for each of the years then ended, inconformity with accounting principles generally accepted in the United States.Also, in our opinion, the related financial statement schedule, when consideredin relation to the basic financial statements taken as a whole, presents fairlyin all material respects the information set forth therein. 

 

As discussedin Note 2 to the consolidated financial statements, effective January 1, 2002,the Company adopted Statement of Financial Accounting Standards No. 142,"Goodwill and other Intangible Assets." 

 

 

Dallas, Texas 

January 28, 2003 

 

F-2

----

 

**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

**(In thousands, except par value amounts)**

 
|                                                                                                                            |   | **December  31,** |   |
|---------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|--------|
|                                                                                                                            |   | **2003**          |   | **2002** |   |
| **Assets**                                                                                                                      |   |              |   |   |   |
| Current Assets:                                                                                                                 |   |              |   |   |   |
| Cash and cash equivalents                                                                                                       |   | $                 | 974    |   | $ | 2,898 |   |
| Short-term investments                                                                                                          |   | 1,705             |   | 7,825 |   |
| Accounts receivable, net of allowance for  doubtful accounts and returns of $574 in 2003 and $934 in 2002                       |   | 972               |   | 2,363 |   |
| Inventories                                                                                                                     |   | 1,286             |   | 1,411 |   |
| Prepaid expenses                                                                                                                |   | 449               |   | 759 |   |
| Total current assets                                                                                                            |   | 5,386             |   | 15,256 |   |
| Property and Equipment:                                                                                                         |   |              |   |   |   |
| Machinery and equipment                                                                                                         |   | 2,424             |   | 10,845 |   |
| Furniture and fixtures                                                                                                          |   | 77                |   | 1,441 |   |
| Leasehold improvements                                                                                                          |   | 178               |   | 998 |   |
|                                                                                                                            |   | 2,679             |   | 13,284 |   |
| Accumulated depreciation and amortization                                                                                       |   | (2,382            | )      | (11,687 | ) |
|                                                                                                                            |   | 297               |   | 1,597 |   |
| Other assets                                                                                                                    |   | 77                |   | 86 |   |
| **TOTAL ASSETS**                                                                                                                |   | $                 | 5,760  |   | $ | 16,939 |   |
|                                                                                                                            |   |              |   |   |   |
| **Liabilities and  Stockholders’ Equity**                                                                                  |   |              |   |   |   |
| Current Liabilities:                                                                                                            |   |              |   |   |   |
| Accounts payable, trade                                                                                                         |   | $                 | 1,080  |   | $ | 1,159 |   |
| Accrued vacation expense                                                                                                        |   | 303               |   | 341 |   |
| Accrued warranty expense                                                                                                        |   | 200               |   | 300 |   |
| Other accrued expenses                                                                                                          |   | 605               |   | 1,105 |   |
| Deferred revenue                                                                                                                |   | 788               |   | 1,650 |   |
| Total current liabilities                                                                                                       |   | 2,976             |   | 4,555 |   |
| **TOTAL LIABILITIES**                                                                                                           |   | 2,976             |   | 4,555 |   |
|                                                                                                                            |   |              |   |   |   |
| Stockholders’ Equity:                                                                                                      |   |              |   |   |   |
| Preferred stock, $0.01 par value:                                                                                               |   |              |   |   |   |
| Authorized shares-5,000  No shares issued and outstanding                                                                       |   | —            |   | — |   |
| Common stock, $0.01 par value:                                                                                                  |   |              |   |   |   |
| Authorized shares-80,000  Issued shares-20,690 in 2003 and 20,686 in 2002  Outstanding shares-20,650 in 2003 and 20,646 in 2002 |   | 207               |   | 207 |   |
| Additional paid-in-capital                                                                                                      |   | 47,371            |   | 47,371 |   |
| Common stock held in treasury, at cost-40  shares                                                                               |   | (362              | )      | (362 | ) |
| Accumulated deficit                                                                                                             |   | (44,204           | )      | (34,604 | ) |
| Accumulated other comprehensive loss                                                                                            |   | (228              | )      | (228 | ) |
| Total stockholders’ equity                                                                                                 |   | 2,784             |   | 12,384 |   |
| **TOTAL LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                            |   | $                 | 5,760  |   | $ | 16,939 |   |

 

See accompanying notes.

 

F-3

----

 

**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(In thousands, except per share amounts)**

 

 
|                                                             |   | **Year Ended  December 31,** |   |
|------------------------------------------------------------------|--------|------------------------------|--------|
|                                                             |   | **2003**                     |   | **2002** |   | **2001** |   |
|                                                             |   |                         |   |   |   |   |   |
| Net revenue                                                      |   | $                            | 6,478  |   | $ | 7,834 |   | $ | 16,685 |   |
| Cost of revenue                                                  |   | 3,988                        |   | 6,147 |   | 13,490 |   |
| Gross profit                                                     |   | 2,490                        |   | 1,687 |   | 3,195 |   |
| Operating expenses:                                              |   |                         |   |   |   |   |   |
| Sales and marketing                                              |   | 6,230                        |   | 11,789 |   | 23,550 |   |
| Research and development                                         |   | 3,498                        |   | 6,088 |   | 12,549 |   |
| General and administrative                                       |   | 1,632                        |   | 2,576 |   | 4,481 |   |
| Amortization of intangibles                                      |   | —                       |   | 798 |   | 1,233 |   |
| Impairment of intangibles                                        |   | —                       |   | 3,009 |   | — |   |
| Litigation settlement                                            |   | 450                          |   | — |   | — |   |
| Severance costs                                                  |   | 472                          |   | 200 |   | 4,673 |   |
| Operating loss                                                   |   | (9,792                       | )      | (22,773 | ) | (43,291 | ) |
| Interest income, net                                             |   | 182                          |   | 351 |   | 1,687 |   |
| Other income (expense), net                                      |   | 10                           |   | (7 | ) | 112 |   |
| Loss from continuing operations before  income taxes             |   | (9,600                       | )      | (22,429 | ) | (41,492 | ) |
| Income tax benefit                                               |   | —                       |   | (608 | ) | (1,877 | ) |
| Loss from continuing operations                                  |   | (9,600                       | )      | (21,821 | ) | (39,615 | ) |
| Income (loss) from discontinued operations,  net of income taxes |   | —                       |   | 544 |   | (6,165 | ) |
| Net loss                                                         |   | $                            | (9,600 | ) | $ | (21,277 | ) | $ | (45,780 | ) |
|                                                             |   |                         |   |   |   |   |   |
| Loss per share, continuing operations  (basic and diluted)       |   | $                            | (0.46  | ) | $ | (1.06 | ) | $ | (1.93 | ) |
|                                                             |   |                         |   |   |   |   |   |
| Net loss per share (basic and diluted)                           |   | $                            | (0.46  | ) | $ | (1.03 | ) | $ | (2.23 | ) |
|                                                             |   |                         |   |   |   |   |   |
| Weighted average shares outstanding  —(basic and diluted)   |   | 20,649                       |   | 20,640 |   | 20,565 |   |

 

See accompanying notes.

 

F-4

----

 

**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’EQUITY**

**(In thousands)**

 

 
| **YEAR ENDED DECEMBER 31,**                                                |   | **2003** |    | **2002** |   | **2001** |   |
|----------------------------------------------------------------------------|--------|----------|---------|----------|--------|----------|--------|
|                                                                       |   |     |    |     |   |     |   |
| **NUMBER OF  SHARES—ISSUED**                                          |   |     |    |     |   |     |   |
| Balance, beginning of year                                                 |   | 20,686   |    | 20,649   |   | 20,525   |   |
| Issuance of common stock under warrants,  stock options and purchase plans |   | 4        |    | 37       |   | 124      |   |
| Balance, end of year                                                       |   | 20,690   |    | 20,686   |   | 20,649   |   |
| **NUMBER OF  SHARES—OUTSTANDING**                                     |   |     |    |     |   |     |   |
| Balance, beginning of year                                                 |   | 20,646   |    | 20,609   |   | 20,485   |   |
| Issuance of common stock under warrants,  stock options and purchase plans |   | 4        |    | 37       |   | 124      |   |
| Balance, end of year                                                       |   | 20,650   |    | 20,646   |   | 20,609   |   |
| **COMMON STOCK**                                                           |   |     |    |     |   |     |   |
| Balance, beginning of year                                                 |   | $        | 207     |     | $      | 206      |   | $ | 205 |   |
| Issuance of common stock under warrants,  stock options and purchase plans |   | —   |    | 1        |   | 1        |   |
| Balance, end of year                                                       |   | $        | 207     |     | $      | 207      |   | $ | 206 |   |
| **ADDITIONAL  PAID-IN-CAPITAL**                                            |   |     |    |     |   |     |   |
| Balance, beginning of year                                                 |   | $        | 47,371  |     | $      | 47,320   |   | $ | 46,916 |   |
| Issuance of common stock under warrants,  stock options and purchase plans |   | —   |    | 51       |   | 396      |   |
| Tax benefit derived from exercise of  employee stock options               |   | —   |    | —   |   | 8        |   |
| Balance, end of year                                                       |   | $        | 47,371  |     | $      | 47,371   |   | $ | 47,320 |   |
| **TREASURY SHARES**                                                        |   |     |    |     |   |     |   |
| Balance, beginning of year                                                 |   | $        | (362    | )        | $      | (362     | )      | $ | (362 | ) |
| Purchase of treasury shares                                                |   | —   |    | —   |   | —   |   |
| Balance, end of year                                                       |   | $        | (362    | )        | $      | (362     | )      | $ | (362 | ) |
| **ACCUMULATED OTHER  COMPREHENSIVE LOSS**                                  |   |     |    |     |   |     |   |
| Balance, beginning of year                                                 |   | $        | (228    | )        | $      | (339     | )      | $ | (425 | ) |
| Foreign currency translation adjustment (a)                                |   | —   |    | 111      |   | 86       |   |
| Balance, end of year                                                       |   | $        | (228    | )        | $      | (228     | )      | $ | (339 | ) |
| **RETAINED EARNINGS  (ACCUMULATED DEFICIT)**                               |   |     |    |     |   |     |   |
| Balance, beginning of year                                                 |   | $        | (34,604 | )        | $      | (13,327  | )      | $ | 32,453 |   |
| Net loss (b)                                                               |   | (9,600   | )       | (21,277  | )      | (45,780  | )      |
| Balance, end of year                                                       |   | $        | (44,204 | )        | $      | (34,604  | )      | $ | (13,327 | ) |
| **TOTAL STOCKHOLDERS’  EQUITY**                                       |   | $        | 2,784   |     | $      | 12,384   |   | $ | 33,498 |   |
|                                                                       |   |     |    |     |   |     |   |
| **TOTAL COMPREHENSIVE  LOSS (a+b)**                                        |   | $        | (9,600  | )        | $      | (21,166  | )      | $ | (45,694 | ) |

 

See accompanying notes.

 

F-5

----

 

**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

 

 
|                                                                                                |   | **Year Ended  December 31,** |   |
|-----------------------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                                                |   | **2003**                     |   | **2002** |   | **2001** |   |
|                                                                                                |   |                         |   |   |   |   |   |
| Operating Activities:                                                                               |   |                         |   |   |   |   |   |
| Loss from continuing operations                                                                     |   | $                            | (9,600 | ) | $ | (21,821 | ) | $ | (39,615 | ) |
| Adjustments to reconcile loss from  continuing operations to net cash used in operating activities: |   |                         |   |   |   |   |   |
| Depreciation and amortization                                                                       |   | 1,400                        |   | 2,955 |   | 4,369 |   |
| Impairment of intangible assets                                                                     |   | —                       |   | 3,009 |   | 3,109 |   |
| Deferred income tax expense                                                                         |   | —                       |   | — |   | 1,923 |   |
| Changes in operating assets and  liabilities:                                                       |   |                         |   |   |   |   |   |
| Accounts receivable                                                                                 |   | 1,391                        |   | 2,843 |   | 1,681 |   |
| Income tax receivable                                                                               |   | —                       |   | 2,779 |   | (1,036 | ) |
| Inventories                                                                                         |   | 125                          |   | 3,605 |   | 3,343 |   |
| Other assets                                                                                        |   | 319                          |   | (137 | ) | 851 |   |
| Accounts payable and accrued expenses                                                               |   | (717                         | )      | (3,095 | ) | (3,905 | ) |
| Deferred revenue                                                                                    |   | (862                         | )      | (8 | ) | 374 |   |
| Net cash used in operating activities of  continuing operations                                     |   | (7,944                       | )      | (9,870 | ) | (28,906 | ) |
| Investing Activities:                                                                               |   |                         |   |   |   |   |   |
| Purchases of short-term investments                                                                 |   | (3,475                       | )      | (16,290 | ) | (14,369 | ) |
| Maturities of short-term investments                                                                |   | 9,595                        |   | 13,117 |   | 34,798 |   |
| Purchases of property and equipment                                                                 |   | (100                         | )      | (151 | ) | (680 | ) |
|                                                                                                |   |                         |   |   |   |   |   |
| Net cash provided by (used in) investing  activities of continuing operations                       |   | 6,020                        |   | (3,324 | ) | 19,749 |   |
| Financing Activities:                                                                               |   |                         |   |   |   |   |   |
| Exercise of warrants and employee stock  options                                                    |   | —                       |   | 51 |   | 405 |   |
| Other                                                                                               |   | —                       |   | 1 |   | (3 | ) |
| Net cash provided by financing activities  of continuing operations                                 |   | —                       |   | 52 |   | 402 |   |
| Net cash provided by discontinued  operations                                                       |   | —                       |   | 146 |   | 4,107 |   |
| Effect of foreign currency translation  adjustment on cash and cash equivalents                     |   | —                       |   | 111 |   | 86 |   |
| Net decrease in cash and cash equivalents                                                           |   | (1,924                       | )      | (12,885 | ) | (4,562 | ) |
| Cash and cash equivalents at beginning of  year                                                     |   | 2,898                        |   | 15,783 |   | 20,345 |   |
|                                                                                                |   |                         |   |   |   |   |   |
| Cash and cash equivalents at end of year                                                            |   | $                            | 974    |   | $ | 2,898 |   | $ | 15,783 |   |

 

See accompanying notes.

 

F-6

----

 

**INTRUSION INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**1. Description of Business**

 

We develop, market and support a family of network intrusion detectionand prevention systems and regulated information compliance systems thataddress vital security issues facing organizations with mission criticalapplications or housing classified, confidential or customer informationassets.  Our growth strategy is focusedon three primary network security product segments — intrusion detectionsystems (“IDS”), intrusion prevention systems (“IPS”), and regulatedinformation compliance systems (“RICS”). We have sold our network security products to over 300 customersincluding many fortune 500 companies, departments of the U.S. Government, andManaged Security Service Providers (“MSSP”).

 

We are headquartered in Richardson, Texas and have 44 employees,including 17 in sales and marketing, and 15 in engineering.  Our principal executive offices are locatedat 1101 East Arapaho Road, Richardson, Texas 75081, and our telephone number is(972) 234-6400.  Our Web site iswww.intrusion.com and our common stock is traded on the NASDAQ Small Cap Marketunder the symbol “INTZC”.

 

We organized in Texas in September 1983 and reincorporated inDelaware in October 1995. For more than 15 years, we provided localarea networking equipment and were known as Optical Data Systems or ODSNetworks. On April 17, 2000, we announced plans to sell, or otherwisedispose of, our networking divisions, which include our EssentialCommunications Division (“Essential”) and our 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 ODSNetworks, Inc. to Intrusion.com, Inc., and our NASDAQ ticker symbolfrom ODSI to INTZ to reflect our focus on intrusion detection solutions. OnNovember 1, 2001, we changed our name from Intrusion.com, Inc. toIntrusion Inc.

 

References to “we”, “us”, “our” or “Intrusion Inc.” refer toIntrusion Inc. and its subsidiaries.

 

As of December 31, 2003, we had cash, cash equivalents and investmentsin the amount of approximately $2.7 million, down from approximately $10.7million as of December 31, 2002. However, throughout 2003, we reduced expenses.  As a result, our cash used in operations, excluding thelitigation settlement and severance charges in the fourth quarter wasapproximately $1.4 million.  Includinglitigation settlement and severance charges, our cash used in operations in thefourth quarter of 2003 was $1.9 million. On March 25, 2004, we closed a $5.0 million private placement of 5%Convertible Preferred Stock and warrants (See Note 13).  With this additional financing, we believethat we have sufficient cash resources to finance our operations and expectedcapital expenditures for the next twelve months.  The sufficiency of our cash resources may depend to a certainextent on general economic, financial, competitive or other factors beyond ourcontrol.  Moreover, despite actions toreduce our cost and improve our profitability, we expect our operating lossesand net operating cash outflows to continue through at least the first half of2004.  We do not currently have anyfurther arrangements for financing, and we may not be able to secure additionaldebt or equity financing on terms that are acceptable to us, or at all, at thetime when we need such funding.  If ourbusiness does not generate sufficient cash flows from operations and sufficientfinancings are not available, we may not be able to operate or grow ourbusiness, pay our expenses when due or fund our other liquidity needs.

 

**2. Summary of Significant Accounting Policies**

 

***Principlesof Consolidation***

 

Our consolidated financial statements include our accounts and those ofour wholly owned subsidiaries. Intercompany balances and transactions have beeneliminated in consolidation.

 

***Cashand Cash Equivalents***

 

Cash and all highly liquid investments purchased with an originalmaturity of less than three months as of the balance sheet date are consideredto be cash and cash equivalents.

 

F-7

----

 

***Short-termInvestments***

 

Short-term investments consist of U.S. government obligations andcorporate securities with maturities between 90 days and one year as ofthe balance sheet date. Short-term investments are classified as available forsale. These investments are valued at market value, which approximatesamortized cost. The difference between fair market value and amortized cost isnot material.  Realized gains and lossesfrom the sale of short-term investments are included in other income, net andare derived using the specific identification method for determining the costof securities.

 

***RiskConcentration***

 

Financial instruments, which potentially subject us to concentrationsof credit risk, are primarily cash and cash equivalents, investments andaccounts receivable. We place our investments in U.S. government obligations,corporate securities and money market funds. Substantially all of our cash,cash equivalents and investments are maintained with two major U.S. financialinstitutions.

 

We sell our products to customers in diversified industries worldwide,primarily in North America, Europe, Asia and Latin America. Fluctuations incurrency exchange rates and adverse economic developments in foreign countriescould adversely affect the Company’s operating results. We perform ongoingcredit evaluations of our customers’ financial condition and generally requireno collateral. We maintain reserves for potential credit losses, and suchlosses, in the aggregate, have not exceeded management expectations.

 

While we believe that many of the materials used in the production ofour products are generally readily available from a variety of sources, certaincomponents are available from one or a limited number of suppliers. Theinability of any supplier or manufacturer to fulfill supply requirements of theCompany could impact future results.

 

***AccountsReceivable, Allowance for Doubtful Accounts and Returns***

 

Trade accounts receivable are stated at the amount we expect tocollect.  We maintain allowances fordoubtful accounts for estimated losses resulting from the inability of ourcustomers to make required payments. Management considers the following factors when determining thecollectibility of specific customer accounts: customer credit-worthiness, past transaction history with the customer,current economic industry trends, and changes in customer payment terms.  If the financial condition of our customerswere to deteriorate, adversely affecting their ability to make payments,additional allowances would be required. Based on management’s assessment, we provide for estimated uncollectibleamounts through a charge to earnings and a credit to a valuationallowance.  Balances that remainoutstanding after we have used reasonable collection efforts are written offthrough a charge to the valuation allowance and a credit to accountsreceivable.

 

***Inventories***

 

Inventories are stated at the lower of cost or market. Cost is computedusing standard cost, which approximates actual cost on a first-in, first-outbasis. Our management estimates the allowance required to state inventory atthe lower of cost or market. There is a risk that we will forecast demand forour products and market conditions incorrectly and maintain excess inventories.Therefore, there can be no assurance that we will not maintain excess inventoryand incur inventory lower of cost or market charges in the future.

 

***Propertyand Equipment***

 

Property and equipment is stated at cost less accumulated depreciationand is depreciated on a straight-line basis over the estimated useful lives ofthe assets. Such lives vary from 3 to 20 years. Leasehold improvements areamortized over the shorter of their useful lives or the terms of the leases.Repair and maintenance costs are expensed as incurred. Depreciation andamortization expense totaled approximately $1.4, $2.2 and $3.1 million forthe years ended December 31, 2003, 2002 and 2001, respectively.

 

F-8

----

 

***Goodwilland Other Intangible Assets***

 

Effective January 1, 2002, we adopted the provisions of Statementof Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and OtherIntangible Assets”, which requires companies to cease amortizing goodwill andcertain intangible assets with indefinite useful lives. SFAS 142 requiresthat goodwill and intangible assets deemed to have indefinite useful lives bereviewed for impairment upon adoption of SFAS 142, annually thereafter,and upon the occurrence of any event that indicates potential impairments.

 

In accordance with SFAS 142, we discontinued recording goodwillamortization effective January 1, 2002. Operating results, excluding theeffect of amortization expense related to goodwill, for the years endedDecember 31, 2003, 2002 and 2001 is as follows (in thousands, except pershare data):

 
|                                                 |   | **2003** |   | **2002** |   | **2001** |   |
|------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                 |   |     |   |     |   |     |   |
| Net loss                                             |   | $        | (9,600 | )        | $      | (21,277  | )      | $ | (45,780 | ) |
| Add back: Goodwill amortization net of  income taxes |   | —   |   | —   |   | 578      |   |
| Pro forma net loss                                   |   | $        | (9,600 | )        | $      | (21,277  | )      | $ | (45,202 | ) |
|                                                 |   |     |   |     |   |     |   |
| Net loss per share:                                  |   |     |   |     |   |     |   |
| As reported (basic and diluted)                      |   | $        | (0.46  | )        | $      | (1.03    | )      | $ | (2.23 | ) |
| Pro forma (basic and diluted)                        |   | $        | (0.46  | )        | $      | (1.03    | )      | $ | (2.20 | ) |

 

SFAS 142 prescribes a two-phase process for impairment testing ofgoodwill. The first phase screens for potential impairment, while the secondphase (if necessary) measures the impairment. Goodwill is potentially impairedif the net book value of a reporting unit exceeds its estimated fair value. Wehave determined that we have one reporting unit. This methodology differs fromour previous policy, as permitted under accounting standards existing at thattime, of using undiscounted cash flows on an enterprise-wide basis to determineif goodwill is recoverable.

 

We elected to perform our annual impairment review during the fourthquarter of each year, commencing in the fourth quarter of 2002. In connectionwith our annual impairment review, we determined that the value of goodwill wasimpaired. At the time of our impairment review, the remaining goodwill of $0.4 millionwas associated with the MimeStar purchase transaction (see Note 3). Basedon the decline in our market value as indicated by the decline in our stockprice during 2002, we determined that the goodwill carrying value should bezero at December 31, 2002. Therefore, an impairment charge of$0.4 million was recorded and is included in impairment of intangibles inthe accompanying consolidated statement of operations.

 

***Long-LivedAssets***

 

Effective January 1, 2002, we adopted the provisions of SFASNo. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”,which supersedes SFAS No. 121, “Accounting for the Impairment ofLong-Lived Assets and for Long-Lived Assets to Be Disposed Of,” and accountingand reporting provisions of Accounting Principles Bulletin Opinion 30,“Reporting the Results of Operations,” for a disposal of a segment. The primaryobjective of SFAS 144 is to develop one accounting model based on theframework established in SFAS 121 for long-lived assets to be disposed ofand significantly changes the criteria that would have to be met to classify anasset as held for sale. SFAS 144 also requires expected future operatinglosses from discontinued operations to be displayed in the period(s) in whichthe losses are incurred, rather than as of the measurement date. Our adoptionof SFAS 144 had no effect on our financial position or results ofoperations.

 

F-9

----

 

We review long-lived assets, other than goodwill, for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. Conditions that would necessitate an impairment assessment includematerial adverse changes in operations, significant adverse differences inactual results in comparison with initial valuation forecasts prepared at thetime of acquisition, a decision to abandon acquired products, services ortechnologies, or other significant adverse changes that would indicate thecarrying amount of the recorded asset might not be recoverable.  Recoverability of assets held and used ismeasured by a comparison of the carrying amount of an asset to undiscounted pretax future net cash flows expected to be generated by that asset.  An impairment loss is recognized for theamount by which the carrying amount of the assets exceeds the fair value of theassets.  Long-lived assets held for saleare reported at the lower of cost or fair value less costs to sell.

 

As a result of the write-off of goodwill during the fourth quarter of2002, we determined that a triggering event indicating potential impairment ofthe associated intangibles had occurred. At December 31, 2002, the remaining intangibles of$2.6 million principally included purchased software associated with theMimeStar purchase transaction (see Note 3).  We determined that the undiscounted pre-tax cash flows associatedwith this software was not likely to exceed the remaining carrying value.  Due to technological changes that had takenplace with respect to the core software code acquired, it was determined thatthe carrying value should be zero at December 31, 2002.  Therefore, we recorded an impairment chargeof $2.6 million, which is included in impairment of intangibles in theaccompanying consolidated statement of operations.

 

***ForeignCurrency Translation***

 

Beginning with fiscal year 2003, we determined that our internationalsubsidiaries should use the United States dollar as their functional currency,as allowed under SFAS No. 52, “Foreign Currency Translation”.  Although, our international offices payoperating expenses in their local currency, they are fully funded by us inUnited States dollars, and we exchange the United States dollars locally tosettle operating expenses incurred.  Asoutlined in SFAS 52, assets and liabilities are translated at the exchange ratein effect at the balance sheet date, and income and expense accounts at averageexchange rates during the year. Resulting translation adjustments totaling approximately $50,000 wererecorded as operating expenses in the statement of operations during 2003.

 

***Accountingfor Stock Options***

 

In December 2002, the FASB issued SFAS No. 148, “Accountingfor Stock-Based Compensation-Transition and Disclosure”.SFAS 148 amends SFAS No. 123, “Accounting for Stock-BasedCompensation”, to provide alternative methods of transition to SFAS 123’sfair value method of accounting for stock-based employee compensation.

 

SFAS 148 also amends the disclosure provisions of SFAS 123and APB Opinion No. 28, “Interim Financial Reporting,” to requiredisclosure in the summary of significant accounting policies of the effects ofan entity’s accounting policy with respect to stock-based employeecompensation on reported net income and earnings per share in annual andinterim financial statements.  WhileSFAS 148 does not amend SFAS 123 to require companies to account foremployee stock options using the fair value method, the disclosure provisionsof SFAS 148 are applicable to all companies with stock-basedemployee compensation, regardless of whether they account for that compensationusing the fair value method of SFAS 123 or the intrinsic value method ofAPB Opinion No. 25, “Accounting for Stock Issued to Employees”(“APB 25”).  Under APB 25, ifthe exercise price of an employee’s stock option equals or exceeds the marketprice of the underlying stock on the date of grant, no compensation expense isrecognized.  However, if the exerciseprice of an employee’s stock option is less than the market price of theunderlying stock on the date of grant, compensation expense is recorded for thedifference in the exercise price and the market price.  As allowed by SFAS 123, we have electedto continue to utilize the accounting method prescribed by APB 25 and haveadopted the disclosure requirements of SFAS 123 and SFAS 148.

 

F-10

----

 

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 ofSFAS 123 had been applied for the years ended December 31, 2003, 2002and 2001 (in thousands, except per share data):

 
|                                                                                            |   | **2003** |   | **2002** |   | **2001** |   |
|-------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                                                            |   |     |   |     |   |     |   |
| Net loss, as reported                                                                           |   | $        | (9,600 | )        | $      | (21,277  | )      | $ | (45,780 | ) |
| Deduct: Total stock-based compensation  determined under fair value-based method for all awards |   | (256     | )      | (667     | )      | (1,897   | )      |
| Pro forma net loss                                                                              |   | $        | (9,856 | )        | $      | (21,944  | )      | $ | (47,677 | ) |
|                                                                                            |   |     |   |     |   |     |   |
| Net loss per share:                                                                             |   |     |   |     |   |     |   |
| As reported (basic and diluted)                                                                 |   | $        | (0.46  | )        | $      | (1.03    | )      | $ | (2.23 | ) |
| Pro forma (basic and diluted)                                                                   |   | $        | (0.48  | )        | $      | (1.06    | )      | $ | (2.32 | ) |
| Weighted-average shares used in  computation:                                                   |   |     |   |     |   |     |   |
| Basic and diluted                                                                               |   | 20,649   |   | 20,640   |   | 20,565   |   |

 

As required, the pro forma disclosures above include options grantedsince January 1, 1995. Consequently, the effects of applying SFAS 123for providing pro forma disclosures may not be representative of the effects onreported operating results for future years until all options outstanding are includedin the pro forma disclosures. For purposes of pro forma disclosures, theestimated fair value of stock-based compensation plans and other optionsare amortized to expense primarily over the vesting period. See Note 10for further discussion of our stock-based employee compensation.

 

***NetLoss Per Share***

 

We report two separate earnings per share (“EPS”) numbers, basic EPSand diluted EPS with additional disclosure made between continuing anddiscontinued operations.  Basic net lossper share is computed by dividing net loss for the year by the weighted averagenumber of common shares outstanding for the year.  Diluted net loss per share is computed by dividing the net lossfor the year by the weighted average number of common shares and common stockequivalents outstanding for the year. Our common stock equivalents are not included in the diluted loss pershare for the years ended December 31, 2003, 2002 and 2001, as they areanti-dilutive.  Such options areexcluded due to incurring a net loss per share during the applicable years.

 

***RevenueRecognition***

 

We generally recognize product revenue upon shipment of product. Weaccrue for estimated warranty costs, sales returns and other allowances at thetime of shipment based on our experience. Shipping and handling costs incurredare included in cost of sales. Revenue from maintenance contracts is deferredand recognized over the contractual period the services are performed. To date,warranty costs and sales returns have not been material. There is a risk thattechnical issues on new products could result in unexpected warranty costs andreturns.

 

We recognize software revenue from the licensing of our softwareproducts in accordance with Statement of Position (“SOP”) No. 97-2,“Software Revenue Recognition,” SOP 98-9, “Modification of 97-2, SoftwareRevenue Recognition, with respect to certain transactions” and Staff AccountingBulletin (“SAB”) 104 “Revenue Recognition” whereby revenue from the licensingof our products is not recognized until all four of the following have beenmet: (i) execution of a written purchase order, license agreement orcontract; (ii) shipment of the product has occurred; (iii) thelicense fee is fixed and determinable; and (iv) collectibility isprobable. We defer and recognize maintenance and support revenue over the termof the contract period, which is generally one year. Allocation of revenue inan arrangement including maintenance is based on the proportion of the fairvalue of the maintenance when sold separately to the fair value of other itemssold in the arrangement.

 

F-11

----

 

We have signed distribution agreements with distributors in the UnitedStates, Europe and Asia. In general, these relationships are non-exclusive.Distributors typically maintain an inventory of our products. Under theseagreements, we provide certain protection to the distributors for theirinventory of our products for price reductions as well as products that areslow moving or have been discontinued. Recognition of sales to distributors andrelated gross profits are deferred until the distributors resell themerchandise. However, since we have legally sold the inventory to thedistributor and we no longer have care, custody or control over the inventory,we recognize the trade accounts receivable and reduce inventory related to thesale at the time of shipment to the distributor. Revenue, offset by deferredcost of sales, is included in deferred revenue in the accompanying financialstatements. Inventory held by distributors at December 31, 2003 and 2002was approximately $0.1 million and $0.6 million, respectively.

 

***AdvertisingCosts***

 

Advertising expense is charged to operations in the period in whichsuch costs are incurred. Total advertising included in sales and marketingexpenses was $0.03 million, $0.02 million and $0.5 million forthe years ended December 31, 2003, 2002 and 2001, respectively.

 

***Researchand Development Costs***

 

We incur research and development costs that relate primarily to thedevelopment of new security software, appliances and integrated solutions, andmajor enhancements to existing services and products. Research developmentcosts are comprised primarily of salaries and related benefits expenses,contract labor and prototype and other related expenses.

 

Software development costs are included in research and development andare expensed as incurred. SFAS No. 86, “Accounting for the Costs ofComputer Software to Be Sold, Leased, or Otherwise Marketed,” requires thatsoftware development costs incurred subsequent to reaching technologicalfeasibility be capitalized, if material. If the process of developing a newproduct or major enhancement does not include a detailed program design,technological feasibility is determined only after completion of a workingmodel. To date, the period between achieving technological feasibility and thegeneral availability of such software has been short, and the softwaredevelopment costs qualifying for capitalization have been insignificant.

 

***SeveranceCharges***

 

In connection with our continued shift to our new intrusion detectionand security appliance product lines during 2001, 2002 and 2003, we streamlinedoperations and activities that are not aligned with these core markets andstrategies.  In 2001, this shift indemand resulted in a charge of $3.1 million to recognize impairment ofintangible assets (primarily developed technology) related to ourSecurityAnalyst and Secure Enterprise product lines.  We also recorded $1.3 million for severance charges and $0.2million for early termination of lease space in the year ended December 31,2001.  For the year ended December 31,2002, the severance charge recorded was $0.2 million.  In 2003, the continued shift in demand resulted in a charge of$0.5 million for severance as a result of reductions in force.  All severance obligations were paid prior toDecember 31, 2003, and we were not receiving further benefit from thesevered individuals after December 31, 2003.  In addition to the severance charges in 2003, contractualseverance payments were made in January 2004, resulting in additionalseverance of $0.1 million being incurred at that time.

 

***Useof Estimates***

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities at the date of the financial statements and the reported amounts ofrevenue and expenses during the reporting period. Estimates are used for, butnot limited to, the accounting for doubtful accounts, sales discounts, salesreturns, revenue recognition, warranty costs, inventory obsolescence,depreciation and taxes. Actual results could differ from these estimates.

 

***Reclassifications***

 

Certain 2002 amounts have been reclassified toconform to the 2003 presentation.

 

F-12

----

 

***IncomeTaxes***

 

We account forincome taxes pursuant to SFAS No. 109, “Accounting for Income Taxes,”which uses the liability method to calculate deferred income taxes. Deferredtax assets and liabilities are recognized for the expected tax consequences oftemporary differences between the tax basis of assets and liabilities and theirreported amounts. The realization of deferred tax assets is based on historicaltax positions and expectations about future taxable income. The liabilitymethod also requires the recognition of future tax benefits such as netoperating loss carryforwards, to the extent that realization of such benefitsis more likely than not.  Valuationallowances are established when necessary to reduce deferred tax assets to theamount expected to be realized.

 

**3. Business Combinations and Acquisition ofAssets**

 

OnSeptember 25, 1998, we completed an acquisition of certain assets fromScience Applications International Corporation (“SAIC”), a privately heldcompany in San Diego, California. We acquired certain assets of the ComputerMisuse and Detection System (“CMDS”) Division of SAIC and certain otherinformation security products under development. In exchange for the CMDSassets, the information security products under development and$1.5 million dollars in cash, we issued to SAIC 1.6 million shares ofthe Company’s common stock and warrants to purchase an additional1.5 million shares of its common stock. Two separate warrants each grant SAICthe right to purchase 750,000 shares of Intrusion Inc. common stock. Thefirst warrant had an exercise price of $8.00 per share and a term of18 months and was exercised on March 23, 2000. The second warrant hadan exercise price of $10.50 per share and a term of 24 months and wasexercised on September 22, 2000. Our acquisition has been accounted for asa purchase of software, in-process research and development and certain otherassets. The transaction value of approximately $6.9 million less the $1.5 millioncash received was allocated to the net assets acquired based on their estimatedfair market value. Assets acquired included approximately $1.1 million ofin-process research and development, $0.1 million of other intangibleassets and approximately $4.2 million of purchased software to beamortized over seven years on a straight-line basis. In June 2001, werecorded a restructuring charge of $2.6 million to recognize theimpairment of the remaining net book value of this intangible asset. See “Long-LivedAssets” in Note 2.

 

OnSeptember 30, 1999, we entered into a technology licensing agreement withRSA Security Inc. under which we are the exclusive licensee of RSA’s KaneSecurity Products in North America and Europe. The Kane Security Products includethe Kane SecurityAnalyst, a security assessment tool, and the Kane SecurityMonitor, a host-based intrusion detection tool. We are responsible formarketing, sales, support, maintenance and development for Kane Securitysoftware. In June 2001, we recorded a restructuring charge of$0.4 million to recognize the impairment of the remaining net book valueof this intangible asset. See “Goodwill and Other Intangible Assets” inNote 2.

 

OnJune 30, 2000, we acquired MimeStar, Inc., a Virginia corporation. MimeStardeveloped an advanced, network based intrusion detection system calledSecureNet ProTM. The acquisition, accounted for using the purchase method, wasaffected by the merger of a wholly owned subsidiary of the Company (“MergerSub”) with and into MimeStar, pursuant to an Agreement and Plan of Merger, byand among the Company, MimeStar, the Merger Sub and the sole stockholder ofMimeStar (the “Merger”). Pursuant to the Merger, the stockholder of MimeStarreceived $4 million in cash and 95,969 shares of the Company’s commonstock (which was valued at approximately $1 million on the date of theMerger). Transaction costs for this acquisition totaled approximately $100,000.The acquisition costs of $5.1 million were capitalized as approximately$3.6 million of purchased software, approximately $0.5 million ofgoodwill and approximately $1.0 million of other intangibles. InDecember 2002, we recorded impairment charges totaling $3.0 million underSFAS 142 and SFAS 144 to recognize the impairment of the remainingnet book values of these intangible assets. See “Goodwill and Other IntangibleAssets” and “Long-Lived Assets” in Note 2.

 

F-13

----

 

**4.Balance Sheet Detail (in thousands)**

 

**Inventories**

 
|                  |   | **December  31,** |   |
|-----------------------|--------|-------------------|--------|
|                  |   | **2003**          |   | **2002** |   |
|                  |   |              |   |   |   |
| Raw materials         |   | $                 | — |   | $ | 70 |   |
| Finished products     |   | 851               |   | 1,157 |   |
| Work in process       |   | 261               |   | — |   |
| Demonstration systems |   | 174               |   | 184 |   |
|                  |   | $                 | 1,286  |   | $ | 1,411 |   |

 

**Other Accrued Expenses**

 
|                      |   | **December  31,** |   |
|---------------------------|--------|-------------------|--------|
|                      |   | **2003**          |   | **2002** |   |
|                      |   |              |   |   |   |
| Accrued sales commissions |   | $                 | 99     |   | $ | 188 |   |
| Accrued travel expenses   |   | 48                |   | 220 |   |
| Accrued payroll           |   | 110               |   | 112 |   |
| Accrued property taxes    |   | 144               |   | 187 |   |
| Accrued taxes—other  |   | 60                |   | 300 |   |
| Other                     |   | 144               |   | 98 |   |
|                      |   | $                 | 605    |   | $ | 1,105 |   |

 

**5. Goodwill and Intangible Assets, Net**

 

Amortizationof intangibles for continuing operations is comprised of the following for theyears ended December 31, 2003, 2002 and 2001 (in thousands):

 
|                    |   | **2003** |   | **2002** |   | **2001** |   |
|-------------------------|--------|----------|--------|----------|--------|----------|--------|
|                    |   |     |   |     |   |     |   |
| Goodwill                |   | $        | — |     | $      | —   |   | $ | 64 |   |
| Purchased software      |   | —   |   | 527      |   | 811      |   |
| Other intangible assets |   | —   |   | 271      |   | 358      |   |
| Total amortization      |   | $        | — |     | $      | 798      |   | $ | 1,233 |   |

 

Prior to theadoption of SFAS 142, goodwill was amortized using the straight-linemethod over 7 years. Purchased software and other intangible assets wereamortized using the straight-line method over their useful lives of7 years.

 

As discussedin Note 2, all intangibles were deemed to be fully impaired atDecember 31, 2002. As such, included in accumulated amortization atDecember 31, 2002 for goodwill, purchased software and other intangiblesare impairment charges of $0.4 million, $2.3 million and$0.3 million, respectively.

 

F-14

----

 

**6. Commitments and Contingencies**

 

***Leases***

 

We leaseoffice space for our corporate headquarters in Richardson, Texas under anoperating lease, the base term of which expires in February 2005, with twoseven-year options to extend the term of the lease, subject to compliance withcertain conditions. We lease office space in San Diego, California for a portionof our security software research and development staff under an operatinglease that expires in August 2004. In addition, we lease office space forour U.S. and international sales and engineering offices. Total rental expenseof $1.1 million, $1.4 million and $1.9 million was charged tooperations during 2003, 2002, and 2001, respectively.

 

Subsequent toDecember 31, 2003, we successfully renegotiated our lease agreement for ourheadquarters in Richardson, Texas, which decreased the amount of square feet weleased and extended the lease term for an additional five years (See Note13).  According to the new leaseagreement, our Richardson, Texas headquarters will be located in the samebuilding.  However, our lease will nowexpire in February 2010.

 

The followingtable sets forth certain information concerning our contractual obligations atDecember 31, 2003 and outlines the expected future payments to be madeunder such obligations and commitments. The following table also shows the information concerning futurecontractual obligations based on the renegotiated lease agreement for ourheadquarters.

 

Future minimumlease payments consisted of the following on December 31, 2003 (in thousands):

 
|                |   | **Contractual  Obligations at  December 31, 2003** |   | **Renegotiated  Contractual  Obligations dated back to  December 31, 2003** |   |
|---------------------|--------|----------------------------------------------------|--------|-----------------------------------------------------------------------------|--------|
|                |   |                                               |   |                                                                        |   |
| 2004                |   | $                                                  | 944    |                                                                        | $      | 563 |   |
| 2005                |   | 197                                                |   | 428                                                                         |   |
| 2006                |   | —                                             |   | 376                                                                         |   |
| 2007                |   | —                                             |   | 378                                                                         |   |
| 2008                |   | —                                             |   | 393                                                                         |   |
| 2009 and thereafter |   | —                                             |   | 477                                                                         |   |
|                |   |                                               |   |                                                                        |   |
|                |   | $                                                  | 1,141  |                                                                        | $      | 2,615 |   |

 

***LegalProceedings***

 

We are subjectto legal proceedings and claims that arise in the ordinary course of business.We do not believe that the outcome of those matters will have a materialadverse affect on our consolidated financial position, operating results orcash flows. However, there can be no assurance such legal proceedings will nothave a material impact.

 

OnMarch 22, 2002, Morgan Newton Company, L.P. (“Morgan Newton”) filed suitagainst us in Dallas County District Court, Case No. DV02-02339-C, allegingclaims for breach of contract, promissory estoppel, and fraud.  The claims arose out of an alleged oralrepresentation to Morgan Newton concerning a request for quotation for thepurchase of a large amount of Morgan Newton’s products.  Morgan Newton did not specify the amount ofdamages it was seeking in the lawsuit. During the third quarter of 2003, thecase was settled out of court.  Inaccordance with the settlement, Intrusion paid Morgan Newton $450 thousandduring the fourth quarter of 2003.  Thesettlement amount of this claim is recorded as litigation settlement in thestatement of operations for 2003.  Thisclaim has been completely satisfied at December 31, 2003 and should have nofurther financial impact on our operating results.

 

We are notaware of any material claims outstanding or pending against Intrusion atDecember 31, 2003.

 

F-15

----

 

**7.Discontinued Operations**

 

In the secondquarter of 2000, we discontinued our networking operations and accordingly haveshown the networking operations as discontinued in the accompanying financialstatements.

 

During thefirst quarter of 2001, we closed the sale of our legacy local area networkingdivision generating a gain of $2.1 million, which was used to reduce theestimated net realizable value of the net assets of the remaining discontinuedoperations of our Essential communications division. During the second quarterof 2001, in response to unfavorable market conditions and efforts to sellEssential, we recorded additional charges to write down the net assets ofEssential to reflect an estimated net realizable value of $0.8 million.The $5.0 million second quarter charge included $0.8 million foroperating losses expected to be incurred between July and the end of the firstquarter of 2002, by which time we expected to have exited, disposed of orotherwise transitioned a majority of our ownership in Essential.

 

InMarch 2002 we sold Essential for $1.0 million, generating a gain onsale of $0.5 million. Terms of the sale included transferring$0.7 million in net property, plant and equipment, $0.1 million incurrent liabilities and product maintenance obligations for which$0.4 million was recorded in deferred revenue.

 

A condition ofthe sale was to give Essential personnel 60 days to exit Essential’sleased facility, the obligation for which we retained as part of the sale.Included in the gain on the sale of Essential was management’s estimate of$0.3 million to terminate this lease agreement, which was equivalent to2 years’ lease and maintenance of the facility. The contractual term ofthe lease ran through February 2009. Successful termination of the leaseduring the fourth quarter of 2002 for less than $0.3 million resulted inadditional gain on sale of $0.1 million.

 

The followingrepresents a summary of net income (loss) from discontinued operations for theyears ended December 31, 2003, 2002 and 2001 (in thousands):

 
|                                       |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                       |   |     |   |     |   |     |   |
| Net sales                                  |   | $        | — |     | $      | 727      |   | $ | 4,693 |   |
| Cost of sales                              |   | —   |   | 323      |   | 2,970    |   |
| Gross profit                               |   | —   |   | 404      |   | 1,723    |   |
| Operating expenses                         |   | —   |   | 503      |   | 4,774    |   |
| Operating loss                             |   | —   |   | (99      | )      | (3,051   | )      |
| Gain on sale                               |   | —   |   | 643      |   | —   |   |
| Net realizable value adjustment            |   | —   |   | —   |   | (3,025   | )      |
| Income (loss) before income taxes          |   | —   |   | 544      |   | (6,076   | )      |
| Income tax expense (benefit)               |   | —   |   | —   |   | 89       |   |
| Income (loss) from discontinued operations |   | $        | — |     | $      | 544      |   | $ | (6,165 | ) |

 

The netrealizable value adjustment was recorded in the second quarter of 2001 and wasin response to unfavorable market conditions and efforts to sell Essential. Theadjustment reduced the carrying value of Essential to $0.8 million.

 

F-16

----

 

**8.Employee Benefit Plans**

 

***EmployeeStock Purchase Plan***

 

OnApril 24, 1997, we adopted an Employee Stock Purchase Plan (the “PurchasePlan”) under which 0.5 million shares of common stock have been reservedfor issuance. Eligible employees may designate not more than 10% of theircompensation to be deducted each pay period for the purchase of common stockunder the Purchase Plan. The Purchase Plan was amended January 17, 2001 toincrease the maximum number of shares that can be purchased per participantfrom 500 shares to 1,000 shares per offering. Each participant maypurchase up to 2,000 shares in any one calendar year. On January 31and July 31 of each calendar year, shares of common stock are purchasedwith the employees’ payroll deductions over the immediately preceding sixmonths at a price per share of 85% of the lesser of the market price of thecommon stock on the purchase date or the market price on the first day of thesix-month period. The Purchase Plan will terminate no later than April 24,2007. A total of 180,374 shares have been issued under the Purchase Planas of December 31, 2003.

 

***Employee401(k) Plan***

 

We adopted aplan known as the Intrusion Inc. 401(k) Savings Plan (the “Plan”) toprovide retirement and incidental benefits for our employees.  The Plan covers substantially all employeeswho meet minimum age and service requirements. As allowed under Section 401(k) of the Internal Revenue Code, thePlan provides tax deferred salary deductions for eligible employees.

 

The Plan wasamended on January 10, 2002 to allow employees to contribute from 1% to25% of their annual compensation to the Plan, limited to a maximum amount asset by the Internal Revenue Service. This limit was increased from 19%. A feature was also added to the Plan to allow participants who are overthe age of 50 to contribute an additional amount of their salary per year, asdefined annually by the Internal Revenue Service.  We match employee contributions at the rate of $0.25 per each$1.00 of contribution on the first 4% of compensation.  Matching contributions to the Plan wereapproximately $17,000, $44,500, and $110,000 in 2003, 2002 and 2001, respectively.

 

**9. Income Taxes**

 

Deferredincome taxes reflect the net tax effects of temporary differences between thecarrying amounts of assets and liabilities for financial reporting purposes andthe amounts used for income tax purposes. There are no deferred tax liabilitiesas of December 31, 2003 and 2002. Significant components of our deferred tax assets as ofDecember 31, 2003 and 2002 are as follows (in thousands):

 

F-17

----

 
|                                                  |   | **December  31** |   |
|-------------------------------------------------------|--------|------------------|--------|
|                                                  |   | **2003**         |   | **2002** |   |
|                                                  |   |             |   |   |   |
| Foreign subsidiaries net operating loss  carryforward |   | $                | 374    |   | $ | 374 |   |
| Net operating loss carryforwards                      |   | 26,743           |   | 21,230 |   |
| Book over tax depreciation                            |   | 900              |   | 273 |   |
| Intangibles                                           |   | 1,478            |   | 1,602 |   |
| Equity Investments                                    |   | 458              |   | 458 |   |
| Vacation accrual                                      |   | 111              |   | 125 |   |
| Allowance for doubtful accounts and returns           |   | 164              |   | 342 |   |
| Warranty accrual                                      |   | 73               |   | 110 |   |
| Inventory allowance                                   |   | 469              |   | 2,505 |   |
| Other                                                 |   | 689              |   | 931 |   |
| Deferred tax assets                                   |   | 31,459           |   | 27,950 |   |
| Valuation allowance for deferred tax assets           |   | (31,459          | )      | (27,950 | ) |
| Deferred tax assets, net of allowance                 |   | $                | — |   | $ | — |   |

 

Deferred taxassets are required to be reduced by a valuation allowance if it is more likelythan not that some portion or all of the deferred tax assets will not berealized.  Realization of the futurebenefits related to the deferred tax assets is dependent on many factors,including the Company’s ability to generate taxable income within the near tomedium term.  Management has consideredthese factors in determining the valuation allowance for 2003 and 2002.

 

Significantcomponents of the benefit for income taxes for the years endedDecember 31, 2003, 2002 and 2001 are as follows (in thousands):

 
|                           |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                           |   |     |   |     |   |     |   |
| Income tax provision (benefit) |   |     |   |     |   |     |   |
| Federal:                       |   |     |   |     |   |     |   |
| Current                        |   | $        | — |     | $      | (608     | )      | $ | (4,050 | ) |
| Deferred                       |   | —   |   | —   |   | 3,063    |   |
| State:                         |   |     |   |     |   |     |   |
| Current                        |   | —   |   | —   |   | (136     | )      |
| Deferred                       |   | —   |   | —   |   | (1,140   | )      |
| Foreign:                       |   |     |   |     |   |     |   |
| Current                        |   | —   |   | —   |   | 475      |   |
|                           |   | $        | — |     | $      | (608     | )      | $ | (1,788 | ) |

 

Income taxbenefit is included in the consolidated financial statements for the yearsended December 31, 2003, 2002 and 2001 as follows (in thousands):

 
|                    |   | **2003** |   | **2002** |   | **2001** |   |
|-------------------------|--------|----------|--------|----------|--------|----------|--------|
|                    |   |     |   |     |   |     |   |
| Continuing Operations   |   | $        | — |     | $      | (608     | )      | $ | (1,877 | ) |
| Discontinued Operations |   | —   |   | —   |   | 89       |   |
|                    |   | $        | — |     | $      | (608     | )      | $ | (1,788 | ) |

 

F-18

----

 

Thedifferences between the provision for income taxes and income taxes computedusing the federal statutory rate for the years ended December 31, 2003,2002, and 2001 are as follows (in thousands):

 
|                                                     |   | **2003** |   | **2002** |   | **2001** |   |
|----------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                     |   |     |   |     |   |     |   |
| Reconciliation of income tax benefit to  statutory rate: |   |     |   |     |   |     |   |
| Income tax benefit at statutory rate                     |   | $        | (3,264 | )        | $      | (7,660   | )      | $ | (16,649 | ) |
| State income taxes, net of federal income  tax benefit   |   | (256     | )      | (38      | )      | (829     | )      |
| Change in valuation allowance                            |   | 3,509    |   | 7,448    |   | 18,570   |   |
| Goodwill amortization                                    |   | —   |   | —   |   | 578      |   |
| Tax credit carryforwards                                 |   | —   |   | —   |   | (607     | )      |
| Other                                                    |   | 11       |   | (358     | )      | (2,851   | )      |
|                                                     |   | $        | — |     | $      | (608     | )      | $ | (1,788 | ) |

 

AtDecember 31, 2003, we had federal net operating loss carryforwards of $86.4million for income tax purposes that begin to expire in 2008 and are subject tothe ownership change limitations under Internal Revenue Code Section 382.We also had $100.9 million of state net operating loss carryforwards. Netoperating loss carryforwards of the foreign subsidiaries of $0.7 million atDecember 31, 2003 are available indefinitely for offset only againsttaxable income generated by the foreign subsidiaries.

 

We made nofederal tax payments during 2003 and 2002, and received federal income taxrefunds of $3.2 million in 2002 (none in 2003) for income taxes paid inprevious years.

 

**10. Stock, Stock Options and Warrants**

 

AtDecember 31, 2003, we had four stock-based compensation plans, whichare described below. These plans were developed to retain and attract keyemployees and directors.

 

In 1987, anadditional Incentive Stock Option Plan was established, which provides for theissuance of options to our key employees of the Company to purchase our commonstock.  The 1987 Incentive Stock OptionPlan was terminated on January 26, 1997. The 1987 plan provided for the issuance of up to 1.2 million sharesof common stock upon exercise of options granted pursuant to the plan.  Options to purchase a total of30,700 shares of common stock are outstanding with no optionsremaining available for issuance for the 1987 plan.

 

In 1995, weadopted our 1995 Stock Option Plan (the “1995 Plan”), which provides for theissuance of up to 1.6 million shares of common stock upon exercise ofoptions granted pursuant to the 1995 Plan. On April 19, 2000, ourstockholders approved an 850,000-share increase, and on April 26, 2001,our stockholders approved an additional 850,000-share increase to the 1995Plan. Therefore, the overall number of shares available for issuance pursuantto the plan was increased to 3.3 million shares of common stock. The 1995Plan provides for the issuance of both non-qualified and incentive stockoptions to our employees, officers, and employee-directors. At December31, 2003, options to purchase a total of 1,278,945 shares of common stockare outstanding and options for 1,770,182 shares remain available forfuture grant.

 

F-19

----

 

In 1995, weadopted the 1995 Non-Employee Director Stock Option Plan (the “1995Non-Employee Director Plan”) which provided for the issuance of up to160,000 shares of common stock upon exercise of options granted pursuantto the 1995 Non-Employee Director Plan. On April 25, 2002, ourstockholders approved an amendment to the 1995 Non-Employee Director Plan. Thisamendment increased the number of shares available for option to260,000 shares, replaced the automatic grant feature prospectively from20,000 shares on the fifth anniversary to 10,000 shares annually andreduced the vesting schedule from five years to three years for options grantedprospectively. The 1995 Non-Employee Director Plan provides for the issuance ofnon-qualified stock options to non-employee directors. No shares have beenexercised under the 1995 Non-Employee Director Plan. Options to purchase atotal of 178,000 shares of common stock are outstanding and options for82,000 shares remain available for issuance. Since inception,220,000 shares have been granted to directors pursuant to the 1995 Non-EmployeeDirector Plan, of which, 42,000 have been cancelled.

 

Common sharesreserved for future issuance, including outstanding options, under all of thestock option plans and employee stock purchase plans total approximately3.7 million shares at December 31, 2003.

 
|                            |   | **Outstanding  Options** |   | **Available  for  Future Grant** |   |
|---------------------------------|--------|--------------------------|--------|----------------------------------|--------|
|                            |   |                     |   |                             |   |
|                            |   |                     |   |                             |   |
| 1987 Plan                       |   | 30,700                   |   | —                           |   |
| 1995 Plan                       |   | 1,278,945                |   | 1,770,182                        |   |
| 1995 Non-Employee Director Plan |   | 178,000                  |   | 82,000                           |   |
| Employee Stock Purchase Plan    |   | —                   |   | 319,626                          |   |
| Director Grants prior to Plan   |   | 8,000                    |   | —                           |   |
| Total                           |   | 1,495,645                |   | 2,171,808                        |   |

 

TheCompensation Committee of our Board of Directors determines the term of eachoption, option exercise price within limits set forth in the plans, number ofshares for which each option is granted and the rate at which each option isexercisable (generally ratably over three or five years from grant date).However, the exercise price of any incentive stock option may not be less thanthe fair market value of the shares on the date granted (or less than 110% ofthe fair market value in the case of optionees holding more than 10% of ourvoting stock of the Company), and the term cannot exceed ten years (five yearsfor incentive stock options granted to holders of more than 10% of our votingstock).

 

A summary ofour stock option activity and related information for the years endedDecember 31, 2003, 2002 and 2001, is as follows:

 
|                               |   | **2003**                               |   | **2002**                               |   | **2001**                               |   |
|------------------------------------|--------|----------------------------------------|--------|----------------------------------------|--------|----------------------------------------|--------|
|                               |   | **Number of  Options (in  thousands)** |   | **Weighted  Average  Exercise  Price** |   | **Number of  Options (in  thousands)** |   | **Weighted  Average  Exercise  Price** |   | **Number of  Options (in  thousands)** |   | **Weighted  Average  Exercise  Price** |   |
|                               |   |                                   |   |                                   |   |                                   |   |   |   |   |   |   |   |
| Outstanding at beginning of year   |   | 1,685                                  |   | $                                      | 4.89   |                                   | 1,989  |   | $ | 6.71 |   | 1,589 |   | $ | 10.03 |   |
| Granted                            |   | 650                                    |   | 0.51                                   |   | 930                                    |   | 1.31 |   | 1,578 |   | 4.05 |   |
| Exercised                          |   | —                                 |   | —                                 |   | —                                 |   | — |   | (55 | ) | 2.75 |   |
| Cancelled                          |   | (839                                   | )      | 3.48                                   |   | (1,234                                 | )      | 5.14 |   | (1,123 | ) | 7.85 |   |
| Outstanding at end of year         |   | 1,496                                  |   | 3.77                                   |   | 1,685                                  |   | 4.89 |   | 1,989 |   | 6.71 |   |
| Options exercisable at end of year |   | 803                                    |   | $                                      | 5.83   |                                   | 565    |   | $ | 8.46 |   | 622 |   | $ | 9.28 |   |

 

F-20

----

 

Informationrelated to stock options outstanding at December 31, 2003, is summarizedbelow:

 
|                         |   | **Options  Outstanding**                      |   | **Options  Exercisable**                            |   |
|------------------------------|--------|-----------------------------------------------|--------|-----------------------------------------------------|--------|
| **Range of Exercise Prices** |   | **Outstanding  at  12/31/03 (in  thousands)** |   | **Weighted  Average  Remaining   Contractual Life** |   | **Weighted  Average  Exercise  Price** |   | **Exercisable  at  12/31/03 (in  thousands)** |   | **Weighted  Average  Exercise  Price** |   |
|                         |   |                                          |   |                                                |   |   |   |   |   |   |   |
| $0.19-$1.01                  |   | 624                                           |   | 8.63 years                                          |   | $ | 0.51 |   | 103 |   | $ | 0.43 |   |
| 1.05-9.50                    |   | 673                                           |   | 7.16 years                                          |   | 3.17 |   | 517 |   | 3.29 |   |
| 11.44-23.25                  |   | 199                                           |   | 4.79 years                                          |   | 16.05 |   | 183 |   | 16.08 |   |
|                         |   | 1,496                                         |   | 7.46 years                                          |   | 3.77 |   | 803 |   | 5.83 |   |
|                              |        |                                               |        |                                                     |        |  |  |  |  |  |  |  |  |

 

Pro formainformation regarding net loss and net loss per share, as disclosed inNote 2, has been determined as if we had accounted for employee stock-basedcompensation plans and other stock options under the fair value method ofSFAS 123. The fair value for these options was estimated at the date ofgrant using a Black-Scholes option-pricing model with the followingweighted average assumptions used for grants under the option plans:

 
|                     |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------|--------|----------|--------|----------|--------|----------|--------|
|                     |   |     |   |     |   |     |   |
| Expected dividend yield  |   | 0.0      | %      | 0.0      | %      | 0.0      | %      |
| Risk-free interest rate  |   | 2.4      | %      | 3.1      | %      | 4.3      | %      |
| Expected volatility      |   | 147.0    | %      | 140.0    | %      | 130.0    | %      |
| Expected life (in years) |   | 3.3      |   | 3.4      |   | 3.0      |   |

 

The Black-Scholesoption valuation model was developed for use in estimating the fair value oftraded options that have no vesting restrictions and are fully transferable. Inaddition, option valuation models require the input of highly subjectiveassumptions including the expected stock price volatility. Because our employeestock options have characteristics significantly different from those of tradedoptions, and because changes in the subjective input assumptions can materiallyaffect the fair value estimate, in management’s opinion, the existing models donot necessarily provide a reliable single measure of the fair value of itsemployee stock options. In addition, because SFAS 123 is applicable onlyto options granted subsequent to December 31, 1994, the pro formainformation does not reflect the pro forma effect of all of our previous stockoption grants, and thus the pro forma information is not necessarily indicativeof future amounts until SFAS 123 is applied to all outstanding stockoptions.

 

Informationrelating to the fair value of option grants made during 2003, 2002 and 2001 isas follows:

 
|                                                                                         |   | **2003** |   | **2002** |   | **2001** |   |
|----------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                                                         |   |     |   |     |   |     |   |
| Options granted (with exercise price equal  to fair value of common stock):                  |   |     |   |     |   |     |   |
| Number of options (in thousands)                                                             |   | 600      |   | 898      |   | 1,578    |   |
| Weighted average exercise price per share                                                    |   | $        | 0.49   |     | $      | 1.34     |   | $ | 4.05 |   |
| Weighted average fair value of stock  options grants per Black-Sholes option valuation model |   | $        | 0.41   |     | $      | 1.08     |   | $ | 3.02 |   |
| Options granted (with exercise price  greater than fair value of common stock):              |   |     |   |     |   |     |   |
| Number of options (in thousands)                                                             |   | 50       |   | 32       |   | —   |   |
| Weighted average exercise price per share                                                    |   | $        | 0.69   |     | $      | 0.57     |   | — |   |
| Weighted average fair value of stock  options grants per Black-Sholes option valuation model |   | $        | 0.49   |     | $      | 0.41     |   | — |   |

 

F-21

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**11.Loss per Share**

 
|                                                                                        |   | **For the  Year Ended December 31,** |   |
|---------------------------------------------------------------------------------------------|--------|--------------------------------------|--------|
|                                                                                        |   | **2003**                             |   | **2002** |   | **2001** |   |
|                                                                                        |   |                                 |   |   |   |   |   |
| Numerator:                                                                                  |   |                                 |   |   |   |   |   |
| Net loss                                                                                    |   | $                                    | (9,600 | ) | $ | (21,277 | ) | $ | (45,780 | ) |
| Numerator for basic and diluted loss per  share                                             |   | $                                    | (9,600 | ) | $ | (21,277 | ) | $ | (45,780 | ) |
| Loss from continuing operations                                                             |   | $                                    | (9,600 | ) | $ | (21,821 | ) | $ | (39,615 | ) |
| Numerator for basic and diluted loss per  share, continuing operations                      |   | $                                    | (9,600 | ) | $ | (21,821 | ) | $ | (39,615 | ) |
| Denominator:                                                                                |   |                                 |   |   |   |   |   |
| Denominator for basic loss per  share-weighted average common shares outstanding            |   | 20,649                               |   | 20,640 |   | 20,565 |   |
| Effect of dilutive securities:                                                              |   |                                 |   |   |   |   |   |
| Stock options and warrants                                                                  |   | —                               |   | — |   | — |   |
| Denominator for diluted loss per share-adjusted  weighted average common shares outstanding |   | 20,649                               |   | 20,640 |   | 20,565 |   |
| Loss per share, continuing operations  (basic and diluted)                                  |   | $                                    | (0.46  | ) | $ | (1.06 | ) | $ | (1.93 | ) |
| Loss per share (basic and diluted)                                                          |   | $                                    | (0.46  | ) | $ | (1.03 | ) | $ | (2.23 | ) |

 

Total stockoptions and warrants outstanding in 2003, 2002 and 2001 that are not includedin the diluted earnings per share computation due to the antidilutive effectare 1.5 million, 1.7 million and 2.0 million, respectively. Suchoptions are excluded due to us incurring a net loss per share in those years.

 

**12. Major Customers and GeographicInformation**

 

The Company’scontinuing operations are concentrated in one segment—the design, development,marketing and support of data security via a suite of security software andappliances. There were no sales to customers in 2003, 2002 or 2001 thatexceeded 10% of total sales for that year.

 

Export sales,primarily to Europe, Asia, Latin America and Canada, were $2.0 million in2003, $2.6 million in 2002 and $6.1 million in 2001. No significantlong-lived assets were deployed outside of the United States.

 

**13. Subsequent Events**

 

Subsequent to December 31, 2003,we successfully renegotiated our lease agreement for our headquarters inRichardson, Texas, which decreased the amount of square feet we lease andextended the lease term for an additional five years.  In accordance with the new lease agreement, our Richardson, Texasheadquarters will be located in the same building. However, we will reduce theamount of space that we lease from approximately 95,000 square feet toapproximately 30,000 square feet of floor space and the term of our new leasewill expire in February 2010.

 

On March 25,2004, we completed a $5.0 million private placement of 5% Convertible PreferredStock and warrants.  In the privateplacement, the company sold 1,000,000 shares of preferred stock at a price of$5.00 per share, which convert into 6,361,323 shares of common stock at aninitial conversion price of $0.786 per share, and warrants to purchase2,226,459 shares of common stock at an exercise price of $0.786 per share.  In connection with the closing of thisprivate placement, we issued warrants to purchase 257,633 shares of our commonstock at an exercise price of $0.786 per share to our financial advisor for theprivate placement.

 

On March 18,2004, at a special meeting, our stockholders approved an amendment to ourcertificate of incorporation to effect a four-for-one (4:1) reverse stock splitof our common stock.  The reverse stocksplit will become effective on March 29, 2004. All outstanding share numbers and related common stock numbers, such asearnings per share and outstanding options, included in this report are setforth on a pre-split basis.

 

F-22

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Had the pershare amounts been adjusted to give retroactive effect for the reverse split,net loss per share, continuing operations (basic and diluted) for the yearsended December 31, 2003, 2002 and 2001 would have been $1.86, $4.23 and $7.71,respectively.  Net loss per share (basicand diluted) for the years ended December 31, 2003, 2002 and 2001 would havebeen $1.86, $4.12 and $8.90, respectively.

 

**Supplemental Financial Data**

 

**Summarized Quarterly Data (Unaudited)**

 
|                                      |   | **2003**                                      |       |
|-------------------------------------------|--------|-----------------------------------------------|------------|
|                                      |   | **Q1**                                        |       | **Q2** |   | **Q3** |   | **Q4** |   | **Total** |   |
|                                      |   | **(In  thousands, except per share amounts)** | ** ** |
|                                      |   |                                          |       |   |   |   |   |   |   |   |   |
| Revenue                                   |   | $                                             | 1,476      |   | $ | 1,483 |   | $ | 1,556 |   | $ | 1,963 |   | $ | 6,478 |   |
| Gross profit                              |   | 472                                           |       | 392 |   | 660 |   | 966 |   | 2,490 |   |
| Net loss                                  |   | (2,782                                        | )          | (2,934 | ) | (2,413 | ) | (1,471 | ) | (9,600 | ) |
| Net loss per share—Basic and diluted |   | (0.13                                         | )          | (0.14 | ) | (0.12 | ) | (0.07 | ) | (0.46 | ) |
|                                           |        |                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                                   |   | **2002**                                      |       |
|----------------------------------------|--------|-----------------------------------------------|------------|
|                                   |   | **Q1**                                        |       | **Q2** |   | **Q3** |   | **Q4(1)** |   | **Total** |   |
|                                   |   | **(In  thousands, except per share amounts)** | ** ** |
|                                   |   |                                          |       |   |   |   |   |   |   |   |   |
| Continuing Operations:                 |   |                                          |       |   |   |   |   |   |   |   |   |
| Revenue                                |   | $                                             | 2,514      |   | $ | 1,465 |   | $ | 2,394 |   | $ | 1,461 |   | $ | 7,834 |   |
| Gross profit                           |   | 805                                           |       | 323 |   | 1,072 |   | (513 | ) | 1,687 |   |
| Net loss                               |   | (5,394                                        | )          | (4,657 | ) | (3,649 | ) | (7,577 | ) | (21,277 | ) |
| Net loss per share-Basic and diluted   |   | (0.26                                         | )          | (0.23 | ) | (0.18 | ) | (0.37 | ) | (1.03 | ) |
| Discontinued Operations:               |   |                                          |       |   |   |   |   |   |   |   |   |
| Income, net of tax                     |   | 401                                           |       | — |   | — |   | 143 |   | 544 |   |
| Net income per share-Basic and diluted |   | 0.02                                          |       | 0.00 |   | 0.00 |   | 0.01 |   | 0.03 |   |
|                                        |        |                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)                                  Net loss from Continuing Operations includes a fourth quarter 2002 chargeof $3.0 million to recognize the impairment of the remainder of intangibleassets related to MimeStar along with a $1.0 million charge related toobsolete inventory. See Note 2.

 

F-23

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**Intrusion Inc.and Subsidiaries**

**Item15(a)(2)**

**ScheduleII****—Valuation andQualifying Accounts**

**(In thousands)**

 
|                                        |   | **Balance  at Beg.  of Period** |   | **Charged to  Costs and  Expense** |   | **Additions  (Deductions)** |   | **Balance  at End of  Period** |   |
|---------------------------------------------|--------|---------------------------------|--------|------------------------------------|--------|-----------------------------|--------|--------------------------------|--------|
|                                        |   |                            |   |                               |   |                        |   |                           |   |
| Year ended December 31, 2001                |   |                            |   |                               |   |                        |   |                           |   |
| Deducted from asset accounts:               |   |                            |   |                               |   |                        |   |                           |   |
| Allowance for doubtful accounts and returns |   | $                               | 919    |                               | $      | —                      |   | $                              | (122   | )(1) | $ | 797 |   |
| Year ended December 31, 2002                |   |                            |   |                               |   |                        |   |                           |   |
| Deducted from asset accounts:               |   |                            |   |                               |   |                        |   |                           |   |
| Allowance for doubtful accounts and returns |   | $                               | 797    |                               | $      | 137                         |   | $                              | — |   | $ | 934 |   |
| Year ended December 31, 2003 :              |   |                            |   |                               |   |                        |   |                           |   |
| Deducted from asset accounts                |   |                            |   |                               |   |                        |   |                           |   |
| Allowance for doubtful accounts and returns |   | $                               | 934    |                               | $      | 31                          |   | $                              | (391   | )(1) | $ | 574 |   |

 

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(1)  Net of uncollectibleaccounts written off.

 

S-1

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