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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549


FORM 10-Q

|           |  |                                                                                         
|---------- |  | ----------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                         
|[X]        |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
|           |  |                                                                                         
|           |  | For the quarterly period ended September 30, 2003                                       
|           |  |                                                                                         
|           |  | OR                                                                                      
|           |  |                                                                                         
|[  ]       |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|           |  |                                                                                         
|           |  | For the transition period from  to                                                      

Commission File Number 000-23655

INTERNET SECURITY SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

|                                                                  |  |                                                
|----------------------------------------------------------------- |  | -----------------------------------------------
|DELAWARE
(State or jurisdiction of
incorporation or organization) |  | 58-2362189
(I.R.S. Employer
Identification No.)

6303 BARFIELD ROAD, ATLANTA, GEORGIA 30328
(Address of principal executive offices)

Registrants telephone number, including area code (404) 236-2600

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X]   No [  ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X]   No [  ]

Indicate the number of shares outstanding of each of the registrants
classes of common stock, as of the latest practicable date.

|                                                                   |  |                                                               
|------------------------------------------------------------------ |  | --------------------------------------------------------------
|Title
of each class of common stock
Common stock, $0.001 par value |  | Number of Shares
Outstanding
as of October 31, 2003
49,787,000





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TABLE OF CONTENTS



|                                             |                                                                                               |                                            |  |  |  |  |  | 
|-------------------------------------------- | --------------------------------------------------------------------------------------------- | ------------------------------------------ |  |  |  |  |  | 
|PART I. FINANCIAL INFORMATION               
|                                             | Item 1. Consolidated Financial Statements                                                    
|                                             |                                                                                               | CONSOLIDATED BALANCE SHEETS               
|                                             |                                                                                               | CONSOLIDATED STATEMENTS OF OPERATIONS     
|                                             |                                                                                               | CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                                             |                                                                                               | NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|                                             | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                                             | Item 3. Quantitative and Qualitative Disclosures About Market Risk                           
|                                             | Item 4. Controls and Procedures                                                              
|PART II. OTHER INFORMATION                  
|                                             | Item 6. Exhibits and Reports on Form 8-K                                                     
|SIGNATURES                                  
|EX-10.1 FORM OF RETENTION AGREEMENT         
|EX-31.1 SECTION 302 CERTIFICATION OF THE PEO
|EX-31.2 SECTION 302 CERTIFICATION OF THE PFO
|EX-32.1 SECTION 906 CERTIFICATION OF THE PEO
|EX-32.2 SECTION 906 CERTIFICATION OF THE PFO



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|       |  |                                                                                                                            |  |       
|------ |  | -------------------------------------------------------------------------------------------------------------------------- |  | ------
|       |  |                                                                                                                            |  | PAGE  
|       |  |                                                                                                                            |  | NUMBER
|       |  |                                                                                                                            |  |       
|       |  | PART I  FINANCIAL INFORMATION                                                                                             |  |       
|Item 1 |  | Consolidated (Unaudited) Financial Statements:                                                                             |  | 3     
|       |  | Consolidated Balance Sheets at September 30, 2003 and
December 31, 2002                                                    |  | 3     
|       |  | Consolidated Statements of Operations for the three months
and nine months ended September 30, 2003 and September
30, 2002 |  | 4     
|       |  | Consolidated Statements of Cash Flows for the nine
months ended September 30, 2003 and September 30, 2002                  |  | 5     
|       |  | Notes to Consolidated Financial Statements                                                                                 |  | 6     
|Item 2 |  | Managements Discussion and Analysis of
Financial Condition and Results of Operations                                      |  | 12    
|Item 3 |  | Quantitative and Qualitative Disclosures about Market Risk                                                                 |  | 24    
|Item 4 |  | Controls and Procedures                                                                                                    |  | 24    
|       |  | PART II - OTHER INFORMATION                                                                                                |  |       
|Item 6 |  | Exhibits and Reports on Form 8-K                                                                                           |  | 24    

2



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##### Table of Contents






PART I. FINANCIAL INFORMATION




Item 1. Consolidated Financial Statements




INTERNET SECURITY SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(amounts in thousands, except share and per share amounts)

|                                                                                     |                                                                                                                              |                                            |                                      |         |         |               |         |              |         |  |  | 
|------------------------------------------------------------------------------------ | ---------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------------------------------------ | ------- | ------- | ------------- | ------- | ------------ | ------- |  |  | 
|                                                                                     |                                                                                                                              |                                            |                                      |         |         | September 30, |         | December 31,
|                                                                                     |                                                                                                                              |                                            |                                      |         |         | 2003          |         | 2002        
|                                                                                     |                                                                                                                              |                                            |                                      |         |         |               |         |             
|                                                                                     |                                                                                                                              |                                            |                                      |         |         | (unaudited)   |         |              |         | 
|                                                                                     |                                                                                                                              |                                            |                                      | ASSETS  |         |               |         |              |         |  |  | 
|Current assets:                                                                      |                                                                                                                              |                                            |                                      |         |         |               |         |             
|                                                                                     | Cash and cash equivalents                                                                                                    |                                            | $                                    | 170,997 |         |               | $       | 148,317      |        
|                                                                                     | Marketable securities                                                                                                        |                                            |                                      | 56,136  |         |               |         | 53,999       |        
|                                                                                     | Accounts receivable, less allowance for doubtful accounts
of $3,472 and $2,790, respectively                                 |                                            |                                      | 57,505  |         |               |         | 56,700       |        
|                                                                                     | Inventory                                                                                                                    |                                            |                                      | 528     |         |               |         | 1,055        |        
|                                                                                     | Prepaid expenses and other current assets                                                                                    |                                            |                                      | 9,010   |         |               |         | 7,000        |        
|                                                                                     |                                                                                                                              |                                            |                                      |         |         |               |         |             
|                                                                                     |                                                                                                                              | Total current assets                       |                                      |         | 294,176 |               |         |              | 267,071 | 
|Property and equipment:                                                              |                                                                                                                              |                                            |                                      |         |         |               |         |             
|                                                                                     | Computer equipment                                                                                                           |                                            |                                      | 44,364  |         |               |         | 38,403       |        
|                                                                                     | Office furniture and equipment                                                                                               |                                            |                                      | 21,218  |         |               |         | 21,446       |        
|                                                                                     | Leasehold improvements                                                                                                       |                                            |                                      | 22,103  |         |               |         | 21,183       |        
|                                                                                     |                                                                                                                              |                                            |                                      |         |         |               |         |             
|                                                                                     |                                                                                                                              |                                            | 87,685                               |         |         |               | 81,032  |             
|                                                                                     | Less accumulated depreciation                                                                                                |                                            |                                      | 50,055  |         |               |         | 39,313       |        
|                                                                                     |                                                                                                                              |                                            |                                      |         |         |               |         |             
|                                                                                     |                                                                                                                              |                                            | 37,630                               |         |         |               | 41,719  |             
|Restricted marketable securities                                                     |                                                                                                                              |                                            | 14,125                               |         |         |               | 14,690  |             
|Goodwill, net                                                                        |                                                                                                                              |                                            | 201,162                              |         |         |               | 200,464 |             
|Other intangibles, less accumulated amortization of
$12,959 and $9,223, respectively |                                                                                                                              |                                            | 11,648                               |         |         |               | 15,384  |             
|Other assets                                                                         |                                                                                                                              |                                            | 7,417                                |         |         |               | 7,240   |             
|                                                                                     |                                                                                                                              |                                            |                                      |         |         |               |         |             
|                                                                                     |                                                                                                                              | Total assets                               |                                      | $       | 566,158 |               |         | $            | 546,568 | 
|                                                                                     |                                                                                                                              |                                            |                                      |         |         |               |         |              |        
|                                                                                     |                                                                                                                              |                                            | LIABILITIES AND STOCKHOLDERS EQUITY |         |         |               |         |              |         |  | 
|Current liabilities:                                                                 |                                                                                                                              |                                            |                                      |         |         |               |         |             
|                                                                                     | Accounts payable                                                                                                             |                                            | $                                    | 3,458   |         |               | $       | 1,765        |        
|                                                                                     | Accrued expenses                                                                                                             |                                            |                                      | 20,869  |         |               |         | 22,332       |        
|                                                                                     | Deferred revenues                                                                                                            |                                            |                                      | 54,392  |         |               |         | 55,587       |        
|                                                                                     |                                                                                                                              |                                            |                                      |         |         |               |         |             
|                                                                                     |                                                                                                                              | Total current liabilities                  |                                      |         | 78,719  |               |         |              | 79,684  | 
|Non-current liabilities                                                              |                                                                                                                              |                                            | 2,567                                |         |         |               | 2,328   |             
|Commitments and contingencies                                                        |                                                                                                                              |                                            |                                      |         |         |               |         |             
|Stockholders equity:                                                                |                                                                                                                              |                                            |                                      |         |         |               |         |             
|                                                                                     | Preferred stock, $.001 par value, 20,000,000 shares authorized,
none issued or outstanding                                   |                                            |                                      |        |         |               |         |             |        
|                                                                                     | Common stock, $.001 par value, 120,000,000 shares authorized,
49,767,000 and 49,544,000 issued and outstanding, respectively |                                            |                                      | 50      |         |               |         | 50           |        
|                                                                                     | Additional paid-in capital                                                                                                   |                                            |                                      | 474,415 |         |               |         | 463,779      |        
|                                                                                     | Deferred compensation                                                                                                        |                                            |                                      | (208    | )       |               |         | (702         | )      
|                                                                                     | Accumulated other comprehensive income                                                                                       |                                            |                                      | 4,301   |         |               |         | 949          |        
|                                                                                     | Retained earnings                                                                                                            |                                            |                                      | 17,802  |         |               |         | 2,514        |        
|                                                                                     | Treasury stock, at cost (911,000 and 133,000 shares, respectively)                                                           |                                            |                                      | (11,488 | )       |               |         | (2,034       | )      
|                                                                                     |                                                                                                                              |                                            |                                      |         |         |               |         |             
|                                                                                     |                                                                                                                              | Total stockholders equity                 |                                      |         | 484,872 |               |         |              | 464,556 | 
|                                                                                     |                                                                                                                              |                                            |                                      |         |         |               |         |             
|                                                                                     |                                                                                                                              | Total liabilities and stockholders equity |                                      | $       | 566,158 |               |         | $            | 546,568 | 
|                                                                                     |                                                                                                                              |                                            |                                      |         |         |               |         |              |        

See accompanying notes

3



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INTERNET SECURITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(amounts in thousands, except per share amounts)
(unaudited)

|                                             |                                                                |                                         |        |                    |        |                   |        |        |        |      |         |        |        |   |         |        |        | 
|-------------------------------------------- | -------------------------------------------------------------- | --------------------------------------- | ------ | ------------------ | ------ | ----------------- | ------ | ------ | ------ | ---- | ------- | ------ | ------ | - | ------- | ------ | ------ | 
|                                             |                                                                |                                         |        | Three months ended |        | Nine months ended
|                                             |                                                                |                                         |        | September 30,      |        | September 30,    
|                                             |                                                                |                                         |        |                    |        |                  
|                                             |                                                                |                                         |        | 2003               |        | 2002              |        | 2003   |        | 2002
|                                             |                                                                |                                         |        |                    |        |                   |        |        |        |     
|Revenues:                                    |                                                                |                                         |        |                    |        |                   |        |        |        |      |         |        |        |   |         |       
|                                             | Product licenses and sales                                     |                                         | $      | 25,545             |        |                   | $      | 30,150 |        |      | $       | 76,158 |        |   | $       | 90,550 |       
|                                             | Subscriptions                                                  |                                         |        | 28,211             |        |                   |        | 24,153 |        |      |         | 83,035 |        |   |         | 67,263 |       
|                                             | Professional services                                          |                                         |        | 6,331              |        |                   |        | 7,465  |        |      |         | 19,472 |        |   |         | 22,363 |       
|                                             |                                                                |                                         |        |                    |        |                   |        |        |        |      |         |        |        |   |         |       
|                                             |                                                                |                                         | 60,087 |                    |        |                   | 61,768 |        |        |      | 178,665 |        |        |   | 180,176 |       
|Costs and expenses:                          |                                                                |                                         |        |                    |        |                   |        |        |        |      |         |        |        |   |         |       
|                                             | Cost of revenues:                                              |                                         |        |                    |        |                   |        |        |        |      |         |        |        |   |         |        |       
|                                             |                                                                | Product licenses and sales              |        |                    | 2,407  |                   |        |        | 1,928  |      |         |        | 5,652  |   |         |        | 5,599  | 
|                                             |                                                                | Subscriptions and professional services |        |                    | 11,784 |                   |        |        | 12,766 |      |         |        | 36,671 |   |         |        | 38,637 | 
|                                             |                                                                |                                         |        |                    |        |                   |        |        |        |      |         |        |        |   |         |       
|                                             | Total cost of revenues                                         |                                         |        | 14,191             |        |                   |        | 14,694 |        |      |         | 42,323 |        |   |         | 44,236 |       
|                                             | Research and development                                       |                                         |        | 10,496             |        |                   |        | 8,692  |        |      |         | 30,288 |        |   |         | 26,120 |       
|                                             | Sales and marketing                                            |                                         |        | 21,113             |        |                   |        | 23,780 |        |      |         | 63,284 |        |   |         | 70,369 |       
|                                             | General and administrative                                     |                                         |        | 5,428              |        |                   |        | 5,918  |        |      |         | 16,407 |        |   |         | 18,194 |       
|                                             | Amortization of other intangibles and stock-based
compensation |                                         |        | 1,317              |        |                   |        | 1,326  |        |      |         | 4,046  |        |   |         | 4,286  |       
|                                             |                                                                |                                         |        |                    |        |                   |        |        |        |      |         |        |        |   |         |       
|                                             |                                                                |                                         | 52,545 |                    |        |                   | 54,410 |        |        |      | 156,348 |        |        |   | 163,205 |       
|Operating income                             |                                                                |                                         | 7,542  |                    |        |                   | 7,358  |        |        |      | 22,317  |        |        |   | 16,971  |       
|Interest income                              |                                                                |                                         | 610    |                    |        |                   | 877    |        |        |      | 1,990   |        |        |   | 2,479   |       
|Minority interest                            |                                                                |                                         | (168   | )                  |        |                   | (66    | )      |        |      | (270    | )      |        |   | (273    | )     
|Other income                                 |                                                                |                                         | 68     |                    |        |                   | 2,068  |        |        |      | 101     |        |        |   | 3,904   |       
|Foreign currency exchange gain               |                                                                |                                         | 28     |                    |        |                   | 145    |        |        |      | 497     |        |        |   | 68      |       
|                                             |                                                                |                                         |        |                    |        |                   |        |        |        |      |         |        |        |   |         |       
|Income before income taxes                   |                                                                |                                         | 8,080  |                    |        |                   | 10,382 |        |        |      | 24,635  |        |        |   | 23,149  |       
|Provision for income taxes                   |                                                                |                                         | 3,045  |                    |        |                   | 4,041  |        |        |      | 9,347   |        |        |   | 9,314   |       
|                                             |                                                                |                                         |        |                    |        |                   |        |        |        |      |         |        |        |   |         |       
|Net income                                   |                                                                | $                                       | 5,035  |                    |        | $                 | 6,341  |        |        | $    | 15,288  |        |        | $ | 13,835  |       
|                                             |                                                                |                                         |        |                    |        |                   |        |        |        |      |         |        |        |   |         |        |       
|Basic net income per share of Common Stock   |                                                                | $                                       | 0.10   |                    |        | $                 | 0.13   |        |        | $    | 0.31    |        |        | $ | 0.29    |       
|                                             |                                                                |                                         |        |                    |        |                   |        |        |        |      |         |        |        |   |         |        |       
|Diluted net income per share of Common Stock |                                                                | $                                       | 0.10   |                    |        | $                 | 0.13   |        |        | $    | 0.31    |        |        | $ | 0.28    |       
|                                             |                                                                |                                         |        |                    |        |                   |        |        |        |      |         |        |        |   |         |        |       
|Weighted average shares:                     |                                                                |                                         |        |                    |        |                   |        |        |        |      |         |        |        |   |         |       
|                                             | Basic                                                          |                                         |        | 49,142             |        |                   |        | 48,393 |        |      |         | 49,123 |        |   |         | 48,080 |       
|                                             |                                                                |                                         |        |                    |        |                   |        |        |        |      |         |        |        |   |         |       
|                                             | Diluted                                                        |                                         |        | 49,884             |        |                   |        | 48,855 |        |      |         | 49,773 |        |   |         | 48,865 |       
|                                             |                                                                |                                         |        |                    |        |                   |        |        |        |      |         |        |        |   |         |       

See accompanying notes

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INTERNET SECURITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(amounts in thousands)
(unaudited)

|                                                                                  |                                    |                                                          |                                                        |   |                   |        |         |   |         |         |  
|--------------------------------------------------------------------------------- | ---------------------------------- | -------------------------------------------------------- | ------------------------------------------------------ | - | ----------------- | ------ | ------- | - | ------- | ------- | -
|                                                                                  |                                    |                                                          |                                                        |   | Nine months ended
|                                                                                  |                                    |                                                          |                                                        |   | September 30,    
|                                                                                  |                                    |                                                          |                                                        |   |                  
|                                                                                  |                                    |                                                          |                                                        |   | 2003              |        | 2002   
|                                                                                  |                                    |                                                          |                                                        |   |                   |        |        
|Operating activities                                                              |                                    |                                                          |                                                        |   |                   |        |         |  
|Net income                                                                        |                                    | $                                                        | 15,288                                                 |   |                   | $      | 13,835  |  
|Adjustments to reconcile net income to net cash provided by operating activities: |                                    |                                                          |                                                        |   |                   |        |         |  
|                                                                                  |                                    | Depreciation                                             |                                                        |   | 10,742            |        |         |   | 10,781  |        
|                                                                                  |                                    | Amortization of intangibles and stock-based compensation |                                                        |   | 4,046             |        |         |   | 4,286   |        
|                                                                                  |                                    | Accretion of discount on marketable securities           |                                                        |   | 172               |        |         |   | 230     |        
|                                                                                  |                                    | Minority interest                                        |                                                        |   | 270               |        |         |   | 273     |        
|                                                                                  |                                    | Income tax benefit from exercise of stock options        |                                                        |   | 8,146             |        |         |   | 6,952   |        
|                                                                                  |                                    | Gain on issuance of subsidiary stock                     |                                                        |   | (127              | )      |         |   | (2,560  | )      
|                                                                                  | Changes in assets and liabilities: |                                                          |                                                        |   |                   |        |         |   |        
|                                                                                  |                                    | Accounts receivable                                      |                                                        |   | (805              | )      |         |   | (11,566 | )      
|                                                                                  |                                    | Inventory                                                |                                                        |   | 527               |        |         |   | (505    | )      
|                                                                                  |                                    | Prepaid expenses and other assets                        |                                                        |   | (1,996            | )      |         |   | (3,377  | )      
|                                                                                  |                                    | Accounts payable and accrued expenses                    |                                                        |   | 136               |        |         |   | (2,215  | )      
|                                                                                  |                                    | Deferred revenues                                        |                                                        |   | (1,195            | )      |         |   | 5,480   |        
|                                                                                  |                                    |                                                          |                                                        |   |                   |        |         |  
|                                                                                  |                                    |                                                          | Net cash provided by operating activities              |   |                   | 35,204 |         |   |         | 21,614  |  
|Investing activities                                                              |                                    |                                                          |                                                        |   |                   |        |         |  
|Acquisitions, net of cash received                                                |                                    |                                                          |                                                       |   |                   |        | (1,348  | )
|Net proceeds from maturity of marketable securities                               |                                    |                                                          | 49,977                                                 |   |                   |        | 63,315  |  
|Purchases of marketable securities                                                |                                    |                                                          | (52,284                                                | ) |                   |        | (63,208 | )
|Proceeds from restricted marketable securities                                    |                                    |                                                          | 565                                                    |   |                   |        |        |  
|Purchases of property and equipment                                               |                                    |                                                          | (6,653                                                 | ) |                   |        | (9,207  | )
|Issuance of subsidiary stock                                                      |                                    |                                                          | 189                                                    |   |                   |        |        |  
|                                                                                  |                                    |                                                          |                                                        |   |                   |        |         |  
|                                                                                  |                                    |                                                          | Net cash used in investing activities                  |   |                   | (8,206 | )       |   |         | (10,448 | )
|Financing activities                                                              |                                    |                                                          |                                                        |   |                   |        |         |  
|Proceeds from exercise of stock options                                           |                                    |                                                          | 439                                                    |   |                   |        | 2,892   |  
|Proceeds from employee stock purchase plan                                        |                                    |                                                          | 1,609                                                  |   |                   |        | 2,086   |  
|Purchases of treasury stock                                                       |                                    |                                                          | (9,454                                                 | ) |                   |        | (1,989  | )
|                                                                                  |                                    |                                                          |                                                        |   |                   |        |         |  
|                                                                                  |                                    |                                                          | Net cash provided by (used in) in financing activities |   |                   | (7,406 | )       |   |         | 2,989   |  
|Foreign currency impact on cash                                                   |                                    |                                                          | 3,088                                                  |   |                   |        | 1,506   |  
|                                                                                  |                                    |                                                          |                                                        |   |                   |        |         |  
|Net increase in cash and cash equivalents                                         |                                    |                                                          | 22,680                                                 |   |                   |        | 15,661  |  
|Cash and cash equivalents at beginning of period                                  |                                    |                                                          | 148,317                                                |   |                   |        | 108,038 |  
|                                                                                  |                                    |                                                          |                                                        |   |                   |        |         |  
|Cash and cash equivalents at end of period                                        |                                    | $                                                        | 170,997                                                |   |                   | $      | 123,699 |  
|                                                                                  |                                    |                                                          |                                                        |   |                   |        |         |  
|Supplemental cash flow disclosure                                                 |                                    |                                                          |                                                        |   |                   |        |         |  
|Income taxes paid                                                                 |                                    | $                                                        | 1,302                                                  |   |                   | $      | 2,770   |  
|                                                                                  |                                    |                                                          |                                                        |   |                   |        |         |  

See accompanying notes

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INTERNET SECURITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Significant Accounting Policies

Basis of Presentation

The consolidated financial statements of Internet Security Systems, Inc.
(ISS or the Company) as of September 30, 2003 and for the three months and
nine months ended September 30, 2003 and 2002 are unaudited and, in the opinion
of management, contain all adjustments, consisting of normal recurring items,
necessary for the fair presentation of the financial position and results of
operations for the interim periods. The consolidated financial statements
include the accounts of Internet Security Systems, Inc. and its majority-owned
subsidiaries. The consolidated balance sheet at December 31, 2002 has been
derived from the audited financial statements at that date but does not include
all of the footnotes required by accounting principles generally accepted in
the United States for complete financial statements.

These consolidated financial statements should be read in conjunction with
the Consolidated Financial Statements and Notes thereto included in our Annual
Report on Form 10-K for the year ended December 31, 2002. The results of
operations for the three months and nine months ended September 30, 2003 are
not necessarily indicative of the results to be expected for the entire year.
All significant intercompany accounts and transactions have been eliminated.

Certain prior year amounts have been reclassified to conform to current
year presentation.

The preparation of financial statements and related disclosures in
conformity with accounting principles generally accepted in the United States
requires management to make estimates and assumptions that affect the amounts
reported in the financial statements and accompanying notes. Actual results may
differ from those estimates, and such differences may be material to the
consolidated financial statements.

Goodwill and Intangibles

Goodwill and intangible assets are comprised of the following, as of the
dates indicated (in thousands):

|                               |                        |       |   |                    |        |                   |   |                |         |              |   |         |        |  |   |         |        |  
|------------------------------ | ---------------------- | ----- | - | ------------------ | ------ | ----------------- | - | -------------- | ------- | ------------ | - | ------- | ------ |  | - | ------- | ------ | -
|                               |                        |       |   | September 30, 2003 |        | December 31, 2002
|                               |                        |       |   |                    |        |                  
|                               |                        |       |   | Gross Carrying     |        | Accumulated       |   | Gross Carrying |         | Accumulated 
|                               |                        |       |   | Amount             |        | Amortization      |   | Amount         |         | Amortization
|                               |                        |       |   |                    |        |                   |   |                |         |             
|Unamortized intangible assets: |                        |       |   |                    |        |                   |   |                |         |              |   |         |        |  |   |        
|                               | Goodwill               |       | $ | 228,543            |        |                   | $ | (27,381        | )       |              | $ | 227,845 |        |  | $ | (27,381 | )     
|                               |                        |       |   |                    |        |                   |   |                |         |              |   |         |        |  |   |        
|Amortized intangible assets:   |                        |       |   |                    |        |                   |   |                |         |              |   |         |        |  |   |        
|                               | Core technology        |       |   | 3,853              |        |                   |   | (2,400         | )       |              |   | 3,853   |        |  |   | (2,039  | )     
|                               | Developed technology   |       |   | 17,808             |        |                   |   | (8,319         | )       |              |   | 17,808  |        |  |   | (5,654  | )     
|                               | Work force             |       |   | 1,407              |        |                   |   | (542           | )       |              |   | 1,407   |        |  |   | (216    | )     
|                               | Customer relationships |       |   | 1,539              |        |                   |   | (1,698         | )       |              |   | 1,539   |        |  |   | (1,314  | )     
|                               |                        |       |   |                    |        |                   |   |                |         |              |   |         |        |  |   |        
|                               |                        | Total |   | $                  | 24,607 |                   |   | $              | (12,959 | )            |   | $       | 24,607 |  |   | $       | (9,223 | )
|                               |                        |       |   |                    |        |                   |   |                |         |              |   |         |        |  |   |         |       

The Company amortizes intangible assets over their estimated useful lives of
eight years for core technology, five years for developed technology, three to
six years for work force and three years for customer relationships.
Amortization expense of intangible assets is as follows (in thousands):

|                       |       |   |                    |       |                   |   |      |       |      |   |       |       |  |   |       |       | 
|---------------------- | ----- | - | ------------------ | ----- | ----------------- | - | ---- | ----- | ---- | - | ----- | ----- |  | - | ----- | ----- | 
|                       |       |   | Three months ended |       | Nine months ended
|                       |       |   | September 30,      |       | September 30,    
|                       |       |   |                    |       |                  
|                       |       |   | 2003               |       | 2002              |   | 2003 |       | 2002
|                       |       |   |                    |       |                   |   |      |       |     
|Core technology        |       | $ | 122                |       |                   | $ | 120  |       |      | $ | 361   |       |  | $ | 361   |      
|Developed technology   |       |   | 902                |       |                   |   | 890  |       |      |   | 2,722 |       |  |   | 2,671 |      
|Work force             |       |   | 108                |       |                   |   | 9    |       |      |   | 326   |       |  |   | 27    |      
|Customer relationships |       |   | 109                |       |                   |   | 109  |       |      |   | 327   |       |  |   | 327   |      
|                       |       |   |                    |       |                   |   |      |       |      |   |       |       |  |   |       |      
|                       | Total |   | $                  | 1,241 |                   |   | $    | 1,128 |      |   | $     | 3,736 |  |   | $     | 3,386 | 
|                       |       |   |                    |       |                   |   |      |       |      |   |       |       |  |   |       |      

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INTERNET SECURITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The estimated future amortization expense of intangible assets as of
September 30, 2003 is as follows (in thousands):

|             |                               |  |        |        | 
|------------ | ----------------------------- |  | ------ | ------ | 
|             |                               |  | Amount
|             |                               |  |       
|Fiscal Year: |                               |  |        |       
|             | 2003 (remaining three months) |  | $      | 1,181  | 
|             | 2004                          |  |        | 4,458  | 
|             | 2005                          |  |        | 4,220  | 
|             | 2006                          |  |        | 1,789  | 
|             |                               |  |        |       
|             | Total                         |  | $      | 11,648 | 
|             |                               |  |        |       

Stock-Based Compensation

Statement of Financial Accounting Standard 123, Accounting for Stock-Based
Compensation (SFAS 123), as amended by SFAS 148, Accounting for Stock-Based
Compensation - Transition and Disclosure, establishes accounting and reporting
standards for stock-based employee compensation plans. As permitted by SFAS
123, ISS continues to account for stock-based compensation in accordance with
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees (APB 25), and has elected the pro forma disclosure alternative of
SFAS 123.

Although SFAS 123 allows the Company to continue to follow APB 25
guidelines, the following is pro forma net loss and pro forma net loss per
share for the periods indicated as if the Company had adopted SFAS 123. The
following table illustrates the effect on net income per share if the
provisions of SFAS 123 had been applied. The pro forma impact of applying SFAS
123 as illustrated below will not necessarily be representative of the pro
forma impact in future years. Pro forma information is as follows (amounts in
thousands, except per share amounts):

|                                                                                               |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  
|---------------------------------------------------------------------------------------------- |  | ------------------ | ------ | ----------------- |  | ---- | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                               |  | Three months ended |        | Nine months ended
|                                                                                               |  | September 30,      |        | September 30,    
|                                                                                               |  |                    |        |                  
|                                                                                               |  | 2003               |        | 2002              |  | 2003 |        | 2002
|                                                                                               |  |                    |        |                   |  |      |        |     
|Net income, as reported                                                                        |  | $                  | 5,035  |                   |  | $    | 6,341  |      |  | $ | 15,288  |   |  | $ | 13,835  |  
|Pro forma stock compensation expense
computed under the fair value method, net
of income taxes |  |                    | (7,424 | )                 |  |      | (7,062 | )    |  |   | (21,626 | ) |  |   | (21,616 | )
|                                                                                               |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  
|Pro forma net loss                                                                             |  |                    | (2,389 | )                 |  |      | (721   | )    |  |   | (6,338  | ) |  |   | (7,781  | )
|                                                                                               |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  
|Basic net income per share of Common
Stock, as reported                                        |  | $                  | 0.10   |                   |  | $    | 0.13   |      |  | $ | 0.31    |   |  | $ | 0.29    |  
|                                                                                               |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  
|Diluted net income per share of
Common Stock, as reported                                      |  | $                  | 0.10   |                   |  | $    | 0.13   |      |  | $ | 0.31    |   |  | $ | 0.28    |  
|                                                                                               |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  
|Pro forma basic and diluted net loss per
share of Common Stock                                 |  | $                  | (0.05  | )                 |  | $    | (0.01  | )    |  | $ | (0.13   | ) |  | $ | (0.16   | )
|                                                                                               |  |                    |        |                   |  |      |        |      |  |   |         |   |  |   |         |  

Recently Issued Accounting Standards

In November 2002, the Emerging Issues Task Force (EITF) of the Financial
Accounting Standards Board (FASB) issued EITF 00-21, Revenue Arrangements
with Multiple Deliverables, which addresses certain aspects of the accounting
for arrangements that involve the delivery or performance of multiple products,
services and/or rights to use assets. Under EITF 00-21, revenue arrangements
with multiple deliverables should be divided into separate units of accounting
if the deliverables meet certain criteria, including whether the fair value of
the delivered items can be determined and whether there is evidence of fair
value of the undelivered items. In addition, the consideration should be
allocated among the separate units of accounting based on their fair values,
and the applicable revenue recognition criteria should be considered separately
for each of the separate units of accounting. The Company adopted the
provisions of EITF 00-21 for all revenue arrangements entered into after June
30, 2003. The adoption of EITF No. 00-21 did not have an impact on the
Companys financial position, results of operations or liquidity.

In November 2002, the FASB issued Financial Interpretation No. 45,
Guarantors Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others (FIN 45), which is an
interpretation of SFAS Nos. 5, 57, and 107 and rescission of FASB
Interpretation No. 34. The Interpretation requires that a guarantor recognize,
at the inception of a guarantee, a liability for the fair value of the
obligation undertaken by issuing the guarantee. The Interpretation also
requires additional

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disclosures to be made by a guarantor in its interim and annual financial
statements about its obligations under certain guarantees it has issued. The
accounting requirements for the initial recognition of guarantees are
applicable on a prospective basis for guarantees issued or modified after
December 31, 2002. The disclosure requirements were effective during the first
quarter of 2003 for all guarantees outstanding, regardless of when they were
issued or modified. The adoption of FIN 45 did not have a material effect on
our condensed consolidated financial statements for the first nine months of
2003. The following is a summary of our agreements that we have determined are
within the scope of FIN 45.

Our sales agreements with customers generally contain infringement
indemnity provisions. Under these agreements, we agree to indemnify, defend and
hold harmless the customer in connection with patent, copyright or trade secret
infringement claims made by third parties with respect to the customers
authorized use of our products and services. The indemnity provisions generally
provide for our control of defense and settlement and cover costs and damages
finally awarded against the customer, as well as our modification of the
product so it is no longer infringing or, if it cannot be corrected, return of
the product for a partial refund that reflects the reasonable value of prior
use. Our sales agreements with customers sometimes also contain indemnity
provisions for death, personal injury or property damage caused by our
personnel or contractors in the course of performing services to customers.
Under these agreements, we agree to indemnify, defend and hold harmless the
customer in connection with death, personal injury and property damage claims
made by third parties with respect to actions of our personnel or contractors.
The indemnity provisions generally provide for our control of defense and
settlement and cover costs and damages finally awarded against the customer.
The indemnity obligations contained in sales agreements generally have no
specified expiration date and no specified monetary limitation on the amount of
award covered. We have not previously incurred costs to settle claims or pay
awards under these indemnification obligations. As a result, we believe the
estimated fair value of these obligations is nominal. Accordingly, we have no
liabilities recorded for these agreements as of September 30, 2003.

We warrant that our software products will perform in all material
respects in accordance with our standard published specifications in effect at
the time of delivery of the licensed products to the customer for ninety days.
We also warrant that for one year after shipment, all hardware will be free
from defects in materials and workmanship under normal authorized use,
consistent with the instructions contained in the product documentation.
Additionally, we warrant that our services will be performed consistent with
generally accepted industry standards or specific service levels through
completion of the agreed upon services. If necessary, we would provide for the
estimated cost of product and service warranties based on specific warranty
claims and claim history, however, we have not incurred significant recurring
expense under our product or service warranties and hardware warranties are
covered by the manufacturer warranties. As a result, we believe the estimated
fair value of these agreements is nominal. Accordingly, we have no liabilities
recorded for these agreements as of September 30, 2003.

Payments for certain operating leases for our office space are secured by
collateralized standby letters of credit totaling $11.3 million at September
30, 2003. These standby letters of credit guarantee payments on certain lease
obligations and are renewed annually unless cancelled by either party. The
lease obligations have terms that expire at various dates through 2013. The
beneficiary of the standby letters of credit can draw on the letters of credit
if we default on the related lease obligation. Each standby letter of credit is
collateralized by securities. At September 30, 2003, $14.1 million of
commercial paper investments are pledged as collateral and are shown on the
balance sheet as restricted cash.

In January 2003, the FASB issued Financial Interpretation No. 46,
Consolidation of Variable Interest Entities (FIN 46), which addresses
consolidation by business enterprises of variable interest entities that
either: (1) do not have sufficient equity investment at risk to permit the
entity to finance its activities without additional subordinated financial
support, or (2) the equity investors lack an essential characteristic of a
controlling financial interest. On October 8, 2003, the FASB agreed to defer
the effective date of FIN 46 to December 31, 2003. The previous rule required
adoption as of July 1, 2003. The adoption of the new accounting standard is not
expected to have a material impact on our financial position, results of
operations or liquidity.

Note 2. Income Taxes

The Company recorded tax provisions of $3.0 million and $4.0 million for
the three-month periods ended September 30, 2003 and 2002, respectively and tax
provisions of $9.3 million for both the nine months ended September 30, 2003
and 2002. While income tax expense was recorded on domestic income, the amount
of domestic taxes payable was reduced by deductions related to the employee
exercise of stock options in current and prior periods. The tax benefit of
these deductions was recorded as additional paid-in-capital. Taxes paid
generally relate to foreign operations and certain state taxes for which net
operating loss deductions have been suspended.

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The effective tax rate was approximately 38% and 39% for the quarters
ended September 30, 2003 and 2002, respectively and 38% and 40% for the
nine-month periods ended September 30, 2003 and 2002, respectively. The
effective rates differ from the statutory rates due primarily to the impact of
acquisition related intangibles that are not deductible for income tax
purposes.

As of September 30, 2003, ISS had a net operating loss carryforward of
approximately $32.0 million. The tax benefit of this carryforward will be
recorded as additional paid-in-capital as realized. There are also
approximately $6.9 million of research and development tax credit carryforwards
that expire between 2011 and 2022 and foreign tax credit carryforwards of $2.5
million that expire in 2006 and 2007.

Note 3. Business Acquisition

In August 2002, Internet Security Systems KK (ISS KK), the Companys
Asia/Pacific subsidiary, acquired a primary ISS KK distributor in Singapore,
TriSecurity Holdings Pte Ltd. During the first quarter of 2003, ISS KK amended
its agreement with TriSecurity Holdings Pte Ltd. and agreed to make payment of
245 shares of ISS KK stock in each of the first quarters of 2004 and 2005,
relating to the annual contingent consideration payments defined in the 2002
purchase agreement. The additional consideration of $626,000, based on current
fair market value of the shares, was recorded as additional goodwill and
additional paid-in-capital during the first quarter of 2003. When such shares
are actually issued, a gain or loss will be recognized to the extent of any
difference between the $626,000 fair value of the shares to be issued and the
book value of those shares, in accordance with Staff Accounting Bulletin No.
51, Accounting for Sales of Stock by a Subsidiary.

Note 4. Comprehensive Income

The components of comprehensive income are as follows (in thousands):

|                                            |  |                    |       |                   |  |      |       |      |  |   |        |  |  |   |        | 
|------------------------------------------- |  | ------------------ | ----- | ----------------- |  | ---- | ----- | ---- |  | - | ------ |  |  | - | ------ | 
|                                            |  | Three months ended |       | Nine months ended
|                                            |  | September 30,      |       | September 30,    
|                                            |  |                    |       |                  
|                                            |  | 2003               |       | 2002              |  | 2003 |       | 2002
|                                            |  |                    |       |                   |  |      |       |     
|Net income, as reported                     |  | $                  | 5,035 |                   |  | $    | 6,341 |      |  | $ | 15,288 |  |  | $ | 13,835 | 
|Change in cumulative translation adjustment |  |                    | 2,635 |                   |  |      | (903  | )    |  |   | 3,352  |  |  |   | 1,506  | 
|                                            |  |                    |       |                   |  |      |       |      |  |   |        |  |  |   |        | 
|Comprehensive income                        |  | $                  | 7,670 |                   |  | $    | 5,438 |      |  | $ | 18,640 |  |  | $ | 15,341 | 
|                                            |  |                    |       |                   |  |      |       |      |  |   |        |  |  |   |        | 

Note 5. Income per Share

The computation of net income per share is as follows (amounts in
thousands, except per share amounts):

|                              |                                                                        |   |                    |        |                   |   |      |        |      |   |      |        |  |   |      |        | 
|----------------------------- | ---------------------------------------------------------------------- | - | ------------------ | ------ | ----------------- | - | ---- | ------ | ---- | - | ---- | ------ |  | - | ---- | ------ | 
|                              |                                                                        |   | Three months ended |        | Nine months ended
|                              |                                                                        |   | September 30,      |        | September 30,    
|                              |                                                                        |   |                    |        |                  
|                              |                                                                        |   | 2003               |        | 2002              |   | 2003 |        | 2002
|                              |                                                                        |   |                    |        |                   |   |      |        |     
|Basic net income per share:   |                                                                        |   |                    |        |                   |   |      |        |      |   |      |        |  |   |      |       
|                              | Net income                                                             |   | $                  | 5,035  |                   |   | $    | 6,341  |      |   | $    | 15,288 |  |   | $    | 13,835 | 
|                              | Weighted average number of common shares
outstanding during the period |   |                    | 49,142 |                   |   |      | 48,393 |      |   |      | 49,123 |  |   |      | 48,080 | 
|                              |                                                                        |   |                    |        |                   |   |      |        |      |   |      |        |  |   |      |       
|Basic net income per share    |                                                                        | $ | 0.10               |        |                   | $ | 0.13 |        |      | $ | 0.31 |        |  | $ | 0.29 |       
|                              |                                                                        |   |                    |        |                   |   |      |        |      |   |      |        |  |   |      |       
|Diluted net income per share: |                                                                        |   |                    |        |                   |   |      |        |      |   |      |        |  |   |      |       
|                              | Net income                                                             |   | $                  | 5,035  |                   |   | $    | 6,341  |      |   | $    | 15,288 |  |   | $    | 13,835 | 
|                              | Weighted average number of common shares
outstanding during the period |   |                    | 49,142 |                   |   |      | 48,393 |      |   |      | 49,123 |  |   |      | 48,080 | 
|                              | Dilutive stock options                                                 |   |                    | 742    |                   |   |      | 462    |      |   |      | 650    |  |   |      | 785    | 
|                              |                                                                        |   |                    |        |                   |   |      |        |      |   |      |        |  |   |      |       
|                              | Total shares for purpose of calculating
diluted net income per share   |   |                    | 49,884 |                   |   |      | 48,855 |      |   |      | 49,773 |  |   |      | 48,865 | 
|                              |                                                                        |   |                    |        |                   |   |      |        |      |   |      |        |  |   |      |       
|Diluted net income per share  |                                                                        | $ | 0.10               |        |                   | $ | 0.13 |        |      | $ | 0.31 |        |  | $ | 0.28 |       
|                              |                                                                        |   |                    |        |                   |   |      |        |      |   |      |        |  |   |      |       

Note 6. Segment and Geographic Information

ISS conducts business in one operating segment, providing information
security management solutions. The Company does, however, prepare information
for internal use on a geographic basis. This information consists of the
operating results of each geographic segment. The segment operating costs
reported internally generally consist of direct sales expenses, expenses
related to an executive team and related infrastructure, billing systems and
financial systems. Unallocated corporate expenses include research and

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development, general and administrative costs that support the global
organization and amortization of intangibles and stock-based compensation.

The accounting policies of the segments are the same as those described in
the summary of significant accounting policies. There are no intersegment
sales. The chief executive officer and chief financial officer of ISS evaluate
performance based on operating profit or loss from operations and trade
accounts receivable for each segment. Other than trade accounts receivable,
assets and liabilities are not discretely allocated or reviewed by segment.

The following table presents ISSs revenues, operating expenses and
operating income (loss) by reportable operating segment (in thousands):

|                                  |                                         |   |                    |        |      |   |                                      |       |             |   |        |       |  |   |         |   |  |   |        |        | 
|--------------------------------- | --------------------------------------- | - | ------------------ | ------ | ---- | - | ------------------------------------ | ----- | ----------- | - | ------ | ----- |  | - | ------- | - |  | - | ------ | ------ | 
|                                  |                                         |   |                    |        |      |   | As of and for the three months ended |       |             |   |       
|                                  |                                         |   | September 30, 2003
|                                  |                                         |   |                   
|                                  |                                         |   | Americas           |        | EMEA |   | Asia/Pac                             |       | Unallocated |   | Total 
|                                  |                                         |   |                    |        |      |   |                                      |       |             |   |       
|Revenues from external customers: |                                         |   |                    |        |      |   |                                      |       |             |   |        |       |  |   |         |   |  |   |        |       
|                                  | Product licenses
and sales              |   | $                  | 16,853 |      |   | $                                    | 4,584 |             |   | $      | 4,108 |  |   | $       |  |  |   | $      | 25,545 | 
|                                  | Subscriptions                           |   |                    | 20,600 |      |   |                                      | 5,044 |             |   |        | 2,567 |  |   |         |  |  |   |        | 28,211 | 
|                                  | Professional services                   |   |                    | 3,621  |      |   |                                      | 1,277 |             |   |        | 1,433 |  |   |         |  |  |   |        | 6,331  | 
|                                  |                                         |   |                    |        |      |   |                                      |       |             |   |        |       |  |   |         |   |  |   |        |       
|Total revenue                     |                                         |   | 41,074             |        |      |   | 10,905                               |       |             |   | 8,108  |       |  |   |        |   |  |   | 60,087 |       
|Cost of revenues:                 |                                         |   |                    |        |      |   |                                      |       |             |   |        |       |  |   |         |   |  |   |        |       
|                                  | Product licenses and sales              |   |                    | 1,779  |      |   |                                      | 276   |             |   |        | 352   |  |   |         |  |  |   |        | 2,407  | 
|                                  | Subscriptions and professional
services |   |                    | 8,070  |      |   |                                      | 1,634 |             |   |        | 2,080 |  |   |         |  |  |   |        | 11,784 | 
|                                  |                                         |   |                    |        |      |   |                                      |       |             |   |        |       |  |   |         |   |  |   |        |       
|Total cost of revenues            |                                         |   | 9,849              |        |      |   | 1,910                                |       |             |   | 2,432  |       |  |   |        |   |  |   | 14,191 |       
|Operating expenses                |                                         |   | 14,419             |        |      |   | 4,885                                |       |             |   | 1,809  |       |  |   | 17,241  |   |  |   | 38,354 |       
|                                  |                                         |   |                    |        |      |   |                                      |       |             |   |        |       |  |   |         |   |  |   |        |       
|Total expenses                    |                                         |   | 24,268             |        |      |   | 6,795                                |       |             |   | 4,241  |       |  |   | 17,241  |   |  |   | 52,545 |       
|Segment operating income (loss)   |                                         | $ | 16,806             |        |      | $ | 4,110                                |       |             | $ | 3,867  |       |  | $ | (17,241 | ) |  | $ | 7,542  |       
|                                  |                                         |   |                    |        |      |   |                                      |       |             |   |        |       |  |   |         |   |  |   |        |       
|Accounts receivable, net          |                                         | $ | 36,499             |        |      | $ | 10,455                               |       |             | $ | 10,551 |       |  | $ |        |   |  | $ | 57,505 |       
|                                  |                                         |   |                    |        |      |   |                                      |       |             |   |        |       |  |   |         |   |  |   |        |       

|                                  |                                         |   |                    |        |      |   |                                      |       |             |   |        |       |  |   |         |   |  |   |        |        | 
|--------------------------------- | --------------------------------------- | - | ------------------ | ------ | ---- | - | ------------------------------------ | ----- | ----------- | - | ------ | ----- |  | - | ------- | - |  | - | ------ | ------ | 
|                                  |                                         |   |                    |        |      |   | As of and for the three months ended |       |             |   |       
|                                  |                                         |   | September 30, 2002
|                                  |                                         |   |                   
|                                  |                                         |   | Americas           |        | EMEA |   | Asia/Pac                             |       | Unallocated |   | Total 
|                                  |                                         |   |                    |        |      |   |                                      |       |             |   |       
|Revenues from external customers: |                                         |   |                    |        |      |   |                                      |       |             |   |        |       |  |   |         |   |  |   |        |       
|                                  | Product licenses
and sales              |   | $                  | 20,513 |      |   | $                                    | 4,174 |             |   | $      | 5,463 |  |   | $       |  |  |   | $      | 30,150 | 
|                                  | Subscriptions                           |   |                    | 18,494 |      |   |                                      | 3,325 |             |   |        | 2,334 |  |   |         |  |  |   |        | 24,153 | 
|                                  | Professional services                   |   |                    | 5,203  |      |   |                                      | 1,158 |             |   |        | 1,104 |  |   |         |  |  |   |        | 7,465  | 
|                                  |                                         |   |                    |        |      |   |                                      |       |             |   |        |       |  |   |         |   |  |   |        |       
|Total revenue                     |                                         |   | 44,210             |        |      |   | 8,657                                |       |             |   | 8,901  |       |  |   |        |   |  |   | 61,768 |       
|Cost of revenues:                 |                                         |   |                    |        |      |   |                                      |       |             |   |        |       |  |   |         |   |  |   |        |       
|                                  | Product licenses and sales              |   |                    | 1,915  |      |   |                                      |      |             |   |        | 13    |  |   |         |  |  |   |        | 1,928  | 
|                                  | Subscriptions and professional
services |   |                    | 8,571  |      |   |                                      | 2,046 |             |   |        | 2,149 |  |   |         |  |  |   |        | 12,766 | 
|                                  |                                         |   |                    |        |      |   |                                      |       |             |   |        |       |  |   |         |   |  |   |        |       
|Total cost of revenues            |                                         |   | 10,486             |        |      |   | 2,046                                |       |             |   | 2,162  |       |  |   |        |   |  |   | 14,694 |       
|Operating expenses                |                                         |   | 15,847             |        |      |   | 5,502                                |       |             |   | 2,431  |       |  |   | 15,936  |   |  |   | 39,716 |       
|                                  |                                         |   |                    |        |      |   |                                      |       |             |   |        |       |  |   |         |   |  |   |        |       
|Total expenses                    |                                         |   | 26,333             |        |      |   | 7,548                                |       |             |   | 4,593  |       |  |   | 15,936  |   |  |   | 54,410 |       
|Segment operating income (loss)   |                                         | $ | 17,877             |        |      | $ | 1,109                                |       |             | $ | 4,308  |       |  | $ | (15,936 | ) |  | $ | 7,358  |       
|                                  |                                         |   |                    |        |      |   |                                      |       |             |   |        |       |  |   |         |   |  |   |        |       
|Accounts receivable, net          |                                         | $ | 42,561             |        |      | $ | 9,897                                |       |             | $ | 10,644 |       |  | $ |        |   |  | $ | 63,102 |       
|                                  |                                         |   |                    |        |      |   |                                      |       |             |   |        |       |  |   |         |   |  |   |        |       

|                                  |                                         |   |                    |        |      |   |                                     |        |             |   |        |        |  |   |         |   |  |   |         |        | 
|--------------------------------- | --------------------------------------- | - | ------------------ | ------ | ---- | - | ----------------------------------- | ------ | ----------- | - | ------ | ------ |  | - | ------- | - |  | - | ------- | ------ | 
|                                  |                                         |   |                    |        |      |   | As of and for the nine months ended |        |             |   |       
|                                  |                                         |   | September 30, 2003
|                                  |                                         |   |                   
|                                  |                                         |   | Americas           |        | EMEA |   | Asia/Pac                            |        | Unallocated |   | Total 
|                                  |                                         |   |                    |        |      |   |                                     |        |             |   |       
|Revenues from external customers: |                                         |   |                    |        |      |   |                                     |        |             |   |        |        |  |   |         |   |  |   |         |       
|                                  | Product licenses
and sales              |   | $                  | 51,908 |      |   | $                                   | 13,796 |             |   | $      | 10,454 |  |   | $       |  |  |   | $       | 76,158 | 
|                                  | Subscriptions                           |   |                    | 61,168 |      |   |                                     | 14,112 |             |   |        | 7,755  |  |   |         |  |  |   |         | 83,035 | 
|                                  | Professional services                   |   |                    | 12,139 |      |   |                                     | 3,335  |             |   |        | 3,998  |  |   |         |  |  |   |         | 19,472 | 
|                                  |                                         |   |                    |        |      |   |                                     |        |             |   |        |        |  |   |         |   |  |   |         |       
|Total revenue                     |                                         |   | 125,215            |        |      |   | 31,243                              |        |             |   | 22,207 |        |  |   |        |   |  |   | 178,665 |       
|Cost of revenues:                 |                                         |   |                    |        |      |   |                                     |        |             |   |        |        |  |   |         |   |  |   |         |       
|                                  | Product licenses and sales              |   |                    | 4,782  |      |   |                                     | 353    |             |   |        | 517    |  |   |         |  |  |   |         | 5,652  | 
|                                  | Subscriptions and professional
services |   |                    | 24,606 |      |   |                                     | 5,428  |             |   |        | 6,637  |  |   |         |  |  |   |         | 36,671 | 
|                                  |                                         |   |                    |        |      |   |                                     |        |             |   |        |        |  |   |         |   |  |   |         |       
|Total cost of revenues            |                                         |   | 29,388             |        |      |   | 5,781                               |        |             |   | 7,154  |        |  |   |        |   |  |   | 42,323  |       
|Operating expenses                |                                         |   | 43,194             |        |      |   | 15,029                              |        |             |   | 5,061  |        |  |   | 50,741  |   |  |   | 114,025 |       
|                                  |                                         |   |                    |        |      |   |                                     |        |             |   |        |        |  |   |         |   |  |   |         |       
|Total expenses                    |                                         |   | 72,582             |        |      |   | 20,810                              |        |             |   | 12,215 |        |  |   | 50,741  |   |  |   | 156,348 |       
|Segment operating income (loss)   |                                         | $ | 52,633             |        |      | $ | 10,433                              |        |             | $ | 9,992  |        |  | $ | (50,741 | ) |  | $ | 22,317  |       
|                                  |                                         |   |                    |        |      |   |                                     |        |             |   |        |        |  |   |         |   |  |   |         |       
|Accounts receivable, net          |                                         | $ | 36,499             |        |      | $ | 10,455                              |        |             | $ | 10,551 |        |  | $ |        |   |  | $ | 57,505  |       
|                                  |                                         |   |                    |        |      |   |                                     |        |             |   |        |        |  |   |         |   |  |   |         |       

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|                                  |                                         |   |                    |        |      |   |                                     |        |             |   |        |        |  |   |         |   |  |   |         |        | 
|--------------------------------- | --------------------------------------- | - | ------------------ | ------ | ---- | - | ----------------------------------- | ------ | ----------- | - | ------ | ------ |  | - | ------- | - |  | - | ------- | ------ | 
|                                  |                                         |   |                    |        |      |   | As of and for the nine months ended |        |             |   |       
|                                  |                                         |   | September 30, 2002
|                                  |                                         |   |                   
|                                  |                                         |   | Americas           |        | EMEA |   | Asia/Pac                            |        | Unallocated |   | Total 
|                                  |                                         |   |                    |        |      |   |                                     |        |             |   |       
|Revenues from external customers: |                                         |   |                    |        |      |   |                                     |        |             |   |        |        |  |   |         |   |  |   |         |       
|                                  | Product licenses
and sales              |   | $                  | 61,635 |      |   | $                                   | 13,038 |             |   | $      | 15,877 |  |   | $       |  |  |   | $       | 90,550 | 
|                                  | Subscriptions                           |   |                    | 51,918 |      |   |                                     | 9,007  |             |   |        | 6,338  |  |   |         |  |  |   |         | 67,263 | 
|                                  | Professional services                   |   |                    | 15,063 |      |   |                                     | 3,959  |             |   |        | 3,341  |  |   |         |  |  |   |         | 22,363 | 
|                                  |                                         |   |                    |        |      |   |                                     |        |             |   |        |        |  |   |         |   |  |   |         |       
|Total revenue                     |                                         |   | 128,616            |        |      |   | 26,004                              |        |             |   | 25,556 |        |  |   |        |   |  |   | 180,176 |       
|Cost of revenues:                 |                                         |   |                    |        |      |   |                                     |        |             |   |        |        |  |   |         |   |  |   |         |       
|                                  | Product licenses and sales              |   |                    | 5,544  |      |   |                                     |       |             |   |        | 55     |  |   |         |  |  |   |         | 5,599  | 
|                                  | Subscriptions and professional
services |   |                    | 26,200 |      |   |                                     | 6,407  |             |   |        | 6,030  |  |   |         |  |  |   |         | 38,637 | 
|                                  |                                         |   |                    |        |      |   |                                     |        |             |   |        |        |  |   |         |   |  |   |         |       
|Total cost of revenues            |                                         |   | 31,744             |        |      |   | 6,407                               |        |             |   | 6,085  |        |  |   |        |   |  |   | 44,236  |       
|Operating expenses                |                                         |   | 49,053             |        |      |   | 14,664                              |        |             |   | 6,652  |        |  |   | 48,600  |   |  |   | 118,969 |       
|                                  |                                         |   |                    |        |      |   |                                     |        |             |   |        |        |  |   |         |   |  |   |         |       
|Total expenses                    |                                         |   | 80,797             |        |      |   | 21,071                              |        |             |   | 12,737 |        |  |   | 48,600  |   |  |   | 163,205 |       
|Segment operating income (loss)   |                                         | $ | 47,819             |        |      | $ | 4,933                               |        |             | $ | 12,819 |        |  | $ | (48,600 | ) |  | $ | 16,971  |       
|                                  |                                         |   |                    |        |      |   |                                     |        |             |   |        |        |  |   |         |   |  |   |         |       
|Accounts receivable, net          |                                         | $ | 42,561             |        |      | $ | 9,897                               |        |             | $ | 10,644 |        |  | $ |        |   |  | $ | 63,102  |       
|                                  |                                         |   |                    |        |      |   |                                     |        |             |   |        |        |  |   |         |   |  |   |         |       

Note 7. Commitments and Contingencies

The Company and certain of its officers and directors were named as
defendants in a consolidated amended complaint that was filed in the United
States District Court for the Northern District of Georgia on October 9, 2002.
The lawsuit purports to be brought on behalf of a class of investors who
purchased the Companys stock during the period from April 5, 2001 through
August 14, 2001 (the Class Period). The lawsuit alleges violations of the
federal securities laws, including Sections 10(b) and 20(a) of the Securities
Exchange Act of 1934, as amended, and Rule 10b-5 thereunder. The complaint
generally alleges that the Company and the individual defendants violated the
anti-fraud provisions of the federal securities laws and caused the Companys
stock to trade at artificially high prices by making misrepresentations
relating to the Companys financial condition and prospects during the Class
Period. The complaint seeks damages in an unspecified amount. On September 3,
2003, the court dismissed the consolidated amended complaint. The plaintiffs
have moved the court to reconsider its dismissal order and to grant them leave
to amend their complaint. The Company and the individual defendants have
opposed those motions. The court has not yet ruled. The Company believes that
the courts order dismissing the action was appropriate and further that the
Company has meritorious defenses and intends to continue defending the action
vigorously.

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INTERNET SECURITY SYSTEMS, INC.
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the
Consolidated Financial Statements and related Notes thereto included elsewhere
in this Quarterly Report on Form 10-Q. Except for the historical financial
information, the matters discussed in this Quarterly Report on Form 10-Q may be
considered forward-looking statements. Such statements include declarations
regarding our current intent, belief or expectations. Such forward-looking
statements are not guarantees of future performance and involve a number of
risks and uncertainties. Actual results may differ materially from those
indicated by such forward-looking statements. Among the important factors that
could cause actual results to differ materially from those indicated by such
forward-looking statements are the risk factors in this Quarterly Report on
Form 10-Q, as filed with the Securities and Exchange Commission and available
at the SECs Website at www.sec.gov.

Overview

We are a global leader in information security solutions that protect
online business operations from attack and misuse. Our proactive solutions
secure networks, servers, desktops and applications against an ever-changing
spectrum of threats. We offer a comprehensive line of software and appliance
products, a centralized management environment and a full suite of online
security services designed specifically for the enterprise, service provider
and risk management markets. Our protection solutions are based on a unified
engine that identifies and blocks a full spectrum of threats in a single packet
examination, eliminating the redundancy of multiple stand-alone security
products and delivering maximum value for our customers.

Our wide range of proactive protection solutions spans networks, servers,
desktops and applications, and center around the need for comprehensive,
rapidly deployable and cost-effective detection, prevention and response
against Internet attacks and misuse or internal security policy violations.
When properly used, these products and services promote the confidentiality,
privacy, integrity and availability of proprietary business information.

Our family of products is a critical element of an active Internet and
networking security program within todays world of global connectivity,
enabling organizations to proactively monitor, detect and respond to risks to
enterprise information. Our line of products is designed specifically for the
particular needs of enterprise, service provider, risk management, small
business and consumer markets.

Our managed protection services offerings provide remote management of our
best-of-breed security technology, focusing on security assessment and
intrusion detection systems, and also includes firewalls, VPNs, anti-virus and
URL filtering software. We focus on serving as the trusted security provider to
our customers by maintaining within our existing products the latest
counter-measures to security risks, creating new innovative products based on
our customers needs and providing professional and managed services.

Many factors affect financial performance, and past performance is no
assurance of similar future performance. We expect, in the long-term, to
continue to expand our domestic and international sales and marketing
operations; increase our investment in product development including our
proprietary threat and vulnerability database and managed services
capabilities; seek acquisition candidates and alliances with partners whose
products, technologies or services capabilities are complementary to our
solutions; and improve our internal operating and financial infrastructure in
support of our strategic goals and objectives. At the same time, we expect to
adjust our organization size in light of changing economic conditions and
maintain emphasis on controlling discretionary spending and capital
expenditures. While we believe in the long-term success of our business
solutions, our prospects must be considered in light of the experience, risks
and difficulties that are frequently encountered by companies in new and
rapidly evolving markets. See Risk Factors.

Critical Accounting Policies

The consolidated financial statements were prepared in conformity with
accounting principles generally accepted in the United States. As such,
management is required to make certain estimates, judgments and assumptions it
believes are reasonable based upon the information available. These estimates
and assumptions affect the reported amounts of assets and liabilities at the
dates of the financial statements and the reported amounts of revenues and
expenses during the periods presented. The significant accounting policies
which management believes are the most critical to aid in fully understanding
and evaluating our reported financial results include the following:

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Revenue recognition

We
recognize software licence revenue under Statement of Position
(SOP) 97-2, Software Revenue Recognition, as amended,
by SOP 98-9, Software Revenue Recognition, with Respect to Certain
Transactions, when the following criteria have been met:



| |  |  | persuasive evidence of an arrangement exists;        
| | - |  | -----------------------------------------------------
|
| |  |  | delivery has occurred or services have been rendered;
|
| |  |  | price is fixed or determinable; and                  
|
| |  |  | collection is probable.                              

We recognize perpetual license revenues upon (1) delivery of software or,
if the customer has evaluation software, delivery of the software key and (2)
issuance of the related license, assuming that no significant vendor
obligations or customer acceptance rights exist. Where payment terms are
extended over periods greater than 12 months, revenue is recognized as such
amounts become due and payable. Product sales consist of (1) appliances sold in
conjunction with ISS licensed software and (2) software developed by
third-party partners, combined in some instances with associated hardware
appliances and partner product support services. These sales are recognized
upon shipment to the customer provided all other revenue recognition criteria
are met.

License sales of enterprise products are generated both through direct
sales to end-users as well as through various partners, including system
integrators, value-added resellers and distributors. License revenue is
recognized when the sale has occurred for an identified end user, provided all
other revenue recognition criteria are met, with the sale identified through
electronic delivery of a software key that is necessary to operate the product.
At the point of key delivery, the end-user has no right of return.

Subscription revenues include product support, term licenses, and managed
service arrangements. Annual renewable product support is a separate component
of each perpetual license agreement and appliance sold in conjunction with ISS
products with revenue recognized ratably over the product support term. Term
licenses allow customers to use our products and receive product support
coverage for a specified period, generally 12 months. We recognize revenues
from these term agreements ratably over the subscription term. Security
monitoring services of information assets and systems are part of managed
services and revenues are recognized as such services are provided.

Professional services revenues include fee-based service engagements and
training. Service engagements, typically billed on a time-and-materials basis,
primarily focus on security assessments of customer networks and the
development of customers security policies. We recognize such professional
services revenues as the related services are rendered.

Multiple element arrangements can include any combination of hardware,
software or services. When some elements are delivered prior to others in an
arrangement, revenue is deferred until the delivery of the last element unless
there is all of the following:



| |  |  | vendor specific objective evidence (VSOE) of fair value of the undelivered elements;         
| | - |  | ---------------------------------------------------------------------------------------------
|
| |  |  | the functionality of the delivered elements is not dependent on the undelivered elements; and
|
| |  |  | delivery of the delivered elements represents the culmination of the earnings process.       

Our historical rate of return for our software products is negligible. We
offer demonstration software available via download from our website that
allows potential customers to see the functionality of the products on their
own networks. We did not have any transactions in the first nine months of
either 2003 or 2002 involving reciprocal arrangements where goods or services
were purchased from an organization at the same time that we licensed software
or provided services to that organization.

Allowance for doubtful accounts

Our sales are global, with customers located in the United States, Europe,
Latin America and the Asia/Pacific regions. We perform periodic credit
evaluations of our customers financial condition and do not require
collateral. We provide for estimated credit losses as such losses become
probable. We evaluate specific accounts when we become aware of a situation
where a customer may not be able to meet its financial obligations due to
deterioration of its liquidity or financial viability, credit ratings or
bankruptcy. The

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allowance for doubtful accounts is established based on the
best facts available to us and is reevaluated and adjusted as additional
information is received. At September 30, 2003, the allowance for doubtful
accounts totaled $3.5 million, or 5.7%, of the $61.0 million of total trade
receivables.

While actual credit losses have historically been within the provisions
established based on managements expectations, we cannot guarantee that we
will continue to experience the same credit loss rates we have in the past. If
the financial condition of our customers were to deteriorate, resulting in an
impairment of their ability to make payments, additional allowances may be
required.

Impairment of goodwill

We review goodwill for impairment on an annual basis or on an interim
basis whenever events or changes in circumstances indicate that the carrying
amount of an asset may not be recoverable. All other long-lived and intangible
assets are reviewed for impairment whenever events or circumstances indicate
that the carrying amount of an asset may not be recoverable. Such impairment
loss would be measured as the difference between the carrying amount of the
asset and its fair value based on the present value of estimated future cash
flows. Significant judgment is required in the forecasting of future operating
results, which are used in the preparation of projected cash flows. Due to
uncertain market conditions and potential changes in our strategy and products,
it is possible that forecasts used to support our intangible assets may change
in the future which could result in significant non-cash charges that would
adversely affect our results of operations and financial condition.

We currently have intangible assets related to goodwill of approximately
$201 million, with $195 million related to our June 2001 acquisition of Network
ICE. The determination of whether or not this asset is impaired involves
significant judgments based upon short and long-term projections of future
performance. We have concluded that this amount is realizable based on
forecasted discounted cash flows through 2006 and on our stock market
valuation. Neither method indicated that our goodwill had been impaired and as
a result, we did not record any impairment losses related to goodwill during
the quarters or nine-month periods ended September 30, 2003 and 2002.

Results of Operations

The following table sets forth our consolidated historical operating
information, as a percentage of total revenues, for the periods indicated:

|                                                         |                                         |  |                    |     |                   |  |      |     |      |  |    |     |   |  |    |     |  
|-------------------------------------------------------- | --------------------------------------- |  | ------------------ | --- | ----------------- |  | ---- | --- | ---- |  | -- | --- | - |  | -- | --- | -
|                                                         |                                         |  | Three months ended |     | Nine months ended
|                                                         |                                         |  | September 30,      |     | September 30,    
|                                                         |                                         |  |                    |     |                  
|                                                         |                                         |  | 2003               |     | 2002              |  | 2003 |     | 2002
|                                                         |                                         |  |                    |     |                   |  |      |     |     
|Consolidated Statements of Operations Data:              |                                         |  |                    |     |                   |  |      |     |      |  |    |     |   |  |    |    
|Product licenses and sales                               |                                         |  | 43                 | %   |                   |  | 49   | %   |      |  | 43 | %   |   |  | 50 | %  
|Subscriptions                                            |                                         |  | 47                 | %   |                   |  | 39   | %   |      |  | 46 | %   |   |  | 37 | %  
|Professional services                                    |                                         |  | 10                 | %   |                   |  | 12   | %   |      |  | 11 | %   |   |  | 13 | %  
|                                                         |                                         |  |                    |     |                   |  |      |     |      |  |    |     |   |  |    |    
|                                                         | Total revenues                          |  |                    | 100 | %                 |  |      | 100 | %    |  |    | 100 | % |  |    | 100 | %
|                                                         |                                         |  |                    |     |                   |  |      |     |      |  |    |     |   |  |    |    
|Cost of revenues:                                        |                                         |  |                    |     |                   |  |      |     |      |  |    |     |   |  |    |    
|                                                         | Product licenses and sales              |  |                    | 4   | %                 |  |      | 3   | %    |  |    | 3   | % |  |    | 3   | %
|                                                         | Subscriptions and
professional services |  |                    | 20  | %                 |  |      | 21  | %    |  |    | 21  | % |  |    | 22  | %
|                                                         |                                         |  |                    |     |                   |  |      |     |      |  |    |     |   |  |    |    
|                                                         | Total cost of revenues                  |  |                    | 24  | %                 |  |      | 24  | %    |  |    | 24  | % |  |    | 25  | %
|Research and development                                 |                                         |  | 17                 | %   |                   |  | 14   | %   |      |  | 17 | %   |   |  | 14 | %  
|Sales and marketing                                      |                                         |  | 35                 | %   |                   |  | 38   | %   |      |  | 35 | %   |   |  | 39 | %  
|General and administrative                               |                                         |  | 9                  | %   |                   |  | 10   | %   |      |  | 9  | %   |   |  | 10 | %  
|Amortization of intangibles and stock-based compensation |                                         |  | 2                  | %   |                   |  | 2    | %   |      |  | 2  | %   |   |  | 2  | %  
|                                                         |                                         |  |                    |     |                   |  |      |     |      |  |    |     |   |  |    |    
|                                                         | Total costs and expenses                |  |                    | 87  | %                 |  |      | 88  | %    |  |    | 87  | % |  |    | 90  | %
|                                                         |                                         |  |                    |     |                   |  |      |     |      |  |    |     |   |  |    |    
|Operating income                                         |                                         |  | 13                 | %   |                   |  | 12   | %   |      |  | 13 | %   |   |  | 10 | %  
|                                                         |                                         |  |                    |     |                   |  |      |     |      |  |    |     |   |  |    |    

Revenues

Product licenses and sales

Product licenses and sales, including perpetual licenses and sales of partner
software and hardware appliances, represented 43% of total revenues for the
three month period ended September 30, 2003 and 49% for the corresponding
period in 2002. Product licenses

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and sales represented 43% for the nine months ended September 30, 2003 and
50% for the comparable period of 2002. We believe that the general economic
slowdown in information technology spending contributed to the decrease in
product licenses and sales.

In the second quarter of 2003, we began to ship our first network
protection appliance, the Proventia A series, to customers. Proventia
appliances feature unified, multi-function protection capabilities designed to
identify and prevent many forms of attack with minimal user intervention. They
are designed to operate in demanding network environments while being easy to
deploy, easy to use and centrally managed, all in an effort to make our
solution more cost-effective. Revenues from our Proventia appliance represented
14% of total revenues in the third quarter of 2003 and 7% of total revenues for
the nine months ended September 30, 2003. We have also announced plans to ship
the Proventia G series and Proventia M series of appliances, with different
functionality, in the fourth quarter of 2003 with enhancements planned for
2004.

Our present product roadmap focuses our development on product offerings
and enhancements providing more central control and manageability, easier
deployment and more refined information. We expect that this focus will make
our products more cost effective to implement and maintain and will increase
the future level of product licenses and sales.

Subscriptions

Subscriptions revenue represented 47% of total revenues in the three
months ended September 30, 2003 increasing from 39% of total revenues in the
three months ended September 30, 2002. For the nine months ending September 30,
2003, subscriptions revenue increased to 46% from 37% in the nine months ended
September 30, 2002. Subscriptions revenue consists of product content and
support, term licenses of product usage and security-monitoring fees for
managed services offerings. The increase in subscriptions revenue as a
percentage of total revenues was primarily due to an increase in product
content and support revenues, the largest component, which grew from 27% of
total revenues in the three months ended September 30, 2002 to 32% in the
comparable period of 2003 and from 26% for the nine months ended September 30,
2002 to 31% in the comparable period of 2003. Product content and support
includes software updates, technical support and security content, including
advisory updates from the X-Force, our internal team of security experts, and
hardware support of our Proventia appliances. We continue to increase our
software client base that generates product content and support revenues,
through a combination of contracts associated with new product licenses and
renewal of existing contracts.

Managed services revenue accounted for 12% of total revenues for the
quarter ended September 30, 2003, as compared with 8% in the corresponding
period of 2002. On a year-to-date basis, managed services revenue has increased
from 7% of total revenues in 2002 to 11% of total revenues in 2003. We believe
these increases are due to a strong demand in the market for proven,
financially sound, managed security service providers. We are marketing managed
services both directly to end users and through partners, including a number of
new arrangements with integrators and service providers that include managed
services as a part of their service offerings to their customers. We also
expect sales of managed services to continue to increase as a percentage of
total revenues as we focus our efforts on marketing new, innovative offerings,
such as our Managed Protection Services, to new and existing customers. Managed
Protection Services is a premium service combining vulnerability assessment,
managed protection, and other professional services.

Professional services

Professional services revenue represented 10% of total revenues in the
three months ended September 30, 2003 as compared with 12% in the corresponding
period of 2002. For the nine months ended September 30, 2003, professional
services revenue was 11% of total revenues, decreasing from 13% in the
corresponding period of 2002. We believe that entities continue to curtail
costs and limit spending of discretionary dollars on professional services in
current economic times, which resulted in flat to lower levels of demand for
these services. In addition, we have a strategy that promotes professional
services through our system integrator and channel partner relationships.

Although we continue to offer training classes at our Atlanta headquarters
and customers premises, our primary focus is to deliver course materials to
our customers through authorized training centers.

Geographic regions

Geographically, we derived the majority of our revenues from sales to
customers within the Americas region. Revenues by region represented the
following percentages of total revenues for the periods indicated:

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|                 |  |                    |    |                   |  |      |    |      |  |  |    |   |  |  |    |  
|---------------- |  | ------------------ | -- | ----------------- |  | ---- | -- | ---- |  |  | -- | - |  |  | -- | -
|                 |  | Three months ended |    | Nine months ended
|                 |  | September 30,      |    | September 30,    
|                 |  |                    |    |                  
|                 |  | 2003               |    | 2002              |  | 2003 |    | 2002
|                 |  |                    |    |                   |  |      |    |     
|Americas         |  |                    | 69 | %                 |  |      | 72 | %    |  |  | 70 | % |  |  | 71 | %
|EMEA             |  |                    | 18 | %                 |  |      | 14 | %    |  |  | 18 | % |  |  | 15 | %
|Asia/Pacific Rim |  |                    | 13 | %                 |  |      | 14 | %    |  |  | 12 | % |  |  | 14 | %

Revenues in EMEA benefited from volume growth combined with a
strengthening currency in both the three and nine-month periods ended September
30, 2003, since products are primarily sold in the Euro currency. Asia/Pacific
Rim revenue decreased to 13% of total revenues in the three months ended
September 30, 2003 and to 12% in the nine months ended September 30, 2003.
While these are decreases from 14% in the corresponding periods of 2002, there
had been a continued increase each quarter from 10% in the fourth quarter of
2002. Asia/Pacific Rim experienced difficult economic conditions in portions of
the region beginning in the latter part of 2002, which have continued to a
lesser degree throughout 2003. The SARS epidemic had a negative impact in
certain markets within the Asia/Pacific Rim region in the second quarter of
2003. The financial data for each segment can be found in Note 6 to the
Consolidated Financial Statements.

Costs and Expenses

Cost of product licenses and sales

Cost of product licenses and sales consists of several components. Costs
associated with licensing our software products are minor. The substantial
portion of cost of product licenses and sales represents the hardware cost of
our Proventia appliances and payments to partners for their products that we
sell or integrate with our managed service offerings.

Costs of product licenses and sales as a percentage of total revenues
increased from 3% in the three months ended September 30, 2002 to 4% for the
comparable period in 2003. For the nine-month periods ended September 30, 2002
and 2003, costs of product licenses and sales remained flat at 3% of total
revenues. An increase was expected with the introduction of the Proventia
appliance line in the second quarter of 2003 and we expect the increase in cost
of product licenses and sales to continue to increase in future periods as
sales of the Proventia appliances increase. On a year-to-date basis, our
movement away from the direct sales of third-party products offset the impact
of costs related to Proventia.

Cost of subscriptions and professional services

Cost of subscriptions and professional services includes the cost of our
technical support personnel who provide assistance to customers under product
support agreements, the security operations center (SOC) costs of providing
managed security monitoring services and the costs related to our professional
services and training. These costs as a percentage of total revenues decreased
from 21% in the three months ended September 30, 2002 to 20% in the three
months ended September 30, 2003 and from 22% to 21% in the nine months ended
September 30, 2002 and 2003, respectively.

Costs associated with our technical support personnel and our security
operations centers increased to handle our increasing customer base. As our
subscription revenue base increased, we added personnel to handle additional
customers under product support agreements and under managed security
monitoring services, but at a much lower rate than revenue growth. We gained
efficiencies in our security operations centers and restructured our support
groups to be more productive. While we continue to seek increased productivity,
we do expect to increase costs in absolute dollars, assuming a continued
increase in revenues in the future.

Offsetting this increase of costs associated with our technical support
personnel and our security operations centers is a decrease in costs associated
with our professional services and education services. Such costs decreased
both in absolute dollars and as a percentage of total revenues from the quarter
ended September 30, 2002 to the comparable quarter of 2003 and from the nine
month period ended September 30, 2002 to the comparable period of 2003. Cost
decreases accompanied the decrease in revenues that occurred through a
continued narrowing of our consulting offerings to focus on services that
directly contribute to our protection platform strategy, the outsourcing of
educational training outside of Atlanta to authorized partners, and a decrease
in the number of training classes related to third-party products.

Research and development

Research and development expenses consist of salary and related costs of
research and development personnel, including costs for employee benefits, and
depreciation on computer equipment. These costs include those associated with
maintaining and expanding the

16



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X-Force, our internal team of security experts. We believe our primary
research and product development and managed service offerings are important to
retaining our leadership position in the market.

Research and development expenses increased in absolute dollars from $8.7
million in the three months ended September 30, 2002 to $10.5 million in the
three months ended September 30, 2003. On a year-to-date basis, these costs
increased in absolute dollars from $26.1 million in 2002 to $30.3 million in
2003. Research and development expenses represented 17% of total revenues in
the three and nine months ended September 30, 2003, and 14% in the three and
nine months ended September 30, 2002. These increases in absolute dollars and
percentages of total revenues are due to the increases in the number of
development personnel focused on our best-of-breed products, such as Proventia,
enterprise applications, managed services offerings and research for future
product offerings.

We continue to add functionality to our product family, providing network,
server and desktop-based solutions, as well as to our security management
applications. In the first nine months of 2003, we released the first of our
Proventia series of appliances and provided the following major enhancements to
our RealSecure Protection platform:



| |  |  | Proventia A Series models (A201,
A604 and A1204) - network threat
protection for aggregate network bandwidth from 200 Mbps to 1200 Mbps on
1 to 4 network segments.                                                                                                                                           
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | RealSecure Server Sensor 7.0 - assesses host security to detect and
report system security weaknesses, and provides intrusion prevention and
response;                                                                                                                                                        
|
| |  |  | SiteProtector Third Party
Module 1.0 - allows organizations to
automatically collect audit and intrusion detection events from
firewalls into SiteProtectors central management application for
analysis in conjunction with RealSecure®, Proventia, Internet Scanner®
and System Scanner security events;
|
| |  |  | RealSecure® Desktop 7.0 - provides protection against malicious
activity by analyzing application and network (including VPN) behavior
on desktops;                                                                                                                                                           
|
| |  |  | RealSecure Internet Scanner 7.0 - added improved accuracy and new
ease-of-use features to our network assessment solution;                                                                                                                                                                                    
|
| |  |  | RealSecure®
SiteProtector 2.0 - unifies the management of protection
across networks, servers and desktops to increase customers ability to
effectively detect, prevent and respond to todays ever-changing
spectrum of threats; and                                                                       
|
| |  |  | RealSecure Fusion version 2.0. - provides additional features that
allow customers to automate the processes of security monitoring and
correlation of security events against known vulnerabilities.                                                                                                         

While we are committed to continue our investment in X-Force research and
development capabilities that we believe to be a differentiator for ISS, we
intend to seek leverage in the research and development area while enhancing
current technologies and developing new technologies.

Sales and marketing

Sales and marketing expenses consist of salaries, travel expenses,
commissions, advertising, maintenance of our Website, trade show expenses,
costs of recruiting sales and marketing personnel and costs of marketing
materials.

Sales and marketing expenses were $21.1 million in the three months ended
September 30, 2003 and $23.8 million in the corresponding period of 2002.
Gaining leverage in sales and marketing has been a key objective for us as
evidenced by the decrease in these expenses as a percentage of total revenues
from 38% in the three months ended September 30, 2002 to 35% in the three
months ended September 30, 2003. The same trend was exhibited on a year-to-date
basis as sales and marketing expenses decreased from 39% of total revenues in
the nine months ended September 30, 2002 to 35% in the corresponding period of
2003.

The decrease in absolute dollars in sales and marketing was the result of
the changes in headcount along with lower commissions due to the decrease in
product license and sales and lower marketing costs. Marketing costs for print
and media advertising were lower in the first nine months of 2003 compared to
the comparable period of 2002 when we launched our first television and print
advertising campaign designed to demonstrate the multitude of threats that can
compromise the security of a companys networks, servers or desktops.

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In areas where revenue demand did not support our cost base, such as Latin
America and Europe, we reduced headcount throughout 2002. At the same time, we
increased headcount where we believe there are long and near-term
opportunities, such as our United States public sector, which handles
opportunities on the federal, state and local levels.

We expect to continue to achieve leverage in our sales efforts by focusing
our sales force on large customers that are served either directly by us or
through large system integrators. The channel, which includes system
integrators, value-added resellers and distributors, continues to be an
important source of global revenue for us as we use its capabilities to reach
not just departmental and small companies through distributors and resellers,
but larger customers through joint selling efforts. We also anticipate an
increase in marketing expenditures associated with the introduction of our
Proventia line, including a global launch in the fourth quarter of 2003.

General and administrative

General and administrative expenses consist of personnel-related costs for
executive, administrative, finance and human resources, internal information
systems and other support services costs, and legal, accounting and other
professional service fees.

General and administrative expenses of $5.4 million in the third quarter
of 2003 and $5.9 million in the third quarter of 2002 represented 9% of total
revenues in 2003 and 10% in 2002. For the nine months ended September 30, 2003,
general and administrative expenses were $16.4 million, or 9%, of total
revenues and $18.2 million, or 10%, in the corresponding period of 2002. We
continue to look for efficiencies in our administrative processes; in addition,
the decrease is impacted by the expenses in the second quarter of 2002
associated with the relocation of our Asia/Pacific Rim headquarters in Tokyo.

Amortization

We incurred amortization expense related to intangible assets and
stock-based compensation of $1.3 million in both the three months ended
September 30, 2003 and 2002, and $4.0 million and $4.3 million in the nine
months ended September 30, 2003 and 2002, respectively. These intangible assets
and stock-based compensation resulted from acquisitions accounted for under the
purchase method of accounting and are amortized over their estimated useful
lives.

Interest income

The market rate of interest paid on investment-quality commercial paper
and similar investments dropped from approximately 2.0% during the third
quarter of 2002 to approximately 1.0% in the third quarter of 2003. As a
result, interest income decreased despite an increase in total cash and cash
equivalents and interest bearing marketable securities. Specifically, interest
income decreased from $877,000 in the quarter ended September 30, 2002 to
$610,000 in the comparable quarter of 2003 and from $2.5 million in the nine
months ended September 30, 2002 to $2.0 million in the corresponding period of
2003.

Foreign currency exchange gain

The exchange gains of $28,000 and $145,000 in the three months ended
September 30, 2003 and 2002, respectively, and $497,000 and $68,000 in the nine
months ended September 30, 2003 and 2002, respectively, are a result of
fluctuations in currency exchange rates between the U.S. Dollar and other
currencies, primarily the Japanese Yen and the Euro.

Provision for income taxes

Our effective tax rate was approximately 38% and 39% for the quarters
ended September 30, 2003 and 2002, respectively and 38% and 40% for the
nine-month periods ended September 30, 2003 and 2002, respectively. The
effective rates differ from the statutory rates due primarily to the impact of
acquisition related intangibles that are not deductible for income tax
purposes.

Liquidity and Capital Resources

We satisfy our working capital needs and capital equipment needs with cash
provided by operations. Net cash provided by operations in the first nine
months of 2003 was $35.2 million. The major components of cash flows provided
by operating activities in the first nine months of 2003 were net income of
$15.3 million, non-cash depreciation and amortization expense charges of $14.8
million and income tax benefit from employee exercises of stock options of $8.1
million.

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Investing activities in the first nine months of 2003 included purchases
of equipment totaling $6.7 million as we continue to invest in our corporate
infrastructure. The other activities include the purchase of $52.3 million of
intermediate term marketable securities, primarily interest-bearing government
obligations and commercial paper, offset by net proceeds from the maturity of
marketable securities of $50.0 million. These assets have quality
characteristics similar to cash equivalents, except their maturities when we
acquire them are longer than three months.

Our financing activities in the first nine months of 2003 included the
purchase of 778,000 shares of our common stock on the open market at an
aggregate cost of $9.5 million under our previously announced stock repurchase
plan. In July 2003, our Board extended this program through the second quarter
of 2004 with authorization to use up to approximately $46 million of cash to
repurchase our common stock. Since the inception of the plan, we have purchased
911,000 at an average cost of $12.61 per share. Also, in the first nine months
of 2003, the exercise of stock options by our employees and the issuance of
common stock through our employee stock purchase plan generated funds of
approximately $2.0 million.

Other than our non-cancelable operating leases for office space, we have
no off-balance sheet financing arrangements, any relationships with structured
finance or special purpose entities, or any contractual obligations that
would impact our liquidity. Payments for certain operating leases are secured
by five collateralized stand-by letters of credit totaling approximately $11.3
million. The stand-by letters of credit are annually renewable over the
duration of the applicable leases. We do not anticipate utilizing these
stand-by letters of credit to meet any liquidity needs.

As of September 30, 2003, we had $227.1 million of cash and cash
equivalents and marketable securities, consisting primarily of money market
accounts and investment grade commercial paper. An additional $14.1 million of
commercial paper investments are pledged as collateral for stand-by letters of
credit related to the operating leases of our facilities and are shown on the
balance sheet as restricted cash. We believe that such cash and cash
equivalents and marketable securities will be sufficient to meet our working
capital needs and capital expenditures for the foreseeable future. Furthermore,
we are not aware of any trends, events or uncertainties that are reasonably
likely to result in any significant changes to our liquidity. From time to time
we evaluate possible acquisition and investment opportunities in businesses,
products or technologies that are complementary to ours. In the event we
determine to pursue such opportunities, we may use our available cash and cash
equivalents and marketable securities. Pending such uses, we will continue to
invest our available cash in investment-grade, interest-bearing investments.

Risk Factors

Forward-looking statements are inherently uncertain as they are based on
various expectations and assumptions concerning future events and are subject
to known and unknown risks and uncertainties. Our forward-looking statements
contained in this Quarterly Report and elsewhere should be considered in light
of the following important risk factors. Variations from our stated intentions
or failure to achieve objectives could cause actual results to differ from
those projected in our forward-looking statements. With respect to our business
outlook published in our earnings press release each quarter, you may continue
to rely on the revenue and earnings expectations prior to the start of our
quiet period unless we have published a notice stating otherwise. Toward the
end of each quarter, we have a quiet period when we will not comment
concerning the previously published financial expectations, and we disclaim any
obligation to update during the quiet period. The public should not rely on
previously published expectations during the quiet period. The quiet period
runs from the 15th of the last month of the quarter until our earnings release
during the first month of the following quarter. We otherwise undertake no
obligation to update publicly any forward-looking statements for any reason,
even if new information becomes available or other events occur in the future.

We Operate in a Rapidly Evolving Market

We operate in a new and rapidly evolving market and must, among other
things:



| |  |  | respond to competitive developments;                                  
| | - |  | ----------------------------------------------------------------------
|
| |  |  | continue to upgrade and expand our product and services offerings; and
|
| |  |  | continue to attract, retain and motivate our employees.               

We cannot be certain that we will successfully address these issues. As a
result, we cannot assure our investors that we will be able to continue to
operate profitably in the future.

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We introduced our new Proventia appliance line in April 2003. As a result
of our limited history with these products, it may be difficult to plan or
project our revenues accurately. The revenue and income potential of these
products is unproven and the markets addressed by these products are volatile.
If these products fail to gain market acceptance, our revenue could be below
our expectations and our operating results could be adversely affected.

Our Future Operating Results Will Likely Fluctuate Significantly

We cannot predict our future revenues and operating results with
certainty. However, we do expect our future revenues and operating results to
fluctuate due to a combination of factors, including:



| |  |  | the growth in the acceptance of, and activity on, the Internet and
the world wide web, particularly by corporate, institutional and
government users;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the extent to which the public perceives that unauthorized access to
and use of online information are threats to network security;                  
|
| |  |  | the volume and timing of orders, including seasonal trends in
customer purchasing;                                                                   
|
| |  |  | our ability to develop new and enhanced product and managed service
offerings and expand our professional services capabilities;                     
|
| |  |  | the introduction and acceptance rate of ISS branded appliances, including increased cost of goods sold;                                              
|
| |  |  | our ability to accurately forecast and produce demanded quantities of our appliance products and models;                                             
|
| |  |  | reliance on contract manufacturers to produce ISS appliance products;                                                                                
|
| |  |  | availability of component parts of appliance products;                                                                                               
|
| |  |  | our ability to provide scalable managed services offerings through our partners in a cost effective manner;                                          
|
| |  |  | foreign currency exchange rates that affect our international operations;                                                                            
|
| |  |  | product and price competition in our markets; and                                                                                                    
|
| |  |  | general economic conditions, both domestically and in our foreign markets.                                                                           

We increasingly focus our efforts on sales of enterprise-wide security
solutions, which consist of our entire product suite and related professional
services, and managed security services, rather than on the sale of component
products. As a result, each sale requires substantial time and effort from our
sales and support staff. In addition, the revenues associated with particular
sales vary significantly depending on the number of products licensed by a
customer, the number of devices used by the customer and the customers
relative need for our professional services. Large individual sales, or even
small delays in customer orders, can cause significant variation in our
revenues and results of operations for a particular period. The timing of large
orders is usually difficult to predict and, like many software and services
companies, many of our customers typically complete transactions in the last
month of a quarter.

We cannot predict our operating expenses based on our past results.
Instead, we establish our spending levels based in large part on our expected
future revenues. As a result, if our actual revenues in any future period fall
below our expectations, our operating results likely will be adversely affected
because very few of our expenses vary with our revenues. Because of the factors
listed above, we believe that our quarterly and annual revenues, expenses and
operating results likely will vary significantly in the future.

Our ability to provide timely guidance and meet the expectations of
investors with respect to our operating and financial results is impacted by
the tendency of a majority of our sales to be completed in the last month of a
quarter. We may not be able to determine whether we will experience material
deviations from guidance or expectations until the end of a quarter.

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Dependence on Third Party Suppliers and Manufacturers

We currently purchase some Proventia appliance components and contract
manufacturing services from single or limited sources. We carry little
inventory of our appliance products and we rely on suppliers to deliver
necessary components to our contract manufacturer in a timely manner based on
the forecasts we provide. If shortages occur, supplies are interrupted, or we
under forecast sales of demanded models, we may not be able to deliver products
to our customers and our revenue and operating results would be adversely
affected. Because our supply of hardware is based on short-term forecasts and
purchase orders, our contract manufacturer is not obligated to purchase
components for greater quantities over longer periods. We provide six-month
forecasts of our demand to our contract manufacturer. If we overestimate our
requirements, our contract manufacturer many have excess inventory, which could
increase our costs. If we underestimate our requirements, our contract
manufacturer may have an inadequate component inventory and, based on lead
times, this could interrupt manufacturing and result in delays in shipments and
revenues.

We Face Intense Competition in Our Market

The market for network security monitoring, detection and response
solutions is intensely competitive, and we expect competition to increase in
the future. We cannot guarantee that we will compete successfully against our
current or potential competitors, especially those with significantly greater
financial resources or brand name recognition. Our chief competitors generally
fall within one of five categories:



| |  |  | internal information technology departments of our customers and the
consulting firms that assist them in formulating security systems;                                                                                                                                                 
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | relatively smaller software companies offering relatively limited
applications for network and Internet security;                                                                                                                                                                       
|
| |  |  | large companies, including Symantec Corp., Cisco Systems, Inc. and
Network Associates, Inc., that sell or have announced competitive
products and offerings, as well as other large software companies that
have the technical capability and resources to develop competitive
products;
|
| |  |  | software or hardware companies like Cisco Systems, Inc. that could
integrate features that are similar to our products into their own
products; and                                                                                                                                     
|
| |  |  | small and large companies with competitive offerings to components of
our managed services offerings.                                                                                                                                                                                   

Mergers or consolidations among these competitors, or acquisitions of
small competitors by larger companies, represent risks. For example, Symantec
Corp., Cisco Systems, Inc., and Network Associates, Inc. have acquired smaller
companies that have intrusion detection technologies during the past several
years. These acquisitions will make these entities potentially more formidable
competitors to us if such products and offerings are effectively integrated.
Large companies may have advantages over us because of their longer operating
histories, greater name recognition, larger customer bases or greater
financial, technical and marketing resources. As a result, they may be able to
adapt more quickly to new or emerging technologies and changes in customer
requirements. They can also devote greater resources to the promotion and sale
of their products than we can. In addition, these companies have reduced and
could continue to reduce, the price of their security monitoring, detection and
response products and managed security services, which increases pricing
pressures within our market.

Several companies currently sell software products (such as encryption,
firewall, operating system security and virus detection software) that our
customers and potential customers have broadly adopted. Some of these companies
sell products that perform the same functions as some of our products. In
addition, the vendors of operating system software or networking hardware may
enhance their products to include the same kinds of functions that our products
currently provide. The widespread inclusion of comparable features to our
software in operating system software or networking hardware could render our
products obsolete, particularly if such features are of a high quality. Even if
security functions integrated into operating system software or networking
hardware are more limited than those of our software, a significant number of
customers may accept more limited functionality to avoid purchasing additional
software.

For the above reasons, we may not be able to compete successfully against
our current and future competitors. Increased competition may result in price
reductions, reduced gross margins and loss of market share.

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We Face Rapid Technological Change in Our Industry and Frequent Introductions
of New Products

Rapid changes in technology pose significant risks to us. We do not
control nor can we influence the forces behind these changes, which include:



| |  |  | the extent to which businesses and others seek to establish more secure networks;
| | - |  | ---------------------------------------------------------------------------------
|
| |  |  | the extent to which hackers and others seek to compromise secure systems;        
|
| |  |  | evolving computer hardware and software standards;                               
|
| |  |  | changing customer requirements; and                                              
|
| |  |  | frequent introductions of new products and product enhancements.                 

To remain successful, we must continue to change, adapt and improve our
products in response to these and other changes in technology. Our future
success hinges on our ability to both continue to enhance our current line of
products and professional services and to introduce new products and services
that address and respond to innovations in computer hacking, computer
technology and customer requirements. We cannot be sure that we will
successfully develop and market new products that do this. Any failure by us to
timely develop and introduce new products, to enhance our current products or
to expand our professional services capabilities in response to these changes
could adversely affect our business, operating results and financial condition.

Our products involve very complex technology, and as a consequence, major
new products and product enhancements require a long time to develop and test
before going to market. Because this amount of time is difficult to estimate,
we have had to delay the scheduled introduction of new and enhanced products in
the past and may have to delay the introduction of new and enhanced products in
the future.

The techniques computer hackers use to gain unauthorized access to, or to
sabotage, networks and intranets are constantly evolving and increasingly
sophisticated. Furthermore, because new hacking techniques are usually not
recognized until used against one or more targets, we are unable to anticipate
most new hacking techniques. To the extent that new hacking techniques harm our
customers computer systems or businesses, affected or prospective customers
may believe that our products are ineffective, which may cause them or
prospective customers to reduce or avoid purchases of our products.

Risks Associated with Our Global Operations

The expansion of our international operations includes our presence in
dispersed locations throughout the world, including throughout Europe and the
Asia/Pacific and Latin America regions. Our international presence and
expansion exposes us to risks not present in our U.S. operations, such as:



| |  |  | the difficulty in managing an organization spread over various
countries located across the world;                                            
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | compliance with, and unexpected changes in, a wide range of complex
regulatory requirements in countries where we do business;                
|
| |  |  | duties and tariffs imposed on importation of our products in other
jurisdictions where other manufacturers may not bear those same costs;     
|
| |  |  | increased financial accounting and reporting burdens and complexities and potentially adverse tax consequences;                               
|
| |  |  | excess taxation due to overlapping tax structures;                                                                                            
|
| |  |  | fluctuations in foreign currency exchange rates resulting in losses
or gains from transactions and expenses denominated in foreign
currencies;
|
| |  |  | reduced protection for intellectual property rights in some countries;                                                                        

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| |  |  | reduced protection for enforcement of creditor and contractual rights in some countries; and                                                                    
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | import and export license requirements and restrictions on the import
and export of certain technology, especially encryption technology and
trade restrictions.

We rely on distributors extensively in the Asia/Pacific region for the
sale and distribution of our products. Further, countries in the Asia/Pacific
region, particularly China, Japan and Korea, have experienced weakness in their
currency, banking and equity markets. These weaknesses could continue to
adversely affect our distributors ability to pay us and adversely affect
demand for our products in the Asia/Pacific region. Despite these risks, we
believe that we must continue to expand our operations in international markets
to support our growth. To this end, we intend to establish additional foreign
sales operations, expand our existing offices, hire additional personnel,
expand our international sales channels and customize our products for local
markets. If we fail to execute this strategy, our international sales growth
will be limited.

Our Networks, Products and Services May be Targeted by Hackers

Like other companies, our websites, networks, information systems,
products and services may be targets for sabotage, disruption or
misappropriation by hackers. As a leading network security solutions company,
we are a high profile target. Although we believe we have sufficient controls
in place to prevent disruption and misappropriation, and to respond to such
situations, we expect these efforts by hackers to continue. If these efforts
are successful, our operations, reputation and sales could be adversely
affected.

We Must Successfully Integrate Acquisitions

As part of our growth strategy, we have and may continue to acquire or
make investments in companies with products, technologies or professional
services capabilities complementary to our solutions. When engaging in
acquisitions, we could encounter difficulties in assimilating or completing the
development of the technologies, new personnel and operations into our company.
These difficulties may disrupt our ongoing business, distract our management
and employees, increase our expenses and adversely affect our results of
operations. These difficulties could also include accounting requirements, such
as impairment charges related to goodwill or expensing in-process research and
development costs, such as those incurred in the fourth quarter of 2002 related
to the acquisition of vCIS, Inc. We cannot be certain that we will successfully
overcome these risks with respect to any future acquisitions or that we will
not encounter other problems in connection with our recent or any future
acquisitions. In addition, any future acquisitions may require us to incur debt
or issue equity securities. The issuance of equity securities could dilute the
investment of our existing stockholders.

We Depend on Our Intellectual Property Rights and Use Licensed Technology

We rely primarily on copyright, trademark, patent and trade secrets laws,
confidentiality procedures and contractual provisions to protect our
proprietary rights. We have obtained one United States patent and have a number
of patent applications pending, as well as numerous trademarks and trademark
applications pending. We believe that the technological and creative skills of
our personnel, new product developments, frequent product enhancements, our
name recognition, our professional services capabilities and delivery of
reliable product support are essential to establishing and maintaining our
technology leadership position. We cannot assure you that our competitors will
not develop technologies that are similar to ours.

Despite our efforts to protect our proprietary rights, unauthorized
parties may attempt to copy aspects of our products or to obtain and use
information that we regard as proprietary. Policing unauthorized use of our
products is difficult. While we cannot determine the extent to which piracy of
our software products occurs, we expect software piracy to be a persistent
problem. In addition, the laws of some foreign countries do not protect our
proprietary rights to as great an extent as do the laws of the United States,
and many foreign countries do not enforce these laws as diligently as U.S.
government agencies and private parties.

Some Provisions in the ISS Certificate of Incorporation and Bylaws Make a
Takeover of ISS Difficult

Our certificate of incorporation and bylaws contain provisions that could
have the effect of making it more difficult for a third party to acquire, or of
discouraging a third party from attempting to acquire, control of ISS. These
provisions:



| |  |  | establish a classified board of directors;                                                                                                                                                                                                            
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | create preferred stock purchase rights that grant to holders of
common stock the right to purchase shares of Series A Junior Preferred
Stock in the event that a third party acquires 20% or more of the voting
power of our outstanding common stock;

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| |  |  | prohibit the right of our stockholders to act by written consent;                                                                                                                                                                  
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | limit calling special meetings of stockholders; and                                                                                                                                                                                
|
| |  |  | impose a requirement that holders of 66-2/3% of the outstanding
shares of common stock are required to amend the provisions relating to
the classification of our board of directors and action by written
consent of stockholders.




Item 3. Quantitative and Qualitative Disclosures About Market Risk

We have no material changes to the disclosure on this matter made in our
Annual Report on Form 10-K for the year ended December 31, 2002.




Item 4. Controls and Procedures

As required by SEC rules, we have evaluated the effectiveness of the
design and operation of our disclosure controls and procedures as of the end of
the period covered by this quarterly report. This evaluation was carried out
under the supervision and with the participation of our management, including
our principal executive officer and principal financial officer. Based on this
evaluation, these officers have concluded that the design and operation of our
disclosure controls and procedures are effective. There were no significant
changes to our internal controls during the third quarter of 2003 that
materially affected or is reasonably likely to materially affect, the Companys
internal controls over financial reporting.

Disclosure controls and procedures are our controls and other procedures
that are designed to ensure that information required to be disclosed by us in
the reports that we file or submit under the Securities and Exchange Act of
1934 is recorded, processed, summarized, and reported within the time periods
specified in the SECs rules and forms. Disclosure controls and procedures
include, without limitation, controls and procedures designed to ensure that
information required to be disclosed by us in the reports that we file under
the Exchange Act is accumulated and communicated to our management, including
principal executive officer and principal financial officer, as appropriate, to
allow timely decisions regarding disclosure.




PART II. OTHER INFORMATION




Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits.

|    |  |                                                                                                                                                                                                                                
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1 |  | Restated Certificate of Incorporation (filed as Exhibit 3.1 to
the Companys Quarterly Report on Form 10-Q, dated November
14, 2000 and incorporated by reference herein).                                                     
|    |  |                                                                                                                                                                                                                                
|3.2 |  | Bylaws (filed as Exhibit 3.2 to the Companys Registration
Statement on Form S-1, Registration No. 373-44529 and
incorporated by reference herein).                                                                            
|    |  |                                                                                                                                                                                                                                
|3.3 |  | Certificate of Designations of Series A Junior Participating
Preferred Stock dated July 24, 2002 (filed as Exhibit 3.3 to
the Companys Annual Report on Form 10-K, filed March 28, 2003
and incorporated by reference herein).
|    |  |                                                                                                                                                                                                                                
|4.1 |  | Specimen Common Stock certificate (filed as Exhibit 4.3 to the
Companys Registration Statement on Form S-8, Registration No.
333-100954, filed November 1, 2002 and incorporated by
reference herein).                        
|    |  |                                                                                                                                                                                                                                
|4.2 |  | Form of Rights Certificate (filed as Exhibit 4.2 to the
Companys Current Report on Form 8-K filed July 24, 2002 and
incorporated by reference herein.                                                                         

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|     |  |                                                                                                                                                                                      
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|4.3  |  | See Exhibits 3.1 and 3.2 for provisions of the Certificate of
Incorporation and Bylaws of the Company defining the rights of
holders of the Companys Common Stock.                  
|     |  |                                                                                                                                                                                      
|4.4  |  | 1999 Network ICE Stock Option Plan, incorporated by reference
to Exhibit 4.1 to Form S-8, Registration No. 333-62658, filed
on June 8, 2001.                                         
|     |  |                                                                                                                                                                                      
|4.5  |  | Restated 1995 Stock Incentive Plan (as amended and restated as
of May 23, 2001) incorporated by reference to Exhibit 4.2 to
Form S-8, Registration No. 333-62658, filed June 8, 2001.
|     |  |                                                                                                                                                                                      
|4.6  |  | Netrex, Inc. 1998 Stock Plan incorporated by reference to
Exhibit 99.15 to Form S-8, Registration Statement No.
333-89563, filed October 22, 1999.                                   
|     |  |                                                                                                                                                                                      
|4.7  |  | vCIS, Inc. 2001 Stock Plan incorporated by reference to
Exhibit 4.1 to Form S-8, Registration Statement No.
333-100954, filed November 1, 2002.                                      
|     |  |                                                                                                                                                                                      
|10.1 |  | Form of Retention Agreement with CEO and Senior Vice Presidents                                                                                                                      
|     |  |                                                                                                                                                                                      
|11   |  | Computation of Per Share Earnings *                                                                                                                                                  
|     |  |                                                                                                                                                                                      
|31.1 |  | Certification of principal executive officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.                                                                              
|     |  |                                                                                                                                                                                      
|31.2 |  | Certification of principal financial officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.                                                                              
|     |  |                                                                                                                                                                                      
|32.1 |  | Certification pursuant to 18 U.S.C. Section 1350, as adapted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                              
|     |  |                                                                                                                                                                                      
|32.2 |  | Certification pursuant to 18 U.S.C. Section 1350, as adapted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                              
|     |  |                                                                                                                                                                                      

|  |  |                                                                                                                                   
|- |  | ----------------------------------------------------------------------------------------------------------------------------------
|* |  | Data required by SFAS No. 128, Earnings Per Share, is
provided in Note 5 to the consolidated financial statements in
this report

(b) Reports on Form 8-K.

ISS filed the following reports on Form 8-K during the reporting period:



| |  |  | On July 16, 2003 ISS filed a report on Form 8-K relating to a press
release regarding its financial results for the quarter ended June 30,
2003 and providing its Business Outlook for the quarter ending September
30, 2003 and fiscal year ending December 31, 2003.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

|                       |  |                                                  
|---------------------- |  | -------------------------------------------------
|                       |  | INTERNET SECURITY SYSTEMS, INC.                  
|                       |  | (Registrant)                                     
|                       |  |                                                  
|Date: November 5, 2003 |  | By /s/ Richard Macchia                           
|                       |  |                                                  
|                       |  | Senior Vice President, Finance and Administration
|                       |  | and Chief Financial Officer                      
|                       |  |                                                  
|                       |  | By /s/ Maureen Richards                          
|                       |  |                                                  
|                       |  | Vice President and Corporate Controller          

26