**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

** **
| **(Mark****One)** | ** ** | ** **                                                                                                                                                           |
|-------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ý            | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                               |
|              |       |                                                                                                                                                                 |
| ** **        | ** ** | **For the  quarterly period ended September 30, 2005**                                                                                                          |
|              |       |                                                                                                                                                                 |
| ** **        | ** ** | **OR**                                                                                                                                                               |
|              |       |                                                                                                                                                                 |
| o                 | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                              |
|              |       |                                                                                                                                                                 |
| ** **        | ** ** | **For the  transition period  from                     to** |

 

 

**Commission File Number 000-23655**

 

**INTERNETSECURITY SYSTEMS, INC.**

(Exactname of registrant as specified in its charter)

 

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

 

 

**6303 BARFIELD ROAD, ATLANTA, GEORGIA 30328**

(Addressof principal executive offices)

 

Registrant’stelephone 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 or15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes ý No o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).Yes ý No o

 

Indicate by check mark whether the registrantis a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý

 

Indicate the number of shares outstanding ofeach of the registrant’s classes of common stock, as of the latest practicabledate.

 

| ** **                               | ** ** | **Number  of Shares**       |
|------------------------------------------|------------|-----------------------------|
| ** **                               | ** ** | **Outstanding**             |
| **Title  of each class of common stock** | ** ** | **as of  October 28, 2005** |
| **Common stock, $0.001 par value**       |       | 44,912,948                  |

 

----

 
|                                               | **PART I - FINANCIAL INFORMATION**                                                                                                                           |   |
|----------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1                                        | Financial Statements  (Unaudited):                                                                                                                                | 3      |
|                                               | Condensed Consolidated Balance Sheets at September 30,  2005 (unaudited) and December 31, 2004                                                          | 3      |
|                                               | Condensed Consolidated Statements  of Operations for the three months and nine months ended September 30,  2005 and September 30, 2004 (unaudited) | 4      |
|                                               | Condensed Consolidated Statements  of Cash Flows for the nine months ended September 30, 2005 and  September 30, 2004 (unaudited)                  | 5      |
|                                               | Notes to Condensed Consolidated  Financial Statements                                                                                                             | 6      |
| Item 2                                        | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                                       | 13     |
| Item 3                                        | Quantitative  and Qualitative Disclosures about Market Risk                                                                                                       | 26     |
| Item 4                                        | Controls and Procedures                                                                                                                                           | 26     |
|                                               | **PART II - OTHER  INFORMATION**                                                                                                                             | 27     |
| Item 1                                        | Legal Proceedings                                                                                                                                                 | 27     |
| Item 2                                        | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                                      | 27     |
| Item 3                                             | Defaults Upon  Senior Securities                                                                                                                                  | 27     |
| Item 4                                        | Submission of  Matters to a Vote of Security Holders                                                                                                              | 27     |
| Item 5                                             | Other Information                                                                                                                                                 | 27     |
| Item 6                                        | Exhibits                                                                                                                                                          | 28     |
| EX-31.1 SECTION 302  CERTIFICATION OF THE CEO |                                                                                                                                                              |
| EX-31.2 SECTION 302  CERTIFICATION OF THE CFO |                                                                                                                                                              |
| EX-32.1 SECTION 906  CERTIFICATION OF THE CEO |                                                                                                                                                              |
| EX-32.2 SECTION 906  CERTIFICATION OF THE CFO |                                                                                                                                                              |

 

 

2

----

 

 

 

 

**PART I. FINANCIAL INFORMATION**

 

**Item 1. Condensed Consolidated Financial Statements**

 

**INTERNET SECURITY SYSTEMS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

(amountsin thousands, except share and per share amounts)

 
| ** **                                                                                                    | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                    | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| ** **                                                                                                    | ** ** | **(unaudited)**        | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                    |       |                   |       |                  |       |
| Current assets:                                                                                               |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                     |       | $                      | 207,565    |                  | $          | 140,148 |   |
| Marketable securities                                                                                         |       | 10,963                 |       | 70,901                |       |
| Accounts receivable, less allowance for doubtful accounts of $3,279  and $3,099, respectively                 |       | 79,559                 |       | 75,353                |       |
| Inventory                                                                                                     |       | 4,076                  |       | 2,506                 |       |
| Prepaid expenses and other  current assets                                                                    |       | 12,060                 |       | 12,728                |       |
| Total current assets                                                                                          |       | 314,223                |       | 301,636               |       |
|                                                                                                          |       |                   |       |                  |       |
| Property and equipment:                                                                                       |       |                   |       |                  |       |
| Computer equipment and  software                                                                              |       | 56,709                 |       | 52,412                |       |
| Office furniture and  equipment                                                                               |       | 17,904                 |       | 18,091                |       |
| Leasehold improvements                                                                                        |       | 20,992                 |       | 21,098                |       |
|                                                                                                          |       | 95,605                 |       | 91,601                |       |
| Less accumulated  depreciation                                                                                |       | 64,944                 |       | 57,161                |       |
|                                                                                                          |       | 30,661                 |       | 34,440                |       |
|                                                                                                          |       |                   |       |                  |       |
| Restricted cash and marketable securities                                                                     |       | 10,300                 |       | 10,300                |       |
| Goodwill, less accumulated amortization of $27,381                                                            |       | 221,594                |       | 224,065               |       |
| Other intangible assets, less accumulated amortization of $25,834 and  $20,951, respectively                  |       | 12,831                 |       | 19,763                |       |
| Other assets                                                                                                  |       | 7,201                  |       | 8,698                 |       |
| Total assets                                                                                                  |       | $                      | 596,810    |                  | $          | 598,902 |   |
|                                                                                                          |       |                   |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                |       |                   |       |                  |       |
| Current liabilities:                                                                                          |       |                   |       |                  |       |
| Accounts payable                                                                                              |       | $                      | 5,658      |                  | $          | 6,911 |   |
| Accrued expenses                                                                                              |       | 33,600                 |       | 25,238                |       |
| Deferred revenues                                                                                             |       | 69,689                 |       | 70,246                |       |
| Total current liabilities                                                                                     |       | 108,947                |       | 102,395               |       |
|                                                                                                          |       |                   |       |                  |       |
| Non-current portion of  deferred revenues                                                                     |       | 6,660                  |       | 8,432                 |       |
| Other non-current  liabilities                                                                                |       | 5,392                  |       | 6,495                 |       |
|                                                                                                          |       |                   |       |                  |       |
| 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,  51,409,000 and 50,754,000 issued, respectively |       | 51                     |       | 51                    |       |
| Additional paid-in capital                                                                                    |       | 509,854                |       | 499,534               |       |
| Deferred compensation                                                                                         |       | (1,864                 | )          | (3,197                | )          |
| Accumulated other comprehensive income                                                                        |       | 3,179                  |       | 11,041                |       |
| Retained earnings                                                                                             |       | 74,442                 |       | 48,544                |       |
| Treasury stock, at cost (6,511,000 and 4,871,000 shares,  respectively)                                       |       | (109,851               | )          | (74,393               | )          |
| Total stockholders’ equity                                                                               |       | 475,811                |       | 481,580               |       |
| Total liabilities and stockholders’ equity                                                               |       | $                      | 596,810    |                  | $          | 598,902 |   |

 

 

*See accompanying notes*

 

3

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**INTERNET SECURITY SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

(amountsin thousands, except per share amounts)

(unaudited)

 
| ** **                                                      | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                      | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                                       |       |                                       |       |                                      |       |   |   |   |   |
| Product licenses and sales                                      |       | $                                          | 37,164     |                                      | $          | 31,241 |   | $ | 103,047 |   | $ | 88,877 |   |
| Subscriptions                                                   |       | 40,713                                     |       | 35,819                                    |       | 119,403 |   | 102,928 |   |
| Professional services                                           |       | 4,968                                      |       | 5,673                                     |       | 16,287 |   | 17,532 |   |
|                                                            |       | 82,845                                     |       | 72,733                                    |       | 238,737 |   | 209,337 |   |
| Costs and expenses:                                             |       |                                       |       |                                      |       |   |   |   |   |
| Cost of revenues:                                               |       |                                       |       |                                      |       |   |   |   |   |
| Product licenses and sales                                      |       | 7,386                                      |       | 6,463                                     |       | 19,923 |   | 16,312 |   |
| Amortization of acquired  technology                            |       | 1,731                                      |       | 1,732                                     |       | 5,273 |   | 5,072 |   |
| Subscriptions and  professional services                        |       | 13,274                                     |       | 12,278                                    |       | 39,599 |   | 36,497 |   |
| Total cost of revenues                                          |       | 22,391                                     |       | 20,473                                    |       | 64,795 |   | 57,881 |   |
| Research and development                                        |       | 11,406                                     |       | 10,740                                    |       | 32,682 |   | 32,644 |   |
| Sales and marketing                                             |       | 27,659                                     |       | 24,653                                    |       | 81,305 |   | 73,123 |   |
| General and administrative                                      |       | 7,339                                      |       | 7,173                                     |       | 21,985 |   | 19,766 |   |
| Amortization of other  intangibles and stock-based compensation |       | 41                                         |       | 59                                        |       | 127 |   | 337 |   |
|                                                            |       | 68,836                                     |       | 63,098                                    |       | 200,894 |   | 183,751 |   |
| Operating income                                                |       | 14,009                                     |       | 9,635                                     |       | 37,843 |   | 25,586 |   |
| Interest income                                                 |       | 1,565                                      |       | 699                                       |       | 3,877 |   | 1,691 |   |
| Other income (expense),  net                                    |       | (58                                        | )          | (152                                      | )          | (1,073 | ) | (581 | ) |
| Gain on issuance of  subsidiary stock                           |       | 52                                         |       | 38                                        |       | 186 |   | 278 |   |
| Income before income taxes                                      |       | 15,568                                     |       | 10,220                                    |       | 40,833 |   | 26,974 |   |
| Provision for income taxes                                      |       | 5,776                                      |       | 3,809                                     |       | 14,935 |   | 9,883 |   |
| Net income                                                      |       | $                                          | 9,792      |                                      | $          | 6,411 |   | $ | 25,898 |   | $ | 17,091 |   |
| Basic net income per share  of Common Stock                     |       | $                                          | 0.22       |                                      | $          | 0.14 |   | $ | 0.57 |   | $ | 0.36 |   |
| Diluted net income per  share of Common Stock                   |       | $                                          | 0.21       |                                      | $          | 0.14 |   | $ | 0.55 |   | $ | 0.35 |   |
|                                                            |       |                                       |       |                                      |       |   |   |   |   |
| Weighted average shares  and equivalent shares:                 |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                           |       | 44,915                                     |       | 46,267                                    |       | 45,080 |   | 47,460 |   |
| Diluted                                                         |       | 47,336                                     |       | 47,225                                    |       | 47,365 |   | 48,650 |   |

 

 

*See accompanying notes*

 

4

----

 

**INTERNET SECURITY SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

(amountsin thousands)

(unaudited)

 
| ** **                                                                           | ** ** | **Nine months ended**  | ** ** |
|--------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                           | ** ** | **September 30,** | ** ** |
| ** **                                                                           | ** ** | **2005**               | ** ** | **2004** | ** ** |
| **Operating activities**                                                             |       |                   |       |   |   |
| Net income                                                                           |       | $                      | 25,898     |   | $ | 17,091 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities:   |       |                   |       |   |   |
| Depreciation                                                                         |       | 7,783                  |       | 11,866 |   |
| Amortization of acquired  technology, other intangibles and stock-based compensation |       | 5,400                  |       | 5,409 |   |
| Accretion of discount on  marketable securities                                      |       | 114                    |       | 31 |   |
| Deferred compensation  expense                                                       |       | 1,538                  |       | 1,467 |   |
| Minority interest                                                                    |       | 23                     |       | 448 |   |
| Income tax benefit from  exercise of stock options                                   |       | 1,740                  |       | 7,385 |   |
| Gain on issuance of  subsidiary stock                                                |       | (186                   | )          | (278 | ) |
| Changes in assets and  liabilities, excluding the effects of acquisitions:           |       |                   |       |   |   |
| Accounts receivable                                                                  |       | (4,206                 | )          | 829 |   |
| Inventory                                                                            |       | (1,570                 | )          | (474 | ) |
| Prepaid expenses and other  assets                                                   |       | 1,885                  |       | (3,166 | ) |
| Accounts payable and  accrued expenses                                               |       | 6,070                  |       | (1,964 | ) |
| Deferred revenues                                                                    |       | (2,329                 | )          | 5,035 |   |
| Net cash provided by  operating activities                                           |       | 42,160                 |       | 43,679 |   |
|                                                                                 |       |                   |       |   |   |
| **Investing activities**                                                             |       |                   |       |   |   |
| Acquisitions, net of cash  received                                                  |       | (764                   | )          | (34,022 | ) |
| Purchases of marketable  securities                                                  |       | (64,180                | )          | (64,465 | ) |
| Net proceeds from maturity  of marketable securities                                 |       | 94,254                 |       | 44,205 |   |
| Net proceeds from sales of  marketable securities                                    |       | 29,750                 |       | — |   |
| Purchases of property and  equipment                                                 |       | (4,004                 | )          | (11,227 | ) |
| Net proceeds from issuance  of subsidiary stock                                      |       | 438                    |       | 433 |   |
| Net cash provided by (used  in) investing activities                                 |       | 55,494                 |       | (65,076 | ) |
|                                                                                 |       |                   |       |   |   |
| **Financing activities**                                                             |       |                   |       |   |   |
| Proceeds from exercise of  stock options                                             |       | 7,637                  |       | 1,936 |   |
| Proceeds from employee  stock purchase plan                                          |       | 732                    |       | 1,417 |   |
| Purchases of treasury  stock                                                         |       | (35,458                | )          | (49,557 | ) |
| Net cash used in financing  activities                                               |       | (27,089                | )          | (46,204 | ) |
|                                                                                 |       |                   |       |   |   |
| Foreign currency impact on  cash                                                     |       | (3,148                 | )          | (2,194 | ) |
|                                                                                 |       |                   |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                           |       | 67,417                 |       | (69,795 | ) |
| Cash and cash equivalents  at beginning of period                                    |       | 140,148                |       | 184,551 |   |
| Cash and cash equivalents  at end of period                                          |       | $                      | 207,565    |   | $ | 114,756 |   |
|                                                                                 |       |                   |       |   |   |
| **Supplemental cash flow  disclosure**                                               |       |                   |       |   |   |
| Income taxes paid                                                                    |       | $                      | 5,879      |   | $ | 2,800 |   |

 

 

*See accompanying notes*

 

5

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**INTERNET SECURITY SYSTEMS, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(unaudited)**

 

**Note 1.Significant Accounting Policies**

 

*Basis ofPresentation*

 

The unaudited condensed consolidatedfinancial statements of Internet Security Systems, Inc. (“ISS” or the “Company”)as of September 30, 2005 and for the three and nine months endedSeptember 30, 2005 and 2004 contain, in the opinion of management, alladjustments, consisting of normal recurring items, necessary for the fairpresentation of the financial position and results of operations of the Companyfor the interim periods.  Theconsolidated financial statements include the accounts of the Company and itsmajority-owned subsidiaries.  Theconsolidated balance sheet at December 31, 2004 has been derived from theaudited financial statements at that date but does not include all of thefootnotes required by U.S. generally accepted accounting principles forcomplete financial statements.

 

These unaudited condensed consolidatedfinancial statements should be read in conjunction with the ConsolidatedFinancial Statements and Notes thereto included in the Company’s Annual Reporton Form 10-K, as amended, for the year ended December 31, 2004.  The results of operations for the three andnine months ended September 30, 2005 are not necessarily indicative of theresults to be expected for the entire year. All significant intercompany accounts and transactions have beeneliminated.

 

The preparation of financial statements andrelated disclosures in conformity with U.S. generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe amounts reported in the financial statements and accompanying notes.  Actual results will differ from thoseestimates, and such differences may be material to the consolidated financialstatements.

 

*Goodwilland Intangibles*

 

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

 
| ** **                    | ** ** | **September 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|-------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                    | ** ** | **Gross  Carrying**         | ** ** | **Accumulated**            | ** ** | **Gross  Carrying** | ** ** | **Accumulated** | ** ** |
| ** **                    | ** ** | **Amount**                  | ** ** | **Amortization**           | ** ** | **Amount** | ** ** | **Amortization** | ** ** |
| Goodwill                      |       | $                           | 248,975    |                       | $          | (27,381 | ) | $ | 251,446 |   | $ | (27,381 | ) |
|                          |       |                        |       |                       |       |   |   |   |   |
| Amortized intangible  assets: |       |                        |       |                       |       |   |   |   |   |
| Core technology               |       | 3,853                       |       | (3,364                     | )          | 3,853 |   | (3,002 | ) |
| Developed technology          |       | 32,790                      |       | (20,656                    | )          | 34,775 |   | (16,235 | ) |
| Customer relationships        |       | 2,022                       |       | (1,814                     | )          | 2,086 |   | (1,714 | ) |
|                          |       |                        |       |                       |       |   |   |   |   |
| Total                         |       | $                           | 38,665     |                       | $          | (25,834 | ) | $ | 40,714 |   | $ | (20,951 | ) |

 

 

The change in the carrying amounts ofgoodwill and developed technology from December 31, 2004 toSeptember 30, 2005 was the result of reductions due to currencytranslation adjustments for the acquisition of Cobion, a German content filteringand anti-spam provider, that more than offset increases due to the payment ofadditional consideration related to the 2002 acquisition of TriSecurityHoldings Pte Ltd. discussed in Note 3, and the payment of approximately $20,000of final severance payments and related purchase accounting adjustments for theJanuary 2004 acquisition of Cobion.

 

The Company amortizes intangible assets overtheir estimated useful lives of eight years for core technology, five years fordeveloped technology, and three years for customer relationships.  Amortization expense of intangible assets isas follows (in thousands):

 
| ** **             | ** ** | **Three months ended** | ** ** | **Nine months ended**  | ** ** |
|------------------------|------------|------------------------|------------|------------------------|------------|
| ** **             | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **             | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Core technology        |       | $                      | 120        |                   | $          | 120 |   | $ | 361 |   | $ | 361 |   |
| Developed technology   |       | 1,611                  |       | 1,612                  |       | 4,912 |   | 4,711 |   |
| Customer relationships |       | 41                     |       | 43                     |       | 127 |   | 268 |   |
|                   |       |                   |       |                   |       |   |   |   |   |
| Total                  |       | $                      | 1,772      |                   | $          | 1,775 |   | $ | 5,400 |   | $ | 5,340 |   |

 

 

6

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The Company amortized $375,000 and $353,000in the three months ended September 30, 2005 and 2004, respectively and$1,125,000 and $1,146,000 in the nine months ended September 30, 2005 and2004, respectively, relating to the purchase of a software license used incertain of its products.  The asset is included in computer equipment andsoftware and the amortization expenses are included in cost of product licensesand sales.

 

The estimated future amortization expense ofintangible assets as of September 30, 2005 is as follows (in thousands):

 
| ** **                     | ** ** | **Amount** | ** ** |
|--------------------------------|------------|------------|------------|
| Year ending  December 31, |       |       |       |
| 2005 (three months)            |       | $          | 1,771      |   |
| 2006                           |       | 4,988      |       |
| 2007                           |       | 3,038      |       |
| 2008                           |       | 3,034      |       |
|                           |       |       |       |
| Total                          |       | $          | 12,831     |   |

 

 

*Accountingfor stock-based compensation*

 

Statement of Financial Accounting Standard (“SFAS”)123, “*Accounting for Stock-BasedCompensation”*, as amended by SFAS 148, “*Accounting for Stock-Based Compensation - Transition and Disclosure,”*establishes accounting and reporting standards for stock-based employeecompensation plans.  As permitted by SFAS123, ISS continues to account for stock-based compensation in accordance withAccounting Principles Board Opinion (“APB”) No. 25, “*Accounting for Stock Issued to Employees”*, and has elected the pro forma disclosure alternative of SFAS 123.

 

In accordance with the pro forma disclosurealternative of SFAS 123 the following table shows pro forma net income (loss)and pro forma net income (loss) per share for the periods indicated as if theCompany had adopted SFAS 123.  The proforma impact of applying SFAS 123 as illustrated below will not necessarily berepresentative of the pro forma impact in future years.  Pro forma information is as follows (amountsin thousands, except per share amounts):

 
| ** **                                                                                        | ** ** | **Three months ended** | ** ** | **Nine months ended**  | ** ** |
|---------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                                        | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                                                        | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income, as reported                                                                           |       | $                      | 9,792      |                   | $          | 6,411 |   | $ | 25,898 |   | $ | 17,091 |   |
| Add: Stock-based compensation included in reported net income, net of  income taxes               |       | 305                    |       | 384                    |       | 977 |   | 986 |   |
| Less: Stock-based compensation expense computed under the Fair Value  method, net of income taxes |       | (2,968                 | )          | (5,996                 | )          | (10,548 | ) | (18,364 | ) |
|                                                                                              |       |                   |       |                   |       |   |   |   |   |
| Pro forma net income (loss)                                                                       |       | $                      | 7,129      |                   | $          | 799 |   | $ | 16,327 |   | $ | (287 | ) |
| Basic net income (loss) per share of Common Stock and equivalents:                                |       |                   |       |                   |       |   |   |   |   |
| As reported                                                                                       |       | $                      | 0.22       |                   | $          | 0.14 |   | $ | 0.57 |   | $ | 0.36 |   |
| Pro forma                                                                                         |       | $                      | 0.16       |                   | $          | 0.02 |   | $ | 0.36 |   | $ | (0.01 | ) |
|                                                                                              |       |                   |       |                   |       |   |   |   |   |
| Diluted net income (loss) per share of Common Stock and equivalents:                              |       |                   |       |                   |       |   |   |   |   |
| As reported                                                                                       |       | $                      | 0.21       |                   | $          | 0.14 |   | $ | 0.55 |   | $ | 0.35 |   |
| Pro forma                                                                                         |       | $                      | 0.15       |                   | $          | 0.02 |   | $ | 0.34 |   | $ | (0.01 | ) |

 

 

The fair value of options at date of grantwas estimated using the Black-Scholes model with the following assumptions:

 

 

 

 

 
| ** **               | ** ** | **Three months ended** | ** ** |
|--------------------------|------------|------------------------|------------|
| ** **               | ** ** | **September 30,** | ** ** |
| ** **               | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Expected life (years)    |       | 4.6                    |       | 5 |   |
| Risk free interest rates |       | 4.28                   | %          | 3.08 | % |
| Expected volatility      |       | 38                     | %          | 51 | % |
| Expected dividend yield  |       | —                 |       | — |   |

 

7

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During 2005 and 2004, 347,000 restrictedshares were issued to directors, officers and certain key employees ofISS.  The shares issued to directors vestin either one-or two-year periods, with two-year periods having quarterlyvesting.  The shares issued to officers and certain key employeesgenerally vest in two installments: 50% vesting two years from the grant datewith the remaining 50% vesting three years from the grant date.  Upon issuance of restricted shares, unearnedcompensation is recorded in stockholders’ equity as deferred compensation equalto the market value of the restricted shares and is recognized as compensationexpense over the vesting period, net of reversal of previously recorded expensefor any forfeited shares.  Totalcompensation expense for restricted stock awards amounted to $485,000 and $613,000in the three months ended September 30, 2005 and 2004, respectively, and$1.5 million and $1.6 million in the nine months ended September 30, 2005and 2004, respectively.

 

During the three and nine months endedSeptember 30, 2005, the Company issued 217,000 and 598,000 shares of Common Stock,respectively, for the exercise of stock options.  During the three monthsended September 30, 2005, the Company issued 850 shares of restricted stock tocertain employees.

 

*Gain onissuance of subsidiary shares*

 

The gain on issuance of subsidiary sharesresults from Internet Security Systems KK, our Asia/Pacific subsidiary (“ISS KK”),issuing shares related to the exercise of ISS KK stock options.  In 2005,ISS KK has issued 899 shares at an average exercise price of approximately $488per share.  Our ownership percentage of the subsidiary remained at 87% atSeptember 30, 2005.  Deferred income taxes have been provided in theperiod in which the gain is recognized.

 

**Note 2.Income Taxes**

 

The Company recorded tax provisions of$5.8 million and $3.8 million for the three months endedSeptember 30, 2005 and 2004, respectively, and tax provisions of $14.9million and $9.9 million for the nine months ended September 30, 2005 and 2004,respectively.  While income tax expense was recorded on domestic income,the amount of domestic taxes payable was reduced by deductions related to theexercise of employee stock options in current and prior periods.  The tax benefit of these deductions wasrecorded as additional paid-in capital.

 

The effective tax rate was approximately37.1% for the three months ended September 30, 2005 and 37.3% for thethree months ended September 30, 2004. The effective tax rate was 36.6% for the nine months endedSeptember 30, 2005 and September 30, 2004, respectively.  Theeffective rates differ from the statutory rates due to the impact ofacquisition-related intangibles and certain operating expenses that are notdeductible for income tax purposes as well as federal and state tax credits.

 

 

**Note 3.Business Acquisition**

 

 

 In August 2002, ISS KK, ourAsia/Pacific subsidiary, acquired a distributor in Singapore, TriSecurityHoldings Pte Ltd. (“TriSecurity”). TriSecurity was the sole distributor for ISS KK in southeast Asia,including India, and its business was almost exclusively focused on ISSsolutions.  This acquisition provides ourAsia-Pacific subsidiary direct support capabilities for their customers inSoutheast Asia and allows ISS KK to expand its capabilities in this growingmarket.  The consideration consisted of2,000 shares of ISS KK stock and approximately $1.2 million ofcash.  Goodwill of approximately$4.0 million related to the purchase was recorded.  During the first quarter of 2003, ISS KKamended the agreement and agreed to make payment of 490 shares of ISS KKin each of the first quarters of 2004 and 2005, relating to annual contingentconsideration payments under the 2002 purchase agreement.  Due to regulatory issues, the agreement wasamended prior to the 2004 payment to make the 2004 and 2005 payments in cash inlieu of shares.  Additional considerationof $764,000 and $498,000 was paid in February 2005 and 2004, respectively,based on the fair market value of the 490 shares, and is reflected ingoodwill.

 

**Note 4.Comprehensive Income**

 

The components of comprehensive income are asfollows (in thousands):

 
| ** **                                   | ** ** | **Three months ended** | ** ** | **Nine months ended**  | ** ** |
|----------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                   | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                   | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income, as reported                      |       | $                      | 9,792      |                   | $          | 6,411 |   | $ | 25,898 |   | $ | 17,091 |   |
| Change in cumulative  translation adjustment |       | 131                    |       | 464                    |       | (7,862 | ) | (4,056 | ) |
|                                         |       |                   |       |                   |       |   |   |   |   |
| Comprehensive income                         |       | $                      | 9,923      |                   | $          | 6,875 |   | $ | 18,036 |   | $ | 13,035 |   |

 

 

8

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**Note 5.Income per Share**

 

The following table sets forth thecomputation of basic and diluted net income per share (amounts in thousands,except per share amounts):

 
| ** **                                                                              | ** ** | **Three months ended** | ** ** | **Nine months ended**  | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                              | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                                              | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Numerator:                                                                              |       |                   |       |                   |       |   |   |   |   |
| Net income                                                                              |       | $                      | 9,792      |                   | $          | 6,411 |   | $ | 25,898 |   | $ | 17,091 |   |
|                                                                                    |       |                   |       |                   |       |   |   |   |   |
| Denominator:                                                                            |       |                   |       |                   |       |   |   |   |   |
|                                                                                    |       |                   |       |                   |       |   |   |   |   |
| Denominator for basic net  income per share — weighted average shares              |       | 44,915                 |       | 46,267                 |       | 45,080 |   | 47,460 |   |
| Effect of dilutive stock  options                                                       |       | 2,421                  |       | 958                    |       | 2,285 |   | 1,190 |   |
|                                                                                    |       |                   |       |                   |       |   |   |   |   |
| Denominator for diluted  net income per share - weighted average shares and equivalents |       | 47,336                 |       | 47,225                 |       | 47,365 |   | 48,650 |   |
|                                                                                    |       |                   |       |                   |       |   |   |   |   |
| Basic net income per share                                                              |       | $                      | 0.22       |                   | $          | 0.14 |   | $ | 0.57 |   | $ | 0.36 |   |
|                                                                                    |       |                   |       |                   |       |   |   |   |   |
| Diluted net income per  share                                                           |       | $                      | 0.21       |                   | $          | 0.14 |   | $ | 0.55 |   | $ | 0.35 |   |

 

 

Options for 2,080,362 shares in both thethree and nine months ended September 30, 2005, and 6,058,000 and 4,390,000shares in the three and nine months ended September 30, 2004, respectively,were not included in the computation of diluted income per share because theoptions’ exercise price was greater than the average market price of the commonshares, and their impact would have been anti-dilutive.

 

**Note 6.Segment and Geographic Information**

 

ISS conducts business in one operating segment:  providing information security managementsolutions.  The Company does, however,prepare operating results for internal use on a geographic basis.  Geographical based operating costs consist ofdirect sales expenses, infrastructure to support its employee and customer andpartner base, supporting billing and financial systems and a management teamfor the geographic segment.  Corporateexpenses that are not charged directly to the other segments include research anddevelopment, general and administrative costs that support the globalorganization, amortization of acquired technology, amortization of licenseddevelopment source code, amortization of intangibles and stock-basedcompensation and costs that are one-time in nature, such as acquired in-processresearch and development.

 

The accounting policies of the segments arethe same as those described in the summary of significant accountingpolicies.  There are no inter-segmentsales.  Our chief executive officer andchief financial officer evaluate performance based on operating profit or lossfrom operations, and trade accounts receivable for each segment.  Other than trade accounts receivable, assetsand liabilities are not discretely allocated or reviewed by segment.

 

In accordance with SFAS 131, “*Disclosures about Segments of an Enterprise andRelated Information,*” the Company has included a summary of thesegment financial information reported internally.  The geographic segments are the Americas,Europe, Middle East and Africa (“EMEA”), and the Asia/Pacific region.

 

 

9

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The following table presents ISS’ revenues,operating expenses and operating income (loss) by reportable geographicsegment (in thousands):

 
| ** **                                                       | ** ** | **Americas** | ** ** | **EMEA** | ** ** | **Asia/Pacific** | ** ** | **Unallocated** | ** ** | **Total** | ** ** |
|------------------------------------------------------------------|------------|--------------|------------|----------|------------|------------------|------------|-----------------|------------|-----------|------------|
|                                                             |       |         |       |     |       |             |       |            |       |      |       |
| **As of or for the three months  ended September 30, 2005** |       |         |       |     |       |             |       |            |       |      |       |
| **Revenues from external  customers:**                           |       |         |       |     |       |             |       |            |       |      |       |
| Product licenses and sales                                       |       | $            | 24,937     |     | $          | 6,497            |       | $               | 5,730      |      | $          | — |   | $ | 37,164 |   |
| Subscriptions                                                    |       | 25,806       |       | 9,532    |       | 5,375            |       | —          |       | 40,713    |       |
| Professional services                                            |       | 3,508        |       | 446      |       | 1,014            |       | —          |       | 4,968     |       |
| Total revenue                                                    |       | 54,251       |       | 16,475   |       | 12,119           |       | —          |       | 82,845    |       |
| **Cost of revenues:**                                            |       |         |       |     |       |             |       |            |       |      |       |
| Product licenses and sales                                       |       | 4,519        |       | 1,375    |       | 1,117            |       | 375             |       | 7,386     |       |
| Amortization of acquired  technology                             |       | —       |       | —   |       | —           |       | 1,731           |       | 1,731     |       |
| Subscriptions and professional  services                         |       | 9,167        |       | 1,477    |       | 2,630            |       | —          |       | 13,274    |       |
| Total cost of revenues                                           |       | 13,686       |       | 2,852    |       | 3,747            |       | 2,106           |       | 22,391    |       |
| **Operating expenses**                                           |       | 16,143       |       | 7,969    |       | 2,131            |       | 20,202          |       | 46,445    |       |
|                                                             |       |         |       |     |       |             |       |            |       |      |       |
| **Total expenses**                                               |       | 29,829       |       | 10,821   |       | 5,878            |       | 22,308          |       | 68,836    |       |
|                                                             |       |         |       |     |       |             |       |            |       |      |       |
| **Segment operating income (loss)**                              |       | $            | 24,422     |     | $          | 5,654            |       | $               | 6,241      |      | $          | (22,308 | ) | $ | 14,009 |   |
|                                                             |       |         |       |     |       |             |       |            |       |      |       |
| Accounts receivable, net                                         |       | $            | 51,317     |     | $          | 16,662           |       | $               | 11,580     |      | $          | — |   | $ | 79,559 |   |
| Property and equipment,  net                                     |       | $            | 24,335     |     | $          | 1,708            |       | $               | 4,618      |      | $          | — |   | $ | 30,661 |   |
|                                                             |       |         |       |     |       |             |       |            |       |      |       |
| **As of or for the three months  ended September 30, 2004** |       |         |       |     |       |             |       |            |       |      |       |
| **Revenues from external  customers:**                           |       |         |       |     |       |             |       |            |       |      |       |
| Product licenses and sales                                       |       | $            | 19,375     |     | $          | 6,117            |       | $               | 5,749      |      | $          | — |   | $ | 31,241 |   |
| Subscriptions                                                    |       | 23,826       |       | 8,095    |       | 3,898            |       | —          |       | 35,819    |       |
| Professional services                                            |       | 3,769        |       | 758      |       | 1,146            |       | —          |       | 5,673     |       |
| Total revenue                                                    |       | 46,970       |       | 14,970   |       | 10,793           |       | —          |       | 72,733    |       |
| **Cost of revenues:**                                            |       |         |       |     |       |             |       |            |       |      |       |
| Product licenses and sales                                       |       | 4,105        |       | 870      |       | 1,135            |       | 353             |       | 6,463     |       |
| Amortization of acquired  technology                             |       | —       |       | —   |       | —           |       | 1,732           |       | 1,732     |       |
| Subscriptions and  professional services                         |       | 8,621        |       | 1,302    |       | 2,355            |       | —          |       | 12,278    |       |
| Total cost of revenues                                           |       | 12,726       |       | 2,172    |       | 3,490            |       | 2,085           |       | 20,473    |       |
| **Operating expenses**                                           |       | 15,707       |       | 6,745    |       | 2,201            |       | 17,972          |       | 42,625    |       |
|                                                             |       |         |       |     |       |             |       |            |       |      |       |
| **Total expenses**                                               |       | 28,433       |       | 8,917    |       | 5,691            |       | 20,057          |       | 63,098    |       |
|                                                             |       |         |       |     |       |             |       |            |       |      |       |
| **Segment operating income (loss)**                              |       | $            | 18,537     |     | $          | 6,053            |       | $               | 5,102      |      | $          | (20,057 | ) | $ | 9,635 |   |
|                                                             |       |         |       |     |       |             |       |            |       |      |       |
| **Accounts receivable, net**                                     |       | $            | 38,980     |     | $          | 14,769           |       | $               | 12,772     |      | $          | — |   | $ | 66,521 |   |
| **Property and equipment, net**                                  |       | $            | 28,542     |     | $          | 1,604            |       | $               | 5,486      |      | $          | — |   | $ | 35,632 |   |

 

 

10

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| ** **                                                      | ** ** | **Americas** | ** ** | **EMEA** | ** ** | **Asia/Pacific** | ** ** | **Unallocated** | ** ** | **Total** | ** ** |
|-----------------------------------------------------------------|------------|--------------|------------|----------|------------|------------------|------------|-----------------|------------|-----------|------------|
|                                                            |       |         |       |     |       |             |       |            |       |      |       |
| **As of or for the nine months  ended September 30, 2005** |       |         |       |     |       |             |       |            |       |      |       |
| **Revenues from external  customers:**                          |       |         |       |     |       |             |       |            |       |      |       |
| Product licenses and sales                                      |       | $            | 64,487     |     | $          | 21,093           |       | $               | 17,467     |      | $          | — |   | $ | 103,047 |   |
| Subscriptions                                                   |       | 75,825       |       | 27,985   |       | 15,593           |       | —          |       | 119,403   |       |
| Professional services                                           |       | 10,927       |       | 1,519    |       | 3,841            |       | —          |       | 16,287    |       |
| Total revenue                                                   |       | 151,239      |       | 50,597   |       | 36,901           |       | —          |       | 238,737   |       |
| **Cost of revenues:**                                           |       |         |       |     |       |             |       |            |       |      |       |
| Product licenses and sales                                      |       | 11,866       |       | 3,692    |       | 3,240            |       | 1,125           |       | 19,923    |       |
| Amortization of acquired  technology                            |       | —       |       | —   |       | —           |       | 5,273           |       | 5,273     |       |
| Subscriptions and  professional services                        |       | 27,686       |       | 3,925    |       | 7,988            |       | —          |       | 39,599    |       |
| Total cost of revenues                                          |       | 39,552       |       | 7,617    |       | 11,228           |       | 6,398           |       | 64,795    |       |
| **Operating expenses**                                          |       | 48,895       |       | 23,956   |       | 7,037            |       | 56,211          |       | 136,099   |       |
|                                                            |       |         |       |     |       |             |       |            |       |      |       |
| **Total expenses**                                              |       | 88,447       |       | 31,573   |       | 18,265           |       | 62,609          |       | 200,894   |       |
|                                                            |       |         |       |     |       |             |       |            |       |      |       |
| **Segment operating income (loss)**                             |       | $            | 62,792     |     | $          | 19,024           |       | $               | 18,636     |      | $          | (62,609 | ) | $ | 37,843 |   |
|                                                            |       |         |       |     |       |             |       |            |       |      |       |
| **Accounts receivable, net**                                    |       | $            | 51,317     |     | $          | 16,662           |       | $               | 11,580     |      | $          | — |   | $ | 79,559 |   |
| **Property and equipment, net**                                 |       | $            | 24,335     |     | $          | 1,708            |       | $               | 4,618      |      | $          | — |   | $ | 30,661 |   |
|                                                            |       |         |       |     |       |             |       |            |       |      |       |
| **As of or for the nine months  ended September 30, 2004** |       |         |       |     |       |             |       |            |       |      |       |
| **Revenues from external  customers:**                          |       |         |       |     |       |             |       |            |       |      |       |
| Product licenses and sales                                      |       | $            | 54,519     |     | $          | 20,168           |       | $               | 14,190     |      | $          | — |   | $ | 88,877 |   |
| Subscriptions                                                   |       | 70,128       |       | 21,788   |       | 11,012           |       | —          |       | 102,928   |       |
| Professional services                                           |       | 10,863       |       | 2,577    |       | 4,092            |       | —          |       | 17,532    |       |
| Total revenue                                                   |       | 135,510      |       | 44,533   |       | 29,294           |       | —          |       | 209,337   |       |
| **Cost of revenues:**                                           |       |         |       |     |       |             |       |            |       |      |       |
| Product licenses and sales                                      |       | 9,887        |       | 2,711    |       | 2,568            |       | 1,146           |       | 16,312    |       |
| Amortization of acquired  technology                            |       | —       |       | —   |       | —           |       | 5,072           |       | 5,072     |       |
| Subscriptions and  professional services                        |       | 24,862       |       | 3,960    |       | 7,675            |       | —          |       | 36,497    |       |
| Total cost of revenues                                          |       | 34,749       |       | 6,671    |       | 10,243           |       | 6,218           |       | 57,881    |       |
| **Operating expenses**                                          |       | 46,669       |       | 20,134   |       | 6,320            |       | 52,747          |       | 125,870   |       |
|                                                            |       |         |       |     |       |             |       |            |       |      |       |
| **Total expenses**                                              |       | 81,418       |       | 26,805   |       | 16,563           |       | 58,965          |       | 183,751   |       |
|                                                            |       |         |       |     |       |             |       |            |       |      |       |
| **Segment operating income (loss)**                             |       | $            | 54,092     |     | $          | 17,728           |       | $               | 12,731     |      | $          | (58,965 | ) | $ | 25,586 |   |
|                                                            |       |         |       |     |       |             |       |            |       |      |       |
| **Accounts receivable, net**                                    |       | $            | 38,980     |     | $          | 14,769           |       | $               | 12,772     |      | $          | — |   | $ | 66,521 |   |
| **Property and equipment, net**                                 |       | $            | 28,542     |     | $          | 1,604            |       | $               | 5,486      |      | $          | — |   | $ | 35,632 |   |

 

11

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**Note 7.Commitments and Contingencies**

 

Our sales agreements with customers generallycontain infringement indemnity provisions. We have not previously incurred costs to settle claims or pay awardsunder these indemnification obligations. As a result, we believe the estimated fair value of these obligations isnominal.  Accordingly, we have noliabilities recorded for these agreements as of September 30, 2005. In addition, we warrant that our software products will perform in all materialrespects in accordance with our standard published specifications in effect atthe time of delivery of the licensed products to the customer for ninetydays.  We also warrant that for one yearafter shipment, all hardware will be free from defects in materials andworkmanship under normal authorized use, consistent with the instructionscontained in the product documentation. Additionally, we warrant that our services will be performed consistentwith generally accepted industry standards or specific service levels throughcompletion of the agreed upon services. We have not incurred significant recurring expense under our product orservice warranties, and hardware warranties are covered by the manufacturer warranties.  As a result, we believe the estimated fairvalue of these agreements is nominal. Accordingly, we have no liabilities recorded for these agreements as ofSeptember 30, 2005.

 

Payments for certain operating leases for ouroffice space are secured by four collateralized standby letters of credittotaling $8.8 million at September 30, 2005.  These standby letters of credit guaranteepayments on certain lease obligations and are renewed annually unless cancelledby either party.  The lease obligationshave terms that expire at various dates through 2013.  The beneficiary of the standby letters ofcredit can draw on the letters of credit if we default on the related leaseobligation.  Each standby letter ofcredit is collateralized by securities. At September 30, 2005, $10.3 million of commercial paperinvestments are pledged as collateral and are shown on the balance sheet asrestricted cash and marketable securities.

 

On August 17, 2004, the Company’s Georgia operatingsubsidiary filed in the United States District Court for the Northern Districtof Georgia a declaratory judgment action (the “Georgia Action”) against SRIInternational, Inc. (“SRI”).  The actionseeks the court’s declaration that our products and services do not infringeany valid claim of five patents held by SRI and seeks declaration that certainclaims of those patents are invalid.  OnAugust 26, 2004, SRI filed in the United States District Court for Delaware acomplaint against the Company and Symantec Corporation (the “Delaware Action”).  The complaint in the Delaware Action allegesthat our SiteProtector and Proventia products infringe upon claims of two ofthe five patents at issue in the Georgia Action. The Delaware Action seeksunspecified damages and injunctive relief. On April 25, 2005, SRI filed an amended complaint adding the Company’sGeorgia operating subsidiary as a separate defendant to the DelawareAction.  The Company and its subsidiaryanswered SRI’s amended complaint on May 23, 2005, denying that they infringethe two patents asserted by SRI and asserting counterclaims seeking adeclaration from the Delaware court that the five SRI patents are notinfringed, and are invalid and unenforceable. On June 9, 2005, the Georgiacourt transferred the Georgia Action to the United States District Court forthe District of Delaware.  Thetransferred action was consolidated with the Delaware Action.  On June 13, 2005, SRI answered thecounterclaims asserted by the Company and its subsidiary, denying that the fivepatents are not infringed, invalid, and unenforceable.  On August 5, 2005, SRI granted to the Companya covenant never to sue the Company, its distributors, customers, licensees orend users, for damages or any other form of legal or equitable relief based onor arising out of the alleged infringement of one of the five patents-in-suitas a result of the manufacture, use, sale, offer for sale, importation,maintenance, support or servicing of any Company product or service existing onor before the effective date.  The partiesare currently engaged in discovery on the remaining claims, and trial has beenscheduled to begin on or about October 30, 2006.  We intend to defend the Delaware Actionvigorously and believe we have meritorious defenses and counterclaims.  Due to the uncertainty surrounding thelitigation process and the early stage of the proceedings, the Company isunable to reasonably estimate a range of loss, if any, at this time.

 

 

 

**Note8.  Recently Issued Accounting Standards**

 

On December 16, 2004, the FinancialAccounting Standards Board (“FASB”) issued SFAS 123 (revised 2004)(SFAS 123R),*“Share-Based Payment”,*which is a revision of SFAS 123,*“Accountingfor Stock-Based Compensation”.* SFAS 123R supersedes APB Opinion No. 25,*“Accounting for Stock Issued to Employees”.*  Statement 123R requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the financial statements based on their fair values (i.e., proforma disclosure is no longer an alternative to financial statement recognition. The Company is required to implementSFAS 123R at the beginning of the next fiscal year that begins afterJune 15, 2005.  In March 2005, the Securities and Exchange Commissionissued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to the adoptionof SFAS 123(R).  SAB No.107 affects noneof the accounting provisions of SFAS 123R. The impact on the Company’s earnings will include the remainingamortization of the fair value of existing options currently disclosed aspro-forma expense in Note 1 and is contingent upon the number of future optionsgranted, the selected transition and valuation methods.  While the proforma information under SFAS 123 indicates that expensing of stock options willhave a material impact on the Company’s financial results, the specific impactis not known as the Company is currently evaluating valuation and transitionmethods permitted under SFAS 123R.  Theimpact of adoption of Statement 123(R) cannot be predicted at this time becauseit will depend on levels of share-based payments granted in the future.However, had we adopted Statement 123(R) in prior periods, the impact of thatstandard would have approximated the impact of Statement 123 as described inthe disclosure of pro forma net income and earnings per share in Note 1.

 

In May 2005, the FASB issued SFASNo. 154, “*Accounting Changes and ErrorCorrections”. * SFAS 154 requires retroactive application of avoluntary change in accounting principle to prior period financial statementsunless it is impracticable.  SFAS No. 154 also requires that a changein method of depreciation, amortization or depletion for long-lived,non-financial assets be accounted for as a change in accounting estimate thatis affected by a change in accounting principle.  SFAS No. 154replaces APB Opinion No. 20, “*AccountingChanges”* and SFAS No. 3, “*ReportingAccounting Changes in Interim Financial Statements”.*  SFASNo. 154 is effective for fiscal years beginning after December 15,2005.  The Company does not expect the adoption of the provisions of SFASNo. 154 to have a material impact on its results of operations orfinancial condition.

 

12

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**Item 2. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

 

 

*Thefollowing Management’s Discussion and Analysis of Financial Condition andResults of Operations should be read in conjunction with the ConsolidatedFinancial Statements and related Notes thereto included elsewhere in thisForm 10-Q.*

 

*Except forthe historical financial information, many of the matters discussed in thisForm 10-Q may be considered “forward-looking” statements. Forward-lookingstatements can be identified by the use of words such as “may,” “will,” “should,”“could,” “continue,” “future,” “potential,” “believe,” “project,” “plan,” “intend,”“seek,” “estimate,” “predict”, “expect”, “anticipate” and similar expressions,or the negative of such terms, or other comparable terminology.  Forward-looking statements also include theassumptions underlying or relating to any of the foregoing statements.  Such forward-looking statements are notguarantees of future performance and involve a number of risks anduncertainties.  Our actual results coulddiffer materially from those anticipated in these forward-looking statements asa result of various factors, including those set forth below under the caption “RiskFactors” and those otherwise described from time to time in our Securities andExchange Commission reports filed after this Form 10-Q . Allforward-looking statements included in this Form 10-Q are based oninformation available to us on the date hereof. We assume no obligation (except where required by law) to update anyforward-looking statements for any events or circumstances occurring after thedate of this Form 10-Q.*

 

*In thisForm 10-Q, the words “Internet Security Systems,” “ISS,” “the Company,” “we,”“our,” “ours,” and “us” refer to Internet Security Systems, Inc., and itssubsidiaries.*

 

*InternetSecurity Systems and SiteProtector are trademarks and service marks, and theInternet Security Systems logo, X-Force, Proventia and RealSecure areregistered trademarks and service marks, of Internet SecuritySystems, Inc.*

 

**Overview**

 

We focus on providing enterprise-widepre-emptive protection.  We provide suchprotection with our comprehensive line of products and services.  These include ISS’ SiteProtector centralizedmanagement system; a product family consisting of network and host intrusionprevention, integrated security appliances, desktop protection and vulnerabilityprotection; and ISS’ Managed Security Services and Professional SecurityServices.  The integrated securityappliance includes, in addition to intrusion prevention capabilities,firewalls, virtual private network features, anti-virus protection, contentfiltering and e-mail security, including anti-spam technology.

 

This combination of products and servicesforms our Proventia Enterprise Security Platform (“ESP”), which contributes tobusiness process optimization by maintaining a delicate balance betweenIT-performance, availability and risk — ultimately stopping cyber threatsbefore they affect operations.  Unliketraditional approaches to security, which focus on improving reaction times,Proventia ESP is designed to avoid security incidents by combining continuousvulnerability assessment and threat prevention with enterprise-wide informationmanagement and reporting capabilities. Our objective is to enable companies to shield security vulnerabilitiesacross their entire IT infrastructure — before attacks are released.

 

We currently plan to continue to evolve theProventia Enterprise Security Platform by further automating enterprisesecurity policy and delivering it within the context of existing IT processes.

 

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Our managed services offerings currentlyprovide remote management of our best-of-breed security technology, focusing onsecurity assessment and intrusion detection, intrusion prevention and desktopprotection systems, and include firewalls, VPNs, anti-virus capabilities andURL filtering software.  We focus onserving as the trusted security provider to our customers by maintaining withinour existing products the latest counter-measures to security risks, creatingnew innovative products based on our customers’ needs and providingprofessional and managed services.

 

Many factors will affect our future financialperformance, especially our ability to differentiate our offerings fromcompetitors that include much larger companies with greater marketingcapabilities, financial resources and brand recognition.  In order to continue to create suchdifferentiation, we expect to continue to expand our domestic and internationalsales and marketing operations, seek acquisition candidates and alliances withpartners whose products, technologies or service capabilities are complementaryto our solutions; and improve our internal operating and financialinfrastructure in support of our strategic goals and objectives.  At the same time, we expect to adjust ourorganization size in light of changing economic conditions and maintainemphasis on controlling discretionary spending and capital expenditures.  While we believe in the long-term success ofour business solutions, our prospects must be considered in light of the recentexperience, risks and difficulties that are frequently encountered by companiesserving rapidly evolving markets.  See “Risk Factors”.

 

**CriticalAccounting Policies**

 

The consolidated financial statements wereprepared in conformity with U.S. generally accepted accounting principles(“GAAP”).  As such, management isrequired to make certain estimates, judgments and assumptions it believes arereasonable based upon the information available.  These estimates and assumptions affect the reportedamounts of assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the periodspresented.  The significant accountingpolicies which management believes are the most critical to aid in fullyunderstanding and evaluating our reported financial results include thefollowing:

 

*Revenuerecognition*

 

We recognize revenue in the followingcategories:

 

•                  *Productlicenses and sales,* which include revenue from sales of perpetualsoftware licenses and products;

 

•                  *Subscriptionrevenues,* which consists of customer support, includingcontent updates and technical support, term licenses, subscription licenses andmanaged service arrangements; and

 

•                  *Professionalservices revenues,* which includes fee-based service engagements andtraining.

 

We recognize software license revenue underthe American Institute of Certified Public Accountants’ Statement of Position (“SOP”)97-2,*Software Revenue Recognition,*as modified by SOP 98-9,*SoftwareRevenue Recognition with Respect to Certain Transactions,* when thefollowing criteria have been met:

 

•                  persuasive evidence of anarrangement exists;

 

•                  delivery has occurred orservices have been rendered;

 

•                  price is fixed ordeterminable; and

 

•                  collection is probable.

 

*Productlicenses and sales*

 

We recognize perpetual software licenserevenues, assuming all other revenue recognition criteria are met, upon(1) delivery of the software and (2) issuance of the related license,assuming that no significant vendor obligations or customer acceptance rightsexist. Where payment terms are extended over periods greater than twelvemonths, revenue is recognized as such amounts become due and payable.  Revenue is also deferred when payment termsare extended for periods less than twelve months and such sales are deemedeither not to be fixed or determinable or collection is not probable based onevaluation of all terms of the transaction.

 

Product sales consist primarily of appliancessold in conjunction with ISS licensed software. These sales are recognized upon shipment to the customer provided allother criteria for software license revenue recognition are met.

 

Sales of products are generated both throughdirect sales to end-users as well as through various partners, including systemintegrators, value-added resellers and distributors.  Revenue from product licenses and sales isrecognized when the sale has occurred for an identified end user, provided allother revenue recognition criteria are met. We offer evaluation softwareavailable via download from our website and evaluation units forappliance-based products that allow potential customers to see thefunctionality of the products on 

 

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their own networks prior to purchase.  At the point of delivery, the customer has noright of return.

 

*Subscriptionrevenues*

 

Subscription revenues consist of renewablecustomer support, term licenses and security monitoring and managementservices.  Renewable customer support is a separate component of productlicenses and sales.  Term licenses allowcustomers to use our products and receive product support coverage and contentupdates for a specified period, generally twelve months.  We generally invoice for customer support andterm licenses at the beginning of the term and recognize revenue ratably overthe subscription term.  Securitymonitoring and management services for information assets and systems are partof managed services and associated revenues are recognized and billed as suchservices are provided.

 

Historically, our software and intrusionprevention appliance sales have been accounted for primarily as revenue at thetime of sale, with product support and content updates generally representingbetween 20% and 30% of the related license or product amount.  Prior to the second quarter of 2005, themajority of the initial price paid by the customer for certain Proventiaintegrated security appliance models was for selected content blades (sometimesreferred to as “blades”), which customers acquire for a specified term that isrecognized over such term as subscription revenue.  During the second quarter of 2005, we changedthe pricing model for our Proventia integrated security appliances to ourhistorical model under which customers acquire the appliance bundled with mostcontent blades, which are recorded as product revenue at the time of sale, andpay annual customer support fees at an average rate of

22% of the related product price.  This change did not have a material impact onour results for either the second or third quarters of 2005 as the integratedsecurity appliances represented 4% of product license and sales revenues inboth these quarters, which approximates the percentage of quarterly productlicenses and sales that it has historically represented under the prior pricingmodel since 2004.

 

*Professionalservices revenues*

 

Service engagements are typically billed oneither a fixed fee or time-and-materials basis and primarily consist ofsecurity assessments of customer networks and the development of customers’security policies.  These offerings areintended to support our goal of providing products and managed services.  We prefer to have our partners provide theseservices where practical.  We recognizesuch professional services revenues as the related services are rendered.

 

*Multipleelements arrangements*

 

Our sales of product and/or software licensesare multiple element arrangements that include product support and contentupdates and may include other subscription or professional services deliveredafter the product or software license. Revenue is generally recognizable upon delivery of each element of thearrangement when all of the following requirements exist:

 

•                  vendor specific objectiveevidence (“VSOE”) of fair value exists for the undelivered elements;

 

•                  the functionality of thedelivered elements is not dependent on the undelivered elements; and

 

•                  delivery of the deliveredelements represents the culmination of the earnings process.

 

We recognize the difference between the totalarrangement fee and the amount deferred for the undelivered elements asrevenues by  allocating revenue to thedelivered products,  licenses andservices using the residual method. Under the residual method, we allocate discounts inherent in thearrangement to products and customer support and content updates associatedwith products that are initially delivered and recognize the other elements asthey are delivered based on the VSOE of fair value, which is determined basedon transactions where the company sells those elements separately.  We determine fair value of the undeliveredelements based on historical evidence of our stand-alone sales of theseelements to third parties.

 

*Allowancefor doubtful accounts*

 

Our sales are global, with customers locatedin the Americas, EMEA, and Asia/ Pacific regions.  We perform periodic credit evaluations of ourcustomer’s financial condition and do not require collateral.  We provide for estimated credit losses assuch losses become probable.  We evaluatespecific accounts when we become aware of a situation where a customer may notbe able to meet its financial obligations due to deterioration of its liquidityor financial viability, credit ratings or bankruptcy.  The allowance for doubtful accounts isestablished based on the best facts available to us and is reevaluated andadjusted as additional information is received. At September 30, 2005, the allowance for doubtful accounts totaled$3.3 million, or 4.0% of the $82.8 million of total tradereceivables.  This 4.0% allowance ofreceivables reflects our practice to leave accounts on our general ledger andprovide reserves pending final resolution of collectibility rather than towrite-off such accounts.  Our bad debt expense for the quarter endedSeptember 30, 2005 amounted to $268,000 compared to $527,000 in thecorresponding period of 2004 and $653,000 and $1.1 million during the firstnine months of 2005 and 2004, respectively.

 

We continued to monitor the Asia situationthat contributed to a higher bad debt expense level in 2002.  In January 2004, a new distributor forChina assumed the rights and the obligations of the distribution agreement forISS products from the old distributor. In connection with this agreement, we modified the new distributor’sobligations, which resulted in an additional $200,000 of bad debt 

 

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expense recorded in the fourth quarter of2003 and the write-off of $1.1 million against the allowance account.  We established a firm repaymentschedule and received timely payments under this schedule, which resultedin full payment of the receivable by the first quarter of 2005.

 

While actual credit losses have historicallybeen within management’s expectations and the provisions established, we cannotguarantee that we will continue to experience the same credit loss rates wehave in the past. If the financial condition of our customers were todeteriorate, resulting in an impairment of their ability to make payments, additionalallowances may be required.

 

*Impairmentof goodwill and other long-lived and intangible assets*

 

We review goodwill for impairment on anannual basis or on an interim basis whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable.  All other long-lived and intangible assetsare reviewed for impairment whenever events or circumstances indicate that thecarrying amount of an asset may not be recoverable.  Such impairment loss would be measured as thedifference between the carrying amount of the asset and its fair value based onthe present value of estimated future cash flows.  Significant judgment is required in theforecasting of future operating results, which are used in the preparation ofprojected cash flows.  Due to uncertainmarket conditions and potential changes in our strategy and products, it ispossible that forecasts used to support our intangible assets may change in thefuture, which could result in significant non-cash charges that would adverselyaffect our results of operations.

 

We currently have goodwill and otheracquisition related intangibles, net of accumulated amortization, ofapproximately $234 million, with $195 million of goodwill related toour June 2001 acquisition of Network ICE Corporation (“Network ICE”) andapproximately $20 million of goodwill related to the January 2004acquisition of Cobion, a privately held company based in Kassel, Germany.  The determination of whether or not goodwillis impaired involves significant judgments based upon short and long-termprojections of future performance.  Wehave concluded that this amount is realizable based on forecasted discountedcash flows through 2008 and on our stock market valuation.  Neither method indicated that our goodwillhad been impaired and, as a result, we did not record any impairment lossesrelated to goodwill during 2005.  Otherintangibles of approximately $13 million are principally acquiredtechnology from the Network ICE and Cobion acquisitions that are components inour current product offerings.

 

*RecentlyIssued Accounting Standards*

 

On December 16, 2004, the FinancialAccounting Standards Board (“FASB”) issued SFAS 123 (revised 2004)(SFAS 123R),*“Share-Based Payment”,*which is a revision of SFAS 123,*“Accounting for Stock-Based Compensation”.*  SFAS 123R supersedes APB OpinionNo. 25,*“Accounting for Stock Issued toEmployees”.* Statement 123R requires all share-based payments to employees,including grants of employee stock options, to be recognized in the financialstatements based on their fair values (i.e., pro forma disclosure is no longeran alternative to financial statement recognition.  The Company is required to implement SFAS 123Rat the beginning of the next fiscal year that begins after June 15,2005.  In March 2005, the Securities and Exchange Commission issued StaffAccounting Bulletin No. 107 (“SAB 107”) relating to the adoption of SFAS123(R).  SAB No.107 affects none of theaccounting provisions of SFAS 123R.  Theimpact on the Company’s earnings will include the remaining amortization of thefair value of existing options currently disclosed as pro-forma expense in Note1 and is contingent upon the number of future options granted, the selectedtransition and valuation methods.  While the pro forma information underSFAS 123 indicates that expensing of stock options will have a material impacton the Company’s financial results, the specific impact is not known as theCompany is currently evaluating valuation and transition methods permittedunder SFAS 123R.  The impact of adoptionof Statement 123(R) cannot be predicted at this time because it will depend onlevels of share-based payments granted in the future. However, had we adoptedStatement 123(R) in prior periods, the impact of that standard would haveapproximated the impact of Statement 123 as described in the disclosure of proforma net income and earnings per share in Note 1.

 

In May 2005, the FASB issued SFASNo. 154,*Accounting Changes and ErrorCorrections. * SFAS 154 requires retroactive application of avoluntary change in accounting principle to prior period financial statementsunless it is impracticable.  SFAS No. 154 also requires that a changein method of depreciation, amortization or depletion for long-lived, non-financialassets be accounted for as a change in accounting estimate that is affected bya change in accounting principle.  SFAS No. 154 replaces APB OpinionNo. 20,*Accounting Changes*and SFAS No. 3,*Reporting AccountingChanges in Interim Financial Statements.*  SFAS No. 154 iseffective for fiscal years beginning after December 15, 2005.  TheCompany does not expect the adoption of the provisions of SFAS No. 154 tohave a material impact on its results of operations or financial condition.

 

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**Results ofOperations**

 

The following table sets forth ourconsolidated historical operating information, as a percentage of totalrevenues, for the periods indicated:

 
| ** **                                                | ** ** | **Three months ended** | ** ** | **Nine months ended**  | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Consolidated Statements of  Operations Data:**          |       |                   |       |                   |       |   |   |   |   |
| Product licenses and sales                                |       | 45                     | %          | 43                     | %          | 43 | % | 43 | % |
| Subscriptions                                             |       | 49                     | %          | 49                     | %          | 50 | % | 49 | % |
| Professional services                                     |       | 6                      | %          | 8                      | %          | 7 | % | 8 | % |
|                                                      |       |                   |       |                   |       |   |   |   |   |
| Total revenues                                            |       | 100                    | %          | 100                    | %          | 100 | % | 100 | % |
|                                                      |       |                   |       |                   |       |   |   |   |   |
| Cost of revenues:                                         |       |                   |       |                   |       |   |   |   |   |
| Product licenses and sales                                |       | 9                      | %          | 9                      | %          | 8 | % | 8 | % |
| Amortization of acquired  technology                      |       | 2                      | %          | 2                      | %          | 2 | % | 2 | % |
| Subscriptions and  professional services                  |       | 16                     | %          | 17                     | %          | 17 | % | 18 | % |
|                                                      |       |                   |       |                   |       |   |   |   |   |
| Total cost of revenues                                    |       | 27                     | %          | 28                     | %          | 27 | % | 28 | % |
| Research and development                                  |       | 14                     | %          | 15                     | %          | 14 | % | 16 | % |
| Sales and marketing                                       |       | 33                     | %          | 34                     | %          | 34 | % | 35 | % |
| General and administrative                                |       | 9                      | %          | 10                     | %          | 9 | % | 9 | % |
| Amortization of  intangibles and stock-based compensation |       | —                 | %          | —                 | %          | — | % | — | % |
|                                                      |       |                   |       |                   |       |   |   |   |   |
| Total costs and expenses                                  |       | 83                     | %          | 87                     | %          | 84 | % | 88 | % |
|                                                      |       |                   |       |                   |       |   |   |   |   |
| Operating income                                          |       | 17                     | %          | 13                     | %          | 16 | % | 12 | % |

 

 

**Revenues**

 

*Productlicenses and sales*

 

The Proventia family of network protectionappliances provides unified, multi-function protection capabilities designed toidentify and prevent many forms of attack with minimal user intervention.Software offerings include Proventia PC desktop and laptop solutions,RealSecure solutions for networks and servers and vulnerability assessmentofferings.  These products are designedto operate in demanding network environments while being easy to deploy, easyto use and centrally managed, all in an effort to make our solution morecost-effective.

 

Product licenses and sales in the threemonths ended September 30, 2005 increased by 19% compared with the threemonths ended September 30, 2004, and 16% on a year-to-date basis, due tocontinued positive market response to our Proventia appliance line. Proventia appliances grew 40% from 61% of product license and sales in thethird quarter of 2004 to 72% of product license and sales revenues in the thirdquarter of 2005.  For the nine months ended September 30, 2005Proventia represented 68% of total product and sales revenues compared to 53%in the nine months ended September 30, 2004, growth of 47%.

 

Our future growth is dependent on acontinuation of the positive market response to our Proventia family ofproducts.      Our present productroadmap also focuses on product offerings and enhancements that will continue toimprove central control and manageability, easier deployment and more refinedinformation as well as broader Proventia appliance and software offerings.  We expect that this focus will continue tomake our products more cost effective to implement and maintain the goal ofincreasing the future level of product licenses and sales.  Such sales represent not only product andlicense revenues, but also subscription revenues from customer support.

 

*Subscriptions*

 

Subscription revenues consist of customersupport revenues, which include product and technical support and contentupdates, security-monitoring fees for managed services offerings, and termlicenses of products.  Revenues increasedfrom $35.8 million in the third quarter of 2004 to $40.7 million in the thirdquarter of 2005 representing growth of 14%.  On a year-to-date basissubscription revenues increased 16% from $102.9 million in 2004 to $119.4million in 2005.

 

For the third quarter and first nine monthsof 2005, the largest component of subscription revenues, customer support,increased to 32% of total revenues from 31% in the corresponding periods of2004.  Customer support includes hardwaresupport of our Proventia appliances, software updates and software blades,technical support and security content that includes advisory updates fromX-Force, our internal team of security experts. Customer support is provided through contracts executed with customersfor a specified term and billed at the time of contract.  Such billings are recorded as deferredrevenues on our balance sheet and amortized as subscriptions revenue over theterm of the contract.  We expect customersupport revenues to increase in the future as our client base that generatessuch support revenues expands.

 

Managed services revenues increased to 14% oftotal revenues in the three and nine months ended September 30, 2005, ascompared with 13% in the three and nine months ended September 30,2004.  We believe these increases were due to a strong demand in the marketfor proven, financially sound, managed security service providers.  We are marketing managed services bothdirectly to end users and through partners, including a number of newarrangements with integrators and service providers that include managedservices as a part of their service offerings to their customers.  We also expect sales of managed services tocontinue to grow steadily as we focus our efforts on marketing offerings to newand existing customers that meet changing needs in today’s environment.

 

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*Professionalservices*

 

Professional services revenue decreased from$5.7 million in the three months ended September 30, 2004 to $5.0 millionin the three months ended September 30, 2005.  In the nine months ended September 30,2005 professional services revenues were $16.3 million, compared to $17.5million in the nine months ended September 30, 2004.  We continue to focus on high-value offeringsthat utilize our X-Force expertise, and look to our system integration andchannel partners to serve as the primary resource to fulfill the services andeducation needs of our customers.

 

*Geographicregions*

 

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

 
| ** **       | ** ** | **Three months  ended** | ** ** | **Nine months  ended** | ** ** |
|------------------|------------|-------------------------|------------|------------------------|------------|
| ** **       | ** ** | **September 30,**  | ** ** | **September 30,** | ** ** |
| ** **       | ** ** | **2005**                | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Americas         |       | 65                      | %          | 64                     | %          | 63 | % | 65 | % |
| EMEA             |       | 20                      | %          | 21                     | %          | 21 | % | 21 | % |
| Asia/Pacific Rim |       | 15                      | %          | 15                     | %          | 16 | % | 14 | % |

 

 

While there have been changes in theproportion of revenues generated by each region, all of the regions experiencedgrowth in revenues in 2005.  Fluctuations in foreign currency rates impactour financial results.  We sell primarilyin the functional currency of the countries in which we operate. Therefore, changes in exchange rates impact both our revenues and operatingexpenses.  The U.S. dollar strengthened against these foreign currenciesthroughout 2005 and weakened during 2004. The U.S. dollar value of our non-U.S. dollar revenues decreases as theU.S. dollar strengthens against these foreign currencies and increases as theU.S. dollar weakens against these currencies. When the U.S. dollar weakens as occurred during 2004, the value of ourfunctional currency revenues increases.  During the third quarter of 2005,the strengthening of the dollar against both the euro and yen translated intoless U.S. dollars recorded during consolidation of approximately $915,000 inrevenues when comparing to exchange rates during the second quarter of2005.  When comparing rates in the thirdquarter of 2005 against the third quarter of 2004, the U.S. dollar was slightlystronger against the yen and virtually unchanged against the euro, resulting ina reduction of approximately $150,000 in revenues.

 

The financial data for each segment can befound in Note 6 to the Consolidated Financial Statements.

 

**Costs andExpenses**

 

*Personnel*

 

Personnel and related costs represent our largest expensecategory.  Our employee headcountincreased modestly to approximately 1,225 employees with additions primarily inengineering and sales and marketing.

 

*Cost ofproduct licenses and sales*

 

 

Cost of product licenses and sales consistsof several components.  The substantialportion of our cost of product licenses and sales represents the hardware costof our Proventia appliances.  As ourProventia revenues increase so do the direct costs of the appliances. Other elements of cost of product licenses and sales include the personnelcosts of our fulfillment group and the amortization of development source codelicensed at the beginning of 2004, which is amortized over its estimated usefullife of four years.  Costs associatedwith licensing our software products are minor.

 

As a percentage of product licenses and salesrevenues, these costs decreased from 21% in the quarter endedSeptember 30, 2004 to 20% in the quarter ended September 30,2005.  On a year-to-date basis, cost of product licenses and sales increasedfrom 18% of product licenses and sales revenue in 2004 to 19% in 2005. The changes are in contrast to the high growth in Proventia appliances as aresult of more favorable model mix.  Ahigher percentage of the appliance revenues are higher end models for whichhardware is a lower percentage of the purchase price.

 

We also recorded amortization expense relatedto core and developed technology as a result of acquisitions accounted forunder the purchase method of accounting.  This amortization expensetotaled $1.7 million in the three months ended September 30, 2005 andSeptember 30, 2004, respectively. In the nine months ended September 30, 2005 this amortization expensetotaled $5.3 million compared to $5.1 million in the nine months ended September 30,2004.

 

*Cost ofsubscriptions and professional services*

 

Cost of subscriptions and professionalservices includes the cost of our technical support personnel who provideassistance to customers under customer support agreements, the security operationscenter (“SOC”) costs of providing managed security monitoring services and thecosts related to our professional services and training.  These costs were $13.3 million in the threemonths ended September 30, 2005 and $12.2 million in the three months endedSeptember 30, 2004.  In the nine months ended September 30, 2005

 

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these costs were $39.6 million compared to$36.5 million in the corresponding period of 2004.  These costs, as apercentage of subscription and professional services revenues, decreased from30% in the three and nine months ended September 30, 2004 to 29% in boththe three and nine months ended September 30, 2005.  Costs associatedwith our customer support personnel and our SOC’s increased in the thirdquarter of 2005 compared to the same period of 2004, as well as year-to-date2005 compared to 2004,  as we added personnel and equipment to handleadditional customers.

 

*Researchand development*

 

Research and development expenses consist ofsalary and related costs of research and development personnel, including costsfor employee benefits, and depreciation on computer equipment.  These costs include those associated withmaintaining and expanding the X-Force, our internal team of securityexperts.  We believe our primary researchand product development and managed service offerings are important toretaining our leadership position in the market.

 

We continue to add functionality to ourproduct family, including gateway, network, server and desktop-based solutions,vulnerability assessment and security management applications.  These improvements, as well as new offerings,are intended to provide our customers with more powerful and easier-to-use solutionsfor security management across the enterprise. Examples of product introductions in the first nine months of 2005include the following:

 

•                                          *ProventiaDesktop*:  This product adds two significant new features to our existingRealSecure Desktop product:  Virus Prevention System (“VPS”) and BufferOverflow Exploit Prevention (“BOEP”). VPS uses a patent-pending behavioral analysis method to stop known andunknown viruses, Trojans and worms.  BOEPprevents hackers from taking advantage of frequently discovered buffer overflowvulnerabilities and running malicious code on the desktop.

 

•                                          *ProventiaG400 and G2000*:  These intrusion prevention appliances offerthe flexibility of either 400 megabit or 2 gigabit throughput, and enhancedmanagement features such as spy-ware blocking, improved policy management andhigh-availability.

 

Research and development expenses increasedfrom $10.7 million in the three months ended September 30, 2004 to$11.4 million in the three months ended September 30, 2005.  Ona year-to-date basis, these costs increased slightly in absolute dollars from$32.6 million in the first nine months of 2004 to $32.7 million in the firstnine months of 2005. These increases result from increased developmentefforts focused on planned future appliance and software offerings which areexpected to continue in future periods.

 

 

*Sales andmarketing*

 

Sales and marketing expenses consist ofsalaries, travel expenses, commissions, advertising, maintenance of ourwebsite, trade show expenses, costs of recruiting sales and marketing personneland costs of marketing materials.

 

Sales and marketing expenses increased from$24.7 million in the three months ended September 30, 2004 and $73.1million in the nine months ended September 30, 2004 to $27.7 million and$81.3 million, respectively, in the corresponding periods of 2005.  We added quota-carrying headcount and hadhigher variable commission expense associated with higher product license andsales revenues.  Despite these increases, sales and marketing expensesdecreased to 33% and 34% of total revenues in the three and nine month periodsending September 30, 2005, respectively, from 34% and 35% of total revenues inthe corresponding periods of 2004.

 

We expect to achieve leverage in our salesefforts in the future by focusing our direct sales force on large customersthat are served either directly by us or through large systemsintegrators.  We believe our channel,which includes systems integrators, value-added resellers and distributors,will continue to be of increasing importance to us, measured quantitatively byan increasing level of product revenue originating through these partners.  This channel represented approximately 77% ofour sales in the third quarter of 2005 as compared to 73% in 2004.  We intend to use its capabilities in thefuture to reach larger customers through joint selling efforts and to reachdepartmental and medium and small companies with minimal assistance from ISS.

 

*Generaland administrative*

 

General and administrative expenses consistof personnel-related costs for executive, administrative, finance and humanresources, internal information systems and other support services costs, andlegal, accounting and other professional service fees.  General andadministrative expenses of $7.3 in the third quarter of 2005 were relativelyflat compared with $7.2 million in the third quarter of 2004. Expenses of $22.0million in the first nine months of 2005 increased from $19.8 million in thefirst nine months of 2004 primarily due to higher legal costs and additionalcosts related to compliance with the Sarbanes Oxley Act of 2002.

*Interestincome*

 

Interest income increased from $699,000 inthe quarter ended September 30, 2004 to $1.6 million in the comparablequarter of 2005 and from $1.7 million in the nine months ended September 30,2004 to $3.9 million in the nine months ended September 30, 2005 due to anincrease in the yield on investment-quality commercial paper and similarinvestments from approximately 1.4% in the third quarter of 2004 toapproximately 3.3% during the third quarter of 2005.  Year-to-date yields increased from 1.1% in2004 to 2.9%  in 2005.

 

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*Otherincome (expense), net*

 

Other income (expense) consisted of minorityinterest benefit of $38,000 in the third quarter of 2005 and minority interestexpense of $126,000 in the third quarter of 2004.  Minority interest expense totaled $23,000 and$537,000 for the nine months ended September 30, 2005 and 2004, respectively. These fluctuations resulted primarily from the operations of our Middle Eastjoint venture. Foreign currency exchange gain in the third quarter of 2004 of$9,000 compared to a $39,000 loss during the same period of 2005.  On ayear-to-date basis a foreign currency gain of $14,000 in 2004 compares to aloss of $1.0 million in 2005.  These losses in 2005 occurred primarily dueto the strengthening of the dollar against foreign currencies such as the euroand the yen.

 

*Gain onissuance of subsidiary shares*

 

The gain on issuance of subsidiary shares resultedfrom ISS KK, our Asia/Pacific subsidiary, issuing shares related to theexercise of ISS KK stock options.  For the nine months of 2005, ISS KKissued 899 shares at an average exercise price of approximately $488 pershare.  Our ownership percentage of the subsidiary remained at 87% atSeptember 30, 2005.

 

*Provisionfor income taxes*

 

Our effective tax rate was approximately37.1% for the three months ended September 30, 2005 bringing our rate to36.6% for the nine months ended September 30, 2005.  Income taxexpense is computed base on the estimated tax rate for the year. Such rate canchange as actual income is earned in various jurisdictions which have differenttax rates at different levels that projected in setting the estimated rate.

 

The increase in the anticipated annual ratefor 2005 was created by a shift in expected profits for tax reporting purposesto jurisdictions with higher tax rates.  The effective rate for the threeand nine months ended September 30, 2004 was 37.3% and 36.6%, respectively.  The effective rates differ from the statutoryrates due to the impact of acquisition-related intangibles and certainoperating expenses that are not deductible for income tax purposes as well asfederal and state tax credits.

 

**Liquidityand Capital Resources**

 

Our financial position remained strongthrough the first nine months of 2005. Our cash and cash equivalents and marketable security investments were$218.5 million at September 30, 2005. Our investments in marketable securities consisted solely of highlyrated debt obligations with maturities of twelve months or less.

 

We continue to meet our working capital andcapital expenditure needs with cash provided by operations.  Cash provided by operations in the first ninemonths of 2005 totaled $42.2 million. The major components of cash flows provided by operating activities werenet income of $25.9 million, non-cash depreciation and amortizationexpense charges of $13.2 million, and non-cash deferred compensationexpense of $1.5 million.   Also includedin cash flow from operations was $1.7 million of income tax benefit fromexercise of stock options, which will be classified as a financing activitywith the expected adoption in calendar 2006 of SFAS 123R, “*Share Based Payments*”, issued by the FinancialAccounting Standards Board.

 

An important element of our liquidity is thecollection of our accounts receivable. We measure our accounts receivable management by our day’s salesoutstanding (“DSO”).  This is ameasurement of accounts receivable divided by billings in the quarter,represented by the sum of revenues plus the change in the deferred revenuesliability account balance. This measurement was 85 days atSeptember 30, 2005, within our target range of 75 to 85 days.

 

Our net cash provided by investing activitieswas $55.5 million in the first nine months of 2005.  Investingactivities included changes in our marketable securities that have qualitycharacteristics similar to cash equivalents, except their maturities when weacquire them are longer than three months. The cash flow statement included the purchase of $64.2 million ofsuch marketable securities, primarily interest-bearing government obligationsand commercial paper, offset by net proceeds from the maturity and sales ofmarketable securities of $124.0 million.

 

Our financing activities used$27.1 million of cash in the first nine months of 2005.  This was principally due to the repurchase of1.6 million shares of our common stock in the open market at an aggregate costof $35.5 million.  Since the inception ofthe stock repurchase programs in July 2002, we have purchased6.5 million shares at an average cost of $16.87 per share for a total cashoutlay of approximately $109.9 million.  In July 2005, the Boardof Directors authorized a new repurchase program to spend up to $100 millionover the next year.  Also, in the first nine months of 2005, the exerciseof stock options by our employees and the issuance of common stock through ouremployee stock purchase plan generated funds of approximately $8.4 million.

 

We believe our cash and cash equivalents andmarketable securities will be sufficient to meet our working capital needs andcapital expenditures for the foreseeable future.  Furthermore, we are not aware of any trends,events, or uncertainties that are reasonably likely to result in anysignificant change to our liquidity. From time to time, we evaluate possible acquisition and investmentopportunities in businesses, products or technologies that are complementary toours.  In the event we determine topursue such opportunities, we may use our available cash and cash equivalentsand marketable securities for this purpose.

 

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*Off-Balance Sheet Arrangements*

 

Payments for certain of our operating leasesare secured by four collateralized stand-by letters of credit totalingapproximately $8.8 million at September 30, 2005.  These stand-by letters of credit guaranteeour payment obligations on the leases and are renewable annually over theduration of the applicable leases.  If wedefault on the lease payments, the landlords can make a claim against theletters of credit.  We, in turn, would beliable to the letter of credit issuers. Our stand-by letters of credit are collateralized by securities worth$10.3 million at September 30, 2005. Other than these non-cancelable operating leases, we have no off-balancesheet financing arrangements, any relationships with “structured finance” or “specialpurpose” entities, or any contractual obligations with unconsolidated entitiesthat are reasonably likely to impact our liquidity.

 

 

**RiskFactors**

 

There are many factors that affect ISS’business and the results of its operations, some of which are beyond ISS’control.  The following is a descriptionof some of the important factors that may cause the actual results of ISS’operations in future periods to differ materially from those currently expectedor desired. We encourage you to read this section carefully.

 

*We Operatein a Rapidly Evolving Market*

 

We operate in a rapidly evolving market andmust, among other things:

 

•                  respond to competitivedevelopments;

 

•                  continue to upgrade andexpand our product and services offerings; and

 

•                  continue to attract, retainand motivate our employees.

 

We cannot be certain that we willsuccessfully address these issues.  As aresult, we cannot assure our investors that we will be able to continue tooperate profitably in the future.

 

We introduced our Proventia appliance line inApril 2003 that includes intrusion prevention and integrated securityprotection.  While market response tothese products has had a positive impact on our operating results, failure to continueto gain further market acceptance of new appliance products could result inrevenues below our expectations and our operating results could be adverselyaffected.

 

*Our FutureOperating Results Will Likely Fluctuate Significantly*

 

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

 

•                  the extent to which thepublic perceives that unauthorized access to and use of online information arethreats to network security;

 

•                  customer budgets;

 

•                  the mix of product salesamong the various products offered by ISS and whether revenue isrecognized upon sale or deferred to subsequent periods;

 

•                  the volume and timing oforders, including seasonal trends in customer purchasing;

 

•                  our ability to develop andtimely introduce new and enhanced product and managed service offerings;

 

•                  the introduction andacceptance rate of new ISS branded appliances, including increased cost ofgoods sold;

 

•                  our ability to accuratelyforecast and produce demanded quantities of our appliance products and models;

 

•                  availability of componentparts of appliance products and reliance on contract manufacturers to producesuch products;

 

•                  our ability to providescalable managed services offerings in a cost effective manner;

 

•                  foreign currency exchangerates that affect our international operations;

 

•                  whether enterprisesconsolidate their security platforms with fewer venders and whether ISSbenefits from this;

 

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•                  product and pricecompetition in our markets; and

 

•                  general economic conditions,both domestically and in our foreign markets.

 

We focus our direct sales efforts onenterprise-wide security solutions, which consist of our entire product suite,professional services, and managed security services, rather than on the saleof component products.  As a result, eachsale requires substantial time and effort from our sales and support staff.  In addition, the revenues associated withparticular sales vary significantly depending on the number of productsacquired by a customer and the number of devices used by the customer.  Large individual sales, or even small delaysin customer orders, can cause significant variation in our license revenues andresults of operations for a particular period. The timing of large orders is usually difficult to predict and, likemany software-based technology companies, many of our customers typicallycomplete transactions in the last month of a quarter.

 

We cannot predict our operating expensesbased on our past results.  Instead, weestablish our spending levels based in large part on our expected futurerevenues.  As a result, if our actualrevenues in any future period fall below our expectations, our operatingresults likely will be adversely affected because very few of our expenses varywith our revenues.  Because of thefactors 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 andmeet the expectations of investors with respect to our operating and financialresults is affected by the tendency of a majority of our product and licensesales to be completed in the last month of a quarter.  We may not be able to determine whether wewill experience material deviations from guidance or expectations until the endof a quarter.

 

*Dependenceon Third Party Suppliers and Manufacturers*

 

We carry little inventory of our applianceproducts and we rely on suppliers to deliver necessary components to ourcontract manufacturers in a timely manner based on the forecasts weprovide.  We currently purchase someProventia appliance components and contract manufacturing services from singleor limited sources.  If shortages occur,supplies are interrupted, or we underestimate demand for models, we may not beable to deliver products to our customers and our revenue and operating resultswould be adversely affected.  Because oursupply of hardware is based on short-term forecasts and purchase orders, ourcontract manufacturers are not obligated to purchase components for greaterquantities over longer periods.  Weprovide forecasts of our demand to our contract manufacturers.  If we underestimate our requirements, ourcontract manufacturers may have an inadequate component inventory and, based onlead times, this could interrupt manufacturing and result in delays inshipments and revenues.

 

*We FaceIntense Competition in Our Market*

 

The market for network security monitoring,detection, prevention and response solutions is intensely competitive, and weexpect competition to increase in the future. We cannot guarantee that we will compete successfully against ourcurrent or potential competitors, especially those with significantly greaterfinancial resources or brand name recognition. Our chief competitors generally fall within the following categories:

 

•      largecompanies, including Symantec Corp., Cisco Systems, Inc., JuniperNetworks, Inc., and McAfee, Inc., that sell competitive products andofferings, as well as other large software companies that have the technicalcapability and resources to develop competitive products;

 

•      softwareor hardware network infrastructure companies like Cisco Systems, Inc. andJuniper Networks, Inc. that could integrate features that are similar toour products into their own products;

 

•      smallersoftware companies offering relatively limited applications for network andInternet security; and

 

•      smalland large companies with competitive offerings to components of our managedservices offerings.

 

Mergers or consolidations among thesecompetitors, or acquisitions of small competitors by larger companies,represent risks.  For example, SymantecCorp., Cisco Systems, Inc., McAfee, Inc., and JuniperNetworks, Inc. have acquired during the past several years smallercompanies, which have intrusion detection or prevention technologies.  These acquisitions will make these entitiespotentially more formidable competitors to us if such products and offeringsare effectively integrated.  Largecompanies may have advantages over us because of their longer operatinghistories, greater name recognition, larger customer bases or greaterfinancial, technical and marketing resources. As a result, they may be able to adapt more quickly to new or emergingtechnologies and changes in customer requirements.  They can also devote greater resources to thepromotion and sale of their products than we can.  In addition, these companies have reduced andcould continue to reduce, the price of their security monitoring, detection,prevention and response products and managed security services, which increasespricing pressures within our market.

 

Several companies currently sell softwareproducts (such as encryption, firewall, operating system security and virusdetection software) that our customers and potential customers have broadlyadopted.  Some of these companies sellproducts that perform the same functions as some of our products.  In addition, the vendors of operating systemsoftware or networking hardware may enhance their products to include the samekinds of functions that our products currently provide.  The widespread inclusion of comparable 

 

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features to our software in operating systemsoftware or networking hardware could render our products less competitive orobsolete, particularly if such features are of a high quality.  Even if security functions integrated intooperating system software or networking hardware are more limited than those ofour products, a significant number of customers may accept more limitedfunctionality to avoid purchasing additional products.

 

In addition, with the introduction of ourProventia integrated security appliance, we have offerings that compete withvendors of firewalls, VPNs, anti-virus systems, and content and spam filteringproducts.  These offerings arecompetitive with a broader spectrum of network security companies, as well asthose that also offer integrated security appliances or broad product suites.

 

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

 

*We FaceRapid Technological Change in Our Industry and Frequent Introductions of NewProducts*

 

Rapid changes in technology pose significantrisks to us.  We do not control nor canwe influence the forces behind these changes, which include:

 

•      theextent to which businesses and others seek to establish more secure networks;

 

•      theextent to which hackers and others seek to compromise secure systems;

 

•      evolvingcomputer hardware and software standards;

 

•      changingcustomer requirements; and

 

•      frequentintroductions of new products and product enhancements.

 

To remain successful, we must continue tochange, adapt and improve our products in response to these and other changesin technology.  Our future success hingeson our ability to both continue to enhance our current line of products andprofessional services and to introduce new products and services that addressand respond to innovations in computer hacking, computer technology andcustomer requirements.  We cannot be surethat we will successfully develop and market new products that do this.  Any failure by us to timely develop andintroduce new products, to enhance our current products or to expand ourprofessional services capabilities in response to these changes could adverselyaffect our business, operating results and financial condition.

 

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

 

The techniques computer hackers use to gainunauthorized access to, or to sabotage, networks and intranets are constantlyevolving and increasingly sophisticated. Furthermore, because new hacking techniques are usually not recognizeduntil used against one or more targets, we are unable to anticipate most newhacking techniques.  To the extent thatnew hacking techniques harm our customers’ computer systems or businesses,affected or prospective customers may believe that our products areineffective, which may cause them or prospective customers to reduce or avoidpurchases of our products.

 

*UndetectedProduct Errors or Defects Could Result in Loss of Revenues, Delayed MarketAcceptance and Claims Against Us*

 

We offer warranties on our products, allowingthe end customer to have any defective product repaired, or to receive areplacement product for it during the warranty period, or in certaincircumstances return the product for a refund. Our products may contain undetected errors or defects.  If there is a broad product failure acrossour customer base, we may decide to replace all affected products or we maydecide to refund the purchase price for defective units.  Such defects and actions may adversely affectour ability to record revenue.  Someerrors are discovered only after a product has been installed and used by endcustomers.  Any errors discovered aftercommercial release could result in loss of revenues and claims against us.

 

We offer warranties on our service levels formanaged security services.  If we do notmeet warranties, the customer generally may obtain credits for service.

 

If we are unable to fix errors or otherproduct problems that later are identified after full deployment, or if we failto meet our service levels for managed security services, in addition to theconsequences described above, we could experience:

 

•      failureto achieve market acceptance;

 

•      lossof customers;

 

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•      lossof or delay in revenues and loss of market share;

 

•      diversionof development resources;

 

•      increasedservice and warranty costs;

 

•      legalactions by our customers; and

 

•      increasedinsurance costs.

 

*OurProducts are Complex and Are Operated in a Wide Variety of ComputerConfigurations, Which Could Result in Errors or Product Failures*

 

Because we offer very complex products,undetected errors, failures or bugs may occur when they are first introduced orwhen new versions are released.  Ourproducts often are installed and used in large-scale computing environmentswith different operating systems, system management software and equipment andnetworking configurations, which may cause errors or failures in our productsor may expose undetected errors, failures or bugs in our products.  We discover errors, failures and bugs incertain of our product offerings after their introduction and have experienceddelays and could experience lost revenues during the period required to correctthese errors.  Our customers’ computerenvironments are often characterized by a wide variety of standard andnon-standard configurations that make pre-release testing for programming orcompatibility errors very difficult and time-consuming.  Despite testing, errors, failures or bugs maynot be found in new products or releases until after commencement of commercialshipments.  Errors, failures or bugs inproducts released by us could result in negative publicity, product returns,loss of or delay in market acceptance of our products or claims by customers orothers.

 

In addition, if an actual or perceived breachof network security occurs in one of our end customer’s security systems,regardless of whether the breach is attributable to our products, the marketperception of the effectiveness of our products could be harmed.  Because the techniques used by computerhackers to access or sabotage networks change frequently and generally are notrecognized until launched against a target, we may be unable to anticipatethese techniques.  Alleviating any ofthese problems could require significant expenditures of our capital andresources and could cause interruptions, delays or cessation of our productlicensing, which could cause us to lose existing or potential customers andwould adversely affect results of operations.

 

*We MightHave to Defend Lawsuits or Pay Damages in Connection With Any Alleged or ActualFailure of Our Products and Services*

 

Because our products and services provide andmonitor network security and may protect valuable information, we could faceclaims for product liability, tort or breach of warranty.  Anyone who circumvents our security measurescould misappropriate the confidential information or other property of endcustomers using our products, or interrupt their operations.  If that happens, affected end customers orothers may sue us.  In addition, we mayface liability for breaches caused by faulty installation of our products byour service and support organizations. Provisions in our contracts relating to warranty disclaimers andliability limitations may be unenforceable. Some courts, for example, havefound contractual limitations of liability in standard computer and softwarecontracts to be unenforceable in some circumstances.  Defending a lawsuit, regardless of its merit,could be costly and could divert management attention.  Our business liability insurance coverage maybe inadequate or future coverage may be unavailable on acceptable terms or atall.

 

*RisksAssociated with Our Global Operations*

 

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

 

•                  the difficulty in managingan organization spread over various countries located across the world;

 

•                  compliance with, andunexpected changes in, a wide range of complex regulatory requirements incountries where we do business;

 

•                  duties and tariffs imposedon importation of our products in other jurisdictions where other manufacturersmay not bear those same costs;

 

•                  increased financialaccounting and reporting burdens;

 

•                  potentially adverse taxconsequences;

 

•                  fluctuations in foreigncurrency exchange rates resulting in losses or gains from transactions andexpenses denominated in foreign currencies;

 

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•                  reduced protection forintellectual property rights in some countries;

 

•                  reduced protection forenforcement of creditor and contractual rights in some countries; and

 

•                  import and export licenserequirements and restrictions on the import and export of certain technology,especially encryption technology and trade restrictions.

 

Despite these risks, we believe that we mustcontinue to expand our operations in international markets to support ourgrowth.  To this end, we intend toestablish additional foreign sales operations, expand our existing offices,hire additional personnel, expand our international sales channels andcustomize our products for local markets. If we fail to execute this strategy,our international sales growth will be limited.

 

*OurNetworks, 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 profiletarget.  Although we believe we havesufficient controls in place to prevent disruption and misappropriation, and torespond to such situations, we expect these efforts by hackers tocontinue.  If these efforts aresuccessful, our operations, reputation and sales could be adversely affected.

 

*We MustSuccessfully Integrate Acquisitions*

 

As part of our growth strategy, we have andmay continue to acquire or make investments in companies with products,technologies or professional services capabilities complementary to oursolutions.  When engaging inacquisitions, we could encounter difficulties in assimilating or completing thedevelopment of the technologies, new personnel and operations into ourcompany.  These difficulties may disruptour ongoing business, distract our management and employees, increase ourexpenses and adversely affect our results of operations.  These difficulties could also includeaccounting requirements, such as impairment charges related to goodwill orother intangible assets or expensing in-process research and development costs.  We cannot be certain that we willsuccessfully overcome these risks with respect to any future acquisitions orthat we will not encounter other problems in connection with our recent or anyfuture acquisitions.  In addition, anyfuture acquisitions may require us to incur debt or issue equitysecurities.  The issuance of equitysecurities could dilute the investment of our existing stockholders.

 

*OurProprietary Rights May be Difficult to Enforce*

 

We rely primarily on copyright, trademark,patent and trade secrets laws, confidentiality procedures and contractualprovisions to protect our proprietary rights. We hold two United States patents, one Taiwanese patent, and have anumber of patent applications pending. We also hold numerous United States and foreign trademarks and have anumber of trademark applications pending. There can be no assurance that patents will be issued from pendingapplications, or that claims allowed on any patents will be sufficiently broadto protect our technology.  There can beno assurance that any issued patents will not be challenged, invalidated orcircumvented, or that any rights granted under these patents will actuallyprovide competitive advantages to us. Despite our efforts to protect our proprietary rights, unauthorizedparties may attempt to copy aspects of our products or to obtain and useinformation that we regard as proprietary. Policing unauthorized use of our products is difficult.  While we cannot determine the extent to whichpiracy of our software products occurs, we expect software piracy to be apersistent problem.  In addition, thelaws of some foreign countries do not protect our proprietary rights to asgreat an extent as do the laws of the United States, and many foreign countriesdo not enforce these laws as diligently as U.S. government agencies andprivate parties.  If we are unable toprotect our proprietary rights to the totality of the features in our softwareand products (including aspects of our software and products protected otherthan by patent rights), we may find ourselves at a competitive disadvantage toothers who need not incur the additional expense, time and effort required tocreate the innovative products that have enabled us to be successful.

 

*WeMay Be Found to Infringe the Proprietary Rights of Others*

 

Third parties may assert claims or initiatelitigation related to exclusive patent, copyright, trademark and otherintellectual property rights to technologies that are relevant to ourbusiness.  Because of the large number ofpatents in the Internet, networking, security and software fields, the secrecyof some pending patents and the rapid rate of issuance of new patents, it isnot economically practical (or even possible) to determine in advance whether aproduct (or any of its components) infringe or will infringe the patent rightsof others.  Third party asserted claimsand/or initiated litigation can include claims against us or our manufacturers,suppliers, or customers, alleging infringement of proprietary rights withrespect to our existing or future products (or components of those products).  Regardless of the merit of these claims, theycan be time-consuming, result in costly litigation and diversion of technicaland management personnel, or require us to develop a non-infringing technologyor enter into license agreements.  There canbe no assurance that licenses will be available on acceptable terms andconditions, if at all, in these circumstances, or that any indemnification thatmight be available to us would be adequate to cover our costs of defense.  Furthermore, because of the potential forlarge judgments, which are not necessarily predictable, it is not unusual tofind even arguably unmeritorious claims settled for significant funds.  If any infringement or other intellectualproperty claims made against us by a third party is successful, or if we fail 

 

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to develop non-infringing technology orlicense the proprietary rights on commercially reasonable terms and conditions,our business, operating results, financial condition and liquidity could bematerially and adversely affected.

 

 

*SomeProvisions in the ISS Certificate of Incorporation and Bylaws Make a Takeoverof ISS Difficult*

 

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

 

•                  establish a classified boardof directors;

 

•                  create preferred stockpurchase rights that grant to holders of common stock the right to purchaseshares of Series A Junior Preferred Stock in the event that a third partyacquires 20% or more of the voting power of our outstanding common stock;

 

•                  prohibit the right of ourstockholders to act by written consent;

 

•                  limit calling specialmeetings of stockholders; and

 

•                  impose a requirement thatholders of 66 2/3% of theoutstanding shares of common stock are required to amend the provisionsrelating to the classification of our board of directors and action by writtenconsent of stockholders.

 

**Item 3. Quantitative and Qualitative Disclosures AboutMarket Risk**

 

The Company’s operating results are affectedby changes in exchange rates between the U.S. dollar and the euro and theJapanese yen.  The U.S. dollar value of our non-U.S. dollar revenuesdecreases as the U.S. dollar strengthens against these foreign currencies andincreases as the U.S. dollar weakens against these currencies.  In thequarter ended September 30, 2005 the U.S. dollar strengthened against theeuro and the yen by approximately 3% compared to average rates during thesecond quarter of 2005.  The resulting impact of this strengthening in thethird quarter was a decrease in revenues of approximately $915,000 whencompared to exchange rates during the second quarter of 2005.  Since muchof our international operating expenses are also incurred in local currencies,which are the foreign subsidiaries functional currency, the impact of exchangerates on net income or loss is relatively less than the impact onrevenue.  For the third quarter of 2005 the impact was a reduction in netincome of approximately $230,000 when compared to exchange rates for the secondquarter of 2005.  Although our operatingand pricing strategies take into account changes in exchange rates over time,our results of operations may be affected significantly in the short term byfluctuations in foreign currency exchange rates.  As an example, foreign exchange rates havechanged significantly over the last year such that consolidated revenues forthe fourth quarter of 2005 at the current exchange rates are expected to beapproximately 3% lower than such results would be using exchange rates for thefourth quarter of 2004.

 

Assets and liabilities are translated at theexchange rate on the balance sheet date.  As the U.S. dollar strengthensagainst the euro and yen, the assets of our entities, with the euro and yen astheir functional currencies, translate into fewer U.S. dollars duringconsolidation.  As the U.S. dollar weakens against these currencies, theseassets translate into higher U.S. Dollars during consolidation.  Thetranslation adjustments resulting from this process are shown separately as acomponent of stockholders’ equity.

 

Transactions gains or losses are recorded byour entities for transactions denominated in currencies other than theirrespective functional currencies.  We recognized foreign exchange rateloss of approximately $39,000 and an exchange rate gain of approximately $9,000during the three months ended September 30, 2005 and 2004,respectively.  Foreign exchange rate transaction gains and losses areclassified in “Other income (expense)” on our Consolidated Statements ofOperations.

 

The nature and extent of the foreign currencyrisk faced by the Company depends on many factors that cannot be accuratelypredicted.  These factors includesignificant changes in foreign currency market conditions, the Company’sinability to match foreign currency denominated revenues with costs denominatedin the same currency, and changes in the amount or mix of revenues denominatedin various foreign currencies.  As aresult of material unforeseen changes in these factors, the Company’s foreigncurrency risk could have a greater impact on the Company’s results ofoperations in the future.

 

 

**Item 4. Controls and Procedures**

 

*DisclosureControls and Procedures*

 

Our management, with the participation of theChief Executive Officer and Chief Financial Officer, evaluated theeffectiveness of our disclosure controls and procedures, as defined inRules 13a-15(e) and 15d-15(e) under the Securities and ExchangeAct of 1934, as of September 30, 2005.  No system of controls, nomatter how well designed and operated, can provide absolute assurance that theobjectives of the system of controls are met, and no evaluation of controls canprovide absolute assurance that the system of controls has operated effectivelyin all cases.  Our disclosure controls and procedures however are designedto provide reasonable assurance that the objectives of disclosure controls andprocedures are met.

 

Based on such evaluation, these officers haveconcluded that, as of such date, our disclosure controls and procedures wereeffective to 

 

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provide reasonable assurance that informationrequired to be disclosed in the reports the Company files or submits under theSecurities Exchange Act of 1934 is recorded, processed, summarized and reportedon a timely basis.

 

*Changes inInternal Control Over Financial Reporting*

 

There have not been any changes ISS’ internalcontrol over financial reporting during the quarter ended September 30,2005 that have materially affected, or are reasonably likely to materiallyaffect, such controls.

 

**PART II.OTHER INFORMATION**

 

**Item 1.Legal Proceedings**

 

On August 17, 2004, the Company’s Georgiaoperating subsidiary filed in the United States District Court for the NorthernDistrict of Georgia a declaratory judgment action (the “Georgia Action”)against SRI International, Inc. (“SRI”). The action seeks the court’s declaration that our products and servicesdo not infringe any valid claim of five patents held by SRI and seeksdeclaration that certain claims of those patents are invalid.  On August 26, 2004, SRI filed in the UnitedStates District Court for Delaware a complaint against the Company and SymantecCorporation (the “Delaware Action”).  Thecomplaint in the Delaware Action alleges that our SiteProtector and Proventiaproducts infringe upon claims of two of the five patents at issue in theGeorgia Action. The Delaware Action seeks unspecified damages and injunctiverelief.  On April 25, 2005, SRI filed anamended complaint adding the Company’s Georgia operating subsidiary as aseparate defendant to the Delaware Action. The Company and its subsidiary answered SRI’s amended complaint on May23, 2005, denying that they infringe the two patents asserted by SRI andasserting counterclaims seeking a declaration from the Delaware court that thefive SRI patents are not infringed, and are invalid and unenforceable. On June9, 2005, the Georgia court transferred the Georgia Action to the United StatesDistrict Court for the District of Delaware. The transferred action was consolidated with the Delaware Action.  On June 13, 2005, SRI answered thecounterclaims asserted by the Company and its subsidiary, denying that the fivepatents are not infringed, invalid, and unenforceable.  On August 5, 2005, SRI granted to the Companya covenant never to sue the Company, its distributors, customers, licensees orend users, for damages or any other form of legal or equitable relief based onor arising out of the alleged infringement of one of the five patents-in-suitas a result of the manufacture, use, sale, offer for sale, importation,maintenance, support or servicing of any Company product or service existing onor before the effective date.  Theparties are currently engaged in discovery on the remaining claims, and trialhas been scheduled to begin on or about October 30, 2006.  We intend to defend the Delaware Actionvigorously and believe we have meritorious defenses and counterclaims.  Due to the uncertainty surrounding thelitigation process and the early stage of the proceedings, the Company isunable to reasonably estimate a range of loss, if any, at this time.

 

**Item 2. Unregistered Sales of Equity Securities and Useof Proceeds**

 

The following table provides informationabout purchases by the Company of its common stock during the three monthsended September 30, 2005.  All suchpurchases were made in open-market transactions pursuant to a repurchase planpublicly announced on July 27, 2005. Under this repurchase plan, the Company has been authorized by the Boardto repurchase up to $100 million of its outstanding common stock over the 12months ending July 19, 2006.  TheCompany had a prior repurchase plans in place that terminated on July 19,2004 and July 19, 2005, and no further purchases can be made under those plans.  Through September 30, 2005, the Company hadpurchased approximately 6.5 million shares at an aggregate cost ofapproximately $109.9 million under the current and prior repurchase plans.

 

 

 

**Issuer Purchases of Equity Securities**

** **
| ** **     | ** ** | ** **       | ** ** | ** **        | ** ** | **Total Number of**       | ** ** | ** **               | ** ** |
|----------------|------------|------------------|------------|-------------------|------------|---------------------------|------------|--------------------------|------------|
| ** **     | ** ** | ** **       | ** ** | ** **        | ** ** | **Shares Purchased**      | ** ** | **Approximate Dollar**   | ** ** |
| ** **     | ** ** | **Total Number** | ** ** | ** **        | ** ** | **As**                    | ** ** | **Value of Shares**      | ** ** |
| ** **     | ** ** | **of**           | ** ** | **Average Price** | ** ** | **Part of Publicly** | ** ** | **that May Yet Be** | ** ** |
| ** **     | ** ** | **Shares**       | ** ** | **Paid**          | ** ** | **Announced Plans or**    | ** ** | **Purchased Under the**  | ** ** |
| **Period**     | ** ** | **Purchased**    | ** ** | **Per Share**     | ** ** | **Programs**              | ** ** | **Plans or Programs**    | ** ** |
| 7/1/05-7/31/05 |       | —           |       | $                 | —     |                      | —     |                     | $          | 100,000,000 |   |
| 8/1/05-8/31/05 |       | 570,000          |       | $                 | 22.20      |                      | 570,000    |                     | $          | 87,346,000 |   |
| 9/1/05-9/30/05 |       | 190,000          |       | $                 | 23.45      |                      | 190,000    |                     | $          | 82,890,000 |   |

 

 

**Item 3. Defaults Upon Senior Securities**

 

None.

 

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

 

None.

 

**Item 5.Other Information**

 

None.

 

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**Item 6. Exhibits**

 
|   |   | 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 Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 |
|   |   | 32  .2* |   | — |   | Certification  Pursuant to 18 U.S.C. Section 1350. as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 |

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*      Identifiesthose filed exhibits with this Form 10-Q.

 

**    Data requiredby SFAS No. 128, “Earnings Per Share”, is provided in Note 5 tothe consolidated financial statements in this report.

 

 

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**SIGNATURES**

 

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

 
|                         | INTERNET SECURITY SYSTEMS,  INC.                      |
|------------------------------|-------------------------------------------------------|
|                         | (Registrant)                                          |
|                         |                                                  |
| Date: November 9,  2005 | By /s/ Richard Macchia                                |
|                         | Senior Vice President  Finance and Administration     |
|                         | and Chief Financial  Officer (on behalf of registrant |
|                         | and as principal financial  officer)                  |

 

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