UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

|                                  |  |                                                                                         
|--------------------------------- |  | ----------------------------------------------------------------------------------------
|(Mark One)                       
|[X]                               |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 
|                                 
|                                 
|                                 
|                                 
|                                  |  | For the quarterly period ended June 30, 2001                                            
|                                 
|                                 
|                                 
|                                 
|                                  |  | OR                                                                                      
|                                 
|                                 
|                                 
|                                 
|[   ]                             |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
|                                 
|                                 
|                                 
|                                 
|For the transition period from to

Commission File Number 0-23655

INTERNET SECURITY SYSTEMS, INC.

---

(Exact name of registrant as specified in its charter)


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

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

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

NOT APPLICABLE

---

(Former name, former address and former fiscal year, if changed since
last report.)


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

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

|                               |  |                                                  
|------------------------------ |  | -------------------------------------------------
|Title of each class            |  | Number of Shares Outstanding
as of August 3, 2001
|                               |  |                                                  
|Common Stock, $0.001 par value |  | 47,665,490                                       



---



|        |  |                                                                                                                 |  |       
|------- |  | --------------------------------------------------------------------------------------------------------------- |  | ------
|        |  |                                                                                                                 |  | PAGE  
|        |  |                                                                                                                 |  | NUMBER
|        |  |                                                                                                                 |  |       
|PART I  |  | FINANCIAL INFORMATION                                                                                           |  |       
|       
|       
|       
|       
|Item 1  |  | Consolidated Financial Statements:                                                                              |  |       
|       
|       
|       
|       
|        |  | Consolidated Balance Sheets at June 30, 2001 and
December 31, 2000                                              |  | 3     
|       
|       
|       
|       
|        |  | Consolidated Statements of Operations for the three months
and six months ended June 30, 2001 and June 30, 2000 |  | 4     
|       
|       
|       
|       
|        |  | Consolidated Statements of Cash Flows for the six months
ended June 30, 2001 and June 30, 2000                  |  | 5     
|       
|       
|       
|       
|        |  | Notes to Consolidated Financial Statements                                                                      |  | 6     
|       
|       
|       
|       
|Item 2  |  | Managements Discussion and Analysis of
Financial Condition and Results of Operations                           |  | 10    
|       
|       
|       
|       
|Item 3  |  | Quantitative and Qualitative Disclosures about Market Risk                                                      |  | 19    
|       
|       
|       
|       
|PART II |  | OTHER INFORMATION                                                                                               |  |       
|       
|       
|       
|       
|Item 2  |  | Changes in Securities and Use of Proceeds                                                                       |  | 21    
|       
|       
|       
|       
|Item 4  |  | Submission of Matters to a Vote of Security Holders                                                             |  | 21    
|       
|       
|       
|       
|Item 6  |  | Exhibits and Reports on Form 8-K                                                                                |  | 21    

-2-



---



PART I

FINANCIAL INFORMATION

ITEM 1

INTERNET SECURITY SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS
(amounts in thousands, except per share amounts)


|                                                                                    |                                                                                                                                     |                                            |                                      |         |         |             |        |              |         |  |  | 
|----------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------------------------------------ | ------- | ------- | ----------- | ------ | ------------ | ------- |  |  | 
|                                                                                    |                                                                                                                                     |                                            |                                      |         |         | June 30,    |        | December 31,
|                                                                                    |                                                                                                                                     |                                            |                                      |         |         | 2001        |        | 2000        
|                                                                                    |                                                                                                                                     |                                            |                                      |         |         |             |        |             
|                                                                                    |                                                                                                                                     |                                            |                                      |         |         | (unaudited) |       
|                                                                                    |                                                                                                                                     |                                            |                                      | ASSETS  |         |             |        |              |         |  |  | 
|Current assets:                                                                     |                                                                                                                                     |                                            |                                      |         |         |             |        |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Cash and cash equivalents                                                                                                           |                                            | $                                    | 80,619  |         |             | $      | 66,210       |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Marketable securities                                                                                                               |                                            |                                      | 63,759  |         |             |        | 65,938       |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Accounts receivable, less allowance for doubtful accounts
of $1,522 and $1,188, respectively                                        |                                            |                                      | 54,478  |         |             |        | 56,358       |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Inventory                                                                                                                           |                                            |                                      | 1,417   |         |             |        | 2,275        |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Prepaid expenses and other current assets                                                                                           |                                            |                                      | 9,937   |         |             |        | 5,717        |        
|                                                                                    |                                                                                                                                     |                                            |                                      |         |         |             |        |             
|                                                                                    |                                                                                                                                     | Total current assets                       |                                      |         | 210,210 |             |        |              | 196,498 | 
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|Property and equipment:                                                             |                                                                                                                                     |                                            |                                      |         |         |             |        |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Computer equipment                                                                                                                  |                                            |                                      | 27,936  |         |             |        | 20,199       |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Office furniture and equipment                                                                                                      |                                            |                                      | 17,815  |         |             |        | 9,958        |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Leasehold improvements                                                                                                              |                                            |                                      | 12,507  |         |             |        | 6,609        |        
|                                                                                    |                                                                                                                                     |                                            |                                      |         |         |             |        |             
|                                                                                    |                                                                                                                                     |                                            | 58,258                               |         |         |             | 36,766 |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Less accumulated depreciation                                                                                                       |                                            |                                      | 19,157  |         |             |        | 13,673       |        
|                                                                                    |                                                                                                                                     |                                            |                                      |         |         |             |        |             
|                                                                                    |                                                                                                                                     |                                            | 39,101                               |         |         |             | 23,093 |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|Restricted marketable securities                                                    |                                                                                                                                     |                                            | 12,500                               |         |         |             | 12,500 |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|Goodwill, less accumulated amortization of $5,003
and $876, respectively            |                                                                                                                                     |                                            | 218,237                              |         |         |             | 3,167  |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|Other intangibles, less accumulated amortization of
$2,214 and $1,500, respectively |                                                                                                                                     |                                            | 22,151                               |         |         |             | 3,346  |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|Other assets                                                                        |                                                                                                                                     |                                            | 3,941                                |         |         |             | 1,636  |             
|                                                                                    |                                                                                                                                     |                                            |                                      |         |         |             |        |             
|                                                                                    |                                                                                                                                     | Total assets                               |                                      | $       | 506,140 |             |        | $            | 240,240 | 
|                                                                                    |                                                                                                                                     |                                            |                                      |         |         |             |        |             
|                                                                                    |                                                                                                                                     |                                            | LIABILITIES AND STOCKHOLDERS EQUITY |         |         |             |        |              |         |  | 
|Current liabilities:                                                                |                                                                                                                                     |                                            |                                      |         |         |             |        |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Accounts payable                                                                                                                    |                                            | $                                    | 9,884   |         |             | $      | 4,200        |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Accrued expenses                                                                                                                    |                                            |                                      | 16,483  |         |             |        | 15,490       |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Deferred revenues                                                                                                                   |                                            |                                      | 44,453  |         |             |        | 31,675       |        
|                                                                                    |                                                                                                                                     |                                            |                                      |         |         |             |        |             
|                                                                                    |                                                                                                                                     | Total current liabilities                  |                                      |         | 70,820  |             |        |              | 51,365  | 
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|Other non-current liabilities                                                       |                                                                                                                                     |                                            | 397                                  |         |         |             | 486    |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|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,
47,615,000 and 42,415,000 shares issued and outstanding, respectively |                                            |                                      | 48      |         |             |        | 42           |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Additional paid-in capital                                                                                                          |                                            |                                      | 424,566 |         |             |        | 172,985      |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Deferred compensation                                                                                                               |                                            |                                      | (5,674  | )       |             |        | (86          | )      
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Accumulated other comprehensive loss                                                                                                |                                            |                                      | (1,141  | )       |             |        | (745         | )      
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Retained earnings                                                                                                                   |                                            |                                      | 17,124  |         |             |        | 16,193       |        
|                                                                                    |                                                                                                                                     |                                            |                                      |         |         |             |        |             
|                                                                                    |                                                                                                                                     | Total stockholders equity                 |                                      |         | 434,923 |             |        |              | 188,389 | 
|                                                                                    |                                                                                                                                     |                                            |                                      |         |         |             |        |             
|                                                                                    |                                                                                                                                     | Total liabilities and stockholders equity |                                      | $       | 506,140 |             |        | $            | 240,240 | 
|                                                                                    |                                                                                                                                     |                                            |                                      |         |         |             |        |             

-3-



---



INTERNET SECURITY SYSTEMS,
INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(amounts in thousands, except per share amounts)
(unaudited)


|                                                    |                                                          |                                         |         |                    |        |                  |        |        |       |      |         |        |        |   |        |        |        | 
|--------------------------------------------------- | -------------------------------------------------------- | --------------------------------------- | ------- | ------------------ | ------ | ---------------- | ------ | ------ | ----- | ---- | ------- | ------ | ------ | - | ------ | ------ | ------ | 
|                                                    |                                                          |                                         |         | Three months ended |        | Six months ended
|                                                    |                                                          |                                         |         | June 30,           |        | June 30,        
|                                                    |                                                          |                                         |         |                    |        |                 
|                                                    |                                                          |                                         |         | 2001               |        | 2000             |        | 2001   |       | 2000
|                                                    |                                                          |                                         |         |                    |        |                  |        |        |       |     
|Revenues:                                           |                                                          |                                         |         |                    |        |                  |        |        |       |      |         |        |        |   |        |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Product licenses and sales                               |                                         | $       | 28,088             |        |                  | $      | 26,331 |       |      | $       | 64,264 |        |   | $      | 51,109 |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Subscriptions                                            |                                         |         | 15,460             |        |                  |        | 9,537  |       |      |         | 30,596 |        |   |        | 17,626 |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Professional services                                    |                                         |         | 8,162              |        |                  |        | 8,349  |       |      |         | 18,005 |        |   |        | 14,773 |       
|                                                    |                                                          |                                         |         |                    |        |                  |        |        |       |      |         |        |        |   |        |       
|                                                    |                                                          |                                         | 51,710  |                    |        |                  | 44,217 |        |       |      | 112,865 |        |        |   | 83,508 |       
|                                                   
|                                                   
|                                                   
|                                                   
|Costs and expenses:                                 |                                                          |                                         |         |                    |        |                  |        |        |       |      |         |        |        |   |        |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Cost of revenues:                                        |                                         |         |                    |        |                  |        |        |       |      |         |        |        |   |        |        |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    |                                                          | Product licenses and sales              |         |                    | 3,607  |                  |        |        | 4,442 |      |         |        | 10,151 |   |        |        | 9,697  | 
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    |                                                          | Subscriptions and professional services |         |                    | 13,457 |                  |        |        | 8,597 |      |         |        | 25,295 |   |        |        | 15,330 | 
|                                                    |                                                          |                                         |         |                    |        |                  |        |        |       |      |         |        |        |   |        |       
|                                                    | Total cost of revenues                                   |                                         |         | 17,064             |        |                  |        | 13,039 |       |      |         | 35,446 |        |   |        | 25,027 |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Research and development                                 |                                         |         | 8,940              |        |                  |        | 7,566  |       |      |         | 17,255 |        |   |        | 14,368 |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Sales and marketing                                      |                                         |         | 23,913             |        |                  |        | 15,658 |       |      |         | 45,547 |        |   |        | 29,942 |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | General and administrative                               |                                         |         | 5,085              |        |                  |        | 3,491  |       |      |         | 9,596  |        |   |        | 6,375  |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Write-off of lease obligation                            |                                         |         |                   |        |                  |        |       |       |      |         | 1,072  |        |   |        |       |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Charge for in-process research and development           |                                         |         | 2,910              |        |                  |        |       |       |      |         | 2,910  |        |   |        |       |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Amortization of goodwill                                 |                                         |         | 3,930              |        |                  |        | 80     |       |      |         | 4,128  |        |   |        | 159    |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Amortization of intangibles and stock based
compensation |                                         |         | 1,146              |        |                  |        | 168    |       |      |         | 1,314  |        |   |        | 337    |       
|                                                    |                                                          |                                         |         |                    |        |                  |        |        |       |      |         |        |        |   |        |       
|                                                    |                                                          |                                         | 62,988  |                    |        |                  | 40,002 |        |       |      | 117,268 |        |        |   | 76,208 |       
|                                                   
|                                                   
|                                                   
|                                                   
|Operating income (loss)                             |                                                          |                                         | (11,278 | )                  |        |                  | 4,215  |        |       |      | (4,403  | )      |        |   | 7,300  |       
|                                                   
|                                                   
|                                                   
|                                                   
|Interest income, net                                |                                                          |                                         | 1,792   |                    |        |                  | 2,070  |        |       |      | 3,750   |        |        |   | 3,938  |       
|                                                   
|                                                   
|                                                   
|                                                   
|Other income                                        |                                                          |                                         |        |                    |        |                  |       |        |       |      | 1,638   |        |        |   |       |       
|                                                   
|                                                   
|                                                   
|                                                   
|Foreign currency exchange gain (loss)               |                                                          |                                         | (31     | )                  |        |                  | 95     |        |       |      | (282    | )      |        |   | (31    | )     
|                                                    |                                                          |                                         |         |                    |        |                  |        |        |       |      |         |        |        |   |        |       
|Income (loss) before income taxes                   |                                                          |                                         | (9,517  | )                  |        |                  | 6,380  |        |       |      | 703     |        |        |   | 11,207 |       
|                                                   
|                                                   
|                                                   
|                                                   
|Provision (benefit) for income taxes                |                                                          |                                         | (3,907  | )                  |        |                  | 2,299  |        |       |      | (228    | )      |        |   | 4,056  |       
|                                                    |                                                          |                                         |         |                    |        |                  |        |        |       |      |         |        |        |   |        |       
|Net income (loss)                                   |                                                          | $                                       | (5,610  | )                  |        | $                | 4,081  |        |       | $    | 931     |        |        | $ | 7,151  |       
|                                                    |                                                          |                                         |         |                    |        |                  |        |        |       |      |         |        |        |   |        |       
|Basic net income (loss) per share of Common Stock   |                                                          | $                                       | (0.13   | )                  |        | $                | 0.10   |        |       | $    | 0.02    |        |        | $ | 0.17   |       
|                                                    |                                                          |                                         |         |                    |        |                  |        |        |       |      |         |        |        |   |        |       
|Diluted net income (loss) per share of Common
Stock |                                                          | $                                       | (0.13   | )                  |        | $                | 0.09   |        |       | $    | 0.02    |        |        | $ | 0.16   |       
|                                                    |                                                          |                                         |         |                    |        |                  |        |        |       |      |         |        |        |   |        |       
|Weighted average shares:                            |                                                          |                                         |         |                    |        |                  |        |        |       |      |         |        |        |   |        |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Basic                                                    |                                         |         | 44,392             |        |                  |        | 41,882 |       |      |         | 43,299 |        |   |        | 41,635 |       
|                                                    |                                                          |                                         |         |                    |        |                  |        |        |       |      |         |        |        |   |        |       
|                                                    | Diluted                                                  |                                         |         | 44,392             |        |                  |        | 45,203 |       |      |         | 44,922 |        |   |        | 45,022 |       
|                                                    |                                                          |                                         |         |                    |        |                  |        |        |       |      |         |        |        |   |        |       

-4-



---



INTERNET SECURITY SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS


(amounts in thousands)
(unaudited)


|                                                                                  |                                                                           |                                                          |                                           |   |                  |         |         |   |         |       |  
|--------------------------------------------------------------------------------- | ------------------------------------------------------------------------- | -------------------------------------------------------- | ----------------------------------------- | - | ---------------- | ------- | ------- | - | ------- | ----- | -
|                                                                                  |                                                                           |                                                          |                                           |   | Six months ended
|                                                                                  |                                                                           |                                                          |                                           |   | June 30,        
|                                                                                  |                                                                           |                                                          |                                           |   |                 
|                                                                                  |                                                                           |                                                          |                                           |   | 2001             |         | 2000   
|                                                                                  |                                                                           |                                                          |                                           |   |                  |         |        
|OPERATING ACTIVITIES                                                              |                                                                           |                                                          |                                           |   |                  |         |         |  
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|Net income                                                                        |                                                                           | $                                                        | 931                                       |   |                  | $       | 7,151   |  
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|Adjustments to reconcile net income to net cash
provided by operating activities: |                                                                           |                                                          |                                           |   |                  |         |         |  
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                  |                                                                           | Depreciation                                             |                                           |   | 5,205            |         |         |   | 2,953   |      
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                  |                                                                           | Amortization of goodwill                                 |                                           |   | 4,128            |         |         |   | 159     |      
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                  |                                                                           | Amortization of intangibles and stock based compensation |                                           |   | 1,314            |         |         |   | 337     |      
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                  |                                                                           | Accretion of discount on marketable securities           |                                           |   | 73               |         |         |   | (393    | )    
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                  |                                                                           | Charge for in-process research and development           |                                           |   | 2,910            |         |         |   |        |      
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                  |                                                                           | Other non-cash items                                     |                                           |   | 46               |         |         |   | 77      |      
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                  |                                                                           | Income tax benefit from exercise of stock options        |                                           |   | 2,022            |         |         |   | 2,577   |      
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                  | Changes in assets and liabilities, excluding the effects of acquisitions: |                                                          |                                           |   |                  |         |         |   |        
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                  |                                                                           | Accounts receivable                                      |                                           |   | 5,127            |         |         |   | (11,158 | )    
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                  |                                                                           | Inventory                                                |                                           |   | 858              |         |         |   | (98     | )    
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                  |                                                                           | Prepaid expenses and other assets                        |                                           |   | (4,881           | )       |         |   | (2,124  | )    
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                  |                                                                           | Accounts payable and accrued expenses                    |                                           |   | (5,192           | )       |         |   | 473     |      
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                  |                                                                           | Deferred revenues                                        |                                           |   | 4,217            |         |         |   | 6,978   |      
|                                                                                  |                                                                           |                                                          |                                           |   |                  |         |         |  
|                                                                                  |                                                                           |                                                          | NET CASH PROVIDED BY OPERATING ACTIVITIES |   |                  | 16,758  |         |   |         | 6,932 |  
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|INVESTING ACTIVITIES                                                              |                                                                           |                                                          |                                           |   |                  |         |         |  
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|Acquisitions, net of cash received                                                |                                                                           |                                                          | 2,307                                     |   |                  |         |        |  
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|Net proceeds from maturity of marketable securities                               |                                                                           |                                                          | 72,531                                    |   |                  |         | 56,858  |  
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|Purchases of marketable securities                                                |                                                                           |                                                          | (70,425                                   | ) |                  |         | (51,757 | )
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|Purchases of property and equipment                                               |                                                                           |                                                          | (20,193                                   | ) |                  |         | (5,558  | )
|                                                                                  |                                                                           |                                                          |                                           |   |                  |         |         |  
|                                                                                  |                                                                           |                                                          | NET CASH USED IN INVESTING ACTIVITIES     |   |                  | (15,780 | )       |   |         | (457  | )
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|FINANCING ACTIVITIES                                                              |                                                                           |                                                          |                                           |   |                  |         |         |  
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|Payments on long-term debt and capital leases                                     |                                                                           |                                                          |                                          |   |                  |         | (801    | )
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|Proceeds from exercise of stock options                                           |                                                                           |                                                          | 12,599                                    |   |                  |         | 2,901   |  
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|Proceeds from issuance of common stock                                            |                                                                           |                                                          | 1,228                                     |   |                  |         | 655     |  
|                                                                                  |                                                                           |                                                          |                                           |   |                  |         |         |  
|                                                                                  |                                                                           |                                                          | NET CASH PROVIDED BY FINANCING ACTIVITIES |   |                  | 13,827  |         |   |         | 2,755 |  
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|Foreign currency impact on cash                                                   |                                                                           |                                                          | (396                                      | ) |                  |         | (224    | )
|                                                                                  |                                                                           |                                                          |                                           |   |                  |         |         |  
|Net increase in cash and cash equivalents                                         |                                                                           |                                                          | 14,409                                    |   |                  |         | 9,006   |  
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|Cash and cash equivalents at beginning of period                                  |                                                                           |                                                          | 66,210                                    |   |                  |         | 70,090  |  
|                                                                                  |                                                                           |                                                          |                                           |   |                  |         |         |  
|Cash and cash equivalents at end of period                                        |                                                                           | $                                                        | 80,619                                    |   |                  | $       | 79,096  |  
|                                                                                  |                                                                           |                                                          |                                           |   |                  |         |         |  
|SUPPLEMENTAL CASH FLOW DISCLOSURE                                                 |                                                                           |                                                          |                                           |   |                  |         |         |  
|                                                                                 
|                                                                                 
|                                                                                 
|                                                                                 
|Interest paid                                                                     |                                                                           | $                                                        | 3                                         |   |                  | $       | 43      |  
|                                                                                  |                                                                           |                                                          |                                           |   |                  |         |         |  

-5-



---



INTERNET SECURITY SYSTEMS, INC

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS


1. Significant Accounting Policies

The accompanying consolidated financial statements of Internet Security
Systems, Inc. (ISS or the Company) should be read in conjunction with the Companys consolidated financial statements for the year ended December 31, 2000.

ISS is focused on maintaining the latest security threat and vulnerability
checks within existing products and creating new products and services that are
consistent with the Companys goal of providing security management solutions.
This approach entails continuous security risk monitoring and response to
develop an active and informed network security policy.

The accompanying consolidated financial statements are unaudited; however, in
the opinion of management, they include all normal recurring adjustments
necessary for a fair presentation of the consolidated financial position of ISS
at June 30, 2001 and the consolidated results of its operations and cash flows
for the three month and six month periods ended June 30, 2001 and 2000. Results
of operations reported for interim periods are not necessarily indicative of
results for the entire year.

The consolidated balance sheet at December 31, 2000 has been derived from the
audited financial statements at that date but does not include all the
footnotes required by accounting principles generally accepted in the United
States for complete financial statements.

Revenue Recognition

ISS recognizes its perpetual license revenue upon (i) delivery of software or,
if the customer has evaluation software, delivery of the software key, and (ii)
issuance of the related license, assuming no significant vendor obligations or
customer acceptance rights exist. For perpetual license agreements, when
payment terms extend over periods greater than twelve months, revenue is
recognized as such amounts are billable. Product sales consist of (i)
appliances sold in conjunction with ISS licensed software and (ii) software
developed by third party-partners, combined in some instances with associated
hardware appliances and partner maintenance services. These sales are
recognized upon shipment to the customer.

Subscriptions revenues include maintenance, term licenses and security
monitoring services. Annual renewable maintenance is a separate component of
perpetual license agreements for which the revenue is recognized ratably over
the maintenance contract term. Term licenses allow customer use of the product
and maintenance for a specified period, generally twelve months, for which
revenues are also recognized ratably over the contract term. Security
monitoring services of information assets and systems are a part of managed
services and are recognized as such services are provided. Professional
services revenues, including consulting and training, are recognized as such
services are performed.

Cost of Revenues

Costs of revenues include the costs of products and services. Cost of products
represents the cost of product sales, which are incurred upon recognition of
the associated product revenues. Cost of services includes the cost of ISSs
technical support group who provide assistance to customers with maintenance
agreements, the operations center costs of providing managed services and the
costs related to the Companys professional services and training.

2. Business Combination

On June 5, 2001, ISS completed the acquisition of Network
ICE Corporation, a privately held corporation based in San
Mateo, California (Network ICE). Network ICE is a
leading developer of desktop intrusion protection technology and
highly scalable security management systems. ISS acquired all of
the assets of Network ICE, including all of its plant, equipment
and other physical property, which assets will continue to be
used in the business of Network ICE. ISS issued approximately
4,311,000 shares of ISS common stock for all of the outstanding
Network ICE common stock. ISS also assumed all of the
outstanding Network ICE stock options, which totaled
approximately 289,000 shares of ISS common stock. Each
outstanding share of Network ICE common stock, no par value, and
each share of Network ICE common stock issuable upon exercise of
outstanding stock options of Network ICE was converted into the
right to receive 0.13529 shares of ISS common stock, par value
$0.001 per share. The combined total of the common stock issued,
options assumed and acquisition costs was approximately $236.4
million based on the average closing price of ISS common stock
on the merger agreement date of April 30, 2001 and the two
days before and after. Acquisition costs of approximately $8
million consist primarily of financial advisory, legal and
accounting fees.

-6-



---



The merger was accounted for as a purchase and, accordingly, the
operating results of Network ICE are included in the
consolidated financial statements of ISS from the date of
acquisition. Substantially all of the aggregate purchase price
of $236.4 million was allocated to identified intangibles,
including in-process research and development, developed
technology, customer relationships, deferred compensation
related to stock options assumed and goodwill.

The aggregate purchase price was allocated based on a valuation
report from an independent appraisal of the Network ICE
intangibles and in-process research and development as follows:

|                                    |  |   |             |  
|----------------------------------- |  | - | ----------- | -
|Net liabilities of Network ICE      |  | $ | (4,020,000  | )
|In-process research and development |  |   | 2,910,000   |  
|Customer Relationships              |  |   | 2,490,000   |  
|Technology                          |  |   | 17,030,000  |  
|Deferred income taxes               |  |   | (7,418,000  | )
|Deferred compensation               |  |   | 6,231,000   |  
|Goodwill                            |  |   | 219,199,000 |  
|                                    |  |   |             |  
|                                    |  | $ | 236,422,000 |  
|                                    |  |   |             |  

The tangible assets of Network ICE acquired in the merger
consisted primarily of cash, accounts receivable and fixed
assets. The liabilities of Network ICE assumed in the merger
consisted primarily of accounts payable and accrued expenses and
deferred revenue.

In-process research and development of approximately $2.9
million had not reached technological feasibility based on
identifiable technological risk factors, which indicated that
even though successful completion was expected, it was not
assured as of the acquisition date and was immediately charged
to operations. Accordingly, under current accounting standards,
such amount was expensed.

To determine the value of the developed technology, the expected
future cash flow attributable to all existing technology was
discounted, taking into account the risks related to the
characteristics and applications of the technology, existing and
future markets and assessments of the life cycle stage of the
technology. The analysis resulted in a valuation of
approximately $17 million for developed technology which has
reached technological feasibility and therefore was
capitalizable. The amount allocated to technology is being
amortized over the estimated useful life of 5 years.

Customer relationships were based on the identifiable revenue
stream in the future that is related specifically to historical
sales made to existing customers. The amount allocated to
customer relationships of approximately $2.5 million is being
amortized over the estimated useful life of 3 years.

All unvested Network ICE options assumed by ISS were included in
the purchase price based on their fair value; however, the
portion of the intrinsic value of the unvested options that will
be deemed to be earned over the remaining vesting period of
those options has been allocated to deferred compensation and
will be amortized over the remaining vesting period. The fair
value of the options assumed was based on the Black-Scholes
option pricing model using the following assumptions:
fair market value of the underlying shares, which were based on
the average of the closing price of ISSs common stock on
the agreement date of April 30, 2001 and for the two days
before and after April 30, 2001; expected life of two years
for vested options and five years for unvested options; expected
volatility of 1.29; no expected dividend yield; and risk-free
interest rate of 5.34%. The value of the deferred compensation
of approximately $6.2 million was derived using the guidance of
Financial Accounting Standards Board Interpretation
number 44.

The purchase price in excess of tangible assets and identifiable
intangible assets has been allocated to goodwill totaled
approximately $219.2 million and is being amortized over the
estimated useful life of 5 years.

The following table summarizes pro
forma results of operations as if the acquisition of Network ICE was
concluded as of the beginning of the periods presented. This pro forma
information is not necessarily indicative of what combined operations
would have been if ISS had control of such combined businesses for
the periods presented.

The adjustments to the historical data
reflect the following (i) amortization of goodwill and
intangibles, (ii) write off of in-process research and
development, and (iii) deferred stock
compensation.

|                                                             |  |                  |         |      |  |   |         |  
|------------------------------------------------------------ |  | ---------------- | ------- | ---- |  | - | ------- | -
|                                                             |  |                 
|                                                             |  | Six months ended
|Amounts in thousands, except per share amounts               |  | June 30,        
|                                                             | 
|                                                             |  | 2001             |         | 2000
|                                                             |  |                  |         |     
|Revenue                                                      |  | $                | 118,582 |      |  | $ | 85,708  |  
|Net loss                                                     |  | $                | (25,517 | )    |  | $ | (22,738 | )
|Basic and diluted net loss per share of Common
        Stock |  | $                | (.54    | )    |  | $ | (.49    | )

3. Nonrecurring income and expense items

Included in pretax income in the six months ended June 30, 2001, is a
non-recurring other income item of $1.6 million generated from the sale of
approximately 2% of the outstanding shares of our Asia-Pacific subsidiary in
March 2001 to employees and key partners. The Company is presently planning for
an initial public offering (IPO) in Japan of a minority interest in our
Asia-Pacific subsidiary later in 2001. An IPO will provide more visibility of
this operation in its marketplace as well as generate funds for the expansion
of the business in this market. As part of the planning, options were granted
in the subsidiary as a means of key employee retention and approximately 2% of
the outstanding shares were sold to employees and key partners. The price for
the shares and exercise price for options were established based on a valuation
of the subsidiary by an independent appraisal firm. The gain represents the
difference between proceeds received for the shares sold and the underlying
basis in the shares.

In the quarter ended March 31, 2001, the Company recorded a $1.1 million
write-off of the remaining lease obligation on vacated Atlanta office space as
a result of the relocation of Atlanta personnel to new leased corporate
headquarters. This non-recurring expense originated in the first quarter of
2001 as available subleased space in the area grew substantially as the result
of layoffs, closures and consolidations, diminishing the prospects of
subleasing our old space.

-7-



---



4. Income taxes

The Company recorded a tax benefit of $3.9 million for the quarter ended June
30, 2001 and a tax provision of $3.7 million for the quarter ended March 31,
2001. As required under APB Opinion No. 28, Interim Financial
Reporting, we have estimated our effective
annual income tax rate to be (32)% and provided for taxes on year to date
earnings at this rate. As of June 30, 2001, ISS had a net operating loss
carryforward of approximately $89 million. The tax benefit of this carryforward
will be recorded as additional paid-in-capital as realized. There are also
approximately $2.9 million of research and development tax credit carryforwards
that expire between 2011 and 2021.

5. Comprehensive income (loss)

The components of comprehensive income (loss), net of tax, are as follows (in
thousands):

|                                                                                                                             |  |                    |        |                  |  |      |       |      |  |   |      |   |  |   |       |  
|---------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | ------ | ---------------- |  | ---- | ----- | ---- |  | - | ---- | - |  | - | ----- | -
|                                                                                                                             |  | Three months ended |        | Six months ended
|                                                                                                                             |  | June 30,           |        | June 30,        
|                                                                                                                             |  |                    |        |                 
|                                                                                                                             |  | 2001               |        | 2000             |  | 2001 |       | 2000
|                                                                                                                             |  |                    |        |                  |  |      |       |     
|Net income (loss)                                                                                                            |  | $                  | (5,610 | )                |  | $    | 4,081 |      |  | $ | 931  |   |  | $ | 7,151 |  
|                                                                                                                            
|                                                                                                                            
|                                                                                                                            
|                                                                                                                            
|Change in cumulative
translation adjustment,
net of a tax provision
(benefit) of $199, ($68),
($143) and $(81),
respectively |  |                    | 354    |                  |  |      | (121  | )    |  |   | (253 | ) |  |   | (143  | )
|                                                                                                                             |  |                    |        |                  |  |      |       |      |  |   |      |   |  |   |       |  
|Comprehensive income (loss)                                                                                                  |  | $                  | (5,256 | )                |  | $    | 3,960 |      |  | $ | 678  |   |  | $ | 7,008 |  

6. Income (Loss) per share

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

|                                     |                                                                        |   |                    |        |                  |   |      |        |      |   |      |        |  |   |      |        | 
|------------------------------------ | ---------------------------------------------------------------------- | - | ------------------ | ------ | ---------------- | - | ---- | ------ | ---- | - | ---- | ------ |  | - | ---- | ------ | 
|                                     |                                                                        |   | Three months ended |        | Six months ended
|                                     |                                                                        |   | June 30,           |        | June 30,        
|                                     |                                                                        |   |                    |        |                 
|                                     |                                                                        |   | 2001               |        | 2000             |   | 2001 |        | 2000
|                                     |                                                                        |   |                    |        |                  |   |      |        |     
|Basic net income (loss) per share:   |                                                                        |   |                    |        |                  |   |      |        |      |   |      |        |  |   |      |       
|                                    
|                                    
|                                    
|                                    
|                                     | Net income (loss)                                                      |   | $                  | (5,610 | )                |   | $    | 4,081  |      |   | $    | 931    |  |   | $    | 7,151  | 
|                                    
|                                    
|                                    
|                                    
|                                     | Weighted average number of common
shares outstanding during the period |   |                    | 44,392 |                  |   |      | 41,882 |      |   |      | 43,299 |  |   |      | 41,635 | 
|                                     |                                                                        |   |                    |        |                  |   |      |        |      |   |      |        |  |   |      |       
|Basic net income (loss) per share    |                                                                        | $ | (0.13              | )      |                  | $ | 0.10 |        |      | $ | 0.02 |        |  | $ | 0.17 |       
|                                    
|                                    
|                                    
|                                    
|Diluted net income (loss) per share: |                                                                        |   |                    |        |                  |   |      |        |      |   |      |        |  |   |      |       
|                                    
|                                    
|                                    
|                                    
|                                     | Net income (loss)                                                      |   | $                  | (5,610 | )                |   | $    | 4,081  |      |   | $    | 931    |  |   | $    | 7,151  | 
|                                    
|                                    
|                                    
|                                    
|                                     | Weighted average number of common
shares outstanding during the period |   |                    | 44,392 |                  |   |      | 41,882 |      |   |      | 43,299 |  |   |      | 41,635 | 
|                                    
|                                    
|                                    
|                                    
|                                     | Dilutive stock options                                                 |   |                    |       |                  |   |      | 3,321  |      |   |      | 1,623  |  |   |      | 3,387  | 
|                                     |                                                                        |   |                    |        |                  |   |      |        |      |   |      |        |  |   |      |       
|                                     | Total shares for purpose of calculating
diluted net income per share   |   |                    | 44,392 |                  |   |      | 45,203 |      |   |      | 44,922 |  |   |      | 45,022 | 
|                                     |                                                                        |   |                    |        |                  |   |      |        |      |   |      |        |  |   |      |       
|Diluted net income (loss) per share  |                                                                        | $ | (0.13              | )      |                  | $ | 0.09 |        |      | $ | 0.02 |        |  | $ | 0.16 |       

Options aggregating 1,654,544 for the three months ended June 30, 2001 are not
included in the above calculation as they are antidilutive.

7. Recent Accounting Pronouncements

In July, 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standard No. 142, (SFAS 142), Accounting
for Goodwill and Other Intangibles. Under SFAS 142, goodwill and indefinite
lived intangible assets are no longer amortized, but are reviewed annually (or
more frequently if impairment indicators arise)     for impairment. Separable
intangible assets that are not deemed to have an indefinite life will continue
to be amortized over their useful lives. Companies are required to immediately
adopt the amortization provisions of SFAS 142 as it relates to goodwill and
intangible assets acquired after June 30, 2001. With respect to goodwill and
intangible assets acquired prior to July 1, 2001, companies are required to
adopt SFAS 142 in their fiscal year beginning after December 15, 2001. The
Company anticipates adopting SFAS 142 in accordance with the provisions of the
statement. SFAS 142 may not be applied retroactively. Substantially all of
the Companys goodwill balance of $218.2 million as of June 30, 2001, was recorded in
June of 2001, in conjunction with the acquisition of Network ICE. The goodwill
balance is being

-8-



---



amortized over five years. The impact of the adoption as it relates to
goodwill, which exists currently, is to eliminate amortization of
goodwill expense beginning with the year ending December 31, 2002.

-9-



---



ITEM 2

INTERNET SECURITY SYSTEMS, INC.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the Consolidated
Financial Statements and related Notes thereto included elsewhere in this
Quarterly Report on Form 10-Q. Except for the historical financial information,
the matters discussed in this Quarterly Report on Form 10-Q may be considered
forward-looking statements. Such statements include declarations regarding
our intent, belief or current expectations. Such forward-looking statements are
not guarantees of future performance and involve a number of risks and
uncertainties. Actual results may differ materially from those indicated by
such forward-looking statements. Among the important factors that could cause
actual results to differ materially from those indicated by such
forward-looking statements are the risk factors in this Quarterly Report on
Form 10-Q, as well as the risk factors identified in the Annual Report on Form
10-K for the year ended December 31, 2000 as filed with the Securities and
Exchange Commission and available at their Web site at www.sec.gov.

OVERVIEW

We are a leading global provider of security management solutions for
protecting digital business assets. Our continuous lifecycle approach to
information security protects distributed computing environments, such as
internal corporate networks, inter-company networks and electronic commerce
environments, from attacks, misuse and security policy violations, while
ensuring the confidentiality, privacy, integrity and availability of
proprietary information. We deliver an end-to-end security management solution
through our SAFEsuite security management platform coupled with
around-the-clock remote security monitoring through our managed services
offerings. Our SAFEsuite family of products is a critical element of an active
Internet and networking security program within todays world of global
connectivity, enabling organizations to proactively monitor, detect and respond
to risks to enterprise information. Our managed services offerings currently
provide remote management of the industrys best-of-breed security technology
including firewalls, VPNs, anti-virus and URL filtering software, security
assessment and intrusion detection systems. We focus on serving as the trusted
security provider to our customers by maintaining within our existing products
the latest counter-measures to security risks, creating new innovative products
based on our customers needs and providing professional and managed services.

We generate a majority of our revenues from our SAFEsuite family of products in
the form of perpetual licenses and subscriptions, and sales of best-of-breed
technology products developed by our partners. We recognize perpetual license
revenues from ISS developed products upon delivery of software or, if the
customer has evaluation software, delivery of the software key and issuance of
the related license, assuming that no significant vendor obligations or
customer acceptance rights exist. Where payment terms are extended over periods
greater than 12 months, revenue is recognized as such amounts are billable.
Product sales consist of (i) appliances sold in conjunction with ISS licensed
software and (ii) software developed by third-party suppliers, combined in some
instances with associated hardware appliances and supplier maintenance services.
These sales are recognized upon shipment to the customer.

Annual renewable maintenance is a separate component of each perpetual license
agreement for ISS products, with revenue recognized ratably over the
maintenance term. Subscription revenues include maintenance, term licenses, and
managed service arrangements. Term licenses allow customers to use our products
and receive maintenance coverage for a specified period, generally 12 months.
We recognize revenues from these term agreements ratably over the subscription
term. Security monitoring services of information assets and systems are part
of managed services and revenues are recognized as such services are provided.
Professional services revenues include consulting services and training.
Consulting services, typically billed on a fixed price or time-and-materials
basis, assist in the successful deployment of our products within customer
networks, the development of customers security policies and the assessment of
security policy decisions. We recognize such professional services revenues as
the related services are rendered.

We believe that our total solutions approach will grow each of our revenue
categories. This includes our products and managed services offerings, as well
as maintenance and professional services and training. While we expect the
expansion of these product and service offerings to originate primarily from
internal development, our strategy includes acquiring products, technologies
and service capabilities that fit within our strategy and that potentially
accelerate the timing of the commercial introduction of such products and
technologies.

We have experienced significant revenue growth year-after-year, although our
most recent quarter ended June 30, 2001 represented a decrease from the
previous quarter ended March 31, 2001. This was our first quarterly decrease
over the last five years in measuring

-10-



---



sequential quarterly revenues. Many factors effect financial performance, and
past performance is no assurance of similar future performance. We expect, in
the long-term, to continue to expand our domestic and international sales and
marketing operations; increase our investment in product development including
our proprietary threat and vulnerability database and managed services
capabilities; seek acquisition candidates with products, technologies or
services capabilities complimentary to our solutions; and improve our internal
operating and financial infrastructure in support of our strategic goals and
objectives. However, due to the decrease in revenues for the quarter ended
June 30, 2001, we are resizing our operations during the third quarter of 2001,
resulting in personnel reductions and expected decreases in various operating
expenses, with emphasis also on controlling discretionary spending and capital
expenditures. While we believe in the long-term success of our business
solutions, our prospects must be considered in light of the recent experience,
risks and difficulties that are frequently encountered by companies in new and
rapidly evolving markets. See Risk Factors.

RESULTS OF OPERATIONS

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

|                                                         |                          |  |                    |     |                  |  |      |     |      |  |    |     |   |  |    |     |  
|-------------------------------------------------------- | ------------------------ |  | ------------------ | --- | ---------------- |  | ---- | --- | ---- |  | -- | --- | - |  | -- | --- | -
|                                                         |                          |  | Three months ended |     | Six months ended
|                                                         |                          |  | June 30,           |     | June 30,        
|                                                         |                          |  |                    |     |                 
|                                                         |                          |  | 2001               |     | 2000             |  | 2001 |     | 2000
|                                                         |                          |  |                    |     |                  |  |      |    
|Product licenses and sales                               |                          |  | 54                 | %   |                  |  | 60   | %   |      |  | 57 | %   |   |  | 61 | %  
|                                                        
|                                                        
|                                                        
|                                                        
|Subscriptions                                            |                          |  | 30                 | %   |                  |  | 21   | %   |      |  | 27 | %   |   |  | 21 | %  
|                                                        
|                                                        
|                                                        
|                                                        
|Professional services                                    |                          |  | 16                 | %   |                  |  | 19   | %   |      |  | 16 | %   |   |  | 18 | %  
|                                                         |                          |  |                    |     |                  |  |      |     |      |  |    |     |   |  |    |    
|                                                         | Total revenues           |  |                    | 100 | %                |  |      | 100 | %    |  |    | 100 | % |  |    | 100 | %
|                                                         |                          |  |                    |     |                  |  |      |     |      |  |    |     |   |  |    |    
|Cost of product licenses and sales                       |                          |  | 7                  | %   |                  |  | 10   | %   |      |  | 9  | %   |   |  | 12 | %  
|                                                        
|                                                        
|                                                        
|                                                        
|Cost of subscriptions and
professional services          |                          |  | 26                 | %   |                  |  | 19   | %   |      |  | 22 | %   |   |  | 18 | %  
|                                                        
|                                                        
|                                                        
|                                                        
|Research and development                                 |                          |  | 17                 | %   |                  |  | 17   | %   |      |  | 15 | %   |   |  | 17 | %  
|                                                        
|                                                        
|                                                        
|                                                        
|Sales and marketing                                      |                          |  | 46                 | %   |                  |  | 35   | %   |      |  | 40 | %   |   |  | 36 | %  
|                                                        
|                                                        
|                                                        
|                                                        
|General and administrative                               |                          |  | 10                 | %   |                  |  | 8    | %   |      |  | 9  | %   |   |  | 8  | %  
|                                                        
|                                                        
|                                                        
|                                                        
|Write-off of lease obligation                            |                          |  |                   |     |                  |  |     |     |      |  | 1  | %   |   |  |   |    
|                                                        
|                                                        
|                                                        
|                                                        
|Charge
for in-process research and development           |                          |  | 6                  | %   |                  |  |     | %   |      |  | 3  | %   |   |  |   |    
|                                                        
|                                                        
|                                                        
|                                                        
|Amortization
of goodwill                                 |                          |  | 8                  | %   |                  |  |     |     |      |  | 4  | %   |   |  |   |    
|                                                        
|                                                        
|                                                        
|                                                        
|Amortization
of intangibles and stock based compensation |                          |  | 2                  | %   |                  |  | 1    | %   |      |  | 1  | %   |   |  |   |    
|                                                         | Total costs and expenses |  |                    | 122 | %                |  |      | 90  | %    |  |    | 104 | % |  |    | 91  | %
|                                                         |                          |  |                    |     |                  |  |      |     |      |  |    |     |   |  |    |    
|Operating income (loss)                                  |                          |  | (22                | )%  |                  |  | 10   | %   |      |  | (4 | )%  |   |  | 9  | %  
|                                                         |                          |  |                    |     |                  |  |      |     |      |  |    |     |   |  |    |    

REVENUES

Our total revenues increased 17% to $51.7 million for the three months ended
June 30, 2001 and 35% to $112.9 million for the six months ended June 30, 2001
as compared with the same periods in the prior year. Product and license
sales, including perpetual licenses and sales of partner software and hardware
appliances, continued to be the primary source of revenue generation at 54% of
total revenues for the three month period ended June 30, 2001 as compared to
60% for the corresponding period in 2000. Product licenses and sales
represented 57% of total revenues for the six-month period ended June 30, 2001
as compared to 61% for the same period in 2000. The decrease in product and
license sales as a percentage of total revenues is due primarily to a decrease
in the size of larger license sales and, to a lesser degree, the overall level
of sales of third-party products in the quarter ended June 30, 2001.

License sales are generated both through a direct sales force and through
resellers. When our resellers generate sales, revenues are recognized
when the end user sale has occurred, which is identified through electronic
delivery of a software key that is necessary to operate the product.

Our results were impacted by customers reduced technology spending in our core
markets in the Americas and EMEA (Europe, Middle East and Africa) theatres.
Even though we saw a continued strong level of customer licensing of our
products, the quarter was characterized primarily by larger potential sales
either reducing in size or deferred into future periods. Additionally, we made
several changes that impacted the level of sales of third-party products. We
modified our agreement with Nokia, a maker of appliances that work in
conjunction with ISS RealSecure software and certain Checkpoint software. We
previously purchased and resold these Nokia appliances with ISS RealSecure
software, but now the sale of the Nokia appliances occurs primarily through
Nokia resellers, with the sale of ISS RealSecure software directly by us or
through our resellers to our customers. This change lowered our sales because
the

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Nokia appliances component of sales is now occurring through Nokia resellers.
Additionally, it impacted sales by our direct sales force of Checkpoint
solutions that include the Nokia appliance, which now occur through Nokia
resellers. Importantly, this movement away from direct sales of third party
products was a conscious effort on the part of our sales management to simplify
our business by focusing on our own ISS solutions. The business of selling
third party products arose from our Netrex acquisition in 1999. Although we
have de-emphasized sales of third party products, we continue it as part of our
managed security services offerings.

With reduced spending in the Americas and continued international geographic
expansion, second quarter Americas revenues grew over the comparable period in
2000, but represent a smaller percentage of total revenues. In the second
quarter of 2001, 72% of our revenues were generated from customers in the
Americas, while 15% were generated from EMEA customers and 13% from Asia and
Pacific Rim customers. This compares to 81% in the Americas, 12% in EMEA and 8%
in the Asia and Pacific Rim for the second quarter of 2000.

We continue to add functionality to our SAFEsuite product family, including our
vulnerability assessment, intrusion detection products, providing both network
and host based solutions, and our security management applications. In the
second quarter of 2001, the acquisition of Network ICE added desktop intrusion
detection and highly scalable security management systems to the family.
Additionally, we announced our pervasive protection platform strategy to
converge intrusion detection and security assessment technologies into one
system for enhanced accuracy and simplified management. In the quarter, we
released RealSecure 6.0, one of the first releases under this pervasive
protection platform strategy. These improvements and new offerings provide our
customers with more powerful and easier-to-use solutions for security
management across the enterprise.

Subscription revenues grew 62% from $9.5 million in the three months ended June
30, 2000 to $15.5 million in the three months ended June 30, 2001. This
represents an increase from 21% of total revenues in the second quarter of 2000
to 30% of total revenues in the second quarter of 2001. On a year to date
basis, subscriptions revenue represented 27% of total revenues in the six
months ended June 30, 2001 as compared to 21% in the six months ended June 30,
2000. Subscription revenues consist of maintenance, term licenses of product
usage and security-monitoring fees for managed services offerings. While all
components of subscription revenues grew, the increase was primarily due to
maintenance, the largest component, and managed services, which had the highest
growth percentage growth. Managed services, a relatively newer business for us,
grew to 6% of total revenues in the second quarter of 2001.

Professional services revenue decreased 2% from $8.3 million for the three
months ended June 30, 2000 to $8.2 million for the three months ended June 30,
2001, representing 16% of total revenues for the quarter ended June 30, 2001 as
compared to 19% for the corresponding quarter in 2000. For the six months
ended June 30, 2001 professional services revenue increased 22% from $14.8
million for the six months ended June 30, 2000 to $18.0 million for the six
months ended June 30, 2001. The decrease in the second quarter comparison is
further evidence of reduced customer spending in our core markets as entities
curtailed these discretionary costs in the quarter. We have reviewed our
consulting and training offerings and adjusted our corresponding headcount to
address the demand from our customers in the current environment.

COSTS AND EXPENSES

Cost of revenues

Cost of revenues consists of several components. Substantially all of the cost
of product licenses and sales represents payments to partners for their
products that we integrate with our products or directly sell to our customers
in providing a single solution source. Costs associated with licensing our
products are minor. Costs of product revenues as a percentage of total revenues
decreased from 10% for the three months ended June 30, 2000 to 7% for the
comparable period in 2001. For the six months ended June 30, 2001, cost of
product revenues represented 9% of total revenues as compared to 12% in the
corresponding period of 2000. As explained in our discussion of license and
product sales revenues, this reduction was the result of an effort to change
the way that Nokia appliances are sold in connection with our RealSecure
software as well as a reduced interest in sales of third party products.

Cost of subscription and services includes the cost of our technical support
personnel who provide assistance to customers under maintenance agreements, the
security operations center (SOC) costs of providing managed security
monitoring services and the costs related to consulting and training. These
costs represented 19% of total revenues for the three month period ended June
30, 2000 and increased to 26% for the comparable period in 2001. On a
year-to-date basis, these costs represented 18% of total revenues for the six
months ended June 30, 2000 and 22% for the six months ended June 30, 2001. The
percentage increase is partially the result of investment in automated systems
and personnel resources for our Asia/Pacific SOC for contracted business
scheduled to begin in the third quarter and in our United States SOC to handle
anticipated growth. We also added professional services capabilities and more

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automated technical support programs over the last year. With the decrease in
professional services revenues in the second quarter of 2001, we have taken
actions to reduce personnel in the consulting and training groups to achieve
appropriate gross margins at lower expected revenue levels.

Research and development

Research and development expenses consist of salary and related costs of
research and development personnel, including costs for employee benefits, and
depreciation on computer equipment. These costs include those associated with
maintaining and expanding the X-Force, our internal team of security experts
dedicated to understanding, documenting and coding new vulnerability checks,
real-time threats and attack signatures and developing solutions to address
global security issues. We continue to increase these expenditures, as we
perceive primary research and product development and managed service offerings
as essential ingredients for retaining our leadership position in the market.
We also increased the number of our development personnel focused on our
best-of-breed products, enterprise applications, managed services offerings and
research for future product offerings, including the addition of approximately
20 engineers from the June 2001 Network ICE acquisition. Accordingly, research
and development expenses increased from $7.6 million in the three months ended
June 30, 2000 to $8.9 million in the three months ended June 30, 2001, but
remained constant as a percentage of total revenues at 17%. On a year-to-date
basis, research and development expenses increased from $14.4 million in the
six months ended June 30, 2000 to $17.3 million in the six months ended June
30, 2001. As a percentage of revenues, these costs decreased from 17% for the
six months ended June 30, 2000 to 15% for the six months ended June 30, 2001.
We have begun to integrate the Network ICE technologies into our technologies
under the leadership of our Vice President of Engineering and Development, the
former chief executive officer of Network ICE.

Sales and marketing

Sales and marketing expenses consist primarily of salaries, travel expenses,
commissions, advertising, maintenance of our Website, trade show expenses,
costs of recruiting sales and marketing personnel and costs of marketing
materials. In the quarter ended June 30, 2001, sales and marketing expenses
were $23.9 million or 46% of total revenues, compared to $15.7 million or 35%
of total revenues in the quarter ended June 30, 2000. For the six months ended
June 30, sales and marketing expenses increased from $29.9 million in 2000 to
$45.5 million in 2001 and as a percentage of revenues from 36% in 2000 to 40%
in 2001. Sales and marketing expenses increased in total dollars during these
periods primarily from our larger workforce, which has grown each quarter of
2000 and 2001, both domestically and internationally. Sales and marketing
expenses as a percentage of total revenues had approximated between 35% and 36%
each quarter from the first quarter of 2000 until the second quarter of 2001.
The increase in the second quarter of 2001 to 46% was due largely to a level of
license revenues in the quarter below expectations. Actions have begun in the
third quarter of 2001 to reduce sales and marketing personnel, and fully
integrate the Network ICE team, to better match current revenue expectations.

General and administrative

General and administrative expenses in the quarter ended June 30, 2001
increased $1.6 million from the quarter ended June 30, 2000 to $5.1 million,
and increased from 8% of total revenues in the second quarter of 2000 to 10% in
the second quarter of 2001. For the six months ended June 30, general and
administrative expenses remained constant as a percentage of revenues at 8% in
both 2000 and 2001. General and administrative expenses consist of:
personnel-related costs for executive, administrative, finance and human
resources; information systems and other support services costs; and legal,
accounting and other professional service fees. The increase in these expenses
is attributable to our efforts, through additional employees and systems, to
enhance managements ability to obtain and analyze information about our
domestic and international operations and to support a larger employee base.
Expenses in this area are being reduced as the organization is matched to the
current spending environment.

In the quarter ended March 31, 2001, we completed the relocation of our Atlanta
personnel into our new corporate headquarters, incurring expenses associated
with the move and also recording a $1.1 million write-off of the remaining
lease obligation on our previous Atlanta headquarters office space. This
non-recurring expense originated in the first quarter of 2001, as available
subleased space in the area grew substantially in the quarter as the result of
layoffs, closures and consolidations, dimming the prospects of subleasing our
old space.

Charge for in-process research and development and amortization

Expenses for the three month and six month periods ended June 30, 2001 included
a $2.9 million charge for the write-off of in-process research and development
costs associated with the Network ICE acquisition in June 2001. In-process
research and development had

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not reached technological feasibility based on identifiable technological risk
factors which indicated that even though successful completion was expected, it
was not assured at the acquisition date and was immediately charged to
operations.

Amortization of intangibles and stock-based compensation totaled $1.1 million
for the quarter ended June 30, 2001. Amortization of other intangibles
includes amortization of technology and customer relationships. Such amounts
aggregated approximately $547,000 in the quarter ended June 30, 2001 and also
include amortization of compensation charges related to unvested stock options
of approximately $599,000 in the quarter ended June 30, 2001. All unvested
Network ICE options assumed by ISS were included in the purchase price based on
their fair value; however, the portion of the intrinsic value of the unvested
options that was deemed to be earned over the remaining vesting period of those
options has been allocated to deferred compensation and will be amortized over
the remaining vesting period.

Goodwill amortization for the quarter ended June 30, 2001 was $3.9 million.
For the remainder of 2001, we will have quarterly expenses associated with the
amortization of goodwill of approximately $13 million. Under the recently
issued Financial Accounting Standards for Business Combinations and Goodwill
and Other Intangibles, goodwill will no longer be amortized but subject to at
least annual tests for impairment.

Other income

Included in pretax income for the six months ended June 30, 2001 is a
non-recurring other income item of $1.6 million generated from the sale of
approximately 2% of the outstanding shares of our Asia-Pacific subsidiary in
March 2001 to employees and key partners. The Company is presently planning for
an initial public offering (IPO) in Japan of a minority interest in our
Asia-Pacific subsidiary later in 2001. An IPO will provide more visibility of
this operation in its marketplace as well as generate funds for the expansion
of the business in this market. As part of the planning, options were granted
in the subsidiary as a means of key employee retention and approximately 2% of
the outstanding shares were sold to employees and key partners. The price for
the shares and exercise price for options was established based on a valuation
of the subsidiary by an independent appraisal firm. The gain represents the
difference between proceeds received and the underlying basis in the stock.

Net interest income decreased from $2.1 million in the quarter ended June 30,
2000 to $1.8 million in the comparable quarter of 2001, primarily due to
declining interest rates.

Income taxes

Income tax benefit was approximately 41% of pre-tax
net loss for the quarter ended June 30, 2001 and 32% of pre-tax
net income for the six months ended June 30, 2001. This compares
with income tax expense of 36% of pre-tax net income for the quarter
and six month periods ended June 30, 2000. Under APB Opinion
No. 28, Interim Financial Reporting, we are required to
estimate the annual effective
income tax rate each time an interim report is issued. As of
March 31, 2001, we estimated the annual effective income tax
rate for the calendar year 2001 to be 36%. As a result of the
acquisition of Network ICE during the second quarter of 2001, we
will be expensing approximately $26.3 million of goodwill
amortization during the calendar year 2001 that will not be
deductible for income tax purposes. Because of this non-deductible
amortization, we now expect the annual effective income tax rate
for the 2001 calendar year to be (32)% of pre-tax net income or loss.

Net Income (loss)

We recorded a net loss of $5.6 million or $.13 loss per share in the quarter
ended June 30, 2001 compared to net income of $4.1 million or $.09 per share in
the comparable period in 2000. The net income of $931,000 for the six months
ended June 30, 2001 also decreased significantly from $7.1 million for the
comparable period in 2000. The decrease was partially due to the non-cash
charges related to the June 2001 acquisition of Network ICE and was partially
due to lower revenues in the second quarter of 2001 than anticipated. We had
anticipated that revenues would continue to grow on a sequential quarterly
basis, which did not happen. Since our expense base continued to grow to handle
anticipated revenue growth, we experienced a loss even if the non-cash
acquisition related charges are excluded. We have undertaken a resizing of our
expense base in light of the current macro economic spending environment in an
effort to restore the profitability of the Company, if you exclude the impact
of non-cash acquisition related amortization expense.

LIQUIDITY AND CAPITAL RESOURCES

Net cash provided by operations in the first six months of 2001 was $16.8
million. It included net income of $931,000, depreciation of $5.2 million,
acquisition related amortization and in-process research and development write
off of $7.8 million, and an income tax benefit from employee exercises of stock
options of $2.0 million.

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Investing activities in the first six months of 2001 include the purchase of
$70.4 million of marketable securities, primarily commercial paper, offset by
net proceeds from the maturity of marketable securities of $72.5 million. These
assets have quality characteristics similar to cash equivalents except their
maturities are longer than three months. We also invested in equipment totaling
$9.0 million as we provided existing and new personnel with the computer
hardware and software environment necessary to perform their job functions and
incurred leasehold improvement costs for our new headquarters.

Our financing activities provided $13.8 million of cash in the six months ended
June 30, 2001, which consisted primarily of proceeds from the exercise of stock
options by our employees and also from the issuance of common stock through our
Employee Stock Purchase Plan.

As of June 30, 2001, we had $144.4 million of cash and cash equivalents and
marketable securities, consisting primarily of money market accounts and
commercial paper carrying the highest investment grade rating. We believe that
such cash and cash equivalents and marketable securities will be sufficient to
meet our working capital needs and capital expenditures for the foreseeable
future. From time to time we evaluate possible acquisition and investment
opportunities in businesses, products or technologies that are complimentary to
ours. In the event we determine to pursue such opportunities, we may use our
available cash and cash equivalents. Pending such uses, we will continue to
invest our available cash in investment grade, interest-bearing investments.

Additionally, we have restricted marketable securities of $12.5 million
securing a $10 million letter of credit issued in connection with our
commitment to a long-term lease of our Atlanta corporate facilities.

RISK FACTORS

Forward-looking statements are inherently uncertain as they are based on
various expectations and assumptions concerning future events and are subject
to known and unknown risks and uncertainties. Our forward-looking statements
should be considered in light of the following important risk factors.
Variations from our stated intentions or failure to achieve objectives could
cause actual results to differ from those projected in our forward-looking
statements. Except as otherwise required by law, we undertake no obligation to
update publicly any forward-looking statements contained in this Quarterly
Report on Form 10-Q for any reason, even if new information becomes available
or other events occur in the future.

We Have Only Recently Achieved Profitability

We began operations in 1994 and achieved profitability beginning in 1999
and continuing through the first quarter of 2001. While we attribute the loss
in the second quarter of 2001 (excluding amortization and charges associated
with the Network ICE acquisition) primarily to customers reduced technology
spending in our core markets, we also recognize that we operate in a new and
rapidly evolving market and must, among other things:



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

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

Our Future Operating Results Will Likely Fluctuate Significantly

As a result of our limited operating history, we cannot predict our future
revenues and operating results. However, we do expect our future revenues and
operating results to fluctuate due to a combination of factors, including:



| |  |  | the growth in the acceptance of, and activity on, the Internet and
the World Wide Web, particularly by corporate, institutional and
government users;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------

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| |  |  | the extent to which the public perceives that unauthorized access to
and use of online information are threats to network security;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the volume and timing of orders, including seasonal trends in
customer purchasing and customer budgetary priorities;               
|
| |  |  | our ability to develop new and enhanced product and managed service
offerings and expand our professional services capabilities;   
|
| |  |  | our ability to provide scalable managed services offerings through our partners in a cost effective manner;                        
|
| |  |  | foreign currency exchange rates that affect our international operations;                                                          
|
| |  |  | product and price competition in our markets;                                                                                      
|
| |  |  | general economic conditions, both domestically and in our foreign markets; and.                                                    
|
| |  |  | adequacy of personnel resources to fulfill sales.                                                                                  

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

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

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

We Must Attract and Retain Adequate Personnel Resources

We endeavor to employ personnel resources to correspond with our expected
future revenues. We are reducing personnel resources in the third
quarter of 2001 to reflect our expected
revenues in the near-term. Personnel resources could be insufficient to fulfill
unanticipated demand and we believe our future success in an improving market
will depend in part on our ability to recruit and retain highly skilled
engineering, technical, consulting, marketing, sales and management personnel.
To accomplish this, we believe we must continue to provide competitive
compensation, including stock options that may require additional stockholder
approval for increased availability. Without sufficient available stock
options, our ability to attract and retain personnel may be impaired.

We Face Intense Competition in Our Market

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



| |  |  | internal information technology departments of our customers and
the consulting firms that assist them in formulating security systems;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------

-16-



---





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

Mergers or consolidations among these competitors, or acquisitions of
small competitors by larger companies, would make such combined entities more
formidable competitors to us. Large companies may have advantages over us
because of their longer operating histories, greater name recognition, larger
customer bases or greater financial, technical and marketing resources. As a
result, they may be able to adapt more quickly to new or emerging technologies
and changes in customer requirements. They can also devote greater resources to
the promotion and sale of their products than we can. In addition, these
companies have reduced and could continue to reduce, the price of their
security monitoring, detection and response products and managed security
services, which increases pricing pressures within our market.

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

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

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

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



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

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

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

-17-



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scheduled introduction of new and enhanced products in the past and may
have to delay the introduction of new products and product enhancements in the
future.

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

Risks Associated with Our Global Operations

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



| |  |  | the difficulty in managing an organization spread over various
countries located across the world;                                        
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | unexpected changes in regulatory requirements in countries
where we do business;                                                          
|
| |  |  | excess taxation due to overlapping tax structures;                                                                                        
|
| |  |  | fluctuations in foreign currency exchange rates; and                                                                                      
|
| |  |  | export license requirements and restrictions on the export of
certain technology, especially encryption technology and trade
restrictions.

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

Our Networks, Products and Services May be Targeted by Hackers

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

We Must Successfully Integrate Acquisitions

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

We Depend on Our Intellectual Property Rights and Use Licensed Technology

We rely primarily on copyright and trademark laws, trade secrets,
confidentiality procedures and contractual provisions to protect our
proprietary rights. We have obtained one United States patent and have
seventeen patent applications under review. We also believe that the
technological and creative skills of our personnel, new product developments,
frequent product enhancements, our name recognition, our professional services
capabilities and delivery of reliable product maintenance are essential to
establishing and

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maintaining our technology leadership position. We cannot assure you that
our competitors will not independently develop technologies that are similar to
ours.

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

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Sensitivity

The primary objective of our investment activities is to preserve principal
while at the same time maximizing the income we receive from our investments
without significantly increasing risk. Some of the securities in which we have
invested may be subject to market risk. This means that a change in prevailing
interest rates may cause the principal amount of the investment to fluctuate.
For example, if we hold a security that was issued with a fixed interest rate
at the then-prevailing rate and the prevailing interest rate later rises, the
principal value of our investment will probably decline. To minimize this risk,
we maintain our portfolio of cash equivalents and marketable securities in a
variety of relatively short-term investments, including commercial paper and
overnight repurchase agreements. As of June 30, 2001, $38,314,000 of our
securities had maturities beyond 90 days.

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PART II

OTHER INFORMATION

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

In connection with our acquisition of Network ICE Corporation, which
closed on June 5, 2001, we issued an aggregated of approximately
4,311,000
shares of ISS common stock in exchange for all of the issued and outstanding
shares of Network ICE common stock. We also reserved approximately 289,000
additional shares of ISS common stock for issuance upon exercise of outstanding
stock options that were assumed in the acquisition. No underwriters were used
in the transaction and the recipients of ISS common stock were the shareholders
of Network ICE. The shares of ISS common stock were issued pursuant to an
exemption under section 3(a)(10) of the Securities Act of 1933, as amended. The
shares of ISS common stock were issued following a public fairness hearing
conducted before the State of California Department of Corporations on May 31,
2001, resulting in ISS obtaining a permit to issue the shares.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Annual Meeting of Stockholders of Internet Security Systems, Inc. was held
on Wednesday, May 23, 2001.

The following two directors were elected to serve a three-year term ending in
the year 2004: (a) Robert E. Davoli, 38,453,655 votes for and 50,792 votes
withheld, and (b) Christopher W. Klaus 38,233,785 votes for and 270,662 votes
withheld.

Our Restated 1995 Stock Incentive Plan was amended to increase by 3,000,000
shares the number of shares available for issuance under the Plan, and to
increase to 4% the annual automatic increase of shares available for issuance
under the Plan, subject to an annual 2,600,000 share maximum. The vote was as
follows: (a) Voting For: 24,224,268, (b) Voting Against: 11,163,031, (c)
Abstentions: 13,414. There were 3,1073,734 broker non-votes for purposes of
this proposal.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K



|(a) |  | Exhibits
|--- |  | --------

| |      |                               
| | ---- | ------------------------------
| | 21.1 | Subsidiaries of the Registrant



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



| |                                                                                                           
| | ----------------------------------------------------------------------------------------------------------
| | ISS filed a report on Form 8-K on June 8, 2001 with respect to the
acquisition of Network ICE Corporation.

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INTERNET SECURITY SYSTEMS, INC. SIGNATURES

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

|      |                 |  |    |                                                                   
|----- | --------------- |  | -- | ------------------------------------------------------------------
|      |                 |  |    | INTERNET SECURITY SYSTEMS, INC.                                   
|      |                 |  |    |                                                                   
|      |                 |  |    | (Registrant)                                                      
|     
|Date: | August 14, 2001 |  | By | /s/ Richard Macchia                                               
|      |                 |  |    |                                                                   
|      |                 |  |    | Chief Financial Officer
Vice President and Chief Financial Officer
|     
|      |                 |  | By | /s/ Maureen Richards                                              
|      |                 |  |    |                                                                   
|      |                 |  |    | Corporate Controller                                              

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