**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

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**FORM 10-Q**

 

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| **(Mark One)** |
|----------------|
| **ý**     | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|           |   |   |
|           |   | **For the quarterly period ended March 31, 2006** |
|           |   |   |
|           |   | **OR** |
|           |   |   |
| **o**          | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|           |   |   |
|           |   | **For the transition period from               to            ** |

 

**CommissionFile Number 000-23655**

 

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**INTERNET SECURITY SYSTEMS, INC.**

(Exactname of registrant as specified in its charter)

 

| **DELAWARE**                                              | ** ** | **58-2362189**                        |
|-----------------------------------------------------------|------------|---------------------------------------|
| (State  or jurisdiction ofincorporation  or organization) |       | (I.R.S.  EmployerIdentification  No.) |

 

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

(Addressof principal executive offices)

 

Registrant’stelephone number, including area code **(404)236-2600**

 

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Indicateby check mark whether the Registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes   ý   No   o

 

Indicate by a check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act.

 
| Large  accelerated filer   ý |   | Accelerated  filer   o |   | Non-accelerated  filer   o |
|--------------------------------------------------|--------|---------------------------------------|--------|-------------------------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the ExchangeAct). Yes   o   No   ý

 

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

 
| **Title of each class of common stock** | ** ** | **Number of Shares** **Outstanding****as of April 30, 2006** |
|-----------------------------------------|------------|-------------------------------------------------------------------|
| Common  stock, $0.001 par value         |       | 44,726,017                                                        |

 

 

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##### **Table of Contents**

 
|        | ** **                                                                                                      | **PAGE  NUMBER** |
|-------------|-----------------------------------------------------------------------------------------------------------------|------------------|
|        | ** **                                                                                                      | ** **       |
|        | **PART I — FINANCIAL INFORMATION**                                                                         |             |
|        |                                                                                                            |             |
| Item 1 | Consolidated Financial Statements (Unaudited:)                                                                  |             |
|        |                                                                                                            |             |
|        | Consolidated Balance Sheets at March 31, 2006 (unaudited) and  December 31, 2005                                | 3                |
|        |                                                                                                            |             |
|        | Consolidated Statements of Operations for the three months ended  March 31, 2006 and March 31, 2005 (unaudited) | 4                |
|        |                                                                                                            |             |
|        | Consolidated Statements of Cash Flows for the three months ended  March 31, 2006 and March 31, 2005 (unaudited) | 5                |
|        |                                                                                                            |             |
|        | Notes to Consolidated Financial Statements                                                                      | 6                |
| Item 2      | Management’s Discussion and Analysis of Financial Condition and  Results of Operations                     | 15               |
|        |                                                                                                            |             |
| Item 3      | Quantitative and Qualitative Disclosures about Market Risk                                                      | 25               |
|        |                                                                                                            |             |
| Item 4      | Controls and Procedures                                                                                         | 26               |
|        |                                                                                                            |             |
|        | **PART  II - OTHER INFORMATION**                                                                                | ** **       |
|        |                                                                                                            |             |
| Item 1      | Legal  Proceedings                                                                                              | 26               |
|        |                                                                                                            |             |
| Item 1A     | Risk  Factors                                                                                                   | 27               |
|        |                                                                                                            |             |
| Item 2      | Unregistered Sale of Equity Securities and Use of Proceeds                                                      | 34               |
|        |                                                                                                            |             |
| Item 6      | Exhibits                                                                                                        | 34               |
|        |                                                                                                            |             |
| EX-31.1     | SECTION 302 CERTIFICATION OF THE CEO                                                                            |             |
|        |                                                                                                            |             |
| EX-31.2     | SECTION 302 CERTIFICATION OF THE CFO                                                                            |             |
|        |                                                                                                            |             |
| EX-32.1     | SECTION 906 CERTIFICATION OF THE CEO                                                                            |             |
|        |                                                                                                            |             |
| EX-32.2     | SECTION 906 CERTIFICATION OF THE CFO                                                                            |             |

 

2

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**PART I. FINANCIAL INFORMATION**

 

**Item 1. Consolidated FinancialStatements**

 

**INTERNETSECURITY SYSTEMS, INC.**

**CONSOLIDATEDBALANCE SHEETS**

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

 

 
| ** **                                                                                                                     | ** ** | **March 31,**   | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|------------------|------------|
| ** **                                                                                                                     | ** ** | **2006**        | ** ** | **2005**         | ** ** |
| ** **                                                                                                                     | ** ** | **(unaudited)** | ** ** | ** **       | ** ** |
| **ASSETS**                                                                                                                     |       |            |       |             |       |
| Current assets:                                                                                                                |       |            |       |             |       |
| Cash and cash equivalents                                                                                                      |       | $               | 226,801    |             | $          | 238,893 |   |
| Marketable securities                                                                                                          |       | 4,900           |       | —           |       |
| Accounts receivable, less allowance for  doubtful accounts of $3,828 and $3,574 in 2006 and 2005, respectively                 |       | 83,966          |       | 87,769           |       |
| Inventory                                                                                                                      |       | 6,428           |       | 3,076            |       |
| Prepaid expenses and other current assets                                                                                      |       | 11,311          |       | 10,305           |       |
|                                                                                                                           |       |            |       |             |       |
| Total current assets                                                                                                           |       | 333,406         |       | 340,043          |       |
|                                                                                                                           |       |            |       |             |       |
| Property and equipment:                                                                                                        |       |            |       |             |       |
| Computer equipment and software                                                                                                |       | 65,380          |       | 59,492           |       |
| Office furniture and equipment                                                                                                 |       | 18,122          |       | 17,797           |       |
| Leasehold improvements                                                                                                         |       | 21,026          |       | 20,948           |       |
|                                                                                                                           |       |            |       |             |       |
|                                                                                                                           |       | 104,528         |       | 98,237           |       |
| Less accumulated depreciation                                                                                                  |       | 71,203          |       | 67,754           |       |
|                                                                                                                           |       |            |       |             |       |
|                                                                                                                           |       | 33,325          |       | 30,483           |       |
|                                                                                                                           |       |            |       |             |       |
| Restricted cash equivalents and marketable  securities                                                                         |       | 8,600           |       | 8,600            |       |
| Goodwill, less accumulated amortization of  $27,381                                                                            |       | 220,613         |       | 220,224          |       |
| Other intangible assets, less accumulated  amortization of $29,372 and $27,490 in 2006 and 2005, respectively                  |       | 9,329           |       | 10,913           |       |
| Other assets                                                                                                                   |       | 8,249           |       | 8,381            |       |
|                                                                                                                           |       |            |       |             |       |
| Total assets                                                                                                                   |       | $               | 613,522    |             | $          | 618,644 |   |
|                                                                                                                           |       |            |       |             |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                  |       |            |       |             |       |
| Current liabilities:                                                                                                           |       |            |       |             |       |
| Accounts payable                                                                                                               |       | $               | 9,369      |             | $          | 11,261 |   |
| Accrued expenses                                                                                                               |       | 26,188          |       | 35,019           |       |
| Deferred revenues                                                                                                              |       | 75,938          |       | 74,577           |       |
|                                                                                                                           |       |            |       |             |       |
| Total current liabilities                                                                                                      |       | 111,495         |       | 120,857          |       |
| Long-term deferred revenues                                                                                                    |       | 8,596           |       | 7,067            |       |
| Other non-current liabilities                                                                                                  |       | 146             |       | 202              |       |
| Commitments and contingencies                                                                                                  |       |            |       |             |       |
| Minority interest                                                                                                              |       | 4,742           |       | 4,378            |       |
|                                                                                                                           |       |            |       |             |       |
| 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, 52,438,000 and 52,204,000 issued in 2006 and 2005, respectively |       | 52              |       | 52               |       |
| Additional paid-in capital                                                                                                     |       | 530,088         |       | 524,105          |       |
| Deferred compensation                                                                                                          |       | —          |       | (1,830           | )          |
| Accumulated other comprehensive income                                                                                         |       | 2,246           |       | 1,058            |       |
| Retained earnings                                                                                                              |       | 94,139          |       | 87,089           |       |
| Treasury stock, at cost (7,717,000 and  7,129,000 shares in 2006 and 2005, respectively)                                       |       | (137,982        | )          | (124,334         | )          |
|                                                                                                                           |       |            |       |             |       |
| Total stockholders’ equity                                                                                                |       | 488,543         |       | 486,140          |       |
|                                                                                                                           |       |            |       |             |       |
| Total liabilities and stockholders’ equity                                                                                |       | $               | 613,522    |             | $          | 618,644 |   |

 

*Seeaccompanying notes*

 

3

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**INTERNETSECURITY SYSTEMS, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

(amounts in thousands,except per share amounts)

(unaudited)

 
| ** **                                      | ** ** | **Three months ended  March 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                      | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Revenues:                                       |       |                              |       |   |   |
| Product licenses and sales                      |       | $                                 | 32,689     |   | $ | 32,270 |   |
| Subscriptions                                   |       | 42,698                            |       | 38,838 |   |
| Professional services                           |       | 5,374                             |       | 5,684 |   |
|                                            |       |                              |       |   |   |
|                                            |       | 80,761                            |       | 76,792 |   |
| Costs and expenses:                             |       |                              |       |   |   |
| Cost of revenues:                               |       |                              |       |   |   |
| Product licenses and sales                      |       | 6,808                             |       | 6,385 |   |
| Amortization of acquired technology             |       | 1,720                             |       | 1,786 |   |
| Subscriptions and professional services         |       | 13,549                            |       | 13,158 |   |
|                                            |       |                              |       |   |   |
| Total cost of revenues                          |       | 22,077                            |       | 21,329 |   |
|                                            |       |                              |       |   |   |
| Research and development                        |       | 12,694                            |       | 10,291 |   |
| Sales and marketing                             |       | 28,094                            |       | 26,109 |   |
| General and administrative                      |       | 8,309                             |       | 7,344 |   |
| Amortization of other intangibles               |       | 40                                |       | 44 |   |
|                                            |       |                              |       |   |   |
|                                            |       | 71,214                            |       | 65,117 |   |
|                                            |       |                              |       |   |   |
| Operating income                                |       | 9,547                             |       | 11,675 |   |
| Interest income                                 |       | 1,968                             |       | 1,059 |   |
| Other income (expense), net                     |       | (364                              | )          | (539 | ) |
| Gain on issuance of subsidiary stock            |       | 44                                |       | 63 |   |
|                                            |       |                              |       |   |   |
| Income before income taxes                      |       | 11,195                            |       | 12,258 |   |
| Provision for income taxes                      |       | 4,145                             |       | 4,413 |   |
|                                            |       |                              |       |   |   |
| Net income                                      |       | $                                 | 7,050      |   | $ | 7,845 |   |
|                                            |       |                              |       |   |   |
| Basic net income per share of Common Stock      |       | $                                 | 0.16       |   | $ | 0.17 |   |
|                                            |       |                              |       |   |   |
| Diluted net income per share of Common Stock    |       | $                                 | 0.15       |   | $ | 0.16 |   |
|                                            |       |                              |       |   |   |
| Weighted average shares and equivalent  shares: |       |                              |       |   |   |
| Basic                                           |       | 44,713                            |       | 45,495 |   |
|                                            |       |                              |       |   |   |
| Diluted                                         |       | 45,673                            |       | 47,609 |   |

 

*Seeaccompanying notes*

 

4

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**INTERNETSECURITY SYSTEMS, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(amounts in thousands)

(unaudited)

 
| ** **                                                                         | ** ** | **Three months ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| **Operating activities**                                                           |       |                              |       |   |   |
| Net income                                                                         |       | $                                 | 7,050      |   | $ | 7,845 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                              |       |   |   |
| Depreciation                                                                       |       | 3,377                             |       | 2,629 |   |
| Amortization of intangibles                                                        |       | 1,760                             |       | 1,830 |   |
| Stock-based compensation expense                                                   |       | 3,335                             |       | 573 |   |
| Income tax benefit from exercise of stock  options                                 |       | 431                               |       | 286 |   |
| Accretion of discount on marketable  securities                                    |       | 19                                |       | (231 | ) |
| Minority interest                                                                  |       | 332                               |       | 10 |   |
| Gain on issuance of subsidiary stock                                               |       | (44                               | )          | (63 | ) |
| Changes in assets and liabilities,  excluding the effects of acquisitions:         |       |                              |       |   |   |
| Accounts receivable                                                                |       | 4,527                             |       | 2,203 |   |
| Inventory                                                                          |       | (3,305                            | )          | (83 | ) |
| Prepaid expenses and other assets                                                  |       | (752                              | )          | 78 |   |
| Accounts payable and accrued expenses                                              |       | (11,661                           | )          | (1,391 | ) |
| Deferred revenues                                                                  |       | 2,361                             |       | (197 | ) |
|                                                                               |       |                              |       |   |   |
| Net cash provided by operating activities                                          |       | 7,430                             |       | 13,489 |   |
|                                                                               |       |                              |       |   |   |
| **Investing activities**                                                           |       |                              |       |   |   |
| Acquisitions, net of cash received                                                 |       | —                            |       | (764 | ) |
| Purchases of marketable securities                                                 |       | (5,900                            | )          | (35,057 | ) |
| Net proceeds from maturity of marketable  securities                               |       | 1,665                             |       | 36,352 |   |
| Net proceeds from sales of marketable  securities                                  |       | —                            |       | 29,750 |   |
| Additions to cash equivalents in restricted  cashand marketable securities         |       | (684                              | )          | — |   |
| Purchases of property, equipment, and  software                                    |       | (6,059                            | )          | (1,224 | ) |
| Net proceeds from issuance of subsidiary  stock                                    |       | 76                                |       | 117 |   |
|                                                                               |       |                              |       |   |   |
| Net cash provided by (used in) investing  activities                               |       | (10,902                           | )          | 29,174 |   |
|                                                                               |       |                              |       |   |   |
| **Financing activities**                                                           |       |                              |       |   |   |
| Proceeds from exercise of stock options                                            |       | 3,739                             |       | 1,847 |   |
| Proceeds from issuance of common stock                                             |       | —                            |       | 732 |   |
| Purchases of treasury stock                                                        |       | (13,648                           | )          | (9,193 | ) |
| Excess tax benefits from stock option  exercises                                   |       | 308                               |       | — |   |
|                                                                               |       |                              |       |   |   |
| Net cash (used in) financing activities                                            |       | (9,601                            | )          | (6,614 | ) |
|                                                                               |       |                              |       |   |   |
| Foreign currency impact on cash                                                    |       | 981                               |       | (1,968 | ) |
|                                                                               |       |                              |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                              |       | (12,092                           | )          | 34,081 |   |
| Cash and cash equivalents at beginning of period                                   |       | 238,893                           |       | 140,148 |   |
|                                                                               |       |                              |       |   |   |
| Cash and cash equivalents at end of period                                         |       | $                                 | 226,801    |   | $ | 174,229 |   |
|                                                                               |       |                              |       |   |   |
| **Supplemental cash flow disclosure**                                              |       |                              |       |   |   |
| Income taxes paid                                                                  |       | $                                 | 12,080     |   | $ | 1,999 |   |

 

*Seeaccompanying notes*

 

5

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**INTERNETSECURITY SYSTEMS, INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**(unaudited)**

 

**Note 1. Significant Accounting Policies**

 

*Basis of Presentation*

 

The consolidated financial statements of InternetSecurity Systems, Inc. (“ISS” or the “Company”) as of March 31, 2006 and forthe three months ended March 31, 2006 and 2005 are unaudited and, in theopinion of management, contain all adjustments, consisting of normal recurringitems, necessary for the fair presentation of the financial position andresults of operations of the Company for the interim periods. The consolidatedfinancial statements include the accounts of the Company and its majority-ownedsubsidiaries. The consolidated balance sheet at December 31, 2005 has beenderived from the audited financial statements at that date but does not includeall of the footnotes required by U.S. generally accepted accounting principlesfor complete financial statements.

 

These consolidated financial statements should beread in conjunction with the Consolidated Financial Statements and Notesthereto included in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2005. The results of operations for the three months ended March31, 2006 are not necessarily indicative of the results to be expected for theentire year. All significant intercompany accounts and transactions have beeneliminated.

 

The preparation of financial statements and relateddisclosures in conformity with U.S. generally accepted accounting principlesrequires management to make estimates and assumptions that affect the amountsreported in the financial statements and accompanying notes. Actual resultswill differ from those estimates, and such differences may be material to theconsolidated financial statements.

 

*Goodwill and Intangibles*

 

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

 
| ** **                   | ** ** | **March 31,  2006**    | ** ** | **December 31,  2005**   | ** ** |
|------------------------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **                   | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| Goodwill                     |       | $                           | 247,994    |                          | $          | (27,381 | ) | $ | 247,605 |   | $ | (27,381 | ) |
| Amortized intangible assets: |       |                        |       |                          |       |   |   |   |   |
| Core technology              |       | $                           | 3,853      |                          | $          | (3,604 | ) | $ | 3,853 |   | $ | (3,483 | ) |
| Developed technology         |       | 32,825                      |       | (23,873                       | )          | 32,537 |   | (22,158 | ) |
| Customer relationships       |       | 2,023                       |       | (1,895                        | )          | 2,013 |   | (1,849 | ) |
| Total                        |       | $                           | 38,701     |                          | $          | (29,372 | ) | $ | 38,403 |   | $ | (27,490 | ) |

 

The change in the carrying amounts of goodwill anddeveloped technology from December 31, 2005 to March 31, 2006 was theresult of currency translation adjustments for the acquisition of Cobion, aGerman content filtering and anti-spam provider.

 

6

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We amortize intangible assets over their estimateduseful lives of eight years for core technology, five years for developedtechnology and three years for customer relationships. Amortization related tocore technology and developed technology is classified as a component of costof revenues. Amortization expense of intangible assets is as follows (inthousands):

 
| ** **              | ** ** | **Three months ended  March 31,** | ** ** |
|-------------------------|------------|---------------------------------------------|------------|
| ** **              | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| Core  technology        |       | $                                           | 121        |   | $ | 120 |   |
| Developed  technology   |       | 1,599                                       |       | 1,666 |   |
| Customer  relationships |       | 40                                          |       | 44 |   |
|                    |       |                                        |       |   |   |
| Total                   |       | $                                           | 1,760      |   | $ | 1,830 |   |

 

The estimated future amortization expense ofintangible assets as of March 31, 2006 is as follows (in thousands):

 

| ** **               | ** ** | **Amount** | ** ** |
|--------------------------|------------|------------|------------|
| Year ending December 31, |       |       |       |
| 2006 (nine months)       |       | $          | 3,168      |   |
| 2007                     |       | 3,010      |       |
| 2008                     |       | 2,991      |       |
| 2009                     |       | 160        |       |
|                     |       |       |       |
| Total                    |       | $          | 9,329      |   |

 

*Accounting for stock-based compensation*

 

OnJanuary 1, 2006, we adopted Statement of Financial Accounting Standards No. 123(revised 2004), *Share-Based Payment,*(“SFAS No.123(R)”), which requires the measurement of compensation expense for allshare-based payment awards made to employees and directors based on estimatedfair values on date of grant and recognition of compensation over the serviceperiod for awards expected to vest. SFAS No. 123(R) supersedes our previousaccounting under Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*(“APB No. 25”) andrevises guidance in SFAS No. 123, *Accounting for Stock-BasedCompensation*, (“SFAS No. 123”), for periods beginning in fiscal 2006.On March 29, 2005, the SEC published Staff Accounting Bulletin (“SAB”) No. 107,which provides the Staff’s views on a variety of matters relating tostock-based payments. We have applied the provisions of SAB 107 in our adoptionof SFAS No. 123(R).

 

Weadopted SFAS No. 123(R) using the modified prospective method, and accordingly,prior periods results have not been restated, and do not include, the impact ofSFAS No. 123(R). The fair value of restricted stock is determined based on thenumber of shares granted and the quoted price of our common stock; the fairvalue of stock options is determined using the Black-Scholes valuation model,which is consistent with our valuation techniques previously utilized foroptions in footnote disclosures required under SFAS No. 123. Such value isrecognized as expense over the service period, net of estimated forfeitures,using the straight-line single option method under SFAS No. 123(R). SFAS No.123(R) requires forfeitures to be estimated at the time of grant and revised,if necessary, in subsequent periods if

 

7

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actualforfeitures differ from those estimates. In our pro forma information requiredunder SFAS No. 123 for the periods prior to fiscal 2006, we accounted forforfeitures as they occurred. Upon adoption of SFAS No. 123(R), we reclassifiedour current year unamortized deferred compensation related to the issuance ofunvested restricted stock awards to additional paid-in capital in our balancesheet.

 

Stock-basedcompensation expense for the three months ended March 31, 2006 was $3,335,000,which consisted of expense related to employee stock options of $2,930,000 andexpense related to restricted stock of $405,000. Stock-based compensationexpense for the three months ended March 31, 2005 was $573,000, all related torestricted stock awards. Tax benefits recognized in the income statementrelated to stock-based compensation arrangements was $1,234,000 and $212,000for the three months ended March 31, 2006 and 2005, respectively.

 

Taxbenefits resulting from stock-based compensation deductions in excess ofamounts reported for financial reporting purposes were $308,000 for the threemonths ending March 31, 2006. Prior to the adoption of SFAS No. 123(R), cashretained as a result of tax deductions relating to stock-based compensation waspresented in operating cash flows, along with other tax cash flows, inaccordance with the provisions of Emerging Issues Task Force (“EITF”) Issue No.00-15, *Classification in the Statement of Cash Flows ofthe Income Tax Benefit Received by a Company upon Exercise of a NonqualifiedEmployee Stock Option.*SFAS No. 123(R) supersedes EITF No. 00-15,amends SFAS No. 95, *Statement of Cash Flows*,and requires tax benefits relating to excess stock-based compensationdeductions to be prospectively presented in the statement of cash flows as financingcash inflows.

 

OnNovember 10, 2005, the Financial Accounting Standards Board (“FASB”) issuedFASB Staff Position No. FAS 123(R)-3 (“FSP 123(R)-3”), *TransitionElection Related to Accounting for Tax Effects of Share-Based Payment Awards*.This Staff Position provides a simplified method to calculate the beginningpool of excess tax benefits and provides a method of determining the subsequentimpact on the pool and statement of cash flows of awards that are outstandingand fully or partially vested upon the adoption of SFAS No. 123(R). FSP123(R)-3 generally allows companies a year from the initial adoption of SFASNo. 123(R) to elect the methodology to compute the initial pool of excess taxbenefits. We are currently evaluating the transition methods permitted underFSP 123(R)-3.

 

Theapplication of SFAS No. 123(R) has the following effect on the first quarter of2006 reported amounts relative to amounts that would have been reported usingthe intrinsic value method under previous accounting (in thousands, except pershare amounts)

 
| ** **                                     | ** ** | **Using  Previous  Accounting** | ** ** | **SFAS  123(R)  Impact** | ** ** | **As  Reported** | ** ** |
|------------------------------------------------|------------|---------------------------------|------------|--------------------------|------------|------------------|------------|
| Total revenues                                 |       | $                               | 80,761     |                     | $          | —           |       | $ | 80,761 |   |
| Cost of revenues:                              |       |                            |       |                     |       |             |       |
| Product and licenses sales                     |       | 6,794                           |       | 14                       |       | 6,808            |       |
| Amortization of acquired technology            |       | 1,720                           |       | —                   |       | 1,720            |       |
| Subscriptions and professional services        |       | 13,193                          |       | 356                      |       | 13,549           |       |
| Total costs of revenues                        |       | 21,707                          |       | 370                      |       | 22,077           |       |
| Research and development                       |       | 11,891                          |       | 803                      |       | 12,694           |       |
| Sales and marketing                            |       | 27,108                          |       | 986                      |       | 28,094           |       |
| General and administrative                     |       | 7,538                           |       | 771                      |       | 8,309            |       |
| Amortization of other intangibles              |       | 40                              |       | —                   |       | 40               |       |
|                                           |       | 68,284                          |       | 2,930                    |       | 71,214           |       |
| Operating income                               |       | 12,477                          |       | (2,930                   | )          | 9,547            |       |
| Other, net                                     |       | 1,648                           |       | —                   |       | 1,648            |       |
| Income before income taxes                     |       | 14,125                          |       | (2,930                   | )          | 11,195           |       |
| Provision for income taxes                     |       | 5,229                           |       | (1,084                   | )          | 4,145            |       |
| Net income                                     |       | $                               | 8,896      |                     | $          | (1,846           | )          | $ | 7,050 |   |
|                                           |       |                            |       |                     |       |             |       |
| Basic net income per share of Common Stock     |       | $                               | 0.20       |                     | $          | (0.04            | )          | $ | 0.16 |   |
|                                           |       |                            |       |                     |       |             |       |
| Dilutive net income per share of Common  Stock |       | $                               | 0.19       |                     | $          | (0.04            | )          | $ | 0.15 |   |
|                                           |       |                            |       |                     |       |             |       |
| Cash flow from operating activities            |       | $                               | 7,738      |                     | $          | (308             | )          | $ | 7,430 |   |
| Cash flow from financing activities            |       | $                               | (9,909     | )                        | $          | 308              |       | $ | (9,601 | ) |

 

8

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*Gain on issuance of subsidiary shares*

 

The gain on issuance of subsidiary shares resultsfrom Internet Security Systems KK, our Asia/Pacific subsidiary (“ISS KK”),issuing shares related to the exercise of ISS KK stock options.  In 2006,ISS KK has issued 169 shares at an average exercise price of approximately $449per share.  Our ownership percentage of the subsidiary remained at 87% atMarch 31, 2006.  Deferred income taxes have been provided in theperiod in which the gain is recognized.

 

**Note 2. Income Taxes**

 

The Company recorded tax provisions of $4.1 millionand $4.4 million for the three-month periods ended March 31, 2006 and 2005,respectively. The effective tax rate was approximately 37% for the three monthsended March 31, 2006 and 36% for the three months ended March 31, 2005. Theeffective rates differ from the statutory rates due to the impact ofacquisition-related intangibles and certain operating expenses that are notdeductible for income tax purposes as well as federal and state tax credits.

 

**Note 3. Business Acquisition**

 

In August 2002, Internet Security Systems KK (“ISSKK”), our Asia-Pacific subsidiary, acquired a distributor in Singapore,TriSecurity Holdings Pte Ltd. (“TriSecurity”). TriSecurity was the soledistributor for ISS KK in Southeast Asia, including India, and its business wasalmost exclusively focused on ISS solutions. This acquisition provides ourAsia-Pacific subsidiary direct support capabilities for their customers inSoutheast Asia and allows ISS KK to expand its capabilities in this growingmarket. The consideration consisted of 1,000 shares of ISS KK stock andapproximately $1.2 million of cash. Goodwill of approximately $4.0 millionrelated to the purchase was recorded. During the first quarter of 2003, ISS KKamended the agreement and agreed to make payment of 490 shares of ISS KK ineach of the first quarters of 2004 and 2005, relating to annual contingentconsideration payments defined in the 2002 purchase agreement. Due toregulatory issues, the agreement was amended prior to the 2004 payment to makethe 2004 and 2005 payments in cash in lieu of shares. Additional considerationof $764,000 and $498,000 was paid in February 2005 and 2004, respectively,based on the fair market value of the 490 shares, and is reflected in goodwill.

 

**Note 4. Comprehensive Income**

 

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

 
| ** **                                   | ** ** | **Three months ended  March 31,** | ** ** |
|----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| Net income,  as reported                     |       | $                                           | 7,050      |   | $ | 7,845 |   |
| Change in  cumulative translation adjustment |       | 1,188                                       |       | (4,159 | ) |
|                                         |       |                                        |       |   |   |
| Comprehensive  income                        |       | $                                           | 8,238      |   | $ | 3,686 |   |

 

9

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**Note 5. Income per Share**

 

The following table sets forth the computation ofbasic and diluted net income per share (amounts in thousands, except per shareamounts):

 
| ** **                                                                              | ** ** | **Three months ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                              | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Numerator:                                                                              |       |                              |       |   |   |
| Net income                                                                              |       | $                                 | 7,050      |   | $ | 7,845 |   |
|                                                                                    |       |                              |       |   |   |
| Denominator:                                                                            |       |                              |       |   |   |
| Denominator for basic net income per share  - weighted average shares                   |       | 44,713                            |       | 45,495 |   |
| Effect of dilutive stock options                                                        |       | 960                               |       | 2,114 |   |
|                                                                                    |       |                              |       |   |   |
| Denominator for diluted net income per  share - weighted average shares and equivalents |       | 45,673                            |       | 47,609 |   |
|                                                                                    |       |                              |       |   |   |
| Basic net income per share                                                              |       | $                                 | 0.16       |   | $ | 0.17 |   |
|                                                                                    |       |                              |       |   |   |
| Diluted net income per share                                                            |       | $                                 | 0.15       |   | $ | 0.16 |   |

 

In the three months ended March 31, 2006 and 2005, 4,476,000and 3,559,000 options, respectively, were not included in the computation ofdiluted income per share because the options’ exercise price was greater thanthe average market price of the common shares, and their impact would have beenanti-dilutive.

 

**Note 6. Stock option plans**

 

TheInternet Security Systems, Inc. 2005 Stock Incentive Plan (“the Plan”) consistsof equity programs that provide for the granting of qualified or non-qualifiedstock options, the issuance of stock and the automatic option grant program. Underthe terms of the plan the exercise price of options granted shall not be lessthan the fair market value on the date of grant, the options have a maximumterm of seven years and generally vest over a four-year period. Stock issuedunder the Plan generally vests over a period of service or attainment ofspecified performance objectives. The automatic option grant program isavailable to the non-employee member of the Company’s board of directors. AtMarch 31, 2006 there were 7,146,000 shares reserved for future issuance. Anadditional 80,000 shares have been reserved for non-statutory options issued in1997 to non-employee directors.

 

Thefair value of options at date of grant was estimated using the Black-Scholesoption pricing model with the following assumptions:

 
| ** **                                                | ** ** | **Three months ended  March 31,** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| Expected life (years)                                     |       | 4.6                                         |       | 4.6 |   |
| Risk free interest rate                                   |       | 4.28                                        | %          | 3.83 | % |
| Expected volatility                                       |       | 38                                          | %          | 41 | % |
| Expected dividend yield                                   |       | —                                      |       | — |   |
| Weighted-average fair value per share of  options granted |       | $                                           | 8.57       |   | $ | 8.52 |   |
|                                                           |            |                                             |            |  |  |  |  |

 

10

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Expectedlife represents the weighted average period of time that options granted areexpected to be outstanding giving consideration to vesting schedules and ourhistorical exercise patterns. Risk free interest rate is based on the U.S.Treasury yield curve in effect at the time of grant for periods correspondingwith the expected life of the option. Expected volatilities are based on theimplied volatility of public traded options for our common stock.

 

Asummary of ISS’ stock option activity is as follows (number of options inthousands):

 
| ** **                     | ** ** | **Three months ended March 31, 2006** | ** ** |
|--------------------------------|------------|---------------------------------------|------------|
| ** **                     | ** ** | **Number of  Shares**                 | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                           |       |                                  |       |   |   |
| Outstanding at January 1, 2006 |       | 9,327                                 |       | $ | 21.93 |   |
| Granted                        |       | 95                                    |       | 22.32 |   |
| Exercised                      |       | (234                                  | )          | 15.98 |   |
| Canceled:                      |       |                                  |       |   |   |
| Forfeited                      |       | (91                                   | )          | 18.04 |   |
| Expired                        |       | (103                                  | )          | 32.69 |   |
|                           |       |                                  |       |   |   |
| Outstanding at March 31, 2006  |       | 8,994                                 |       | $ | 22.00 |   |
|                           |       |                                  |       |   |   |
| Exercisable at March 31, 2006  |       | 5,571                                 |       | $ | 24.06 |   |

 

Theaggregate intrinsic value of options outstanding and exercisable was $51.0million and $32.7 million as of March 31, 2006 and $26.9 million and $15.7million as of March 31, 2005, respectively. The total intrinsic value ofoptions exercised during the three months ended March 31, 2006 and 2005 was $1.7million and $0.9 million, respectively. Unrecognized non-cash stockcompensation expense related to unvested options outstanding as of March 31,2006 was approximately $19.2 million and will be recorded over the remainingvesting period of four years.

 

Thefollowing table summarizes information about stock options outstanding atMarch 31, 2006 (option amounts in thousands):

 
|                         | ** ** | **Options  Outstanding** | ** ** | **Options  Fully  Vested and Exercisable** | ** ** |
|------------------------------|------------|--------------------------|------------|--------------------------------------------|------------|
|                         | ** ** | **Number  of**           | ** ** | **Weighted**                               | ** ** | ** ** | ** ** | **Number** | ** ** | ** ** | ** ** |
|                         | ** ** | **Options**              | ** ** | **Average**                                | ** ** | **Weighted** | ** ** | **Exercisable** | ** ** | **Weighted** | ** ** |
|                         | ** ** | **Outstanding  at**      | ** ** | **Remaining**                              | ** ** | **Average** | ** ** | **At** | ** ** | **Average** | ** ** |
|                         | ** ** | **March 31,**       | ** ** | **Contractual**                            | ** ** | **Exercise** | ** ** | **March 31,** | ** ** | **Exercise** | ** ** |
| **Range of Exercise Prices** | ** ** | **2006**                 | ** ** | **Life**                                   | ** ** | **Price** | ** ** | **2006** | ** ** | **Price** | ** ** |
|                         |       |                     |       |                                       |       |   |   |   |   |   |   |
| $.08-9.11                    |       | 232                      |       | 2.97                                       |       | $ | 5.26 |   | 232 |   | $ | 5.26 |   |
| $10.00-19.98                 |       | 4,437                    |       | 6.10                                       |       | 14.62 |   | 2,647 |   | 14.20 |   |
| $20.03-29.44                 |       | 2,614                    |       | 5.84                                       |       | 22.13 |   | 981 |   | 21.76 |   |
| $30.63-39.75                 |       | 1,063                    |       | 5.66                                       |       | 33.05 |   | 1,063 |   | 33.05 |   |
| $49.81-85.63                 |       | 648                      |       | 4.46                                       |       | 59.83 |   | 648 |   | 59.83 |   |
|                         |       |                     |       |                                       |       |   |   |   |   |   |   |
|                         |       | 8,994                    |       | 5.77                                       |       | $ | 22.00 |   | 5,571 |   | $ | 24.06 |   |

 

Directors,officers and certain key employees of ISS were issued 0 and 56,000 restrictedshares in the three months ended March 31, 2006 and the year-ended December 31,2005, respectively. In 2005, 33,000

 

11

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restrictedshares were returned prior to vesting. The shares issued to directors vest quarterlyover two years, and the shares issued to officers and certain key employeesvest in two installments:  50% vests twoyears from the grant date, and the remaining 50% vests three years from thegrant date.

 
| **Restricted Stock Summary**                   | ** ** | **Restricted  Stock** | ** ** | **Weighted-  Average  Grant-Date  Fair Value** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|------------------------------------------------|------------|
| Nonvested restricted stock at January 1,  2006 |       | 283,350               |       | $                                              | 18.60      |   |
| Granted                                        |       | —                |       | —                                         |       |
| Vested                                         |       | (114,375              | )          | 17.73                                          |       |
| Forfeited                                      |       | —                |       | —                                         |       |
| Nonvested restricted stock at March 31,  2006  |       | 168,975               |       | $                                              | 19.18      |   |

 

Thetotal fair value of restricted stock which vested during the three months endedMarch 31, 2006 and 2005 was $2.5 million and $0, respectively. Unrecognizednon-cash stock compensation expense related to unvested restricted stockoutstanding as of March 31, 2006 was approximately $1.4 million and will berecorded over the remaining vesting period of approximately 2 years.

 

Stock-basedcompensation for 2005 was determined using the intrinsic value method. Thefollowing table provides supplemental information for the three months endedMarch 31, 2005 as if stock-based compensation had been computed under SFAS No.123 (in thousands, except per share amounts):

 
| ** **                                                                                        | ** ** | **Three months  ended March  31, 2005** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| Net income, as reported                                                                           |       | $                                       | 7,845      |   |
| Add: Stock-based compensation included in  reported net income, net of income taxes               |       | 367                                     |       |
| Less: Stock-based compensation expense  computed under the fair value method, net of income taxes |       | (4,138                                  | )          |
|                                                                                              |       |                                    |       |
| Pro forma net income                                                                              |       | $                                       | 4,074      |   |
|                                                                                              |       |                                    |       |
| Basic net income per share of Common Stock                                                        |       |                                    |       |
| As reported                                                                                       |       | $                                       | 0.17       |   |
|                                                                                              |       |                                    |       |
| Pro forma                                                                                         |       | $                                       | 0.09       |   |
|                                                                                              |       |                                    |       |
| Diluted net income per share of Common  Stock                                                     |       |                                    |       |
| As reported                                                                                       |       | $                                       | 0.16       |   |
|                                                                                              |       |                                    |       |
| Pro forma                                                                                         |       | $                                       | 0.09       |   |

 

12

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**Note 7. Segment and Geographic Information**

 

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

 

The accounting policies of the segments are the sameas those described in the summary of significant accounting policies. There areno inter-segment sales. Our chief executive officer and chief financial officerevaluate performance based on operating profit or loss from operations, andtrade accounts receivable for each segment. Other than trade accountsreceivable, assets and liabilities are not discretely allocated or reviewed bysegment.

 

In accordance with SFAS No. 131, “*Disclosures about Segments of an Enterprise andRelated Information,*” the Company has included a summary of thesegment financial information reported internally. The geographic segments arethe Americas, Europe, Middle East and Africa (“EMEA”), and the Asia/Pacificregion.

 

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

 
| ** **                                              | ** ** | **Americas** | ** ** | **EMEA**   | ** ** | **Asia/Pacific** | ** ** | **Unallocated** | ** ** | **Total**  | ** ** |
|---------------------------------------------------------|------------|--------------|------------|------------|------------|------------------|------------|-----------------|------------|------------|------------|
| **As of or for the three months ended March  31, 2006** | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| **Revenues from external customers:**                   | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| Product licenses and sales                              |       | $            | 20,272     |       | $          | 6,736            |       | $               | 5,681      |       | $          | — |   | $ | 32,689 |   |
| Subscriptions                                           |       | 27,228       |       | 9,445      |       | 6,025            |       | —          |       | 42,698     |       |
| Professional services                                   |       | 3,686        |       | 416        |       | 1,272            |       | —          |       | 5,374      |       |
|                                                    |       |         |       |       |       |             |       |            |       |       |       |
| Total revenue                                           |       | 51,186       |       | 16,597     |       | 12,978           |       | —          |       | 80,761     |       |
| **Cost of revenues:**                                   | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| Product licenses and sales                              |       | 3,808        |       | 1,442      |       | 1,117            |       | 441             |       | 6,808      |       |
| Amortization of acquired technology                     |       | —       |       | —     |       | —           |       | 1,720           |       | 1,720      |       |
| Subscriptions and professional services                 |       | 9,413        |       | 1,067      |       | 2,693            |       | 376             |       | 13,549     |       |
|                                                    |       |         |       |       |       |             |       |            |       |       |       |
| Total cost of revenues                                  |       | 13,221       |       | 2,509      |       | 3,810            |       | 2,537           |       | 22,077     |       |
| **Operating expenses**                                  |       | 18,170       |       | 7,389      |       | 2,535            |       | 21,043          |       | 49,137     |       |
|                                                    |       |         |       |       |       |             |       |            |       |       |       |
| **Total expenses**                                      |       | 31,391       |       | 9,898      |       | 6,345            |       | 23,580          |       | 71,214     |       |
|                                                    |       |         |       |       |       |             |       |            |       |       |       |
| **Segment operating income (loss)**                     |       | $            | 19,795     |       | $          | 6,699            |       | $               | 6,633      |       | $          | (23,580 | ) | $ | 9,547 |   |
|                                                    |       |         |       |       |       |             |       |            |       |       |       |
| **Accounts receivable, net**                            |       | $            | 51,773     |       | $          | 18,133           |       | $               | 14,060     |       | $          | — |   | $ | 83,966 |   |
|                                                    |       |         |       |       |       |             |       |            |       |       |       |
| **Property and equipment, net**                         |       | $            | 27,530     |       | $          | 1,741            |       | $               | 4,054      |       | $          | — |   | $ | 33,325 |   |
|                                                    |       |         |       |       |       |             |       |            |       |       |       |
| **As of or for the three months ended March  31, 2005** | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| **Revenues from external customers:**                   | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| Product licenses and sales                              |       | $            | 19,058     |       | $          | 6,807            |       | $               | 6,405      |       | $          | — |   | $ | 32,270 |   |
| Subscriptions                                           |       | 24,758       |       | 9,148      |       | 4,932            |       | —          |       | 38,838     |       |
| Professional services                                   |       | 3,563        |       | 467        |       | 1,654            |       | —          |       | 5,684      |       |
|                                                    |       |         |       |       |       |             |       |            |       |       |       |
| Total revenue                                           |       | 47,379       |       | 16,422     |       | 12,991           |       | —          |       | 76,792     |       |
| **Cost of revenues:**                                   | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| Product licenses and sales                              |       | 3,671        |       | 1,214      |       | 1,125            |       | 375             |       | 6,385      |       |
| Amortization of acquired technology                     |       | —       |       | —     |       | —           |       | 1,786           |       | 1,786      |       |
| Subscriptions and professional services                 |       | 9,000        |       | 1,294      |       | 2,831            |       | 33              |       | 13,158     |       |
|                                                    |       |         |       |       |       |             |       |            |       |       |       |
| Total cost of revenues                                  |       | 12,671       |       | 2,508      |       | 3,956            |       | 2,194           |       | 21,329     |       |
| **Operating expenses**                                  |       | 15,947       |       | 7,718      |       | 2,443            |       | 17,680          |       | 43,788     |       |
|                                                    |       |         |       |       |       |             |       |            |       |       |       |
| **Total expenses**                                      |       | 28,618       |       | 10,226     |       | 6,399            |       | 19,874          |       | 65,117     |       |
|                                                    |       |         |       |       |       |             |       |            |       |       |       |
| **Segment operating income (loss)**                     |       | $            | 18,761     |       | $          | 6,196            |       | $               | 6,592      |       | $          | (19,874 | ) | $ | 11,675 |   |
|                                                    |       |         |       |       |       |             |       |            |       |       |       |
| **Accounts receivable, net**                            |       | $            | 38,003     |       | $          | 19,892           |       | $               | 15,255     |       | $          | — |   | $ | 73,150 |   |
|                                                    |       |         |       |       |       |             |       |            |       |       |       |
| **Property and equipment, net**                         |       | $            | 26,211     |       | $          | 1,602            |       | $               | 5,222      |       | $          | — |   | $ | 33,035 |   |

 

13

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**Note 8. Commitments and Contingencies**

 

Our sales agreements with customers generallycontain infringement indemnity provisions. We have not previously incurredcosts to settle claims or pay awards under these indemnification obligations. Wehave only incurred costs to defend ISS to date. As a result, we believe theestimated fair value of these obligations is nominal. Accordingly, we have noliabilities recorded for these agreements as of March 31, 2006. In addition, wewarrant that our software products will perform in all material respects inaccordance with our standard published specifications in effect at the time ofdelivery of the licensed products to the customer for ninety days. We alsowarrant that for one year after shipment, all hardware will be free fromdefects in materials and workmanship under normal authorized use, consistentwith the instructions contained in the product documentation. Additionally, wewarrant that our services will be performed consistent with generally acceptedindustry standards or specific service levels through completion of the agreedupon services. While these generally continue to be the performance warranties,there are variations arising from custom contracts. We have not incurredsignificant recurring expense under our product or service warranties andhardware warranties are covered by the manufacturer warranties. As a result, webelieve the estimated fair value of these agreements is nominal. Accordingly,we have no liabilities recorded for these agreements as of March 31, 2006.

 

Payments for certain operating leases for our officespace are secured by collateralized standby letters of credit totaling$7.3 million at March 31, 2006. These standby letters of creditguarantee payments on certain lease obligations and are renewed annually unlesscancelled by either party. The lease obligations have terms that expire atvarious dates through 2013. The beneficiary of the standby letters of creditcan draw on the letters of credit if we default on the related leaseobligation. Each standby letter of credit is collateralized by securities. AtMarch 31, 2006, $8.6 million of cash and marketable securities arepledged as collateral and are shown on the balance sheet as restricted cash andmarketable securities.

 

On August 17, 2004, the Company’s Georgiaoperating subsidiary filed in the United States District Court for the NorthernDistrict of Georgia a declaratory judgment action (the “Georgia Action”)against SRI International, Inc. (“SRI”). The action seeks the court’sdeclaration that our products and services do not infringe any valid claim offive patents held by SRI and seeks declaration that certain claims of thosepatents are invalid. On August 26, 2004, SRI filed in the United StatesDistrict Court for Delaware a complaint against the Company and SymantecCorporation (the “Delaware Action”). The complaint in the Delaware Actionalleges that our SiteProtector and Proventia products infringe upon claims oftwo of the five patents at issue in the Georgia Action. The Delaware Actionseeks unspecified damages and injunctive relief. On April 25, 2005, SRIfiled an amended complaint adding the Company’s Georgia operating subsidiary asa separate defendant to the Delaware Action. The Company and its subsidiaryanswered SRI’s amended complaint on May 23, 2005, denying that theyinfringe the two patents asserted by SRI and asserting counterclaims seeking adeclaration from the Delaware court that the five SRI patents are notinfringed, and are invalid and unenforceable. On June 9, 2005, the Georgiacourt transferred the Georgia Action to the United States District Court forthe District of Delaware. The transferred action was consolidated with theDelaware Action. On June 13, 2005, SRI answered the counterclaims assertedby the Company and its subsidiary, denying that the five patents are notinfringed, invalid, and unenforceable. On August 5, 2005, SRI granted tothe Company a covenant never to sue the Company, its distributors, customers,licensees or end users, for damages or any other form of legal or equitablerelief based on or arising out of the alleged infringement of one of the fivepatents-in-suit as a result of the manufacture, use, sale, offer for sale,importation, maintenance, support or servicing of any Company product orservice

 

14

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existingon or before the effective date. The parties are currently engaged in discoveryon the remaining claims, and trial has been scheduled to begin on or aboutOctober 30, 2006. We intend to defend the Delaware Action vigorously andbelieve we have meritorious defenses and counterclaims

 

**Item 2.  Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

*The following Management’sDiscussion and Analysis of Financial Condition and Results of Operations shouldbe read in conjunction with the Consolidated Financial Statements and relatedNotes thereto included elsewhere in this Form 10-Q.*

 

*Except for the historicalfinancial information, many of the matters discussed in this Form 10-Q maybe considered “forward-looking” statements. Forward-looking statements can beidentified by the use of words such as “may,” “should,” “could,” “continue,” “future,”“potential,” “believe,” “project,” “plan,” “intend,” “seek,” “estimate,” “predict”,“expect”, “anticipate” and similar expressions, or the negative of such terms,or other comparable terminology.  Forward-looking statements also includethe assumptions underlying or relating to any of the foregoingstatements.  Such forward-looking statements are not guarantees of futureperformance and involve a number of risks and uncertainties.  Our actualresults could differ materially from those anticipated in these forward-lookingstatements as a result of various factors, including those set forth belowunder the caption “Risk Factors” and those otherwise described from time totime in our Securities and Exchange Commission reports filed after thisForm 10-Q . All forward-looking statements included in this Form 10-Qare based on information available to us on the date hereof.  We assume noobligation (except where required by law) to update any forward-lookingstatements for any events or circumstances occurring after the date of thisForm 10-Q.*

 

*In this Form 10-Q, the words “InternetSecurity Systems,” “ISS,” “the Company,” “we,” “our,” “ours,” and “us” refer toInternet Security Systems, Inc., and its subsidiaries.*

 

*Internet Security Systems andSiteProtector are trademarks and service marks, and the Internet SecuritySystems logo, X-Force, Proventia and RealSecure are registered trademarks andservice marks, of Internet Security Systems, Inc.*

 

**Overview**

 

We focus on providing enterprise-wide pre-emptiveprotection. We provide such protection with our comprehensive line of productsand services. These include a product family consisting of network and hostintrusion prevention, network anomaly detection, integrated securityappliances, desktop protection and vulnerability assessment and protection; ISS’SiteProtector centralized management system; and ISS’ Managed Security Servicesand Professional Security Services. The integrated security appliance includes,in addition to intrusion prevention, firewalls, virtual private networkfeatures, anti-virus protection, content filtering, e-mail security, and anti-spamtechnology.

 

This combination of products and services forms ourProventia Enterprise Security Platform (ESP), which contributes to businessprocess optimization by maintaining a delicate balance between IT-performance,availability and risk—ultimately stopping cyber threats before they impactoperations. Unlike traditional approaches to security, which focus on improvingreaction times, Proventia ESP is designed to avoid security incidents bycombining continuous vulnerability assessment and threat prevention withenterprise-wide information management and reporting capabilities. Ourobjective is to enable companies to shield security vulnerabilities acrosstheir entire IT infrastructure—before attacks are released.

 

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

 

Our managed services offerings currently provideremote management of our best-of-breed security technology, focusing onsecurity assessment and intrusion detection, intrusion prevention and desktop

 

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protectionsystems, and include firewalls, VPNs, anti-virus and URL filtering software. Wefocus on serving as the trusted security provider to our customers bymaintaining within our existing products the latest counter-measures tosecurity risks, creating new innovative products based on our customers’ needsand providing professional and managed services.

 

Many factors will affect our future financialperformance, especially our ability to differentiate our offerings fromcompetitors that include much larger companies with greater marketingcapabilities, financial resources and brand recognition. In order to continueto create such differentiation, we expect to continue to expand our domesticand international sales and marketing operations’, seek acquisition candidatesand alliances with partners whose products, technologies or servicecapabilities are complementary to our solutions and improve our internaloperating and financial infrastructure in support of our strategic goals andobjectives. At the same time, we expect to adjust our organization size inlight of changing economic conditions and maintain emphasis on controllingdiscretionary spending and capital expenditures. While we believe in thelong-term success of our business solutions, our prospects must be consideredin light of the recent experience, risks and difficulties that are frequentlyencountered by companies serving rapidly evolving markets. See “Risk Factors”.

 

**Critical Accounting Policies**

 

The consolidated financial statements were preparedin conformity with U.S. generally accepted accounting principles (“GAAP”).As such, management is required to make certain estimates, judgments andassumptions it believes are reasonable based upon the information available. Theseestimates and assumptions affect the reported amounts of assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the periods presented. Actual results may differsignificantly from these estimates under different assumptions, judgements, orconditions. The significant accounting policies which management believes arethe most critical to aid in fully understanding and evaluating our reportedfinancial results include the following:

 

***Revenue recognition***

 

We recognize revenue in the following categories:

 

•       *Product licenses and sales,* which include revenue from sales ofperpetual software licenses and products;

 

•       *Subscription revenues,* which consists of customer support,including content updates and technical support, term licenses, subscriptionlicenses and managed service arrangements; and

 

•       *Professional servicesrevenues,* which includesfee-based service engagements and training.

 

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

 

•       persuasive evidence of an arrangement exists;

 

•       delivery has occurred or services have beenrendered;

 

•       price is fixed or determinable; and

 

•       collection is probable.

 

*Product licenses and sales*

 

We recognize perpetual software license revenues,assuming all other revenue recognition criteria are met, upon (1) deliveryof the software and (2) issuance of the related license, assuming that nosignificant vendor obligations or customer acceptance rights exist. Wherepayment terms are extended over periods greater than twelve months,revenue is recognized as such amounts become due and payable. Revenue is alsodeferred when payment terms are extended for periods less than twelve monthsand such sales are deemed either not to be fixed or determinable or collectionis not probable based on evaluation of all terms of the transaction.

 

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Product sales consist primarily of appliances soldin conjunction with ISS licensed software. These sales are recognized uponshipment to the customer provided all other criteria for software licenserevenue recognition are met.

 

Sales of products are generated both through directsales to end-users as well as through various partners, including systemintegrators, value-added resellers and distributors. Revenue from productlicenses and sales is recognized when the sale has occurred for an identifiedend-user, provided all other revenue recognition criteria are met. At the pointof delivery, the customer has no right of return. We offer evaluation softwareavailable via download from our website and evaluation units forappliance-based products that allow potential customers to see thefunctionality of the products on their own networks prior to purchase.

 

*Subscription revenues*

 

Subscription revenues consist of renewable customersupport, term licenses, and security monitoring and management services. Renewablecustomer support is a separate element of sales of perpetual software licensesand products. Term licenses allow customers to use our products and receiveproduct support coverage and content updates for a specified period, generallytwelve months. We generally invoice for customer support and term licenses atthe beginning of the term and recognize revenue ratably over the subscriptionterm. Security monitoring and management services for information assets andsystems are part of managed services and associated revenues are recognized assuch services are rendered.

 

Historically, our software and intrusion preventionappliance sales have been accounted for primarily as revenue at the time ofsale, with product support and content updates generally representing between20% and 30% of the related license or product amount. Prior to the secondquarter of 2005, the majority of the initial price paid by the customer forcertain Proventia integrated security appliance models was for selected contentupdates (sometimes referred to as “blades”), which customers acquire for aspecified term that is recognized over such term as subscription revenue. Duringthe second quarter of 2005, we changed the pricing model for our Proventiaintegrated security appliances to our historical model under which customersacquire the appliance bundled with most content blades, which are recorded asproduct revenue at the time of sale, and pay annual customer support fees at anaverage rate of 22% of the related product price. This change did not have amaterial impact on our results.

 

*Professional services revenues*

 

Service engagements are typically billed on either afixed fee or time-and-materials basis and primarily consist of securityassessments of customer networks and the development of customers’ securitypolicies. These offerings are intended to support our goal of providingproducts and managed services. We prefer to have our partners provide theseservices where practical. We recognize such professional services revenues asthe related services are rendered.

 

*Multiple element arrangements*

 

Our sales of product and/or software licenses aremultiple element arrangements that include product support and content updatesand may include other subscription or professional services delivered after thesale of the product or software license. Revenue is generally recognizablebefore delivery of every element of the arrangement when all of the followingrequirements exist:

 

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

 

•       the functionality of the delivered elementsis not dependent on the undelivered elements; and

 

•       delivery of the delivered elements representsthe culmination of the earnings process.

 

We recognize the difference between the totalarrangement fee and the amount deferred for the undelivered elements asrevenues by allocating revenue to the delivered products, licensesand services using the residual method. Under the residual method, we allocatediscounts inherent in the arrangement to products and customer supportassociated with products that are initially delivered and recognize the otherelements as they are delivered based on the VSOE of fair value, which isdetermined based on transactions

 

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wherethe company sells those elements separately. We determine fair value of theundelivered elements based on historical evidence of our stand-alone sales ofthese elements to third parties.

 

*Allowance for doubtful accounts*

 

Our sales are global, with customers located in theAmericas, EMEA, and Asia/Pacific regions. We perform periodic creditevaluations of our customer’s financial condition and do not requirecollateral. We provide for estimated credit losses as such losses becomeprobable. We evaluate specific accounts when we become aware of a situationwhere a customer may not be able to meet its financial obligations due todeterioration of its liquidity or financial viability, credit ratings orbankruptcy. The allowance for doubtful accounts is established based on thebest facts available to us and is reevaluated and adjusted as additionalinformation is received. At March 31, 2006, the allowance for doubtfulaccounts totaled $3.8 million, or 4.3% of the $87.8 million of totaltrade receivables. This 4.3% allowance of receivables reflects our practice toleave accounts on our general ledger and provide reserves pending finalresolution of collectibility rather than to write-off such accounts.

 

Our bad debt expense for the quarter endedMarch 31, 2006 amounted to $331,000 compared to $145,000 in thecorresponding period of 2005.

 

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

 

*Impairment of goodwill and other long-lived andintangible assets*

 

We review goodwill for impairment on an annual basisor on an interim basis whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable.  All other long-livedand intangible assets are reviewed for impairment whenever events orcircumstances indicate that the carrying amount of an asset may not berecoverable.  Such impairment loss would be measured as the differencebetween the carrying amount of the asset and its fair value based on thepresent value of estimated future cash flows.  Significant judgment isrequired in the forecasting of future operating results, which are used in thepreparation of projected cash flows.  Due to uncertain market conditionsand potential changes in our strategy and products, it is possible thatforecasts used to support our intangible assets may change in the future, whichcould result in significant non-cash charges that would adversely affect ourresults of operations.

 

We currently have goodwill and other acquisitionrelated intangibles, net of accumulated amortization, of approximately$230 million, with $195 million of goodwill related to ourJune 2001 acquisition of Network ICE Corporation (“Network ICE”) andapproximately $20 million of goodwill related to the January 2004acquisition of Cobion, AG (“Cobion”).  The determination of whether or notgoodwill is impaired involves significant judgments based upon short andlong-term projections of future performance.  We have concluded that thisamount is realizable based on forecasted discounted cash flows through 2009 andon our stock market valuation.  Neither method indicated that our goodwillhad been impaired and, as a result, we did not record any impairment lossesrelated to goodwill during the quarter ended March 31, 2006.  Otherintangibles of approximately $9 million are principally acquiredtechnology from the Network ICE and Cobion acquisitions that are components inour current product offerings.

 

*Stock-based compensation*

 

As of January 1, 2006, we adopted SFAS 123(R), whichrequires us to measure compensation cost for stock awards at fair value andrecognize compensation over the service period for awards expected to vest. Theestimation of stock awards that will ultimately vest requires judgment, and tothe extent actual results or updated estimates differ from our currentestimates, such amounts will be recorded as a cumulative adjustment in theperiod estimates are revised. We consider many factors when estimating awards

 

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expectedto vest including type of awards, employee class, and our historical experience.Actual results, and future changes in estimates, may differ substantially fromour current estimates.

 

We use the Black-Scholes valuation model todetermine the fair value of our stock options, and significant judgment isrequired in determining the inputs to the model, particularly for the expectedvolatility. We use the implied volatility of publicly traded options for ourcommon stock to estimate expected volatility. Changes in the input assumptions,including expected volatility, can materially affect the fair value estimate ofour stock options.

 

**Results of Operations**

 

The following table sets forth our consolidatedhistorical operating information, as a percentage of total revenues, for theperiods indicated:

 
| ** **                                      | ** ** | **Three months ended  March 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| **Consolidated Statements of Operations Data:** |       |                                        |       |   |   |
| Product licenses and sales                      |       | 40                                          | %          | 42 | % |
| Subscriptions                                   |       | 53                                          | %          | 51 | % |
| Professional services                           |       | 7                                           | %          | 7 | % |
|                                            |       |                                        |       |   |   |
| Total revenues                                  |       | 100                                         | %          | 100 | % |
|                                            |       |                                        |       |   |   |
| Cost of revenues:                               |       |                                        |       |   |   |
| Product licenses and sales                      |       | 8                                           | %          | 8 | % |
| Amortization of acquired technology             |       | 2                                           | %          | 3 | % |
| Subscriptions and professional services         |       | 17                                          | %          | 17 | % |
|                                            |       |                                        |       |   |   |
| Total cost of revenues                          |       | 27                                          | %          | 28 | % |
| Research and development                        |       | 16                                          | %          | 13 | % |
| Sales and marketing                             |       | 35                                          | %          | 34 | % |
| General and administrative                      |       | 10                                          | %          | 10 | % |
| Amortization of other intangibles               |       | —                                      | %          | — | % |
|                                            |       |                                        |       |   |   |
| Total costs and expenses                        |       | 88                                          | %          | 85 | % |
|                                            |       |                                        |       |   |   |
| Operating income                                |       | 12                                          | %          | 15 | % |

 

**Revenues**

 

*Product licenses and sales*

 

Since the second quarter of 2003, we have offeredthe Proventia family of network protection appliances that collectivelyprovides unified, multi-function protection capabilities designed to identifyand prevent many forms of attack with minimal user intervention. These productsare designed to operate in demanding network environments while being easy todeploy, easy to use and centrally managed, all in an effort to make oursolution more cost-effective. The market response has been dramatic asProventia grew from 23% of product license and sales revenues in its year ofintroduction to 71% in the first quarter of 2006.

 

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Product licenses and sales in the three months endedMarch 31, 2006 increased by 1% compared with the three months ended March 31,2005. The net increase was a result of increases in intrusion preventionappliance revenues offset by a decrease in legacy software revenue andintrusion detection appliances. The Proventia line grew to 71% of productlicense and sales in the first quarter of 2006 from 64% of product license andsales revenues in the first quarter of 2005. Product licenses and salesdecreased slightly to 40% of total revenues in the first quarter of 2006compared to 42% in the corresponding period of 2005 due to the higher growthrate of subscription revenues.

 

We believe our future growth is dependent on acontinuation of the positive market response to our Proventia family ofproducts. Our present product roadmap also focuses on product offerings andenhancements that will continue to improve central control and manageability,easier deployment and more refined information as well as broader Proventiaappliance offerings. We expect that this focus will continue to make ourproducts more cost effective to implement and maintain the goal of increasingthe future level of product licenses and sales. This expected growth iscritical as it represents not only product and license revenues, but alsosubscription revenues from product support and content updates.

 

*Subscriptions*

 

Subscription revenues consist of product support andcontent updates, security-monitoring fees for managed services offerings, andterm licenses of products. Subscriptions grew 10% in the first quarter of 2006compared to the first quarter of 2005, increasing to $42.7 million from $38.8million. Subscriptions revenue represented 53% of total revenues in the firstquarter of 2006 compared to 51% in the first quarter of 2005.

 

The largest component of subscription revenues,product content and support, increased to 36% of total revenues, in the firstquarter of 2006 compared to 33% of total revenues, in the first quarter of 2005.Product content and support includes hardware support of our Proventiaappliances, software updates, technical support and security content thatincludes advisory updates from X-Force, our internal team of security experts. Productcontent and support are provided to our customers through contracts executedwith customers for a specified term and billed at the time of contract. Suchbillings are recorded as deferred revenues on our balance sheet and amortizedas subscriptions revenue over the term of the contract. The increase of ourproduct content and support revenues in the future is dependent on continuedsuccess with product sales and maintenance renewals.

 

Managed services revenues increased 10% from thefirst quarter of 2005. Managed services revenues were 15% of total revenues inthe three months ended March 31, 2006, as compared with 14% of total revenuesin the three months ended March 31, 2005. We believe these increases were dueto a strong demand in the market for proven, financially sound, managedsecurity service providers. We are marketing managed services both directly toend users and through partners, including a number of new arrangements withintegrators and service providers that include managed services as a part oftheir service offerings to their customers.

 

*Professional services*

 

Professional services revenues decreased to $5.4million in the first quarter of 2006 from $5.7 million in the first quarter of2005. Professional services revenues were 7% of total revenues in both thefirst quarter of 2006 and 2005. We continue to focus on high-value offeringsthat utilize our X-Force expertise, and look to our system integration andchannel partners to serve as the primary resource to fulfill the services andeducation needs of our customers.

 

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*Geographic regions*

 

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

 

| ** **   | ** ** | **Three months ended  March 31,** | ** ** |
|--------------|------------|---------------------------------------------|------------|
| ** **   | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| Americas     |       | 63                                          | %          | 62 | % |
| EMEA         |       | 21                                          | %          | 21 | % |
| Asia/Pacific |       | 16                                          | %          | 17 | % |

 

While there have been changes in the proportion ofrevenues generated by each region, all of the regions experienced growth inrevenues in the local currency in 2006. Weakening exchange rates in EMEA andAsia/Pacific compared to the US dollar negatively impacted revenue growth inthose theatres in U.S. dollars. The financial data for each segment can befound in Note 7 to the Consolidated Financial Statements.

 

**Costs and Expenses**

 

*Personnel*

 

Personnel and related costs represent our largestexpense category. We ended the first quarter of 2006 with 1,270 employees, upapproximately 7% from the first quarter of 2005. The majority of headcountgrowth occurred in quota-carrying sales personnel, marketing, managed securityservices operations, and engineering. Our headcount has fluctuated betweenapproximately 1,150 and 1,270 over the last 3 years as we acquired andintegrated acquisitions and continually refined our business targets in lightof economic conditions during these years.

 

OnJanuary 1, 2006 we adopted SFAS No. 123(R), and as required we have recordedstock-based compensation expense starting in the first quarter of 2006. Previouslywe had accounted for stock options under APB No. 25, and as permitted, we hadnot recorded stock-based compensation expense for our options. We adopted SFASNo. 123(R) using the modified prospective method, and accordingly, prior periodresults have not been restated, and do not include, the impact of SFAS No.123(R). Total stock-based compensation expense related to the expensing ofstock options was approximately $2.9 million in the three months ended March31, 2006 (3.6% of total revenues). This expense has affected the comparabilityto prior quarter for the majority of our expense categories as it has beenrecorded in the expense line in which the recipients of the options are placed.Unrecognized non-cash stock compensation expense related to unvested optionsoutstanding as of March 31, 2006 was approximately $19.2 million and will berecorded over the remaining vesting period of four years.

 

Webegan to use restricted stock, in addition to stock options, as an equitycomponent of compensation beginning in the first quarter of 2004. We recorded$0.4 million and $0.6 million of compensation expense in the three monthsended March 31, 2006 and 2005, respectively, associated with restricted stockin the expense categories in which the recipients are placed. Unrecognizednon-cash stock compensation expense related to unvested restricted stockoutstanding as of March 31, 2006 was approximately $1.4 million and will berecorded over the remaining vesting period of approximately 2 years.

 

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*Cost of product licenses and sales*

 

Cost of product licenses and sales consists ofseveral components. Costs associated with licensing our software products areminor. The substantial portion of our cost of product licenses and salesrepresents the hardware cost of our Proventia appliances. As a percentage ofproduct licenses and sales revenues, these costs increased slightly to 21% inthe first quarter of 2006 from 20% in the first quarter of 2005. We also purchaseddevelopment source code in the first quarter of 2006 and in 2004, which isbeing amortized as cost of products sold over its estimated useful life of fouryears.

 

 We incurredapproximately $1.7 million in the first quarter of 2006 and$1.8 million in the first quarter of 2005 of amortization expense relatedto core and developed technology that was recorded as a result of acquisitionsaccounted for under the purchase method of accounting.

 

*Cost of subscriptions and professional services*

 

Cost of subscriptions and professional servicesincludes the cost of our technical support personnel who provide assistance tocustomers under product support agreements, the security operations center (“SOC”)costs of providing managed security monitoring services and the costs relatedto our professional services and training. These costs increased approximately$0.3 million to $13.5 million in the first quarter of 2006 from$13.2 million in the first quarter of 2005. The increase is due tostock-based compensation expense related to stock options with the adoption ofSFAS No. 123(R). As a percentage of subscription and professional servicesrevenues, these costs decreased to 28% in the first quarter of 2006 from 30% inthe first quarter of 2005.

 

Costs associated with our technical supportpersonnel and our security operations centers increased each year in 2005, 2004and 2003 as we added personnel to handle additional customers. We gainedefficiencies in our SOCs and restructured our support groups to be moreproductive so personnel increased at a much lower rate than revenue growth,contributing to the decrease in those costs as a percentage of total revenues. Additionally,our appliances typically require less technical support effort than oursoftware products. While we continue to seek increased productivity, we doexpect increase in costs with a continued increase in revenues in the future.

 

*Research and development*

 

Research and development expenses consist of salaryand related costs of research and development personnel, including costs foremployee benefits, and depreciation on computer equipment. These costs includethose associated with maintaining and expanding the X-Force, our internal teamof security experts. We believe our primary research and product developmentand managed service offerings are important to retaining our leadershipposition in the market.

 

We continue to add functionality to our productfamily, providing gateway, network, server and desktop-based solutions, as wellas to our vulnerability assessment and security management applications. Theseimprovements, as well as new offerings, are intended to provide our customerswith more powerful and easier-to-use solutions for security management acrossthe enterprise.

 

Research and development expenses increased $2.5million to $12.7 million in the three months ended March 31, 2006 from $10.3million in the three months ended March 31, 2005, representing 16% and 13% oftotal revenues for these periods, respectively. Approximately $0.8 million ofthe increase was related to stock options expense with the adoption of SFAS No.123(R). The remaining increase is a result of additional engineering headcount aswe continue to invest in our product offerings.

 

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While we are committed to continue our investment inX-Force research and development capabilities, which we believe distinguishesISS from its competitors, we intend to seek leverage in future periods in theresearch and development area while enhancing current technologies anddeveloping new technologies.

 

*Sales and marketing*

 

Sales and marketing expenses consist of salaries,travel expenses, commissions, advertising, maintenance of our website, tradeshow expenses, costs of recruiting sales and marketing personnel and costs ofmarketing materials.

 

Sales and marketing expenses increased approximately$2.0 million to $28.1 million in the first three months of 2006 from $26.1million in the first three months of 2005, and increased as a percentage oftotal revenues to 35% from 34%. The implementation of SFAS 123(R) on January 1,2006 added approximately $1.0 million (approximately 1% of total revenues) of stockoption expense for the three months ended March 31, 2006.. We addedquota-carrying headcount, but gained leverage from our sales force as wecontinue to increase the percentage of sales fulfilled through our partnersaleschannel. We also increased our advertising expenditures during the threemonths ended March 31, 2006 by approximately $380,000 when compared to the sameperiod in 2005.

 

We expect to continue to achieve leverage in oursales efforts by focusing our direct sales force on large customers that areserved either directly by us or through large systems integrators. Our partnersales channel, which includes systems integrators, value-added resellers anddistributors, will continue to be of increasing importance to us, measuredquantitatively by an increasing level of product revenue originating through it.This channel represented approximately 82% of our sales in the first quarter of2006 as compared to 77% in 2005. We intend to use our channel’s capabilities toreach larger customers through joint selling efforts and to reach departmentaland small companies.

 

*General and administrative*

 

General and administrative expenses consist ofpersonnel-related costs for executive, administrative, finance and humanresources, internal information systems and other support services costs, andlegal, accounting and other professional service fees. General and administrativeexpenses were $8.3 million in the three months ended March 31, 2006 and $7.3million in the three months ended March 31, 2005, representing approximately10% of our total revenues in both 2006 and 2005.

 

The largest increase was approximately $0.8 millionfor the expensing of stock options due to the adoption of SFAS 123(R) onJanuary 1, 2006.

 

*Interest income*

 

Interest income increased to $2.0 million in thequarter ended March 31, 2006 from $1.1 million in the comparable quarter of2005 due to an increase in the yield on investment-quality commercial paper andsimilar investments to approximately 4.0% in the first quarter of 2006 comparedto 2.5% during the first quarter of 2005.

 

*Other income (expense), net*

 

Other income (expense) primarily consisted ofminority interest expense and foreign exchange currency losses of $332,000 and$23,000, respectively in 2006 and $10,000 and $535,000, respectively in 2005.

 

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*Gain on issuance of subsidiary shares*

 

The gain on issuance of subsidiary shares resultsfrom Internet Security Systems KK, our Asia/Pacific subsidiary (“ISS KK”),issuing shares related to the exercise of ISS KK stock options.  In 2006,ISS KK has issued 169 shares at an average exercise price of approximately $449per share.  Our ownership percentage of the subsidiary remained at 87% atMarch 31, 2006.  Deferred income taxes have been provided in theperiod in which the gain is recognized

 

*Provision for income taxes*

 

Our effective tax rate was approximately 37% for thethree months ended March 31, 2006 and 36% for the three months ended March 31,2005. The effective rates differ from the Federal statutory rate due primarilyto certain operating expenses that are not deductible for income tax purposes,state income taxes, foreign operations taxed at different rates and Federal taxcredits

 

**Liquidity and Capital Resources**

 

Our financial position remained strong through thefirst three months of 2006. Our cash and cash equivalents and marketablesecurity investments were $231.7 million at March 31, 2006. Our investments inmarketable securities consisted solely of highly rated debt obligations withmaturities of twelve months or less.

 

We continue to meet our working capital needs andcapital equipment needs with cash provided by operations. Cash provided byoperations in the first three months of 2006 totaled $7.4 million. The majorcomponents of cash flows provided by operating activities were net income of$7.1 million, non-cash depreciation and amortization expense charges of $5.1million, non-cash stock-based compensation expense of $3.3 million, a decrease inaccounts receivable of $4.5 million, offset by an increase in inventory of $3.3million, and a decrease in accounts payable and accrued expenses of $11.7million primarily for the payment of income taxes.

 

An important element of our liquidity is thecollection of our accounts receivable. We measure our accounts receivablemanagement by our day’s sales outstanding (“DSO”). This is a measurement ofaccounts receivable divided by billings in the quarter, represented by the sumof revenues plus the change in the deferred revenues liability account balance.This measurement was at 90 days at March 31, 2006, above our target range of 75to 85 days primarily due to slower collections and the timing of revenue.

 

Our net cash used in investing activities was $10.9million in the first three months of 2006. Investing activities includedchanges in our marketable securities that have quality characteristics similarto cash equivalents, except their maturities when we acquire them are longerthan three months. The cash flow statement included the purchase of $5.9million of intermediate term marketable securities, primarily interest-bearinggovernment obligations and commercial paper, offset by net proceeds from thematurity of marketable securities of $1.7 million. Also included in cash flow frominvesting was the purchase of $6.1 million of property, equipment, and acquiredsource code due to continued investment in our business and infrastructure.

 

Our financing activities used $9.6 million of cashin the first three months of 2006. This was principally due to the repurchaseof 588,000 shares of our common stock in the open market at an aggregate costof $13.6 million. The previous stock repurchase plan expired in July 2005and a new repurchase program to repurchase up to $100.0 million of ourcommon stock through July 2006 was authorized by the Board of Directors inJuly 2005. Since the inception of the stock repurchase plans, we havepurchased 7.7 million shares at an average cost of $17.88 per share for a totalcash outlay of approximately $138.0 million. We can purchase up to anadditional $54.8 million under the current program. Also, in the first threemonths of 2006, the exercise of stock options by our employees generated fundsof approximately $3.7 million.

 

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At March 31, 2006, we had $231.7 millionof cash and cash equivalents. An additional $8.6 million of cashequivalents and marketable securities are pledged as collateral for stand-byletters of credit related to the operating leases of our facilities and areshown on the balance sheet as restricted marketable securities and cash equivalents.We believe that such cash and cash equivalents and marketable securities willbe sufficient to meet our working capital needs and capital expenditures forthe foreseeable future. Furthermore, we are not aware of any trends, events, oruncertainties that are reasonably likely to result in any significant change toour liquidity.

 

From time to time, we evaluate possible acquisitionand investment opportunities in businesses, products or technologies that arecomplementary to ours. In the event we determine to pursue such opportunities,we may use our available cash and cash equivalents, marketable securities andtake on debt for this purpose.

 

*Off-Balance Sheet Arrangements*

 

Payments for certain operating leases for our officespace are secured by collateralized standby letters of credit totaling$7.3 million at March 31, 2006. These standby letters of creditguarantee payments on certain lease obligations and are renewed annually unlesscancelled by either party. The lease obligations have terms that expire atvarious dates through 2013. The beneficiary of the standby letters of creditcan draw on the letters of credit if we default on the related leaseobligation. Each standby letter of credit is collateralized by securities. AtMarch 31, 2006, $8.6 million of cash and marketable securities arepledged as collateral and are shown on the balance sheet as restricted cash andmarketable securities.

 

**Item 3. Quantitative andQualitative Disclosures About Market Risk**

 

ISS is subject to foreign exchange risk as a resultof exposures to changes in currency exchange rates. Our foreign operations are,for the most part, naturally hedged against exchange rate fluctuations sincethe majority of revenues and expenses of each foreign affiliate are denominatedin the same currency. Therefore, we do not engage in formal hedging activities,but we do periodically review the potential impact of this risk to ensure thatthe risk of significant potential losses remains minimal. As a result, anunfavorable change in the exchange rate for any particular foreign subsidiarywould result in lower revenues and expenses with regards to operating results,and lower assets and liabilities with regards to the balance sheet.

 

The Company’s operating results are affected bychanges in exchange rates between the U.S. Dollar and the Euro and theJapanese Yen. When the U.S. Dollar strengthens against these foreigncurrencies, the value of our reporting currency revenues decreases. When theU.S. Dollar weakens, the value of our reporting currency revenuesincreases. Since much of our international operating expenses are also incurredin local currencies, which is the foreign subsidiaries functional currency, theimpact of exchange rates on net income or loss is relatively less than theimpact on revenue. Although our operating and pricing strategies take intoaccount changes in exchange rates over time, our results of operations may beaffected significantly in the short term by fluctuations in foreign currencyexchange rates. A fluctuation of 10% in the average exchange rates of the Eurosand Japanese Yen relative to the US dollar the first quarter of both 2006and 2005 would have resulted in increases or decreases in operating income ofapproximately $1.3 million from the reported operating income.

 

During the first quarter of 2006, the Companyrecorded a net foreign exchange loss of $23,000. The nature and extent of theforeign currency risk faced by the Company depends on many factors that cannotbe accurately predicted. These factors include significant changes in foreigncurrency market conditions, the Company’s inability to match foreign currencydenominated revenues with costs denominated in the same currency, and changesin the amount or mix of revenues denominated in various foreign currencies. Asa result of material unforeseen changes in these factors, the Company’s foreigncurrency risk could have a greater impact on the Company’s results ofoperations in the future.

 

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**Item 4. Controls and Procedures**

 

**Disclosure Controls and Procedures**

 

ISS’ management, with the participation of the ChiefExecutive Officer and Chief Financial Officer, evaluated the effectiveness ofour disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e)under the Securities Exchange Act of 1934, as of March 31, 2006. No system ofcontrols, no matter how well designed and operated, can provide absoluteassurance that the objectives of the system of controls are met, and noevaluation of controls can provide absolute assurance that the system ofcontrols has operated effectively in all cases. Our disclosure controls andprocedures however are designed to provide reasonable assurance that theobjectives of disclosure controls and procedures are met.

 

Based on such evaluation, these officers haveconcluded that, as of such date, our disclosure controls and procedures wereeffective to provide reasonable assurance that information required to bedisclosed in the reports the Company files or submits under the SecuritiesExchange Act of 1934 is recorded, processed, summarized and reported on atimely basis.

 

**Changes in Internal Control Over Financial Reporting**

 

There have not been any changes in ISS’ internalcontrol over financial reporting during the quarter ended March 31, 2006 thathave materially affected, or are reasonably likely to materially affect, suchcontrols.

 

**PART II. OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

On August 17, 2004, the Company’s Georgiaoperating subsidiary filed in the United States District Court for the NorthernDistrict of Georgia a declaratory judgment action (the “Georgia Action”)against SRI International, Inc. (“SRI”). The action seeks the court’sdeclaration that our products and services do not infringe any valid claim offive patents held by SRI and seeks declaration that certain claims of thosepatents are invalid. On August 26, 2004, SRI filed in the United StatesDistrict Court for Delaware a complaint against the Company and SymantecCorporation (the “Delaware Action”). The complaint in the Delaware Actionalleges that our SiteProtector and Proventia products infringe upon claims oftwo of the five patents at issue in the Georgia Action. The Delaware Actionseeks unspecified damages and injunctive relief. On April 25, 2005, SRIfiled an amended complaint adding the Company’s Georgia operating subsidiary asa separate defendant to the Delaware Action. The Company and its subsidiaryanswered SRI’s amended complaint on May 23, 2005, denying that theyinfringe the two patents asserted by SRI and asserting counterclaims seeking adeclaration from the Delaware court that the five SRI patents are notinfringed, and are invalid and unenforceable. On June 9, 2005, the Georgiacourt transferred the Georgia Action to the United States District Court forthe District of Delaware. The transferred action was consolidated with theDelaware Action. On June 13, 2005, SRI answered the counterclaims assertedby the Company and its subsidiary, denying that the five patents are not infringed,invalid, and unenforceable. On August 5, 2005, SRI granted to the Companya covenant never to sue the Company, its distributors, customers, licensees orend users, for damages or any other form of legal or equitable relief based onor arising out of the alleged infringement of one of the five patents-in-suitas a result of the manufacture, use, sale, offer for sale, importation,maintenance, support or servicing of any Company product or service existing onor before the effective date. The parties are currently engaged in discovery onthe remaining claims, and trial has been scheduled to begin on or aboutOctober 30, 2006. We intend to defend the Delaware Action vigorously andbelieve we have meritorious defenses and counterclaims.

 

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**Item 1A.****                ********Risk Factors**

 

There are many factors that affect ISS’ business andthe results of its operations, some of which are beyond ISS’ control. Thefollowing is a description of some of the important factors that may cause theactual results of ISS’ operations in future periods to differ materially fromthose currently expected or desired. We encourage you to read thissection carefully.

 

***We Operate in a Rapidly EvolvingMarket***

 

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

 

•       respond to competitive developments;

 

•       continue to upgrade and expand our productand services offerings; and

 

•       continue to attract, retain and motivate ouremployees.

 

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

 

Weintroduced our Proventia appliance line in April 2003 and continue tointroduce new products in this line. While market response to these productshas had a positive impact on our operating results, failure to continue to gainfurther market acceptance of new products could result in revenues below ourexpectations and our operating results could be adversely affected.

 

***Our Future Operating Results WillLikely Fluctuate Significantly***

 

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

 

•       the extent to which the public perceives thatunauthorized access to and use of online information are threats to networksecurity;

 

•       customer budgets;

 

•       the mix of product sales among the variousproducts offered by ISS and whether revenue is recognized upon sale ordeferred to subsequent periods;

 

•       the volume and timing of orders, includingseasonal trends in customer purchasing;

 

•       our ability to develop and timely introducenew and enhanced product and managed service offerings;

 

•       the introduction and acceptance rate of newISS branded appliances, including related increased cost of goods sold;

 

•       disruption in the sales cycle and supplychain management due to product introductions;

 

•       our ability to accurately forecast andproduce demanded quantities of our appliance products and models;

 

•       availability of component parts of applianceproducts and reliance on contract manufacturers to produce such products;

 

•       our ability to provide scalable managedservices offerings in a cost effective manner;

 

•       foreign currency exchange rates that affectour international operations;

 

•       whether enterprises consolidate theirsecurity platforms with fewer vendors and whether ISS benefits from this;

 

•       product and price competition in ourmarkets; and

 

•       general economic conditions, bothdomestically and in our foreign markets.

 

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We focus our direct sales efforts on enterprise-widesecurity solutions, which consist of our entire product suite, professionalservices, and managed security services, rather than on the sale of componentproducts. As a result, each sale requires substantial time and effort from oursales and support staff. In addition, the revenues associated with particularsales vary significantly depending on the number of products acquired by acustomer and the number of devices used by the customer. Large individualsales, or even small delays in customer orders, can cause significant variationin our license revenues and results of operations for a particular period. Thetiming of large orders is usually difficult to predict and, like manysoftware-based technology companies, many of our customers typically completetransactions in the last month of a quarter.

 

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

 

Our ability to provide timely guidance and meet theexpectations of investors with respect to our operating and financial resultsis affected by the tendency of a majority of our product and license sales tobe completed in the last month of a quarter. We may not be able to determinewhether we will experience material deviations from guidance or expectationsuntil the end of a quarter.

 

***Dependence on Third Party Suppliersand Manufacturers***

 

We carry little inventory of our appliance productsand we rely on suppliers to deliver necessary components to our contractmanufacturers in a timely manner based on the forecasts we provide. Wecurrently purchase some Proventia appliance components and contractmanufacturing services from single or limited sources. If shortages occur, suppliesare interrupted, or we underestimate demand for models, we may not be able todeliver products to our customers and our revenue and operating results wouldbe adversely affected. We provide forecasts of our demand to our contractmanufacturers. Because our supply of hardware is based on short-term forecastsand purchase orders, our contract manufacturers are not obligated to purchasecomponents for greater quantities over longer periods. If we underestimate ourrequirements, our contract manufacturers may have an inadequate componentinventory and, based on lead times, this could interrupt manufacturing andresult in delays in shipments and revenues.

 

***We Face Intense Competition in OurMarket***

 

The market for network security monitoring,detection, prevention and response solutions is intensely competitive, and weexpect competition to increase in the future. We cannot guarantee that we willcompete successfully against our current or potential competitors, especiallythose with significantly greater financial resources or brand name recognition.Our chief competitors generally fall within the following categories:

 

•       large companies, including SymantecCorporation, Cisco Systems, Inc., Juniper Networks, Inc., 3ComCorporation, Check Point Software Technologies, LTD, and McAfee, Inc.,that sell competitive products and offerings, as well as other large softwarecompanies that have the technical capability and resources to developcompetitive products;

 

•       software or hardware network infrastructurecompanies like Cisco Systems, Inc., 3Com Corporation, and JuniperNetworks, Inc. that could integrate features that are similar to ourproducts into their own products;

 

•       smaller software companies offeringrelatively limited applications for network and Internet security; and

 

•       small and large companies with competitiveofferings to components of our managed services offerings.

 

Mergers or consolidations among these competitors,or acquisitions of small competitors by larger companies, represent risks. Forexample, Symantec Corporation., Cisco Systems, Inc., McAfee, Inc.,3Com Corporation, and Juniper Networks, Inc. have acquired during the pastseveral years smaller companies,

 

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whichhave network security technologies. These acquisitions will make these entitiespotentially more formidable competitors to us if such products and offeringsare effectively integrated. Large companies may have advantages over us becauseof their longer operating histories, greater name recognition, larger customerbases or greater financial, technical and marketing resources. As a result,they may be able to adapt more quickly to new or emerging technologies andchanges in customer requirements. They can also devote greater resources to thepromotion and sale of their products than we can. In addition, these companieshave reduced and could continue to reduce, the price of their securitymonitoring, detection, prevention and response products and managed securityservices, which increases pricing pressures within our market.

 

Several companies currently sell software products(such as encryption, firewall, operating system security and virus detectionsoftware) that our customers and potential customers have broadly adopted. Someof these companies sell products that perform the same functions as some of ourproducts. In addition, the vendors of operating system software or networkinghardware may enhance their products to include the same kinds of functions thatour products currently provide. The widespread inclusion of comparable featuresto our software in operating system software or networking hardware couldrender our products less competitive or obsolete, particularly if such featuresare of a high quality. Even if security functions integrated into operatingsystem software or networking hardware are more limited than those of ourproducts, a significant number of customers may accept more limitedfunctionality to avoid purchasing additional products.

 

In addition, with the introduction of our Proventiaintegrated security appliance, we have offerings that compete with vendors offirewalls, VPNs, anti-virus systems, and content and spam filtering products.These offerings are competitive with a broader spectrum of network security companies,as well as those that also offer integrated security appliances or broadproduct suites.

 

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

 

***We Face Risks Associated withGovernmental Contracting***

 

Our customers include the U.S. and other nationalgovernment agencies and a significant number of other state and localgovernments or agencies.

 

•       Procurement—Contracting with public sectorcustomers is highly competitive and can be expensive and time-consuming, oftenrequiring that we incur significant upfront time and expense without anyassurance that we will win a contract;

 

•       Budgetary Constraints and Cycles—Demand andpayment for our products and services are impacted by public sector budgetarycycles and funding availability, with funding reductions or delays adverselyimpacting public sector demand for our products and services;

 

•       Modification or Cancellation ofContracts—Public sector customers often have contractual or other legal rightsto terminate current contracts for convenience or due to a default. If acontract is cancelled for convenience, which can occur if the customer’s productneeds change, we may only be able to collect for products and servicesdelivered prior to termination. If a contract is cancelled because of default,we may only be able to collect for products and alternative products andservices;

 

•       Governmental Audits—National governments andother state and local agencies routinely investigate and audit governmentcontractors’ administrative processes. They may audit our performance andpricing and review our compliance with applicable rules and regulations.If they find that we improperly allocated costs, they may require us to refundthose costs or may refuse to pay us for outstanding balances related to theimproper allocation. An unfavorable audit could result in a reduction ofrevenue, and may result in civil or criminal liability if the audit uncoversimproper or illegal activities.

 

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***We Face Rapid Technological Change in Our Industry and FrequentIntroductions of New Products***

 

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

 

•       the extent to which businesses and othersseek to establish more secure networks;

 

•       the extent to which hackers and others seekto compromise secure systems;

 

•       evolving computer hardware and softwarestandards;

 

•       changing customer requirements; and

 

•       frequent introductions of new products andproduct enhancements.

 

To remain successful, we must continue to change,adapt and improve our products in response to these and other changes intechnology. Our future success hinges on our ability to both continue toenhance our current line of products and professional services and to introducenew products and services that address and respond to innovations in computerhacking, computer technology and customer requirements. We cannot be sure thatwe will successfully develop and market new products that do this. Any failureby us to timely develop and introduce new products, to enhance our current productsor to expand our professional services capabilities in response to thesechanges could adversely affect our business, operating results and financialcondition. In addition, introduction of new and successor products can disruptsales of legacy products as customers await or evaluate the new products orinventories of legacy products are phased out.

 

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

 

We are increasing our investment inengineering and customer support activities and these investments may achievedelayed, or lower than expected, benefits which could harm our operatingresults. We intend to continue to add personnel and other resources to our engineeringand customer support functions as we continue developing advanced technologies.We are likely to recognize the costs associated with these investments earlierthan some of the anticipated benefits and the return on these investments maybe lower, or may develop more slowly, than we expect. If we do not achieve thebenefits anticipated from these investments, or if the achievement of thesebenefits is delayed, our expected operating results may be adversely affected.

 

The techniques computer hackers use to gainunauthorized access to, or to sabotage, networks and intranets are constantlyevolving and increasingly sophisticated. Furthermore, because new hackingtechniques are usually not recognized until used against one or more targets,we are unable to anticipate most new hacking techniques. To the extent that newhacking techniques harm our customers’ computer systems or businesses, affectedor prospective customers may believe that our products are ineffective, whichmay cause them or prospective customers to reduce or avoid purchases of ourproducts.

 

***Undetected Product Errors or DefectsCould Result in Loss of Revenues, Delayed Market Acceptance and Claims AgainstUs***

 

We offer warranties on our products, allowing theend customer to have any defective product repaired, or to receive areplacement product for it during the warranty period, or in certaincircumstances return the product for a refund. Our products may containundetected errors or defects. If there is a broad product failure across ourcustomer base, we may decide to replace all affected products or we may decideto refund the purchase price for defective units. Such defects and actions mayadversely affect our ability to record revenue. Some errors are discovered onlyafter a product has been installed and used by end customers. Any errorsdiscovered after commercial release could result in loss of revenues and claimsagainst us.

 

We offer warranties on our service levels formanaged security services. If we do not meet warranties, the customer generallymay obtain credits for service.

 

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If we are unable to fix errors or other productproblems that later are identified after full deployment, or if we fail to meetour service levels for managed security services, in addition to theconsequences described above, we could experience:

 

•       failure to achieve market acceptance;

 

•       loss of customers;

 

•       loss of or delay in revenues and loss ofmarket share;

 

•       diversion of development resources;

 

•       increased service and warranty costs;

 

•       legal actions by our customers; and

 

•       increased insurance costs.

 

***Our Products are Complex and AreOperated in a Wide Variety of Computer Configurations, Which Could Result inErrors or Product Failures***

 

Because we offer very complex products, undetectederrors, failures or bugs may occur when they are first introduced or when newversions are released. Our products often are installed and used in large-scalecomputing environments with different operating systems, system managementsoftware and equipment and networking configurations, which may cause errors orfailures in our products or may expose undetected errors, failures or bugs inour products. We discover errors, failures and bugs in certain of our productofferings after their introduction and have experienced delays and couldexperience lost revenues during the period required to correct these errors.Our customers’ computer environments are often characterized by a wide varietyof standard and non-standard configurations that make pre-release testing forprogramming or compatibility errors very difficult and time-consuming. Despitetesting, errors, failures or bugs may not be found in new products or releasesuntil after commencement of commercial shipments. Errors, failures or bugs inproducts released by us could result in negative publicity, product returns,loss of or delay in market acceptance of our products or claims by customers orothers.

 

In addition, if an actual or perceived breach ofnetwork security occurs in one of our end customer’s security systems,regardless of whether the breach is attributable to our products, the marketperception of the effectiveness of our products could be harmed. Because thetechniques used by computer hackers to access or sabotage networks changefrequently and generally are not recognized until launched against a target, wemay be unable to anticipate these techniques. Alleviating any of these problemscould require significant expenditures of our capital and resources and couldcause interruptions, delays or cessation of our product licensing, which couldcause us to lose existing or potential customers and would adversely affectresults of operations.

 

***We Might Have to Defend Lawsuits orPay Damages in Connection With Any Alleged or Actual Failure of Our Productsand Services***

 

Because our products and services provide andmonitor network security and may protect valuable information, we could faceclaims for product liability, tort or breach of warranty. Anyone whocircumvents our security measures could misappropriate the confidentialinformation or other property of end customers using our products, or interrupttheir operations. If that happens, affected end customers or others may sue us.In addition, we may face liability for breaches caused by faulty installationof our products by our service and support organizations. Provisions in ourcontracts relating to warranty disclaimers and liability limitations may beunenforceable. Some courts, for example, have found contractual limitations ofliability in standard computer and software contracts to be unenforceable insome circumstances. Defending a lawsuit, regardless of its merit, could becostly and could divert management attention. Our business liability insurancecoverage may be inadequate or future coverage may be unavailable on acceptableterms or at all.

 

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***Risks Associated with Our GlobalOperations***

 

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

 

•       the difficulty in managing an organizationspread over various countries located across the world;

 

•       compliance with, and unexpected changes in, awide range of complex regulatory requirements in countries where we dobusiness;

 

•       duties and tariffs imposed on importation ofour products in other jurisdictions where other manufacturers may not bearthose same costs;

 

•       increased financial accounting and reportingburdens;

 

•       potentially adverse tax consequences;

 

•       fluctuations in foreign currency exchangerates resulting in losses or gains from transactions and expenses denominatedin foreign currencies;

 

•       reduced protection for intellectual propertyrights in some countries;

 

•       reduced protection for enforcement ofcreditor and contractual rights in some countries; and

 

•       import and export license requirements andrestrictions on the import and export of certain technology, especiallyencryption technology and trade restrictions.

 

Despite these risks, we believe that we mustcontinue to expand our operations in international markets to support ourgrowth. To this end, we intend to establish additional foreign salesoperations, expand our existing offices, hire additional personnel, expand ourinternational sales channels and customize our products for local markets. Ifwe fail to execute this strategy, our international sales growth will belimited.

 

***Our Networks, Products and ServicesMay 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 securitysolutions company, we are a high profile target. Although we believe we havesufficient controls in place to prevent disruption and misappropriation, and torespond to such situations, we expect these efforts by hackers to continue. Ifthese efforts are successful, our operations, reputation and sales could beadversely affected.

 

***We Must Successfully IntegrateAcquisitions***

 

As part of our growth strategy, we have and may continueto acquire or make investments in companies with products, technologies orprofessional services capabilities complementary to our solutions. Whenengaging in acquisitions, we could encounter difficulties in assimilating orcompleting the development of the technologies, new personnel and operationsinto our company. These difficulties may disrupt our ongoing business, distractour management and employees, increase our expenses and adversely affect ourresults of operations. These difficulties could also include accountingrequirements, such as impairment charges related to goodwill or otherintangible assets or expensing in-process research and development costs. Wecannot be certain that we will successfully overcome these risks with respectto any future acquisitions or that we will not encounter other problems inconnection with our recent or any future acquisitions. In addition, any futureacquisitions may require us to incur debt or issue equity securities. Theissuance of equity securities could dilute the investment of our existingstockholders.

 

***We Have Authorized the Use of aSubstantial Amount of Our Cash for the Repurchase of Our Shares, and This Useof Funds May Limit Our Ability to Complete Other Transactions or to PursueOther Business Initiatives.***

 

In July 2005, ISS announced a share repurchaseprogram authorizing the use of up to $100 million in cash to repurchaseoutstanding shares of our common stock. We expect to repurchase shares for cashas business conditions warrant through July 19, 2006. The fullimplementation of this repurchase program

 

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woulduse a significant portion of our cash reserves. This use of cash could limitour future flexibility to complete acquisitions of businesses or technology orother transactions.

 

***Our Proprietary Rights May beDifficult to Enforce***

 

We rely primarily on copyright, trademark, patentand trade secrets laws, confidentiality procedures and contractual provisionsto protect our proprietary rights. We hold several United States patents, oneTaiwanese patent, and have a number of patent applications pending. We alsohold numerous United States and foreign trademarks and have a number oftrademark applications pending. There can be no assurance that patents will beissued from pending applications, or that claims allowed on any patents will besufficiently broad to protect our technology. There can be no assurance thatany issued patents will not be challenged, invalidated or circumvented, or thatany rights granted under these patents will actually provide competitiveadvantages to us. Despite our efforts to protect our proprietary rights,unauthorized parties may attempt to copy aspects of our products or to obtainand use information that we regard as proprietary. Policing unauthorized use ofour products is difficult. While we cannot determine the extent to which piracyof our software products occurs, we expect software piracy to be a persistentproblem. In addition, the laws of some foreign countries do not protect ourproprietary 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 asU.S. government agencies and private parties. If we are unable to protectour proprietary rights to the totality of the features in our software andproducts (including aspects of our software and products protected other thanby patent rights), we may find ourselves at a competitive disadvantage toothers who need not incur the additional expense, time and effort required tocreate the innovative products that have enabled us to be successful.

 

***We May Be Found to Infringe theProprietary Rights of Others***

 

Third parties may assert claims or initiatelitigation related to exclusive patent, copyright, trademark and otherintellectual property rights to technologies that are relevant to our business.Because of the large number of patents in the Internet, networking, securityand software fields, the secrecy of some pending patents and the rapid rate ofissuance of new patents, it is not economically practical (or even possible) todetermine in advance whether a product (or any of its components) infringe orwill infringe the patent rights of others. Third party asserted claims and/orinitiated litigation can include claims against us or our manufacturers,suppliers, or customers, alleging infringement of proprietary rights withrespect to our existing or future products (or components of those products).Regardless of the merit of these claims, they can be time-consuming, result incostly litigation and diversion of technical and management personnel, orrequire us to develop a non-infringing technology or enter into licenseagreements. There can be no assurance that licenses will be available on acceptableterms and conditions, if at all, in these circumstances, or that anyindemnification that might be available to us would be adequate to cover ourcosts of defense. Furthermore, because of the potential for large judgments,which are not necessarily predictable, it is not unusual to find even arguablyunmeritorious claims settled for significant funds. If any infringement orother intellectual property claims made against us by a third party issuccessful, or if we fail to develop non-infringing technology or license theproprietary rights on commercially reasonable terms and conditions, ourbusiness, operating results, financial condition and liquidity could bematerially and adversely affected.

 

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

 

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

 

•       establish a classified board of directors;

 

•       create preferred stock purchase rights thatgrant to holders of common stock the right to purchase shares of Series AJunior Preferred Stock in the event that a third party acquires 20% or more ofthe voting power of our outstanding common stock;

 

•       prohibit the right of our stockholders to actby written consent;

 

•       limit calling special meetings ofstockholders; and

 

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•       impose a requirement that holders of 662/3%of the outstanding shares of common stock are required to amend the provisionsrelating to the classification of our board of directors and action by writtenconsent of stockholders.

 

**Item 2. Unregistered Sale of EquitySecurities and Use of Proceeds**

 

The following table provides information aboutpurchases by the Company of its common stock during the three months endedMarch 31, 2006. All such purchases were made in open-market transactionspursuant to a repurchase plan publicly announced on July 27, 2005. Underthis repurchase plan, the Company has been authorized by the Board torepurchase up to $100 million of its outstanding common stock over the 12months ending July 19, 2006. The Company had prior repurchase plans inplace that have terminated, and no further purchases can be made under thoseplans. Through March 31, 2006, the Company had purchased approximately 7.7million shares at an aggregate cost of approximately $138.0 million underthe current and prior repurchase plans.

 

**IssuerPurchases of Equity Securities**

 
| **Period**     | ** ** | **Total Number  of  Shares  Purchased** | ** ** | **Average Price  Paid  Per Share** | ** ** | **Total Number of  Shares Purchased  as  Part of Publicly  Announced Plans or  Programs** | ** ** | **Approximate Dollar  Value of Shares  that May Yet Be  Purchased Under the  Plans or Programs** | ** ** |
|----------------|------------|----------------------------------------------|------------|-----------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|
| 1/1/06-1/31/06 |       | 33,000                                       |       | $                                       | 22.20      |                                                                                                               | 33,000     |                                                                                                            | $          | 67,679,000 |   |
| 2/1/06-2/28/06 |       | 280,000                                      |       | $                                       | 22.90      |                                                                                                               | 280,000    |                                                                                                            | $          | 61,267,000 |   |
| 3/1/06-3/31/06 |       | 275,000                                      |       | $                                       | 23.63      |                                                                                                               | 275,000    |                                                                                                            | $          | 54,769,000 |   |

 

**Item 6. Exhibits**

 
| 10.1+   |   |   |   | Form  of Executive Incentive Plan (filed as Exhibit 10.1 to the Company’s Current  Report on Form 8-K, filed May 4, 2006, and incorporated by reference herein). |
|---------|--------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |   |   |   |                                                                                                                                                                  |
| 11**    |   | — |   | Computation  of Per Share Earnings                                                                                                                                    |
|    |   |   |   |                                                                                                                                                                  |
| 31  .1* |   | — |   | Certification  of principal executive officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                             |
|    |   |   |   |                                                                                                                                                                  |
| 31  .2* |   | — |   | Certification  of principal financial officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                             |
|    |   |   |   |                                                                                                                                                                  |
| 32  .1* |   | — |   | Certification  Pursuant to 18 U.S.C. Section 1350. as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                                              |
|    |   |   |   |                                                                                                                                                                  |
| 32  .2* |   | — |   | Certification  Pursuant to 18 U.S.C. Section 1350. as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                                              |

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*                 Identifies those filed exhibits with thisForm 10-Q. 

 

+                 Management contract or compensatory plan 

 

**          Data required by SFAS No. 128, “Earnings PerShare”, is provided in Note 5 to the consolidated financial statements in thisreport. 

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
|               | INTERNET  SECURITY SYSTEMS, INC. |
|--------------------|----------------------------------|
|               | (Registrant)                     |
|               |                             |
| Date:  May 5, 2006 | By                               | /s/  Raghavan Rajaji  |   |
|               |                             | Senior  Vice President Finance and Administration |
|               |                             | and  Chief Financial Officer (on behalf of registrant |
|               |                             | and  as principal financial officer) |

 

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