**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

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

 

**CommissionFile Number 000-23655**

 

**INTERNETSECURITY SYSTEMS, INC.**

(Exact name ofregistrant as specified in its charter)

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

 

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

(Address ofprincipal executive offices)

 

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

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes ýNo o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act). Yes ýNo o

 

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

 
| ** **                              | ** ** | **Number of Shares**         |
|-----------------------------------------|------------|------------------------------|
| ** **                              | ** ** | **Outstanding**              |
| **Title of each class of common stock** | ** ** | **as of July 29, 2005** |
| **Common  stock, $0.001 par value**     | ** ** | **45,432,384**               |

 

 

----

 
|                                                     |                                                                                                                                       |   |
|----------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                     |                                                                                                                                       |   |
|                                                     | **PART I - FINANCIAL INFORMATION**                                                                                                    |   |
| Item 1                                              | Financial Statements  (Unaudited):                                                                                                         |   |
|                                                     | Condensed Consolidated Balance  Sheets at June 30, 2005 and December 31, 2004 (audited)                                          |   |
|                                                     | Condensed Consolidated Statements of  Operations for the three months and six months ended June 30, 2005 and  June 30, 2004 |   |
|                                                     | Condensed Consolidated Statements of Cash Flows  for the six months ended June 30, 2005 and June 30, 2004                   |   |
|                                                     | Notes to Condensed  Consolidated Financial Statements                                                                                      |   |
| Item 2                                              | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                |   |
| Item 3                                              | Quantitative and Qualitative  Disclosures about Market Risk                                                                                |   |
| Item 4                                              | Controls and Procedures                                                                                                                    |   |
|                                                     | **PART II - OTHER INFORMATION**                                                                                                       |   |
| Item 1                                              | Legal Proceedings                                                                                                                          |   |
| Item 2                                              | Changes in Securities, Use  of Proceeds and Issuer Purchases of Equity Securities                                                          |   |
| Item 3                                                   | Defaults Upon Senior  Securities                                                                                                           |   |
| Item 4                                              | Submission of Matters to a  Vote of Security Holders                                                                                       |   |
| Item 5                                                   | Other information                                                                                                                          |   |
| Item 6                                              | Exhibits                                                                                                                                   |   |
|  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 Financial Statements**

 

**INTERNETSECURITY SYSTEMS, INC.**

**CONSOLIDATEDBALANCE SHEETS**

(amounts inthousands, except share and per share amounts)

 
| ** **                                                                                                     | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                     | ** ** | **2005**          | ** ** | **2004**              | ** ** |
| ** **                                                                                                     | ** ** | **(unaudited)**   | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                     |       |              |       |                  |       |
| Current assets:                                                                                                |       |              |       |                  |       |
| Cash and cash  equivalents                                                                                     |       | $                 | 188,064    |                  | $          | 140,148 |   |
| Marketable  securities                                                                                         |       | 38,500            |       | 70,901                |       |
| Accounts  receivable, less allowance for doubtful accounts of $3,127 and $3,099,  respectively                 |       | 68,161            |       | 75,353                |       |
| Inventory                                                                                                      |       | 3,915             |       | 2,506                 |       |
| Prepaid expenses  and other current assets                                                                     |       | 11,120            |       | 12,728                |       |
| Total current  assets                                                                                          |       | 309,760           |       | 301,636               |       |
|                                                                                                           |       |              |       |                  |       |
| Property and  equipment:                                                                                       |       |              |       |                  |       |
| Computer  equipment and software                                                                               |       | 55,282            |       | 52,412                |       |
| Office furniture  and equipment                                                                                |       | 17,974            |       | 18,091                |       |
| Leasehold  improvements                                                                                        |       | 20,956            |       | 21,098                |       |
|                                                                                                           |       | 94,212            |       | 91,601                |       |
| Less accumulated  depreciation                                                                                 |       | 62,516            |       | 57,161                |       |
|                                                                                                           |       | 31,696            |       | 34,440                |       |
|                                                                                                           |       |              |       |                  |       |
| Restricted cash  and marketable securities                                                                     |       | 10,300            |       | 10,300                |       |
| Goodwill, less  accumulated amortization of $27,381                                                            |       | 221,738           |       | 224,065               |       |
| Other intangible  assets, less accumulated amortization of $24,079 and $20,951, respectively                   |       | 14,609            |       | 19,763                |       |
| Other assets                                                                                                   |       | 7,274             |       | 8,698                 |       |
| Total assets                                                                                                   |       | $                 | 595,377    |                  | $          | 598,902 |   |
|                                                                                                           |       |              |       |                  |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                 |       |              |       |                  |       |
| Current  liabilities:                                                                                          |       |              |       |                  |       |
| Accounts payable                                                                                               |       | $                 | 6,895      |                  | $          | 6,911 |   |
| Accrued expenses                                                                                               |       | 28,511            |       | 25,238                |       |
| Deferred  revenues                                                                                             |       | 67,493            |       | 70,246                |       |
|                                                                                                           |       |              |       |                  |       |
| Total current  liabilities                                                                                     |       | 102,899           |       | 102,395               |       |
| Non-current  portion of deferred revenues                                                                      |       | 7,208             |       | 8,432                 |       |
| Other  non-current liabilities                                                                                 |       | 6,389             |       | 6,495                 |       |
|                                                                                                           |       |              |       |                  |       |
| Commitments and  contingencies                                                                                 |       |              |       |                  |       |
|                                                                                                           |       |              |       |                  |       |
| Stockholders’  equity:                                                                                    |       |              |       |                  |       |
| Preferred stock,  $.001 par value, 20,000,000 shares authorized, none issued or outstanding                    |       | —            |       | —                |       |
| Common stock,  $.001 par value, 120,000,000 shares authorized, 51,207,000 and 50,754,000 issued,  respectively |       | 51                |       | 51                    |       |
| Additional  paid-in capital                                                                                    |       | 506,436           |       | 499,534               |       |
| Deferred  compensation                                                                                         |       | (2,563            | )          | (3,197                | )          |
| Accumulated  other comprehensive income                                                                        |       | 3,048             |       | 11,041                |       |
| Retained  earnings                                                                                             |       | 64,651            |       | 48,544                |       |
| Treasury stock,  at cost (5,751,000 and 4,871,000 shares, respectively)                                        |       | (92,742           | )          | (74,393               | )          |
| Total  stockholders’ equity                                                                               |       | 478,881           |       | 481,580               |       |
| Total  liabilities and stockholders’ equity                                                               |       | $                 | 595,377    |                  | $          | 598,902 |   |

 

*Seeaccompanying notes*

 

3

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**INTERNETSECURITY SYSTEMS, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

(amounts inthousands, except per share amounts)

(unaudited)

 
| ** **                                                      | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                      | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                                       |       |                                  |       |                                |       |   |   |   |   |
| Product licenses  and sales                                     |       | $                                     | 33,613     |                                | $          | 28,851 |   | $ | 65,883 |   | $ | 57,636 |   |
| Subscriptions                                                   |       | 39,852                                |       | 34,267                              |       | 78,690 |   | 67,109 |   |
| Professional  services                                          |       | 5,635                                 |       | 6,422                               |       | 11,319 |   | 11,859 |   |
|                                                            |       | 79,100                                |       | 69,540                              |       | 155,892 |   | 136,604 |   |
| Costs and  expenses:                                            |       |                                  |       |                                |       |   |   |   |   |
| Cost of  revenues:                                              |       |                                  |       |                                |       |   |   |   |   |
| Product licenses  and sales                                     |       | 6,152                                 |       | 5,301                               |       | 12,537 |   | 9,849 |   |
| Amortization of  acquired technology                            |       | 1,756                                 |       | 1,722                               |       | 3,542 |   | 3,341 |   |
| Subscriptions  and professional services                        |       | 13,167                                |       | 12,546                              |       | 26,325 |   | 24,219 |   |
| Total cost of  revenues                                         |       | 21,075                                |       | 19,569                              |       | 42,404 |   | 37,409 |   |
| Research and  development                                       |       | 10,985                                |       | 11,093                              |       | 21,276 |   | 21,904 |   |
| Sales and  marketing                                            |       | 27,537                                |       | 24,116                              |       | 53,646 |   | 48,470 |   |
| General and  administrative                                     |       | 7,302                                 |       | 6,342                               |       | 14,646 |   | 12,593 |   |
| Amortization of  other intangibles and stock-based compensation |       | 42                                    |       | 122                                 |       | 86 |   | 277 |   |
|                                                            |       | 66,941                                |       | 61,242                              |       | 132,058 |   | 120,653 |   |
| Operating income                                                |       | 12,159                                |       | 8,298                               |       | 23,834 |   | 15,951 |   |
| Interest income                                                 |       | 1,253                                 |       | 464                                 |       | 2,312 |   | 992 |   |
| Other income  (expense), net                                    |       | (476                                  | )          | (361                                | )          | (1,015 | ) | (429 | ) |
| Gain on issuance  of subsidiary stock                           |       | 71                                    |       | 165                                 |       | 134 |   | 240 |   |
| Income before  income taxes                                     |       | 13,007                                |       | 8,566                               |       | 25,265 |   | 16,754 |   |
| Provision for  income taxes                                     |       | 4,746                                 |       | 3,106                               |       | 9,159 |   | 6,074 |   |
| Net income                                                      |       | $                                     | 8,261      |                                | $          | 5,460 |   | $ | 16,106 |   | $ | 10,680 |   |
| Basic net income  per share of Common Stock                     |       | $                                     | 0.18       |                                | $          | 0.11 |   | $ | 0.36 |   | $ | 0.22 |   |
| Diluted net  income per share of Common Stock                   |       | $                                     | 0.18       |                                | $          | 0.11 |   | $ | 0.34 |   | $ | 0.22 |   |
|                                                            |       |                                  |       |                                |       |   |   |   |   |
| Weighted average  shares and equivalent shares:                 |       |                                  |       |                                |       |   |   |   |   |
| Basic                                                           |       | 45,243                                |       | 47,654                              |       | 45,284 |   | 48,064 |   |
| Diluted                                                         |       | 47,178                                |       | 48,756                              |       | 47,314 |   | 49,366 |   |

* *

*Seeaccompanying notes*

 

4

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**INTERNETSECURITY SYSTEMS, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(amounts inthousands)

(unaudited)

 
| ** **                                                                           | ** ** | **Six months ended** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                           | ** ** | **June 30,**    | ** ** |
| ** **                                                                           | ** ** | **2005**             | ** ** | **2004** | ** ** |
| **Operating  activities**                                                            |       |                 |       |   |   |
| Net income                                                                           |       | $                    | 16,106     |   | $ | 10,680 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:   |       |                 |       |   |   |
| Depreciation                                                                         |       | 5,355                |       | 6,817 |   |
| Amortization of  acquired technology, other intangibles and stock-based compensation |       | 3,628                |       | 3,618 |   |
| Accretion of  discount on marketable securities                                      |       | (562                 | )          | (4 | ) |
| Deferred  compensation expense                                                       |       | 1,053                |       | 925 |   |
| Minority  interest                                                                   |       | 61                   |       | 411 |   |
| Income tax  benefit from exercise of stock options                                   |       | 945                  |       | 4,694 |   |
| Gain on issuance  of subsidiary stock                                                |       | (134                 | )          | (240 | ) |
| Changes in  assets and liabilities, excluding the effects of acquisitions:           |       |                 |       |   |   |
| Accounts  receivable                                                                 |       | 7,192                |       | 1,377 |   |
| Inventory                                                                            |       | (1,409               | )          | (830 | ) |
| Prepaid expenses  and other assets                                                   |       | 2,752                |       | (1,809 | ) |
| Accounts payable  and accrued expenses                                               |       | 3,206                |       | (2,007 | ) |
| Deferred  revenues                                                                   |       | (3,977               | )          | 4,479 |   |
| Net cash  provided by operating activities                                           |       | 34,216               |       | 28,111 |   |
|                                                                                 |       |                 |       |   |   |
| **Investing  activities**                                                            |       |                 |       |   |   |
| Acquisitions,  net of cash received                                                  |       | (764                 | )          | (34,022 | ) |
| Purchases of  marketable securities                                                  |       | (56,923              | )          | (40,850 | ) |
| Net proceeds  from maturity of marketable securities                                 |       | 60,136               |       | 19,579 |   |
| Net proceeds  from sales of marketable securities                                    |       | 29,750               |       | — |   |
| Purchases of  property and equipment                                                 |       | (2,612               | )          | (8,182 | ) |
| Net proceeds  from issuance of subsidiary stock                                      |       | 357                  |       | 373 |   |
| Net cash provided  by (used in) investing activities                                 |       | 29,944               |       | (63,102 | ) |
|                                                                                 |       |                 |       |   |   |
| **Financing  activities**                                                            |       |                 |       |   |   |
| Proceeds from  exercise of stock options                                             |       | 4,800                |       | 1,175 |   |
| Proceeds from  employee stock purchase plan                                          |       | 732                  |       | 750 |   |
| Purchases of  treasury stock                                                         |       | (18,349              | )          | (29,046 | ) |
| Net cash used in  financing activities                                               |       | (12,817              | )          | (27,121 | ) |
|                                                                                 |       |                 |       |   |   |
| Foreign currency  impact on cash                                                     |       | (3,427               | )          | (2,056 | ) |
|                                                                                 |       |                 |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                           |       | 47,916               |       | (64,168 | ) |
| Cash and cash  equivalents at beginning of period                                    |       | 140,148              |       | 184,551 |   |
| Cash and cash  equivalents at end of period                                          |       | $                    | 188,064    |   | $ | 120,383 |   |
|                                                                                 |       |                 |       |   |   |
| **Supplemental  cash flow disclosure**                                               |       |                 |       |   |   |
| Income taxes  paid                                                                   |       | $                    | 3,509      |   | $ | 1,872 |   |

 

*Seeaccompanying notes*

 

5

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**INTERNETSECURITY SYSTEMS, INC.**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**(unaudited)**

 

**Note 1.Significant Accounting Policies**

 

*Basisof Presentation*

 

The unaudited condensed consolidatedfinancial statements of Internet Security Systems, Inc. (“ISS” or the “Company”)as of June 30, 2005 and for the three and six months ended June 30,2005 and 2004 contain, in the opinion of management, all adjustments,consisting of normal recurring items, necessary for the fair presentation ofthe financial position and results of operations of the Company for the interimperiods. The consolidated financial statements include the accounts of theCompany and its majority-owned subsidiaries. The consolidated balance sheet at December 31,2004 has been derived from the audited financial statements at that date butdoes not include all of the footnotes required by U.S. generally acceptedaccounting principles for complete financial statements.

 

These consolidatedfinancial statements should be read in conjunction with the ConsolidatedFinancial Statements and Notes thereto included in the Company’s Annual Reporton Form 10-K, as amended, for the year ended December 31, 2004. Theresults of operations for the three and six months ended June 30, 2005 arenot necessarily indicative of the results to be expected for the entire year.All significant intercompany accounts and transactions have been eliminated.

 

The preparation offinancial statements and related disclosures in conformity with U.S. generallyaccepted accounting principles requires management to make estimates andassumptions that affect the amounts reported in the financial statements andaccompanying notes. Actual results will differ from those estimates, and suchdifferences may be material to the consolidated financial statements.

 

*Goodwilland Intangibles*

 

Goodwill and intangibleassets are comprised of the following, as of the dates indicated (inthousands): 

 
| ** **                    | ** ** | **June 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|-------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                    | ** ** | **Gross  Carrying**    | ** ** | **Accumulated**            | ** ** | **Gross  Carrying** | ** ** | **Accumulated** | ** ** |
| ** **                    | ** ** | **Amount**             | ** ** | **Amortization**           | ** ** | **Amount** | ** ** | **Amortization** | ** ** |
| Goodwill                      |       | $                      | 249,119    |                       | $          | (27,381 | ) | $ | 251,446 |   | $ | (27,381 | ) |
|                          |       |                   |       |                       |       |   |   |   |   |
| Amortized  intangible assets: |       |                   |       |                       |       |   |   |   |   |
| Core technology               |       | 3,853                  |       | (3,243                     | )          | 3,853 |   | (3,002 | ) |
| Developed  technology         |       | 32,813                 |       | (19,062                    | )          | 34,775 |   | (16,235 | ) |
| Customer  relationships       |       | 2,022                  |       | (1,774                     | )          | 2,086 |   | (1,714 | ) |
|                          |       |                   |       |                       |       |   |   |   |   |
| Total                         |       | $                      | 38,688     |                       | $          | (24,079 | ) | $ | 40,714 |   | $ | (20,951 | ) |

 

The change in thecarrying amounts of goodwill and developed technology from December 31,2004 to June 30, 2005 was the result of additional consideration relatedto the 2002 acquisition of TriSecurity Holdings Pte Ltd. discussed in Note 3,payment of approximately $20,000 of final severance payments and relatedpurchase accounting adjustments for the January 2004 acquisition ofCobion, a German content filtering and anti-spam provider, and reductions dueto currency translation adjustments.

 

The Company amortizesintangible assets over their estimated useful lives of eight years for coretechnology, five years for developed technology, and three years for customerrelationships. Amortization expense of intangible assets is as follows (inthousands):

 
| ** **              | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|-------------------------|------------|------------------------|------------|----------------------|------------|
| ** **              | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **              | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Core technology         |       | $                      | 120        |                 | $          | 120 |   | $ | 240 |   | $ | 240 |   |
| Developed  technology   |       | 1,636                  |       | 1,583                |       | 3,302 |   | 3,081 |   |
| Customer  relationships |       | 42                     |       | 100                  |       | 86 |   | 225 |   |
|                    |       |                   |       |                 |       |   |   |   |   |
| Total                   |       | $                      | 1,798      |                 | $          | 1,803 |   | $ | 3,628 |   | $ | 3,546 |   |

 

6

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The Company amortized$375,000 and $353,000 in the three months ended June 30, 2005 and 2004,and $750,000 and $793,000 in the six months ended June 30, 2005 and 2004,respectively, relating to the purchase of a software license used in certain ofits products.  These costs are includedin cost of product licenses and sales.

 

The estimated futureamortization expense of intangible assets as of June 30, 2005 is asfollows (in thousands): 

 
| ** **                     | ** ** | **Amount** | ** ** |
|--------------------------------|------------|------------|------------|
| Year ending  December 31, |       |       |       |
| 2005 (six  months)             |       | $          | 3,596      |   |
| 2006                           |       | 5,088      |       |
| 2007                           |       | 3,135      |       |
| 2008                           |       | 2,790      |       |
|                           |       |       |       |
| Total                          |       | $          | 14,609     |   |

* *

*Accountingfor stock-based compensation*

 

Statement of FinancialAccounting Standard (“SFAS”) 123, “*Accountingfor Stock-Based Compensation”*, as amended by SFAS 148, “*Accounting for Stock-Based Compensation - Transitionand Disclosure,”* establishes accounting and reporting standards forstock-based employee compensation plans. As permitted by SFAS 123, ISScontinues to account for stock-based compensation in accordance with AccountingPrinciples Board Opinion No. 25, “*Accountingfor Stock Issued to Employees”* (“APB 25”), and has elected the proforma disclosure alternative of SFAS 123.

 

In accordance with thepro forma disclosure alternative of SFAS 123 the following table shows proforma net income (loss) and pro forma net income (loss) per share for theperiods indicated as if the Company had adopted SFAS 123. The pro forma impactof applying SFAS 123 as illustrated below will not necessarily berepresentative of the pro forma impact in future years. Pro forma informationis as follows (amounts in thousands, except per share amounts):

 
| ** **                                                                                         | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                         | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                                                                         | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income, as  reported                                                                           |       | $                      | 8,261      |                 | $          | 5,460 |   | $ | 16,106 |   | $ | 10,680 |   |
| Add: Stock-based  compensation included in reported net income, net of income taxes                |       | 305                    |       | 344                  |       | 672 |   | 590 |   |
| Less:  Stock-based compensation expense computed under the Fair Value method, net of  income taxes |       | (3,457                 | )          | (5,688               | )          | (7,595 | ) | (12,356 | ) |
|                                                                                               |       |                   |       |                 |       |   |   |   |   |
| Pro forma net  income (loss)                                                                       |       | $                      | 5,109      |                 | $          | 116 |   | $ | 9,183 |   | $ | (1,086 | ) |
| Basic net income  (loss) per share of Common Stock and equivalents:                                |       |                   |       |                 |       |   |   |   |   |
| As reported                                                                                        |       | $                      | 0.18       |                 | $          | 0.11 |   | $ | 0.36 |   | $ | 0.22 |   |
| Pro forma                                                                                          |       | $                      | 0.11       |                 | $          | 0.00 |   | $ | 0.20 |   | $ | (0.02 | ) |
|                                                                                               |       |                   |       |                 |       |   |   |   |   |
| Diluted net  income (loss) per share of Common Stock and equivalents:                              |       |                   |       |                 |       |   |   |   |   |
| As reported                                                                                        |       | $                      | 0.18       |                 | $          | 0.11 |   | $ | 0.34 |   | $ | 0.22 |   |
| Pro forma                                                                                          |       | $                      | 0.11       |                 | $          | 0.00 |   | $ | 0.20 |   | $ | (0.02 | ) |

 

The fair value of optionsat date of grant was estimated using the Black-Scholes model with the followingassumptions:

 

7

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| ** **                | ** ** | **Three months ended** | ** ** |
|---------------------------|------------|------------------------|------------|
| ** **                | ** ** | **June 30,**      | ** ** |
| ** **                | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Expected life  (years)    |       | 4.6                    |       | 5 |   |
| Risk free  interest rates |       | 3.83                   | %          | 2.83 | % |
| Expected  volatility      |       | 41                     | %          | 50 | % |
| Expected  dividend yield  |       | —                 |       | — |   |

 

During2005 and 2004, 346,000 restricted shares were issued to directors, officers andcertain key employees of ISS. The shares issued to directors vest in either oneor two year periods, with two-year periods having quarterly vesting.  The shares issued to officers and certain keyemployees generally vest in two installments: 50% vests two years from thegrant date, and the remaining 50% vests three years from the grant date. Uponissuance of restricted shares, unearned compensation is recorded instockholders’ equity as deferred compensation equal to the market value of therestricted shares and is recognized as compensation expense over the vestingperiod, net of reversal of previously recorded expense for any forfeitedshares. Total compensation expense for restricted stock awards amounted to$480,000 and $539,000 in the three months ended June 30, 2005 and 2004, respectively,and $1.1 million and $925,000 in the six months ended June 30, 2005 and2004, respectively.

 

Duringthe three and six months ended June 30, 2005, the Company issued shares of CommonStock totaling 128,000 and 380,000, respectively, for the exercise of stockoptions.  During the three months endedJune 30, 2005, the Company issued 30,000 shares of restricted stock to itsBoard of Directors.

 

*Gain on issuance of subsidiary shares*

* *

The gain on issuance ofsubsidiary shares results from Internet Security Systems KK, our Asia/Pacificsubsidiary (“ISS KK”), issuing shares related to the exercise of ISS KK stockoptions.  In 2005 ISS KK has issued 735shares at an average exercise price of approximately $485 per share.  Our ownership percentage of the subsidiaryremained at 87% at June 30, 2005. Deferred income taxes have been provided in the period in which the gainis recognized.

 

**Note 2.Income Taxes**

 

The Company recorded taxprovisions of $4.7 million and $3.1 million for the three-monthperiods ended June 30, 2005 and 2004, respectively, and tax provisions of$9.2 million and $6.1 million for the six-month periods ended June 30,2005 and 2004, respectively.  Whileincome tax expense was recorded on domestic income, the amount of domestictaxes payable was reduced by deductions related to the exercise of employeestock options in current and prior periods. The tax benefit of these deductionswas recorded as additional paid-in capital. Taxes paid generally relate tocertain foreign operations and state taxes.

 

The effective tax ratewas approximately 36.5% for the three months ended June 30, 2005 and 36.25% for the threemonths ended June 30, 2004. For the six months ended June 30, 2005and June 30, 2004 the effective tax was approximately 36.25%.  The effective rates differ from the statutoryrates due to the impact of acquisition-related intangibles and certainoperating expenses that are not deductible for income tax purposes as well asfederal and state tax credits.

 

##### **Note 3. Business Acquisition**

##### ** **

 In August 2002, ISS KK, our Asia/Pacificsubsidiary, acquired a distributor in Singapore, TriSecurity Holdings Pte Ltd.(“TriSecurity”). TriSecurity was the sole distributor for ISS KK in southeastAsia, including India, and its business was almost exclusively focused on ISSsolutions. This acquisition provides our Asia-Pacific subsidiary direct supportcapabilities for their customers in Southeast Asia and allows ISS KK to expandits capabilities in this growing market. The consideration consisted of 2,000 sharesof ISS KK stock and approximately $1.2 million of cash. Goodwill ofapproximately $4.0 million related to the purchase was recorded. Duringthe first quarter of 2003, ISS KK amended the agreement and agreed to makepayment of 490 shares of ISS KK in each of the first quarters of 2004 and2005, relating to annual contingent consideration payments under the 2002purchase agreement. Due to regulatory issues, the agreement was amended priorto the 2004 payment to make the 2004 and 2005 payments in cash in lieu ofshares. Additional consideration of $764,000 and $498,000 was paid in February 2005and 2004, respectively, based on the fair market value of the 490 shares,and is reflected in goodwill.

 

**Note 4.Comprehensive Income**

 

The components ofcomprehensive income are as follows (in thousands):

 
| ** **                                   | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|----------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                   | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                   | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income, as  reported                     |       | $                      | 8,261      |                 | $          | 5,460 |   | $ | 16,106 |   | $ | 10,680 |   |
| Change in  cumulative translation adjustment |       | (3,834                 | )          | (3,741               | )          | (7,993 | ) | (4,520 | ) |
|                                         |       |                   |       |                 |       |   |   |   |   |
| Comprehensive  income                        |       | $                      | 4,427      |                 | $          | 1,719 |   | $ | 8,113 |   | $ | 6,160 |   |

 

8

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**Note 5.Income per Share**

 

The followingtable sets forth the computation of basic and diluted net income per share(amounts in thousands, except per share amounts):

 
| ** **                                                                              | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                              | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                                                              | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Numerator:                                                                              |       |                   |       |                 |       |   |   |   |   |
| Net income                                                                              |       | $                      | 8,261      |                 | $          | 5,460 |   | $ | 16,106 |   | $ | 10,680 |   |
|                                                                                    |       |                   |       |                 |       |   |   |   |   |
| Denominator:                                                                            |       |                   |       |                 |       |   |   |   |   |
| Denominator for  basic net                                                              |       |                   |       |                 |       |   |   |   |   |
| income per share  - weighted                                                            |       |                   |       |                 |       |   |   |   |   |
| average shares                                                                          |       | 45,243                 |       | 47,654               |       | 45,284 |   | 48,064 |   |
| Effect of  dilutive stock options                                                       |       | 1,935                  |       | 1,102                |       | 2,030 |   | 1,302 |   |
|                                                                                    |       |                   |       |                 |       |   |   |   |   |
| Denominator for  diluted net income per share - weighted average shares and equivalents |       | 47,178                 |       | 48,756               |       | 47,314 |   | 49,366 |   |
|                                                                                    |       |                   |       |                 |       |   |   |   |   |
| Basic net income  per share                                                             |       | $                      | 0.18       |                 | $          | 0.11 |   | $ | 0.36 |   | $ | 0.22 |   |
|                                                                                    |       |                   |       |                 |       |   |   |   |   |
| Diluted net  income per share                                                           |       | $                      | 0.18       |                 | $          | 0.11 |   | $ | 0.34 |   | $ | 0.22 |   |

 

Optionsaggregating 3,579,000 and 6,011,000 in the three months ended June 30,2005 and 2004, respectively, and 3,553,000 and 3,530,000 in the six monthsended June 30, 2005 and 2004, respectively, were not included in thecomputation of diluted income per share because the options’ exercise price wasgreater than the average market price of the common shares, and their impactwould have been anti-dilutive.

 

9

----

 

**Note 6.Segment and Geographic Information**

 

ISS conducts business inone operating segment: providing information security management solutions. TheCompany does, however, prepare operating results for internal use on ageographic basis. Geographical based operating costs consist of direct salesexpenses, infrastructure to support its employee and customer and partner base,supporting billing and financial systems and a management team for thegeographic segment. Corporate expenses that are not charged directly to theother segments include research and development, general and administrativecosts that support the global organization, amortization of acquiredtechnology, amortization of licensed development source code, amortization ofintangibles and stock-based compensation and costs that are one-time in nature,such as acquired in-process research and development.

 

The accounting policiesof the segments are the same as those described in the summary of significantaccounting policies. There are no inter-segment sales. Our chief executiveofficer and chief financial officer evaluate performance based on operatingprofit or loss from operations, and trade accounts receivable for each segment.Other than trade accounts receivable, assets and liabilities are not discretelyallocated or reviewed by segment.

 

In accordance with SFAS No. 131,“*Disclosures about Segments of an Enterpriseand Related 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 tablepresents ISS’s revenues, operating expenses and operating income (loss) byreportable geographic segment (in thousands):

 
| ** **                                                  | ** ** | **Americas** | ** ** | **EMEA** | ** ** | **Asia/Pacific** | ** ** | **Unallocated** | ** ** | **Total** | ** ** |
|-------------------------------------------------------------|------------|--------------|------------|----------|------------|------------------|------------|-----------------|------------|-----------|------------|
|                                                        |       |         |       |     |       |             |       |            |       |      |       |
| **As of  or for the three months ended June 30, 2005** |       |         |       |     |       |             |       |            |       |      |       |
| **Revenues  from external customers:**                      |       |         |       |     |       |             |       |            |       |      |       |
| Product licenses  and sales                                 |       | $            | 20,492     |     | $          | 7,789            |       | $               | 5,332      |      | $          | — |   | $ | 33,613 |   |
| Subscriptions                                               |       | 25,261       |       | 9,305    |       | 5,286            |       | —          |       | 39,852    |       |
| Professional  services                                      |       | 3,856        |       | 606      |       | 1,173            |       | —          |       | 5,635     |       |
| Total revenue                                               |       | 49,609       |       | 17,700   |       | 11,791           |       | —          |       | 79,100    |       |
| Cost of  revenues:                                          |       |         |       |     |       |             |       |            |       |      |       |
| Product licenses  and sales                                 |       | 3,676        |       | 1,103    |       | 998              |       | 375             |       | 6,152     |       |
| Amortization of  acquired technology                        |       | —       |       | —   |       | —           |       | 1,756           |       | 1,756     |       |
| Subscriptions  and professional services                    |       | 9,486        |       | 1,154    |       | 2,527            |       | —          |       | 13,167    |       |
| Total cost of  revenues                                     |       | 13,162       |       | 2,257    |       | 3,525            |       | 2,131           |       | 21,075    |       |
| Operating  expenses                                         |       | 16,805       |       | 8,269    |       | 2,463            |       | 18,329          |       | 45,866    |       |
|                                                        |       |         |       |     |       |             |       |            |       |      |       |
| Total expenses                                              |       | 29,967       |       | 10,526   |       | 5,988            |       | 20,460          |       | 66,941    |       |
|                                                        |       |         |       |     |       |             |       |            |       |      |       |
| Segment  operating income (loss)                            |       | $            | 19,642     |     | $          | 7,174            |       | $               | 5,803      |      | $          | (20,460 | ) | $ | 12,159 |   |
|                                                        |       |         |       |     |       |             |       |            |       |      |       |
| Accounts  receivable, net                                   |       | $            | 39,428     |     | $          | 18,615           |       | $               | 10,118     |      | $          | — |   | $ | 68,161 |   |
| Property and  equipment, net                                |       | $            | 25,080     |     | $          | 1,696            |       | $               | 4,920      |      | $          | — |   | $ | 31,696 |   |
|                                                        |       |         |       |     |       |             |       |            |       |      |       |
| **As of  or for the three months ended June 30, 2004** |       |         |       |     |       |             |       |            |       |      |       |
| **Revenues  from external customers:**                      |       |         |       |     |       |             |       |            |       |      |       |
| Product licenses  and sales                                 |       | $            | 18,164     |     | $          | 6,922            |       | $               | 3,765      |      | $          | — |   | $ | 28,851 |   |
| Subscriptions                                               |       | 23,519       |       | 7,101    |       | 3,647            |       | —          |       | 34,267    |       |
| Professional  services                                      |       | 3,920        |       | 930      |       | 1,572            |       | —          |       | 6,422     |       |
| Total revenue                                               |       | 45,603       |       | 14,953   |       | 8,984            |       | —          |       | 69,540    |       |
| **Cost of  revenues:**                                      |       |         |       |     |       |             |       |            |       |      |       |
| Product licenses  and sales                                 |       | 3,306        |       | 990      |       | 652              |       | 353             |       | 5,301     |       |
| Amortization of  acquired technology                        |       | —       |       | —   |       | —           |       | 1,722           |       | 1,722     |       |
| Subscriptions  and professional services                    |       | 8,429        |       | 1,397    |       | 2,720            |       | —          |       | 12,546    |       |
| Total cost of  revenues                                     |       | 11,735       |       | 2,387    |       | 3,372            |       | 2,075           |       | 19,569    |       |
| **Operating  expenses**                                     |       | 15,539       |       | 6,394    |       | 2,183            |       | 17,557          |       | 41,673    |       |
|                                                        |       |         |       |     |       |             |       |            |       |      |       |
| **Total  expenses**                                         |       | 27,274       |       | 8,781    |       | 5,555            |       | 19,632          |       | 61,242    |       |
|                                                        |       |         |       |     |       |             |       |            |       |      |       |
| **Segment  operating income (loss)**                        |       | $            | 18,329     |     | $          | 6,172            |       | $               | 3,429      |      | $          | (19,632 | ) | $ | 8,298 |   |
|                                                        |       |         |       |     |       |             |       |            |       |      |       |
| **Accounts  receivable, net**                               |       | $            | 40,656     |     | $          | 15,098           |       | $               | 10,219     |      | $          | — |   | $ | 65,973 |   |
| **Property  and equipment, net**                            |       | $            | 30,174     |     | $          | 1,722            |       | $               | 5,741      |      | $          | — |   | $ | 37,637 |   |

 

10

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| ** **                                                | ** ** | **Americas** | ** ** | **EMEA** | ** ** | **Asia/Pacific** | ** ** | **Unallocated** | ** ** | **Total** | ** ** |
|-----------------------------------------------------------|------------|--------------|------------|----------|------------|------------------|------------|-----------------|------------|-----------|------------|
|                                                      |       |         |       |     |       |             |       |            |       |      |       |
| **As of  or for the six months ended June 30, 2005** |       |         |       |     |       |             |       |            |       |      |       |
| **Revenues  from external customers:**                    |       |         |       |     |       |             |       |            |       |      |       |
| Product licenses  and sales                               |       | $            | 39,550     |     | $          | 14,596           |       | $               | 11,737     |      | $          | — |   | $ | 65,883 |   |
| Subscriptions                                             |       | 50,019       |       | 18,453   |       | 10,218           |       | —          |       | 78,690    |       |
| Professional  services                                    |       | 7,419        |       | 1,073    |       | 2,827            |       | —          |       | 11,319    |       |
| Total revenue                                             |       | 96,988       |       | 34,122   |       | 24,782           |       | —          |       | 155,892   |       |
| **Cost of  revenues:**                                    |       |         |       |     |       |             |       |            |       |      |       |
| Product licenses  and sales                               |       | 7,347        |       | 2,317    |       | 2,123            |       | 750             |       | 12,537    |       |
| Amortization of  acquired technology                      |       | —       |       | —   |       | —           |       | 3,542           |       | 3,542     |       |
| Subscriptions  and professional services                  |       | 18,519       |       | 2,448    |       | 5,358            |       | —          |       | 26,325    |       |
| Total cost of  revenues                                   |       | 25,866       |       | 4,765    |       | 7,481            |       | 4,292           |       | 42,404    |       |
| **Operating  expenses**                                   |       | 32,752       |       | 15,987   |       | 4,906            |       | 36,009          |       | 89,654    |       |
|                                                      |       |         |       |     |       |             |       |            |       |      |       |
| **Total  expenses**                                       |       | 58,618       |       | 20,752   |       | 12,387           |       | 40,301          |       | 132,058   |       |
|                                                      |       |         |       |     |       |             |       |            |       |      |       |
| **Segment  operating income (loss)**                      |       | $            | 38,370     |     | $          | 13,370           |       | $               | 12,395     |      | $          | (40,301 | ) | $ | 23,834 |   |
|                                                      |       |         |       |     |       |             |       |            |       |      |       |
| **Accounts  receivable, net**                             |       | $            | 39,428     |     | $          | 18,615           |       | $               | 10,118     |      | $          | — |   | $ | 68,161 |   |
| **Property  and equipment, net**                          |       | $            | 25,080     |     | $          | 1,696            |       | $               | 4,920      |      | $          | — |   | $ | 31,696 |   |
|                                                      |       |         |       |     |       |             |       |            |       |      |       |
| **As of  or for the six months ended June 30, 2004** |       |         |       |     |       |             |       |            |       |      |       |
| **Revenues  from external customers:**                    |       |         |       |     |       |             |       |            |       |      |       |
| Product licenses  and sales                               |       | $            | 35,143     |     | $          | 14,051           |       | $               | 8,442      |      | $          | — |   | $ | 57,636 |   |
| Subscriptions                                             |       | 46,303       |       | 13,692   |       | 7,114            |       | —          |       | 67,109    |       |
| Professional  services                                    |       | 7,094        |       | 1,819    |       | 2,946            |       | —          |       | 11,859    |       |
| Total revenue                                             |       | 88,540       |       | 29,562   |       | 18,502           |       | —          |       | 136,604   |       |
| **Cost of  revenues:**                                    |       |         |       |     |       |             |       |            |       |      |       |
| Product licenses  and sales                               |       | 5,782        |       | 1,841    |       | 1,433            |       | 793             |       | 9,849     |       |
| Amortization of  acquired technology                      |       | —       |       | —   |       | —           |       | 3,341           |       | 3,341     |       |
| Subscriptions  and professional services                  |       | 16,241       |       | 2,658    |       | 5,320            |       | —          |       | 24,219    |       |
| Total cost of  revenues                                   |       | 22,023       |       | 4,499    |       | 6,753            |       | 4,134           |       | 37,409    |       |
| **Operating  expenses**                                   |       | 30,962       |       | 13,389   |       | 4,119            |       | 34,774          |       | 83,244    |       |
|                                                      |       |         |       |     |       |             |       |            |       |      |       |
| **Total  expenses**                                       |       | 52,985       |       | 17,888   |       | 10,872           |       | 38,908          |       | 120,653   |       |
|                                                      |       |         |       |     |       |             |       |            |       |      |       |
| **Segment  operating income (loss)**                      |       | $            | 35,555     |     | $          | 11,674           |       | $               | 7,630      |      | $          | (38,908 | ) | $ | 15,951 |   |
|                                                      |       |         |       |     |       |             |       |            |       |      |       |
| **Accounts  receivable, net**                             |       | $            | 40,656     |     | $          | 15,098           |       | $               | 10,219     |      | $          | — |   | $ | 65,973 |   |
| **Property  and equipment, net**                          |       | $            | 30,174     |     | $          | 1,722            |       | $               | 5,741      |      | $          | — |   | $ | 37,637 |   |

 

**Note 7.Commitments and Contingencies**

 

Our sales agreements withcustomers generally contain infringement indemnity provisions. We have notpreviously incurred costs to settle claims or pay awards under theseindemnification obligations. As a result, we believe the estimated fair valueof these obligations is nominal. Accordingly, we have no liabilities recorded forthese agreements as of June 30, 2005. In addition, we warrant that our software products will perform in allmaterial respects in accordance with our standard published specifications ineffect at the time of delivery of the licensed products to the customer forninety days. We also warrant that for one year after shipment, all hardwarewill be free from defects in materials and workmanship under normal authorizeduse, consistent with the instructions contained in the product documentation.Additionally, we warrant that our services will be performed consistent withgenerally accepted industry standards or specific service levels throughcompletion of the agreed upon services. We have not incurred significantrecurring expense under our product or service warranties and hardwarewarranties are covered by the manufacturer warranties. As a result, we believethe estimated fair value of these agreements is nominal. Accordingly, we haveno liabilities recorded for these agreements as of June 30, 2005.

 

Payments for certainoperating leases for our office space are secured by four collateralizedstandby letters of credit totaling $8.3 million at June 30, 2005. Thesestandby letters of credit guarantee payments on certain lease obligations andare renewed annually unless cancelled by either party. The lease obligationshave terms that expire at various dates through 2013. The beneficiary of thestandby letters of credit can draw on the letters of credit if we default onthe related lease obligation. Each standby letter of credit is collateralizedby securities. At June 30, 2005, $10.3 million of commercial paperinvestments are pledged as collateral and are shown on the balance sheet asrestricted cash and marketable securities.

 

On August 17, 2004,the Company’s Georgia operating subsidiary filed in the United States DistrictCourt for the Northern District of Georgia a declaratory judgment action (the “GeorgiaAction”) against SRI International, Inc. (“SRI”).  The action seeks the court’s declaration thatour products and services do not infringe any valid claim of five patents heldby SRI and seeks declaration that certain 

 

11

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claims of those patentsare invalid.  SRI filed a motion todismiss the action, which we opposed. On August 26, 2004, SRI filed in theUnited States District Court for Delaware a complaint against the Company andSymantec Corporation (the “Delaware Action”). The complaint in the Delaware Action alleges that our SiteProtector andProventia products infringe upon claims of two of the five patents at issue inthe Georgia Action. The Delaware Action seeks unspecified damages andinjunctive relief.  The Company filed amotion to dismiss the Delaware Action, which SRI opposed.  On April 13, 2005, the Company’s motionwas denied, without prejudice, with the opportunity to re-file it afterdiscovery and clarification of the distinction between our Delaware parentcompany and our Georgia operating company. On or about April 25, 2005, SRI filed an amended complaint addingthe Company’s Georgia operating subsidiary as a separate defendant to theDelaware Action.  The Company and itssubsidiary answered SRI’s amended complaint on May 23, 2005, denying thatthey infringe the two patents asserted by SRI and asserting counterclaimsseeking a declaration from the Delaware court that the five SRI patents are notinfringed, invalid, and unenforceable. On or about June 13, 2005, SRI answered the counterclaims assertedby the Company and its subsidiary, denying that the five patents are notinfringed, invalid, and unenforceable. The parties are currently engaged in discovery, and trial has beenscheduled to begin on or about October 30, 2006.  We intend to defend the Delaware Actionvigorously and believe we have meritorious defenses. On or about June 9,2005, the Georgia court transferred the Georgia Action to the United StatesDistrict Court for the District of Delaware. The transferred case is currently pending before the Delaware court.

 

**Note8.  Recently Issued Accounting Standards**

 

On December 16,2004, the Financial Accounting Standards Board issued SFAS No. 123(revised 2004) (SFAS 123R),*“Share-BasedPayment”,* which is a revision of SFAS No. 123,*“Accounting for Stock-Based Compensation”.*SFAS No. 123R supersedes APB Opinion No. 25,*“Accounting for Stock Issued to Employees”.*Statement 123R requires all share-based payments to employees, includinggrants of employee stock options, to be recognized in the financial statementsbased on their fair values (i.e., pro forma disclosure is no longer analternative to financial statement recognition). On April 14, 2005, theSecurities and Exchange Commission adopted a new rule, Staff AccountingBulletin (“SAB”) No. 107, amending the effective date for SFAS 123R.  Under the effective date provisions includedin SFAS 123R, the Company would be required to implement SFAS 123R as of thefirst interim or annual period beginning after June 15, 2005.  SAB No. 107 allows the Company toimplement SFAS 123R at the beginning of the next fiscal year that begins after June 15,2005.  SAB No.107 affects none of theaccounting provisions of SFAS 123R.The Company is required to adopt SFAS 123Rby January 1, 2006.  The impact onthe Company’s earnings will include the remaining amortization of the fairvalue of existing options currently disclosed as pro-forma expense in Note 1and is contingent upon the number of future options granted, the selectedtransition and valuation methods.  Whilethe pro forma information under SFAS 123 indicates that expensing of stockoptions will have a material impact on the Company’s financial results, thespecific impact is not known as the Company is currently evaluating valuationand transition methods permitted under SFAS 123R.

 

In May 2005 the FASBissued SFAS No. 154, “*Accounting Changes andError Corrections”. *SFAS 154requires retroactive application of a voluntary change in accounting principleto prior period financial statements unless it is impracticable.  SFAS No. 154 also requires that a changein method of depreciation, amortization or depletion for long-lived,non-financial assets be accounted for as a change in accounting estimate thatis affected by a change in accounting principle.  SFAS No. 154 replaces APB Opinion No. 20,“*Accounting Changes”* and SFAS No. 3,“*Reporting Accounting Changes in Interim FinancialStatements”.*  SFAS No. 154is effective for fiscal years beginning after December 15, 2005.  The Company does not expect the adoption ofthe provisions of SFAS No. 154 to have a material impact on its results ofoperations or financial condition.

 

12

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| **Item 2.** | ***Management’s Discussion and Analysis of Financial  Condition and Results of Operations*** |
|------------------|---------------------------------------------------------------------------------------------------|

 

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

 

*Except for the historical financial information, many of thematters discussed in this Form 10Q may be considered “forward-looking”statements. Forward-looking statements can be identified by the use of wordssuch as “may,” “will,” “should,” “could,” “continue,” “future,” “potential,” “believe,”“project,” “plan,” “intend,” “seek,” “estimate,” “predict”, “expect”, “anticipate”and similar expressions, or the negative of such terms, or other comparableterminology. Forward-looking statements also include the assumptions underlyingor relating to any of the foregoing statements. Such forward-looking statementsare not guarantees of future performance and involve a number of risks anduncertainties. Our actual results could differ materially from thoseanticipated in these forward-looking statements as a result of various factors,including those set forth below under the caption “Risk Factors” and thoseotherwise described from time to time in our Securities and Exchange Commissionreports filed after this Form 10-Q. All forward-looking statementsincluded in this Form 10-Q are based on information available to us on thedate hereof. We assume no obligation (except where required by law) to updateany forward-looking statements for any events or circumstances occurring afterthe date of this Form 10-Q.*

 

*Inthis Form 10-Q, the words “Internet Security Systems,” “ISS,” “theCompany,” “we,” “our,” “ours,” and “us” refer to Internet Security Systems, Inc.,and its subsidiaries.*

 

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

 

**Overview**

 

We focus on providingenterprise-wide pre-emptive protection. We provide such protection with ourcomprehensive line of products and services. These include ISS’ SiteProtectorcentralized management system; a product family consisting of network and hostintrusion prevention, integrated security appliances, desktop protection andvulnerability protection; and ISS’ Managed Security Services and ProfessionalSecurity Services. The integrated security appliance includes, in addition tointrusion prevention capabilities, firewalls, virtual private network features,anti-virus protection, content filtering and e-mail security, includinganti-spam technology.

 

This combination ofproducts and services forms our Proventia Enterprise Security Platform (“ESP”),which contributes to business process optimization by maintaining a delicatebalance between IT-performance, availability and risk — ultimatelystopping cyber threats before they affect operations. Unlike traditionalapproaches to security, which focus on improving reaction times, Proventia ESPis designed to avoid security incidents by combining continuous vulnerabilityassessment and threat prevention with enterprise-wide information managementand reporting capabilities. Our objective is to enable companies to shieldsecurity vulnerabilities across their entire IT infrastructure — beforeattacks are released.

 

We currently plan tocontinue to evolve the Proventia Enterprise Security Platform by furtherautomating enterprise security policy and delivering it within the context ofexisting IT processes.

 

Our managed servicesofferings currently provide remote management of our best-of-breed securitytechnology, focusing on security assessment and intrusion detection, intrusionprevention and desktop protection systems, and include firewalls, VPNs,anti-virus capabilities and URL filtering software. We focus on serving as thetrusted security provider to our customers by maintaining within our existingproducts the latest counter-measures to security risks, creating new innovativeproducts based on our customers’ needs and providing professional and managedservices.

 

Many factors will affectour future financial performance, especially our ability to differentiate ourofferings from competitors that include much larger companies with greatermarketing capabilities, financial resources and brand recognition. In order tocontinue to create such differentiation, we expect to continue to expand ourdomestic and international sales and marketing operations, seek acquisitioncandidates and 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”.

 

**CriticalAccounting Policies**

 

The consolidatedfinancial statements were prepared in conformity with U.S. generallyaccepted accounting principles (“GAAP”). 

 

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As such, management isrequired to make certain estimates, judgments and assumptions it believes arereasonable based upon the information available. These estimates andassumptions affect the reported amounts of assets and liabilities at the dateof the financial statements and the reported amounts of revenues and expensesduring the periods presented. The significant accounting policies whichmanagement believes are the most critical to aid in fully understanding andevaluating our reported financial results include the following:

 

*Revenuerecognition*

 

We recognize revenue inthe following categories:

 

•                  *Product licenses and sales,* which includerevenue from sales of perpetual software licenses and products;

 

•                  *Subscription revenues,* which consists of customersupport, including content updates, term licenses, subscription licenses andmanaged service arrangements; and

 

•                  *Professional services revenues,* whichincludes fee-based service engagements and training.

 

We recognize softwarelicense revenue under Statement of Position (“SOP”) 97-2,*Software Revenue Recognition,* as modifiedby SOP 98-9,*Software RevenueRecognition with Respect to Certain Transactions,* when the followingcriteria have been met:

 

•                  persuasiveevidence of an arrangement exists;

 

•                  deliveryhas occurred or services have been rendered;

 

•                  priceis fixed or determinable; and

 

•                  collectionis probable.

 

*Product licenses and sales*

 

We recognize perpetualsoftware license revenues, assuming all other revenue recognition criteria aremet, upon (1) delivery of the software and (2) issuance of therelated license, assuming that no significant vendor obligations or customeracceptance rights exist. Where payment terms are extended over periods greaterthan twelve months, revenue is recognized as such amounts become due andpayable. Revenue is also deferred when payment terms are extended for periodsless than twelve months and such sales are deemed either not to be fixed ordeterminable or collection is not probable based on evaluation of all terms ofthe transaction.

 

Product sales consistprimarily of appliances sold in conjunction with ISS licensed software. Thesesales are recognized upon shipment to the customer provided all other criteriafor software license revenue recognition are met.

 

Sales of products aregenerated both through direct sales to end-users as well as through variouspartners, including system integrators, value-added resellers and distributors.Revenue from product licenses and sales is recognized when the sale hasoccurred for an identified end user, provided all other revenue recognitioncriteria are met. We offer evaluation software available via download from ourwebsite and evaluation units for appliance-based products that allow potentialcustomers to see the functionality of the products on their own networks priorto purchase. At the point of delivery, the customer has no right of return.

 

*Subscriptionrevenues*

 

Subscription revenuesconsist of renewable customer support, term licenses and security monitoringand management services.  Renewablecustomer support is a separate component of product licenses and sales. Termlicenses allow customers to use our products and receive product supportcoverage and content updates for a specified period, generally twelve months.We generally invoice for customer support and term licenses at the beginning ofthe term and recognize revenue ratably over the subscription term. Securitymonitoring and management services for information assets and systems are partof managed services and associated revenues are recognized and billed as suchservices are provided.

 

Historically, oursoftware and intrusion prevention appliance sales have been accounted forprimarily as revenue at the time of sale, with product support and contentupdates generally representing between 20% and 30% of the related license orproduct amount. Prior to the second quarter of 2005, the majority of theinitial price paid by the customer for certain Proventia integrated securityappliance models was for selected content blades (sometimes referred to as “blades”),which customers acquire for a specified term that is recognized over such termas subscription revenue. During the second quarter of 2005, we changed thepricing model for our Proventia integrated security appliances to ourhistorical model under which customers acquire the appliance bundled with mostcontent blades, which are recorded as product revenue at the time of sale, andpay annual customer support fees at an average rate of 

 

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22% of the productprice.This change did not have a material impact on our results for the secondquarter as the integrated security appliances represented 4% of product licenseand sales revenues in the second quarter using our historical pricing model,which approximates the percentage of quarterly product licenses and sales thatit has historically represented since introduced in late 2003, under the priorpricing model.

* *

*Professionalservices revenues*

 

Service engagements aretypically billed on either a fixed fee or time-and-materials basis andprimarily consist of security assessments of customer networks and thedevelopment of customers’ security policies. These offerings are intended tosupport our goal of providing products and managed services. We prefer to haveour partners provide these services where practical. We recognize suchprofessional services revenues as the related services are rendered.

 

*Multipleelements arrangements*

 

Our sales of productand/or software licenses are multiple element arrangements that include productsupport and content updates and may include other subscription or professionalservices delivered after the product or software license. Revenue is generallyrecognizable upon delivery of each element of the arrangement when all of thefollowing requirements exist:

 

•                  vendorspecific objective evidence (“VSOE”) of fair value exists for the undeliveredelements;

 

•                  thefunctionality of the delivered elements is not dependent on the undeliveredelements; and

 

•                  deliveryof the delivered elements represents the culmination of the earnings process.

 

We recognize thedifference between the total arrangement fee and the amount deferred for theundelivered elements as product and license revenues. We allocate revenue tothe delivered products and licenses using the residual method. Under theresidual method, we allocate discounts inherent in the arrangement to productsand product support and content updates associated with products that areinitially delivered and recognize the other elements as they are deliveredbased on the VSOE of fair value, which is determined based on transactionswhere the company sells those elements separately. We determine fair value ofthe undelivered elements based on historical evidence of our stand-alone salesof these elements to third parties.

 

*Allowance for doubtful accounts*

* *

Our sales are global,with customers located in the Americas, EMEA, and Asia/ Pacific regions. Weperform periodic credit evaluations of our customer’s financial condition anddo not require collateral. We provide for estimated credit losses as suchlosses become probable. We evaluate specific accounts when we become aware of asituation where a customer may not be able to meet its financial obligationsdue to deterioration 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 additional informationis received. At June 30, 2005, the allowance for doubtful accounts totaled$3.1 million, or 4.4% of the $71.3 million of total trade receivables.This 4.4% allowance of receivables reflects our practice to leave accounts onour general ledger and provide reserves pending final resolution ofcollectibility rather than to write-off suchaccounts.    Our bad debt expense for the quarter ended June 30,2005 amounted to $241,000 compared to $240,000 in the corresponding period of2004 and $386,000 and $529,000 during the first six months of 2005 and 2004,respectively.

 

We continued to monitorthe Asia situation that contributed to a higher bad debt expense level in 2002.In January 2004, a new distributor for China assumed the rights and theobligations of the distribution agreement for ISS products from the olddistributor. In connection with this agreement, we modified the new distributor’sobligations, which resulted in an additional $200,000 of bad debt expenserecorded in the fourth quarter of 2003 and the write-off of $1.1 millionagainst the allowance account. We established a firm repayment schedule andreceived timely payments under this schedule, which resulted in full payment ofthe receivable in the first quarter of 2005.

 

While actual creditlosses have historically been within management’s expectations and theprovisions established, we cannot guarantee that we will continue to experiencethe same credit loss rates we have in the past. If the financial condition ofour customers were to deteriorate, resulting in an impairment of their abilityto make payments, additional allowances may be required.

 

*Impairment of goodwill and other long-lived and intangibleassets*

* *

We review goodwill forimpairment on an annual basis or on an interim basis whenever events or changesin circumstances indicate that the carrying amount of an asset may not berecoverable. All other long-lived and intangible assets are reviewed forimpairment whenever events or circumstances indicate that the carrying amountof an asset may not be recoverable. Such impairment loss would be measured asthe difference between the carrying amount of the asset and its fair valuebased on the present value of 

 

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estimated future cash flows.Significant judgment is required in the forecasting of future operatingresults, which are used in the preparation of projected cash flows. Due touncertain market conditions and potential changes in our strategy and products,it is possible that forecasts used to support our intangible assets may changein the future, which could result in significant non-cash charges that wouldadversely affect our results of operations.

 

We currently havegoodwill and other acquisition related intangibles, net of accumulatedamortization, of approximately $236 million, with $195 million ofgoodwill related to our June 2001 acquisition of Network ICE Corporation (“NetworkICE”) and approximately $20 million of goodwill related to the January 2004acquisition of Cobion, a privately held company based in Kassel, Germany . Thedetermination of whether or not goodwill is impaired involves significantjudgments based upon short and long-term projections of future performance. Wehave concluded that this amount is realizable based on forecasted discountedcash flows through 2008 and on our stock market valuation. Neither methodindicated that our goodwill had been impaired and, as a result, we did notrecord any impairment losses related to goodwill during 2005. Other intangiblesof approximately $15 million are principally acquired technology from theNetwork ICE and Cobion acquisitions that are components in our current productofferings.

 

*RecentlyIssued Accounting Standards*

 

On December 16,2004, the Financial Accounting Standards Board issued SFAS Statement No. 123(revised 2004) (SFAS 123R),*Share-BasedPayment,* which is a revision of SFAS Statement No. 123,*Accounting for Stock-Based Compensation.*SFAS No. 123R supersedes APB Opinion No. 25,*Accounting for Stock Issued to Employees.*Statement 123R requires all share-based payments to employees, includinggrants of employee stock options, to be recognized in the financial statementsbased on their fair values (i.e., pro forma disclosure is no longer analternative to financial statement recognition). On April 14, 2005, theSecurities and Exchange Commission adopted a new rule, Staff AccountingBulletin (“SAB”) No. 107, amending the effective date for SFAS 123R.  Under the effective date provisions includedin SFAS 123R, the Company would be required to implement SFAS 123R as of thefirst interim or annual period beginning after June 15, 2005.  SAB No. 107 allows the Company toimplement SFAS 123R at the beginning of the next fiscal year that begins after June 15,2005.  SAB No.107 affects none of theaccounting provisions of SFAS 123R.The Company is required to adopt SFAS 123Rby January 1, 2006.  The impact onthe Company’s earnings will include the remaining amortization of the fairvalue of existing options currently disclosed as pro-forma expense in Note 1and is contingent upon the number of future options granted, the selectedtransition and valuation methods.  Whilethe pro forma information under SFAS 123 indicates that expensing of stockoptions will have a material impact on the Company’s financial results, thespecific impact is not known as the Company is currently evaluating valuationand transition methods permitted under SFAS 123R.

 

In May 2005 the FASBissued SFAS No. 154, *Accounting Changes andError Corrections. *SFAS 154requires retroactive application of a voluntary change in accounting principleto prior period financial statements unless it is impracticable.  SFAS No. 154 also requires that a changein method of depreciation, amortization or depletion for long-lived,non-financial assets be accounted for as a change in accounting estimate thatis affected by a change in accounting principle.  SFAS No. 154 replaces APB Opinion No. 20,*Accounting Changes* and SFAS No. 3, *Reporting Accounting Changes in Interim Financial Statements.*  SFAS No. 154 is effective for fiscalyears beginning after December 15, 2005. The Company does not expect the adoption of the provisions of SFAS No. 154to have a material impact on its results of operations or financial condition.

 

**Resultsof Operations**

 

The following table setsforth our consolidated historical operating information, as a percentage oftotal revenues, for the periods indicated:

 
| ** **                                                | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                                | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Consolidated  Statements of Operations Data:**          |       |                   |       |                 |       |   |   |   |   |
| Product licenses  and sales                               |       | 43                     | %          | 42                   | %          | 42 | % | 42 | % |
| Subscriptions                                             |       | 50                     | %          | 49                   | %          | 51 | % | 49 | % |
| Professional  services                                    |       | 7                      | %          | 9                    | %          | 7 | % | 9 | % |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Total revenues                                            |       | 100                    | %          | 100                  | %          | 100 | % | 100 | % |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Cost of  revenues:                                        |       |                   |       |                 |       |   |   |   |   |
| Product licenses  and sales                               |       | 8                      | %          | 8                    | %          | 8 | % | 7 | % |
| Amortization of  acquired technology                      |       | 2                      | %          | 2                    | %          | 2 | % | 2 | % |
| Subscriptions  and professional services                  |       | 17                     | %          | 18                   | %          | 17 | % | 18 | % |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Total cost of  revenues                                   |       | 27                     | %          | 28                   | %          | 27 | % | 27 | % |
| Research and  development                                 |       | 14                     | %          | 16                   | %          | 14 | % | 16 | % |
| Sales and  marketing                                      |       | 35                     | %          | 35                   | %          | 35 | % | 36 | % |
| General and  administrative                               |       | 9                      | %          | 9                    | %          | 9 | % | 9 | % |
| Amortization of  intangibles and stock-based compensation |       | —                 | %          | —               | %          | — | % | — | % |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Total costs and  expenses                                 |       | 85                     | %          | 88                   | %          | 85 | % | 88 | % |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Operating income                                          |       | 15                     | %          | 12                   | %          | 15 | % | 12 | % |

 

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**Revenues**

 

*Productlicenses and sales*

 

The Proventia family ofnetwork protection appliances provides unified, multi-function protectioncapabilities designed to identify and prevent many forms of attack with minimaluser intervention. These products are designed to operate in demanding networkenvironments while being easy to deploy, easy to use and centrally managed, allin an effort to make our solution more cost-effective.

 

Product licenses andsales in the three months ended June 30, 2005 increased by 17% comparedwith the three months ended June 30, 2004, and 14% on a year-to-datebasis, due to continued positive market response to our Proventia applianceline.  Proventia appliances grew from 50%of product license and sales in the second quarter of 2004 to 67% of productlicense and sales revenues in the second quarter of 2005, an increase of 57%.  For the six months ended June 30, 2005Proventia represented 65% of total product and sales revenues compared to 49%in the six months ended June 30, 2004, growth of 51%.

 

Our future growth isdependent on a continuation of the positive market response to our Proventiafamily of products. At the end of the first quarter of 2005 we extendedProventia to our PC desktop and laptop solutions, which were delivered as asoftware offering.  We also expect toextend Proventia to our server solutions in the future. Our present productroadmap also focuses on product offerings and enhancements that will continueto improve central control and manageability, easier deployment and morerefined information as well as broader Proventia appliance offerings. We expectthat this focus will continue to make our products more cost effective toimplement and maintain the goal of increasing the future level of productlicenses and sales. Such sales represent not only product and license revenues,but also subscription revenues from customer support.

 

*Subscriptions*

 

Subscription revenues,the largest revenue category, consist of customer support revenues, whichinclude product and technical support and content updates, security-monitoringfees for managed services offerings, and term licenses of products. Revenues increasedfrom $34.3 million in the second quarter of 2004 to $39.9 million in the secondquarter of 2005 representing growth of 16%. On a year-to-date basis subscription revenues increased 17% from $67.1million in 2004 to $78.7 million in 2005.

 

For both the secondquarter and first half of 2005, the largest component of subscription revenues,customer support, increased to 32% of total revenues from 31% in thecorresponding periods of 2004. Customer support includes hardware support ofour Proventia appliances, software updates and software blades, technicalsupport and security content that includes advisory updates from X-Force, ourinternal team of security experts. Customer support is provided throughcontracts executed with customers for a specified term and billed at the timeof contract. Such billings are recorded as deferred revenues on our balancesheet and amortized as subscriptions revenue over the term of the contract. Weexpect customer support revenues to increase in the future as our client basethat generates such support revenues expands.

 

Managed services revenuesincreased to 15% of total revenues in the three months ended June 30,2005, as compared with 13% in the three months ended June 30, 2004.  For the six months ended June 30, 2005managed services revenues increased to 14% of total revenues compared with 13%in the corresponding period of 2004. We believe these increases were due to astrong demand in the market for proven, financially sound, managed securityservice providers. We are marketing managed services both directly to end usersand through partners, including a number of new arrangements with integratorsand service providers that include managed services as a part of their serviceofferings to their customers. We also expect sales of managed services tocontinue to grow steadily as we focus our efforts on marketing offerings to newand existing customers that meet changing needs in today’s environment.

 

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*Professionalservices*

 

Professional servicesrevenue decreased in absolute dollars from $6.4 million in the three monthsended June 30, 2004 to $5.6 million in the three months ended June 30,2005.In the six months ended June 30, 2005 professional services revenueswere $11.3 million, compared to $11.9 million in the six months ended June 30,2004.We continue to focus on high-value offerings that utilize our X-Forceexpertise, and look to our system integration and channel partners to serve asthe primary resource to fulfill the services and education needs of ourcustomers.

 

*Geographicregions*

 

Geographically, wederived the majority of our revenues from sales to customers within theAmericas region. Revenues by region represented the following percentages oftotal revenues for the periods indicated:

 
| ** **       | ** ** | **Three months  ended** | ** ** | **Six months  ended** | ** ** |
|------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **       | ** ** | **June 30,**       | ** ** | **June 30,**     | ** ** |
| ** **       | ** ** | **2005**                | ** ** | **2004**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Americas         |       | 63                      | %          | 65                    | %          | 62 | % | 65 | % |
| EMEA             |       | 22                      | %          | 22                    | %          | 22 | % | 22 | % |
| Asia/Pacific Rim |       | 15                      | %          | 13                    | %          | 16 | % | 13 | % |

 

While there have beenchanges in the proportion of revenues generated by each region, all of theregions experienced growth in revenues in 2005. Fluctuations in foreign currency rates impact our financial results. Wesell primarily in the functional currency of the countries in which we operate.  Therefore, changes in exchange rates impactboth our revenues and operating expenses.  When the U.S. dollar strengthens against theseforeign currencies, the U.S. dollar value of our non-functional currencyrevenues decreases. When the U.S. dollar weakens, the value of our functionalcurrency revenues increases.  During thesecond quarter of 2005, the dollar strengthened against both the euro and theyen, which translated into less U.S. dollars recorded during consolidation ofapproximately $1.0 million in revenue.When comparing rates in the secondquarter of 2005 against the second quarter of 2004, the U.S. dollar wasslightly weaker against both the euro and yen, providing a benefit ofapproximately $1.0 million in revenues. Assuming the current rates remain stable, revenues for the second halfof the year will be negatively impacted by approximately 1.5% when comparingEMEA and Asia/Pacific Rim results to the second half of 2004.

 

The financial data foreach segment can be found in Note 6 to the Consolidated FinancialStatements.

 

**Costsand Expenses**

 

*Personnel*

 

Personnel and relatedcosts represent our largest expense category. Our headcount remained relativelyconstant in the first half of 2005, slightly exceeding 1,200 employees.

 

###### *Costof product licenses and sales*

###### * *

Cost of product licensesand sales consists of several components. The substantial portion of our costof product licenses and sales represents the hardware cost of our Proventiaappliances. As our Proventia revenues increase so do the direct costs of theappliances.  Other elements of cost ofproduct licenses and sales include the personnel costs of our fulfillment groupand the amortization of development source code licensed at the beginning of2004, which is amortized over its estimated useful life of four years. Costsassociated with licensing our software products are minor.

 

As a percentage ofproduct licenses and sales revenues, these costs increased from 18% in thequarter ended June 30, 2004 to 19% in the quarter ended June 30, 2005.  On a year-to-date basis, cost of productlicenses and sales increased from 17% of product licenses and sales revenue in2004 to 19% in 2005.  These modestincreases, in the costs as a percentage of the related revenues, resulted from anincrease in Proventia appliance revenues, which grew by more than 50% on both aquarterly and year-to-date basis in 2005 compared to 2004.  The hardware costs represent a smallerportion of the related appliance revenue as the costs are growing less than thecorresponding revenues.

 

We also recordedamortization expense related to core and developed technology as a result ofacquisitions accounted for under the purchase method of accounting.  This amortization expense totaled $1.8million in the three months ended June 30, 2005, $1.7 million in the threemonths ended June 30, 2004, $3.5 million in the six months ended June 30,2005 and $3.3 million in the six 

 

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months ended June 30,2004.

 

*Cost ofsubscriptions and professional services*

 

Costof subscriptions and professional services includes the cost of our technicalsupport personnel who provide assistance to customers under product supportagreements, the security operations center (“SOC”) costs of providing managedsecurity monitoring services and the costs related to our professional servicesand training. These costs were $13.2 million in the three months ended June 30,2005 and $12.5 million in the three months ended June 30, 2004.   Inthe six months ended June 30, 2005 these costs were $26.3 million comparedto $24.2 million in the corresponding period of 2004.  These costs, as a percentage of subscriptionand professional services revenues, decreased from 31% in the three and sixmonths ended June 30, 2004 to 29% in both the three and six months ended June 30,2005.  Costs associated with ourtechnical support personnel and our SOC’s increased the second quarter of 2005compared to the same period of 2004, as well as year-to-date 2005 compared to2004,  as we added personnel andequipment to handle additional customers.

 

*Researchand development*

 

Research and developmentexpenses consist of salary and related costs of research and developmentpersonnel, including costs for employee benefits, and depreciation on computerequipment. These costs include those associated with maintaining and expandingthe X-Force, our internal team of security experts. We believe our primaryresearch and product development and managed service offerings are important toretaining our leadership position in the market.

 

We continue to addfunctionality to our product family, providing gateway, network, server anddesktop-based solutions, as well as to our vulnerability assessment andsecurity management applications. These improvements, as well as new offerings,are intended to provide our customers with more powerful and easier-to-usesolutions for security management across the enterprise. Examples of productintroductions in the first six months of 2005 include the following:

 

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

 

•                  *Proventia G400 and G2000*:  These intrusion prevention appliances offerthe flexibility of either 400 megabit or 2 gigabit throughput, and enhancedmanagement features such as spy-ware blocking, improved policy management andhigh-availability.

 

Research and developmentexpenses decreased slightly from $11.1 million in the three months ended June 30,2004 to $11.0 million in the three months ended June 30, 2005.  On a year-to-date basis, these costsdecreased in absolute dollars from $21.9 million in the first half of 2004 to$21.3 million in the first half of 2005. These decreases are the benefits of streamlining operations as werelocated some engineering functions from our California development facilityto Atlanta and offshore and completed the closure of our Sydney engineeringfacility during 2004.

 

While we are committed tocontinue our investment in X-Force research and development capabilities, whichwe believe distinguishes ISS from its competitors, we intend to seek leveragein future periods in the research and development area while enhancing currenttechnologies and developing new technologies.

 

*Salesand marketing*

 

Salesand marketing expenses consist of salaries, travel expenses, commissions,advertising, maintenance of our website, trade show expenses, costs ofrecruiting sales and marketing personnel and costs of marketing materials.

 

Sales and marketingexpenses increased from $24.1 million in the three months ended June 30,2004 and $48.5 million in the six months ended June 30, 2004 to $27.5million and $53.6 million, respectively, in the corresponding periods of2005.We added quota-carrying headcount, had higher variable commission expenseassociated with higher product license and sales revenues and increased ourmarketing expenditures.  Despite theseincreases, sales and marketing expenses continued to represent between 34% and35% of total revenues in the three month and six month periods ended June 30,2004 and 2005.

 

We expect to achieveleverage in our sales efforts in the future by focusing our direct sales forceon large customers that are served either directly by us or through largesystems integrators. We believe our channel, which includes systemsintegrators, value-added resellers and distributors, will continue to be ofincreasing importance to us, measured quantitatively by an increasing level ofproduct revenue originating through the channel. This channel representedapproximately 75% of our sales in the second quarter of 2005 as compared to 73%in 2004. We intend to use its capabilities in the future to reach largercustomers through joint selling efforts and to reach departmental and smallcompanies with minimal assistance from ISS.

 

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*Generaland administrative*

 

General andadministrative expenses consist of personnel-related costs for executive, administrative,finance and human resources, internal information systems and other supportservices costs, and legal, accounting and other professional service fees.  General and administrative expenses were $7.3in the second quarter of 2005 and $14.6 million in the first half of 2005compared with $6.3 million in the second quarter of 2004 and $12.6 million inthe first half of 2004.  General andadministrative expenses increased in the 2005 periods compared to the 2004periods primarily due to higher legal costs and additional costs related to compliancewith the Sarbanes Oxley Act of 2002.

 

*Interestincome*

 

Interest income increasedfrom $464,000 in the quarter ended June 30, 2004 to $1.3 million in thecomparable quarter of 2005 and from $1.0 million in the six months ended June 30,2004 to $2.3 million in the six months ended June 30, 2005 due to anincrease in the yield on investment-quality commercial paper and similarinvestments from approximately 0.8% in the second quarter of 2004 toapproximately 2.9% during the second quarter of 2005.Year-to-date yieldsincreased from 1.0% in 2004 to 2.6% in 2005.

 

*Other income (expense), net*

* *

Other income (expense)consisted of minority interest expense of $51,000 in the second quarter of 2005and $284,000 in the second quarter of 2004 and $61,000 and $411,000 for the sixmonths ended June 30, 2005 and 2004, respectively.  Foreign currency exchange loss in the secondquarter of 2004 of $72,000 compared to a $445,000 loss during the same periodof 2005.  On a year-to-date basis aforeign currency gain of $5,000 in 2004 compares to a loss of $980,000 in2005.  These losses in 2005 occurredprimarily due to the strengthening of the dollar against foreign currenciessuch as the euro and the yen.

 

*Gain on issuance of subsidiary shares*

* *

The gain on issuance ofsubsidiary shares resulted from, ISS KK, our Asia/Pacific subsidiary issuingshares related to the exercise of ISS KK stock options.  For the six months of 2005, ISS KK issued 735shares at an average exercise price of approximately $485 per share.  Our ownership percentage of the subsidiaryremained at 87% at June 30, 2005.

 

*Provisionfor income taxes*

 

Our effective tax ratewas approximately 36.5% for the three months ended June 30,2005 bringing our rate to 36.25% for the six months ended June 30,2005.  The increase in the anticipatedannual rate for 2005 was created by a shift in expected profits for taxreporting purposes to jurisdictions with higher tax rates.  Although the effective rate for the three andsix months ended June 30, 2004 was 36.25%, thefinal effective tax rate for 2004 was higher at 36.9%. The effective ratesdiffer from the statutory rates due to the impact of acquisition-relatedintangibles and certain operating expenses that are not deductible for incometax purposes as well as federal and state tax credits.

 

**Liquidityand Capital Resources**

 

Our financial positionremained strong through the first six months of 2005. Our cash and cashequivalents and marketable security investments were $226.6 million at June 30,2005. Our investments in marketable securities consisted solely of highly rateddebt obligations with maturities of twelve months or less.

 

We continue to meet ourworking capital needs and capital equipment needs with cash provided byoperations. Cash provided by operations in the first six months of 2005 totaled$34.2 million. The major components of cash flows provided by operatingactivities were net income of $16.1 million, non-cash depreciation andamortization expense charges of $9.0 million, non-cash deferredcompensation expense of $1.1 million, and a decrease in accounts receivable of$7.2 million.

 

An important element ofour liquidity is the collection of our accounts receivable. We measure ouraccounts receivable management by our day’s sales outstanding (“DSO”). This isa measurement of accounts receivable divided by billings in the quarter,represented by the sum of revenues plus the change in the deferred revenuesliability account balance. This measurement was 81 days at June 30,2005, well within our target range of 75 to 85 days.

 

Our net cash provided byinvesting activities was $29.9 million in the first six months of2005.  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$56.9 million of intermediate term marketable securities, primarilyinterest-bearing government obligations and commercial paper, offset by netproceeds from the maturity and sales of marketable securities of$89.9 million.  Also included incash flow from operations was $0.9 million of income tax benefit from exerciseof stock options, which will be classified as a financing activity with theexpected adoption in calendar 2006 

 

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of SFAS 123R, “*Share Based Payments*”, issued by the Financial AccountingStandards Board.

 

Our financing activitiesused $12.8 million of cash in the first six months of 2005. This wasprincipally due to the repurchase of 880,000 shares of our common stock in theopen market at an aggregate cost of $18.3 million.Since the inception of thestock repurchase programs in July 2002, we have purchased 5.8 millionshares at an average cost of $16.13 per share for a total cash outlay ofapproximately $92.7 million.  In July 2005the Board of Directors authorized a new repurchase program to spend up to $100million over the next year.  Also, in thefirst six months of 2005, the exercise of stock options by our employees andthe issuance of common stock through our employee stock purchase plan generatedfunds of approximately $5.5 million.

 

We believe our cash andcash equivalents and marketable securities will be sufficient to meet ourworking capital needs and capital expenditures for the foreseeable future.Furthermore, we are not aware of any trends, events, or uncertainties that arereasonably likely to result in any significant change to our liquidity. Fromtime to time, we evaluate possible acquisition and investment opportunities inbusinesses, products or technologies that are complementary to ours. In theevent we determine to pursue such opportunities, we may use our available cashand cash equivalents and marketable securities for this purpose.

 

###### *Off-BalanceSheet Arrangements*

###### * *

Payments for certain ofour operating leases are secured by four collateralized stand-by letters ofcredit totaling approximately $8.8 million at June 30, 2005. Thesestand-by letters of credit guarantee our payment obligations on the leases andare renewable annually over the duration of the applicable leases. If wedefault on the lease payments, the landlords can make a claim against theletters of credit. We, in turn, would be liable to the letter of creditissuers. Our stand-by letters of credit are collateralized by securities worth$10.3 million at June 30, 2005. Other than these non-cancelableoperating leases, we have no off-balance sheet financing arrangements, anyrelationships with “structured finance” or “special purpose” entities, or anycontractual obligations with unconsolidated entities that are reasonably likelyto impact our liquidity.

 

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**RiskFactors**

 

There are many factorsthat affect ISS’ business and the results of its operations, some of which arebeyond ISS’ control. The following is a description of some of the importantfactors that may cause the actual results of ISS’ operations in future periodsto differ materially from those currently expected or desired. We encourage youto read this section carefully.

 

*WeOperate in a Rapidly Evolving Market*

 

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

 

•                  respondto competitive developments;

 

•                  continueto upgrade and expand our product and services offerings; and

 

•                  continueto attract, retain and motivate our employees.

 

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

 

We introduced ourProventia appliance line in April 2003 that includes intrusion preventionand integrated security protection. While market response to these products hashad a positive impact on our operating results, failure to continue to gainfurther market acceptance of new appliance products could result in revenuesbelow our expectations and our operating results could be adversely affected.

 

*OurFuture Operating Results Will Likely Fluctuate Significantly*

 

We cannot predict ourfuture revenues and operating results with certainty. However, we do expect ourfuture revenues and operating results to fluctuate due to a combination offactors, including:

 

•                  the extent to whichthe public perceives that unauthorized access to and use of online informationare threats to network security;

 

•                  customerbudgets;

 

•                  the mix ofproduct sales among the various products offered by ISS and whetherrevenue is recognized upon sale or deferred to subsequent periods;

 

•                  the volume andtiming of orders, including seasonal trends in customer purchasing;

 

•                  our ability todevelop and timely introduce new and enhanced product and managed serviceofferings;

 

•                  the introductionand acceptance rate of new ISS branded appliances, including increasedcost of goods sold;

 

•                  our ability toaccurately forecast and produce demanded quantities of our appliance productsand models;

 

•                  availability ofcomponent parts of appliance products and reliance on contract manufacturers toproduce such products;

 

•                  our ability toprovide scalable managed services offerings in a cost effective manner;

 

•                  foreign currencyexchange rates that affect our international operations;

 

•                  whetherenterprises consolidate their security platforms with fewer venders and whetherISS benefits from this;

 

•                  product andprice competition in our markets; and

 

•                  general economicconditions, both domestically and in our foreign markets.

 

We focus our efforts onsales of enterprise-wide security solutions, which consist of our entireproduct suite and related professional services, and managed security services,rather than on the sale of component products. As a result, each sale requiressubstantial time and effort from our sales and support staff. In addition, therevenues associated with particular sales vary significantly depending on thenumber of products acquired by a customer, the number of devices used by thecustomer and the customer’s relative 

 

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need for our professionalservices. Large individual sales, or even small delays in customer orders, cancause significant variation in our license revenues and results of operationsfor a particular period. The timing of large orders is usually difficult topredict and, like many software-based technology companies, many of ourcustomers typically complete transactions in the last month of a quarter.

 

We cannot predict ouroperating expenses based on our past results. Instead, we establish ourspending levels based in large part on our expected future revenues. As aresult, if our actual revenues in any future period fall below ourexpectations, our operating results likely will be adversely affected becausevery few of our expenses vary with our revenues. Because of the factors listedabove, we believe that our quarterly and annual revenues, expenses andoperating results likely will vary significantly in the future.

 

Our ability to providetimely guidance and meet the expectations of investors with respect to ouroperating and financial results is affected by the tendency of a majority ofour product and license sales to be completed in the last month of a quarter.We may not be able to determine whether we will experience material deviationsfrom guidance or expectations until the end of a quarter.

 

*Dependenceon Third Party Suppliers and Manufacturers*

 

We carry little inventoryof our appliance products and we rely on suppliers to deliver necessarycomponents to our contract manufacturers in a timely manner based on theforecasts we provide. We currently purchase some Proventia appliance componentsand contract manufacturing services from single or limited sources. Ifshortages occur, supplies are interrupted, or we underestimate demand formodels, we may not be able to deliver products to our customers and our revenueand operating results would be adversely affected. Because our supply ofhardware is based on short-term forecasts and purchase orders, our contractmanufacturers are not obligated to purchase components for greater quantitiesover longer periods. We provide forecasts of our demand to our contractmanufacturers. If we overestimate our requirements, our contract manufacturersmay have excess inventory, which could increase our costs. If we underestimateour requirements, our contract manufacturers may have an inadequate componentinventory and, based on lead times, this could interrupt manufacturing andresult in delays in shipments and revenues.

 

*WeFace Intense Competition in Our Market*

 

The market for networksecurity monitoring, detection, prevention and response solutions is intenselycompetitive, and we expect competition to increase in the future. We cannotguarantee that we will compete successfully against our current or potentialcompetitors, especially those with significantly greater financial resources orbrand name recognition. Our chief competitors generally fall within thefollowing categories:

 

•                  large companies,including Symantec Corp., Cisco Systems, Inc., Juniper Networks, Inc.,and McAfee, Inc., that sell competitive products and offerings, as well asother large software companies that have the technical capability and resourcesto develop competitive products;

 

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

 

•                  smaller softwarecompanies offering relatively limited applications for network and Internetsecurity; and

 

•                  small and largecompanies with competitive offerings to components of our managed servicesofferings.

 

Mergers or consolidationsamong these competitors, or acquisitions of small competitors by largercompanies, represent risks. For example, Symantec Corp., Cisco Systems, Inc.,McAfee, Inc., and Juniper Networks, Inc. have acquired during thepast several years smaller companies, which have intrusion detection orprevention 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 companiescurrently sell software products (such as encryption, firewall, operatingsystem security and virus detection software) that our customers and potentialcustomers have broadly adopted. Some of these companies sell products thatperform the same functions as some of our products. In addition, the vendors ofoperating system software or networking hardware may enhance their products toinclude the same kinds of functions that our products currently provide. Thewidespread inclusion of comparable features to our software in operating systemsoftware or networking hardware could render our products less competitive orobsolete, particularly if such features are of a high quality. Even if securityfunctions integrated into operating system software or networking hardware aremore limited than those of our products, a significant number of customers mayaccept more limited functionality to avoid purchasing additional products.

 

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In addition, with theintroduction of our Proventia integrated security appliance, we have offeringsthat compete with vendors of firewalls, VPNs, anti-virus systems, and contentand spam filtering products. These offerings are competitive with a broaderspectrum of network security companies, as well as those that also offerintegrated security appliances or broad product suites.

 

For the above reasons, wemay not be able to compete successfully against our current and futurecompetitors. Increased competition may result in price reductions, reduced grossmargins and loss of market share.

 

*WeFace Rapid Technological Change in Our Industry and Frequent Introductions ofNew Products*

 

Rapid changes intechnology pose significant risks to us. We do not control nor can we influencethe forces behind these changes, which include:

 

•                  the extent towhich businesses and others seek to establish more secure networks;

 

•                  the extent towhich hackers and others seek to compromise secure systems;

 

•                  evolvingcomputer hardware and software standards;

 

•                  changing customerrequirements; and

 

•                  frequentintroductions of new products and product enhancements.

 

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

 

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

 

The techniques computerhackers use to gain unauthorized access to, or to sabotage, networks andintranets are constantly evolving and increasingly sophisticated. Furthermore,because new hacking techniques are usually not recognized until used againstone or more targets, we are unable to anticipate most new hacking techniques.To the extent that new hacking techniques harm our customers’ computer systemsor businesses, affected or prospective customers may believe that our productsare ineffective, which may cause them or prospective customers to reduce oravoid purchases of our products.

 

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

 

We offer warranties onour products, allowing the end customer to have any defective product repaired,or to receive a replacement product for it during the warranty period, or incertain circumstances 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 onour service levels for managed security services. If we do not meet warranties,the customer generally may obtain credits for service.

 

If we are unable to fixerrors or other product problems that later are identified after fulldeployment, or if we fail to meet our service levels for managed securityservices, in addition to the consequences described above, we could experience:

 

•                  failure toachieve market acceptance;

 

•                  loss ofcustomers;

 

•                  loss of or delayin revenues and loss of market share;

 

•                  diversion ofdevelopment resources;

 

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•                  increasedservice and warranty costs;

 

•                  legal actions byour customers; and

 

•                  increasedinsurance costs.

 

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

 

Because we offer verycomplex products, undetected errors, failures or bugs may occur when they arefirst introduced or when new versions are released. Our products often areinstalled and used in large-scale computing environments with differentoperating systems, system management software and equipment and networkingconfigurations, which may cause errors or failures in our products or mayexpose undetected errors, failures or bugs in our products. We discover errors,failures and bugs in certain of our product offerings after their introductionand have experienced delays and could experience lost revenues during theperiod required to correct these errors. Our customers’ computer environmentsare often characterized by a wide variety of standard and non-standardconfigurations that make pre-release testing for programming or compatibilityerrors very difficult and time-consuming. Despite testing, errors, failures orbugs may not be found in new products or releases until after commencement ofcommercial shipments. Errors, failures or bugs in products released by us couldresult in negative publicity, product returns, loss of or delay in marketacceptance of our products or claims by customers or others.

 

In addition, if an actualor perceived breach of network security occurs in one of our end customer’ssecurity systems, regardless of whether the breach is attributable to ourproducts, the market perception of the effectiveness of our products could beharmed. Because the techniques used by computer hackers to access or sabotagenetworks change frequently and generally are not recognized until launchedagainst a target, we may be unable to anticipate these techniques. Alleviatingany of these problems could require significant expenditures of our capital andresources and could cause interruptions, delays or cessation of our productlicensing, which could cause us to lose existing or potential customers andwould adversely affect results of operations.

 

*WeMight Have to Defend Lawsuits or Pay Damages in Connection With Any Alleged orActual Failure of Our Products and Services*

 

Because our products andservices provide and monitor network security and may protect valuableinformation, we could face claims for product liability, tort or breach ofwarranty. Anyone who circumvents our security measures could misappropriate theconfidential information or other property of end customers using our products,or interrupt their operations. If that happens, affected end customers orothers may sue us. In addition, we may face liability for breaches caused byfaulty installation of our products by our service and support organizations.Provisions in our contracts relating to warranty disclaimers and liabilitylimitations may be unenforceable. Some courts, for example, have foundcontractual limitations of liability in standard computer and softwarecontracts to be unenforceable in some circumstances. Defending a lawsuit,regardless of its merit, could be costly and could divert management attention.Our business liability insurance coverage may be inadequate or future coveragemay be unavailable on acceptable terms or at all.

 

*RisksAssociated with Our Global Operations*

 

The expansion of ourinternational operations includes our presence in dispersed locationsthroughout the world, including throughout EMEA and the Asia/ Pacific and LatinAmerica regions. Our international presence and expansion exposes us to risksnot present in our U.S. operations, such as:

 

•                  the difficultyin managing an organization spread over various countries located across theworld;

 

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

 

•                  duties andtariffs imposed on importation of our products in other jurisdictions where othermanufacturers may not bear those same costs;

 

•                  increasedfinancial accounting and reporting burdens;

 

•                  potentiallyadverse tax consequences;

 

•                  fluctuations inforeign currency exchange rates resulting in losses or gains from transactionsand expenses denominated in 

 

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foreign currencies;

 

•                  reducedprotection for intellectual property rights in some countries;

 

•                  reducedprotection for enforcement of creditor and contractual rights in some countries; and

 

•                  import andexport license requirements and restrictions on the import and export ofcertain technology, especially encryption technology and trade restrictions.

 

Despite these risks, webelieve that we must continue to expand our operations in international marketsto support our growth. To this end, we intend to establish additional foreignsales operations, expand our existing offices, hire additional personnel,expand our international sales channels and customize our products for localmarkets. If we fail to execute this strategy, our international sales growthwill be limited.

 

*OurNetworks, Products and Services May be Targeted by Hackers*

 

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

 

*WeMust Successfully Integrate Acquisitions*

 

As part of our growthstrategy, we have and may continue to acquire or make investments in companieswith products, technologies or professional services capabilities complementaryto our solutions. When engaging in acquisitions, we could encounterdifficulties in assimilating or completing the development of the technologies,new personnel and operations into our company. These difficulties may disruptour ongoing business, distract our management and employees, increase ourexpenses and adversely affect our results of operations. These difficulties couldalso include accounting requirements, such as impairment charges related togoodwill or other intangible assets or expensing in-process research anddevelopment costs. We cannot be certain that we will successfully overcomethese risks with respect to any future acquisitions or that we will notencounter other problems in connection with our recent or any futureacquisitions. In addition, any future acquisitions may require us to incur debtor issue equity securities. The issuance of equity securities could dilute theinvestment of our existing stockholders.

 

*OurProprietary Rights May be Difficult to Enforce*

 

We rely primarily oncopyright, trademark, patent and trade secrets laws, confidentiality proceduresand contractual provisions to protect our proprietary rights. We hold two UnitedStates patent, one Taiwanese patent, and have a number of patent applicationspending. We also hold numerous United States and foreign trademarks and have anumber of trademark applications pending. There can be no assurance thatpatents will be issued from pending applications, or that claims allowed on anypatents will be sufficiently broad to protect our technology. There can be noassurance that any issued patents will not be challenged, invalidated orcircumvented, or that any rights granted under these patents will actuallyprovide competitive advantages to us. Despite our efforts to protect ourproprietary rights, unauthorized parties may attempt to copy aspects of ourproducts or to obtain and use information that we regard as proprietary.Policing unauthorized use of our products is difficult. While we cannotdetermine the extent to which piracy of our software products occurs, we expectsoftware piracy to be a persistent problem. In addition, the laws of some foreigncountries do not protect our proprietary rights to as great an extent as do thelaws of the United States, and many foreign countries do not enforce these lawsas diligently as U.S. government agencies and private parties. If we areunable to protect our proprietary rights to the totality of the features in oursoftware and products (including aspects of our software and products protectedother than by patent rights), we may find ourselves at a competitivedisadvantage to others who need not incur the additional expense, time andeffort required to create the innovative products that have enabled us to besuccessful. 

 

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

 

Third parties may assertclaims or initiate litigation related to exclusive patent, copyright, trademarkand other intellectual property rights to technologies that are relevant to ourbusiness. Because of the large number of patents in the Internet, networking,security and software fields, the secrecy of some pending patents and the rapidrate of issuance of new patents, it is not economically practical (or evenpossible) to determine in advance whether a product (or any of its components)infringe or will infringe the patent rights of others. Third party assertedclaims and/or initiated litigation can include claims against us or ourmanufacturers, suppliers, or customers, alleging infringement of proprietaryrights with respect to our existing or future products (or components of thoseproducts). Regardless of the merit of these claims, they can be time-consuming,result in costly litigation and diversion of technical and managementpersonnel, or require us to develop a non-infringing technology or enter intolicense agreements. There can be no assurance that licenses will be availableon acceptable terms and conditions, if at all, in these circumstances, or thatany indemnification that might be available to us would be adequate to coverour costs of defense. Furthermore, because of the potential 

 

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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.

 

*WeMust Continue to Attract and Retain Personnel in a Competitive Marketplace*

 

We believe that ourfuture success will depend in part on our ability to recruit and retain highlyskilled management, sales, marketing and technical personnel. To accomplishthis, we believe that we must provide personnel with a competitive compensationpackage, including stock options, restricted stock or similar incentive stockawards. Our current incentive stock plan expires in September 2005 and webelieve that sufficient shares are available for issuance under that plan tomeet our needs until it expires. We have proposed a new incentive stock plan tostockholders for consideration at our annual stockholders meeting in 2005, butthere is no assurance that shareholders will approve such plan, which wouldimpair our ability to attract and retain necessary personnel.

 

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

 

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

 

•                  establish aclassified board of directors;

 

•                  create preferredstock purchase rights that grant to holders of common stock the right topurchase shares of Series A Junior Preferred Stock in the event that athird party acquires 20% or more of the voting power of our outstanding commonstock;

 

•                  prohibit theright of our stockholders to act by written consent;

 

•                  limit callingspecial meetings of stockholders; and

 

•                  impose arequirement that holders of 66 2/3% of the outstandingshares of common stock are required to amend the provisions relating to theclassification of our board of directors and action by written consent ofstockholders.

 

**Item 3.Quantitative and Qualitative Disclosures About Market Risk**

 

The Company’s operatingresults are affected by changes in exchange rates between the U.S. dollarand the euro and the Japanese yen.  TheU.S. dollar value of our non-U.S. dollar revenues decreases as the U.S. dollarstrengthens against these foreign currencies. When the U.S. dollar weakens, the value of our functional currencyrevenues increases.  In the quarter endedJune 30, 2005 the U.S. dollar strengthened against the euro byapproximately 4% and against the yen by approximately 3%.  The resulting impact of this strengthening inthe second quarter was a decrease in revenues of approximately $1 million.  Since much of our international operatingexpenses are also incurred in local currencies, which are the foreignsubsidiaries functional currency, the impact of exchange rates on net income orloss is relatively less than the impact on revenue.  For the second quarter of 2005 the impact wasa reduction in net income of approximately $250,000.  Assuming the current rates remain stable,revenues for the second half of the year will be negatively impacted byapproximately 1.5% when comparing EMEA and Asia/Pacific Rim results to thesecond half of 2004.  Although ouroperating and pricing strategies take into account changes in exchange ratesover time, our results of operations may be affected significantly in the shortterm by fluctuations in foreign currency exchange rates.

 

Assets and liabilitiesare translated at the exchange rate on the balance sheet date.  As the U.S. dollar strengthens against theeuro and yen, the assets of our entities, with the euro and yen as theirfunctional currencies, translate into fewer U.S. dollars during consolidation.  As the U.S. dollar weakens against thesecurrencies, these assets translate into higher U.S. Dollars duringconsolidation.  The translationadjustments resulting from this process are shown separately as a component ofstockholders’ equity.

 

Transactions gains orlosses are recorded by our entities for transactions denominated in currenciesother than their respective functional currencies.  We recognized foreign exchange rate losses ofapproximately $445,000 and $72,000 during the three months ended June 30,2005 and 2004, respectively.  Foreignexchange rate transaction gains and losses are classified in “Other income(expense)” on our Consolidated Statements of Operations.

 

The nature and extent ofthe foreign currency risk faced by the Company depends on many factors thatcannot be accurately predicted. These factors include significant changes inforeign currency market conditions, the Company’s inability to match foreigncurrency denominated revenues with costs denominated in the same currency, andchanges in the amount or mix of revenues denominated in various foreigncurrencies. As a result of material unforeseen changes in these factors, theCompany’s foreign currency risk could have a greater impact on the Company’sresults of operations in the future.

 

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**Item 4.Controls and Procedures**

 

*Disclosure Controls andProcedures*

 

Our management, with theparticipation of the Chief Executive Officer and Chief Financial Officer,evaluated the effectiveness of our disclosure controls and procedures, asdefined in Rules 13a-15(e) and 15d-15(e) under the Securitiesand Exchange Act of 1934, as of June 30, 2005.  No system of controls, no matter how welldesigned and operated, can provide absolute assurance that the objectives ofthe system of controls are met, and no evaluation of controls can provideabsolute assurance that the system of controls has operated effectively in allcases.  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 have concluded that, as of such date, our disclosure controlsand procedures were effective to provide reasonable assurance that informationrequired to be disclosed in the reports the Company files or submits under theSecurities Exchange Act of 1934 is recorded, processed, summarized and reportedon a timely basis.

 

*Changes in Internal Control OverFinancial Reporting*

 

There have not been anychanges ISS’ internal control over financial reporting during the quarter endedJune 30, 2005 that have materially affected, or are reasonably likely tomaterially affect, such controls.

 

**PART II. OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

On August 17, 2004,the Company’s Georgia operating subsidiary filed in the United States DistrictCourt for the Northern District of Georgia a declaratory judgment action (the “GeorgiaAction”) against SRI International, Inc. (“SRI”).  The action seeks the court’s declaration thatour products and services do not infringe any valid claim of five patents heldby SRI and seeks declaration that certain claims of those patents areinvalid.  SRI filed a motion to dismissthe action, which we opposed. On August 26, 2004, SRI filed in the UnitedStates District Court for Delaware a complaint against the Company and SymantecCorporation (the “Delaware Action”).  Thecomplaint in the Delaware Action alleges that our SiteProtector and Proventiaproducts infringe upon claims of two of the five patents at issue in theGeorgia Action. The Delaware Action seeks unspecified damages and injunctiverelief.  The Company filed a motion todismiss the Delaware Action, which SRI opposed. On April 13, 2005, the Company’s motion was denied, withoutprejudice, with the opportunity to re-file it after discovery and clarificationof the distinction between our Delaware parent company and our Georgiaoperating company.  On or about April 25,2005, SRI filed an amended complaint adding the Company’s Georgia operatingsubsidiary as a separate defendant to the Delaware Action.  The Company and its subsidiary answered SRI’samended complaint on May 23, 2005, denying that they infringe the twopatents asserted by SRI and asserting counterclaims seeking a declaration fromthe Delaware court that the five SRI patents are not infringed, invalid, andunenforceable.  On or about June 13,2005, SRI answered the counterclaims asserted by the Company and its subsidiary,denying that the five patents are not infringed, invalid, andunenforceable.  The parties are currentlyengaged in discovery, and trial has been scheduled to begin on or about October 30,2006.  We intend to defend the DelawareAction vigorously and believe we have meritorious defenses. On or about June 9,2005, the Georgia court transferred the Georgia Action to the United StatesDistrict Court for the District of Delaware. The transferred case is currently pending before the Delaware court.

 

**Item 2.Unregistered Sale of Equity Securities and Use of Proceeds**

 

The following table provides information about purchases by the Company of its common stock during the three months ended June 30, 2005. All such purchases were made in open-market transactions pursuant to a repurchase plan publicly announced on July 21, 2004. Under this repurchase plan, the Company has been authorized by the Board to repurchase up to $50 million of its outstanding common stock over the 12 months ending July 19, 2005. The Company had a prior repurchase plan in place that terminated on July 14, 2004 and no further purchases can be made under that plan. Through June 30, 2005, the Company had purchased approximately 5.8 million shares at an aggregate cost of approximately $92.7 million under the current and prior repurchase plans.  In July 2005 the Board of Directors authorized a new repurchase program to spend up to $100 million over the next year.

 

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**IssuerPurchases of Equity Securities**

** **
| ** **      | ** ** | ** **       | ** ** | ** **       | ** ** | ** **                | ** ** | ** **               | ** ** |
|-----------------|------------|------------------|------------|------------------|------------|---------------------------|------------|--------------------------|------------|
| ** **      | ** ** | ** **       | ** ** | ** **       | ** ** | **Total Number of**       | ** ** | ** **               | ** ** |
| ** **      | ** ** | ** **       | ** ** | ** **       | ** ** | **Shares Purchased**      | ** ** | **Approximate Dollar**   | ** ** |
| ** **      | ** ** | **Total Number** | ** ** | ** **       | ** ** | **as**                    | ** ** | **Value of Shares**      | ** ** |
| ** **      | ** ** | **of**           | ** ** | **AveragePrice** | ** ** | **Part of Publicly** | ** ** | **that May Yet Be** | ** ** |
| ** **      | ** ** | **Shares**       | ** ** | **Paid**         | ** ** | **Announced Plans or**    | ** ** | **Purchased Under the**  | ** ** |
| **Period**      | ** ** | **Purchased**    | ** ** | **Per Share**    | ** ** | **Programs**              | ** ** | **Plans or Programs**    | ** ** |
| 4/1/05-4/300/05 |       | —           |       | $                | —     |                      | —     |                     | $          | 13,841,000 |   |
| 5/1/05-5/31/05  |       | 284,000          |       | $                | 20.60      |                      | 284,000    |                     | $          | 7,991,000 |   |
| 6/1/05-6/30/05  |       | 153,000          |       | $                | 21.59      |                      | 153,000    |                     | $          | 4,687,000 |   |

 

**Item 3.Defaults Upon Senior Securities**

 

**None.**

 

**Item 4.Submission of Matters to a Vote of Security Holders**

 

The Annual Meeting ofStockholders of Internet Security Systems, Inc. was held on Tuesday, May 24,2005.

 

The following threedirectors were elected to serve a three-year term ending in the year 2008: (a) RichardS. Bodman, 38,961,678 votes for and 3,294,471 votes withheld, (b) Kevin J.O’Connor, 37,258,349 votes for and 4,997,800 votes withheld, and (c) StevenJ. Heyer, 40,555,022 votes for and 1,701,127 votes withheld. Directorscontinuing in office are Robert E. Davoli, Christopher W. Klaus, Thomas E.Noonan, Sam Nunn and David N. Strohm.

 

A proposal was submittedto approve our 2005 Stock Incentive Plan. The 2005 Plan replaces the Restated 1995 Stock Incentive Plan, whichotherwise expires September 6, 2005.The vote was as follows: (a) VotingFor: 23,219,115, (b) Voting Against: 9,444,370, (c) Abstentions:21,149, (d) Broker non-votes: 9,571,515.

 

**Item 5. Other Information**

 

**None.**

 

**Item 6. Exhibits**

 
|   | 10.11  |   |   |   | Employment and Succession Agreement and Full and  Complete Release between Richard Macchia and Internet Security Systems, Inc.  dated May 11, 2005 (incorporated by reference from Exhibit 10.11 to the  Company’s Current Report on Form 8-K filed May 11, 2005). |
|--------|--------|--------|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | 10.12  |   |   |   | Internet Security Systems, Inc. 2005 Stock Incentive  Plan (incorporated by reference from Appendix A to the Company’s Definitive  Proxy Statement filed April 18, 2005).                                                                                          |
|   | 10.13* |   |   |   | Form of Incentive Stock Option Agreement and Notice  of Grant for Employees Under 2005 Stock Incentive Plan.                                                                                                                                                            |
|   | 10.14* |   |   |   | Form of Nonqualified Stock Option Agreement and  Notice of Grant for Employees Under 2005 Stock Incentive Plan.                                                                                                                                                         |
|   | 10.15* |   |   |   | Form of Restricted Stock Award Agreement for  Employees Under 2005 Stock Incentive Plan.                                                                                                                                                                                |
|   | 10.16* |   |   |   | Form of Restricted Stock Unit Award Agreement for  Employees Under 2005 Stock Incentive Plan.                                                                                                                                                                           |
|   | 10.17* |   |   |   | Form of Nonqualified Stock Option Agreement and  Notice of Grant for Directors Under 2005 Stock Incentive Plan.                                                                                                                                                         |
|   | 10.18* |   |   |   | Form of Restricted Stock Award Agreement for  Directors Under 2005 Stock Incentive Plan.                                                                                                                                                                                |
|   | 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 this Form 10-Q.                                                                                                     |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                           |
| **     |   | Data required by  SFAS No. 128, “Earnings Per Share”, is provided in Note 5 to  the consolidated financial statements in this report. |

 

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** **

**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

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

 

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