##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-Q (Mark One)[X]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934For the quarterly period ended June 30, 2004OR[   ]
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934For the transition period fromto
 Commission File Number 000-23655 INTERNET SECURITY SYSTEMS, INC. (Exact name of registrant as specified in its charter) DELAWARE
(State or jurisdiction of
incorporation or organization)
    
    58-2362189
(I.R.S. Employer
Identification No.)
 6303 BARFIELD ROAD, ATLANTA, GEORGIA 30328
(Address of principal executive offices) Registrants telephone number, including area code (404) 236-2600 Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [   ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [   ] Indicate the number of shares outstanding of each of the registrants
classes of common stock, as of the latest practicable date. Number of SharesOutstandingTitle of each class of common stock
    
    as of July 31, 2004Common stock, $0.001 par value
    
    47,218,678




---



PAGENUMBERPART I  FINANCIAL INFORMATIONItem 1
    
    Consolidated Financial Statements:Consolidated Balance Sheets at June 30, 2004 and December
31, 2003
    
    3Consolidated Statements of Operations for the three
months and six months ended June 30, 2004 and June 30,
2003
    
    4Consolidated Statements of Cash Flows for the six months
ended June 30, 2004 and June 30, 2003
    
    5Notes to Consolidated Financial Statements
    
    6Item 2
    
    Managements Discussion and Analysis of Financial
Condition and Results of Operations
    
    12Item 3
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    26Item 4
    
    Controls and Procedures
    
    26PART II - OTHER INFORMATIONItem 1
    
    Legal Proceedings
    
    27Item 2
    
    Changes in Securities, Use of Proceeds and Issuer
Purchases of Equity Securities
    
    27Item 4
    
    Submission of Matters to a Vote of Security Holders
    
    27Item 6
    
    Exhibits and Reports on Form 8-K
    
    27EX-31.1 SECTION 302 CERTIFICATION OF THE CEOEX-31.2 SECTION 302 CERTIFICATION OF THE CFOEX-32.1 SECTION 906 CERTIFICATION OF THE CEOEX-32.2 SECTION 906 CERTIFICATION OF THE CFO
  2




---



##### Table of Contents



PART I. FINANCIAL INFORMATION 
 Item 1. Consolidated Financial Statements INTERNET SECURITY SYSTEMS, INC. 
 CONSOLIDATED BALANCE SHEETS
 June 30,
    
    December 31,2004
    
    2003(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    120,383
    
    
    $
    184,551Marketable securities
    
    
    74,905
    
    
    
    53,630Accounts receivable, less allowance for doubtful accounts
of $3,011 and $2,755, respectively
    
    
    65,973
    
    
    
    66,588Inventory
    
    
    1,580
    
    
    
    750Prepaid expenses and other current assets
    
    
    10,499
    
    
    
    10,732Total current assets
    
    
    273,340
    
    
    
    316,251Property and equipment:Computer equipment and software
    
    
    53,550
    
    
    
    45,261Office furniture and equipment
    
    
    21,728
    
    
    
    21,311Leasehold improvements
    
    
    21,603
    
    
    
    21,67496,881
    
    
    
    88,246Less accumulated depreciation
    
    
    59,244
    
    
    
    52,42737,637
    
    
    
    35,819Restricted cash and marketable securities
    
    
    12,760
    
    
    
    12,760Goodwill, less accumulated amortization of $27,381
    
    
    222,240
    
    
    
    201,303Other intangible assets, less accumulated amortization of
$17,045 and $13,499, respectively
    
    
    21,695
    
    
    
    9,728Other assets
    
    
    7,407
    
    
    
    5,421Total assets
    
    $
    575,079
    
    
    $
    581,282LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    5,282
    
    
    $
    5,145Accrued expenses
    
    
    25,459
    
    
    
    26,092Deferred revenues
    
    
    58,790
    
    
    
    55,271Total current liabilities
    
    
    89,531
    
    
    
    86,508Other non-current liabilities
    
    
    5,887
    
    
    
    2,573Deferred revenues, less current portion
    
    
    9,303
    
    
    
    5,858Commitments 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,
50,324,000 and 49,841,000 issued, respectively
    
    
    50
    
    
    
    50Additional paid-in capital
    
    
    486,262
    
    
    
    475,062Deferred compensation
    
    
    (4,391
    )
    
    
    (92
    )Accumulated other comprehensive income
    
    
    2,932
    
    
    
    7,452Retained earnings
    
    
    32,931
    
    
    
    22,251Treasury stock, at cost (3,193,000 and 1,310,000 shares, respectively)
    
    
    (47,426
    )
    
    
    (18,380
    )Total stockholders equity
    
    
    470,358
    
    
    
    486,343Total liabilities and stockholders equity
    
    $
    575,079
    
    
    $
    581,282
 See accompanying notes 3




---



##### Table of Contents



INTERNET SECURITY SYSTEMS, INC. 
 CONSOLIDATED STATEMENTS OF OPERATIONS
 Three months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Revenues:Product licenses and sales
    
    $
    28,851
    
    
    $
    24,349
    
    
    $
    57,636
    
    
    $
    50,613Subscriptions
    
    
    34,267
    
    
    
    27,926
    
    
    
    67,109
    
    
    
    54,824Professional services
    
    
    6,422
    
    
    
    6,850
    
    
    
    11,859
    
    
    
    13,14169,540
    
    
    
    59,125
    
    
    
    136,604
    
    
    
    118,578Costs and expenses:Cost of revenues:Product licenses and sales
    
    
    4,948
    
    
    
    1,804
    
    
    
    9,056
    
    
    
    3,245Subscriptions and professional services
    
    
    12,546
    
    
    
    12,539
    
    
    
    24,219
    
    
    
    24,887Total cost of revenues
    
    
    17,494
    
    
    
    14,343
    
    
    
    33,275
    
    
    
    28,132Research and development
    
    
    11,446
    
    
    
    10,121
    
    
    
    22,697
    
    
    
    19,792Sales and marketing
    
    
    24,116
    
    
    
    20,995
    
    
    
    48,470
    
    
    
    42,171General and administrative
    
    
    6,342
    
    
    
    5,439
    
    
    
    12,593
    
    
    
    10,979Amortization of other intangibles and stock-based
compensation
    
    
    1,844
    
    
    
    1,325
    
    
    
    3,618
    
    
    
    2,72961,242
    
    
    
    52,223
    
    
    
    120,653
    
    
    
    103,803Operating income
    
    
    8,298
    
    
    
    6,902
    
    
    
    15,951
    
    
    
    14,775Interest income
    
    
    464
    
    
    
    737
    
    
    
    992
    
    
    
    1,380Minority interest
    
    
    (284
    )
    
    
    (14
    )
    
    
    (411
    )
    
    
    (102
    )Other income
    
    
    160
    
    
    
    9
    
    
    
    217
    
    
    
    33Foreign currency exchange gain (loss)
    
    
    (72
    )
    
    
    225
    
    
    
    5
    
    
    
    469Income before income taxes
    
    
    8,566
    
    
    
    7,859
    
    
    
    16,754
    
    
    
    16,555Provision for income taxes
    
    
    3,106
    
    
    
    2,968
    
    
    
    6,074
    
    
    
    6,302Net income
    
    $
    5,460
    
    
    $
    4,891
    
    
    $
    10,680
    
    
    $
    10,253Basic net income per share of Common Stock
    
    $
    0.11
    
    
    $
    0.10
    
    
    $
    0.22
    
    
    $
    0.21Diluted net income per share of Common Stock
    
    $
    0.11
    
    
    $
    0.10
    
    
    $
    0.22
    
    
    $
    0.21Weighted average shares:Basic
    
    
    47,654
    
    
    
    49,510
    
    
    
    48,064
    
    
    
    49,249Diluted
    
    
    48,756
    
    
    
    50,452
    
    
    
    49,366
    
    
    
    49,934
 See accompanying notes 4




---



##### Table of Contents



INTERNET SECURITY SYSTEMS, INC. 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 Six months endedJune 30,2004
    
    2003Operating activitiesNet income
    
    $
    10,680
    
    
    $
    10,253Adjustments to reconcile net income to net cash provided by operating activities:Depreciation
    
    
    6,817
    
    
    
    7,296Amortization of other intangibles and stock-based compensation
    
    
    3,618
    
    
    
    2,729Accretion of discount on marketable securities
    
    
    (4
    )
    
    
    117Minority interest
    
    
    411
    
    
    
    102Deferred compensation expense
    
    
    925
    
    
    
    Income tax benefit from exercise of stock options
    
    
    4,694
    
    
    
    5,492Gain on issuance of subsidiary stock
    
    
    (240
    )
    
    
    (66
    )Changes in assets and liabilities, excluding the effects of acquisitions:Accounts receivable
    
    
    1,377
    
    
    
    5,389Inventory
    
    
    (830
    )
    
    
    605Prepaid expenses and other assets
    
    
    (1,809
    )
    
    
    (1,214
    )Accounts payable and accrued expenses
    
    
    (2,007
    )
    
    
    (805
    )Deferred revenues
    
    
    4,479
    
    
    
    (2,467
    )Net cash provided by operating activities
    
    
    28,111
    
    
    
    27,431Investing activitiesAcquisitions, net of cash received
    
    
    (34,022
    )
    
    
    Purchases of marketable securities
    
    
    (40,850
    )
    
    
    (37,867
    )Net proceeds from maturity of marketable securities
    
    
    19,579
    
    
    
    31,563Release of restricted cash and marketable securities
    
    
    
    
    
    
    565Purchases of property and equipment
    
    
    (8,182
    )
    
    
    (4,394
    )Net proceeds from issuance of subsidiary stock
    
    
    373
    
    
    
    97Net cash used in investing activities
    
    
    (63,102
    )
    
    
    (10,036
    )Financing activitiesProceeds from exercise of stock options
    
    
    1,175
    
    
    
    317Proceeds from employee stock purchase plan
    
    
    750
    
    
    
    853Purchases of treasury stock
    
    
    (29,046
    )
    
    
    (2,145
    )Net cash used in financing activities
    
    
    (27,121
    )
    
    
    (975
    )Foreign currency impact on cash
    
    
    (2,056
    )
    
    
    751Net increase (decrease) in cash and cash equivalents
    
    
    (64,168
    )
    
    
    17,171Cash and cash equivalents at beginning of period
    
    
    184,551
    
    
    
    148,317Cash and cash equivalents at end of period
    
    $
    120,383
    
    
    $
    165,488Supplemental cash flow disclosureIncome taxes paid
    
    $
    1,872
    
    
    $
    590
 See accompanying notes 5




---



##### Table of Contents



INTERNET SECURITY SYSTEMS, INC. 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 Note 1. Significant Accounting Policies Basis of Presentation The consolidated financial statements of Internet Security Systems, Inc.
(ISS or the Company) as of June 30, 2004 and for the three months and six
months ended June 30, 2004 and 2003 are unaudited and, in the opinion of
management, contain all adjustments, consisting of normal recurring items,
necessary for the fair presentation of the financial position and results of
operations of the Company for the interim periods. The consolidated financial
statements include the accounts of the Company and its majority-owned
subsidiaries. The consolidated balance sheet at December 31, 2003 has been
derived from the audited financial statements at that date but does not include
all of the footnotes required by accounting principles generally accepted in
the United States for complete financial statements. These consolidated financial statements should be read in conjunction with
the Consolidated Financial Statements and Notes thereto included in the
Companys Annual Report on Form 10-K for the year ended December 31, 2003. The
results of operations for the three months and six months ended June 30, 2004
are not necessarily indicative of the results to be expected for the entire
year. All significant intercompany accounts and transactions have been
eliminated. Certain prior period amounts have been reclassified to conform to current
period presentation. The preparation of financial statements and related disclosures in
conformity with accounting principles generally accepted in the United States
requires management to make estimates and assumptions that affect the amounts
reported in the financial statements and accompanying notes. Actual results may
differ from those estimates, and such differences may be material to the
consolidated financial statements. Goodwill and Intangibles Goodwill and intangible assets are comprised of the following, as of the
dates indicated (in thousands): June 30, 2004
    
    December 31, 2003Gross Carrying
    
    Accumulated
    
    Gross Carrying
    
    AccumulatedAmount
    
    Amortization
    
    Amount
    
    AmortizationGoodwill
    
    $
    249,621
    
    
    $
    (27,381
    )
    
    $
    228,684
    
    
    $
    (27,381
    )Amortized intangible assets:Core technology
    
    
    3,853
    
    
    
    (2,761
    )
    
    
    3,853
    
    
    
    (2,521
    )Developed technology
    
    
    32,837
    
    
    
    (12,657
    )
    
    
    17,808
    
    
    
    (9,576
    )Customer relationships
    
    
    2,050
    
    
    
    (1,627
    )
    
    
    1,566
    
    
    
    (1,402
    )Total
    
    $
    38,740
    
    
    $
    (17,045
    )
    
    $
    23,227
    
    
    $
    (13,499
    )
 The changes in the carrying amounts of goodwill and other intangibles from
December 31, 2003 to June 30, 2004 were primarily a result of the purchase of
Cobion AG (Cobion) (see Note 3) and additional consideration related to a
2002 acquisition of TriSecurity Holdings Pte Ltd., resulting in approximately
$22.3 million of goodwill and $16.5 million of other intangibles recorded
during the first quarter of 2004. The remaining fluctuation is the result of
currency translation adjustments. The Company amortizes intangible assets over their estimated useful lives
of eight years for core technology, five years for developed technology, three
to six years for work force and three years for customer relationships.
Amortization expense of intangible assets is as follows (in thousands): Three months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Core technology
    
    $
    120
    
    
    $
    119
    
    
    $
    240
    
    
    $
    239Developed technology
    
    
    1,583
    
    
    
    891
    
    
    
    3,081
    
    
    
    1,781Work force
    
    
    
    
    
    
    109
    
    
    
    
    
    
    
    218Customer relationships
    
    
    100
    
    
    
    128
    
    
    
    225
    
    
    
    257Total
    
    $
    1,803
    
    
    $
    1,247
    
    
    $
    3,546
    
    
    $
    2,495
 6




---



##### Table of Contents



The estimated future amortization expense of intangible assets as of June
30, 2004 is as follows (in thousands): AmountYear ending December 31,2004 (six months)
    
    $
    3,5282005
    
    
    7,0562006
    
    
    4,9482007
    
    
    3,0062008
    
    
    3,157Total
    
    $
    21,695
 The
Company amortized $375,000 relating to the purchase of a software
license used in certain of its products. Those costs are included in
research and development expense. Stock-Based Compensation Statement of Financial Accounting Standard 123, Accounting for
Stock-Based Compensation(SFAS 123), as amended by SFAS 148, Accounting for
Stock-Based Compensation - Transition and Disclosure,establishes accounting
and reporting standards for stock-based employee compensation plans. As
permitted by SFAS 123, ISS continues to account for stock-based compensation in
accordance with Accounting Principles Board Opinion No. 25, Accounting for
Stock Issued to Employees(APB 25), and has elected the pro forma disclosure
alternative of SFAS 123. Although SFAS 123 allows the Company to continue to follow APB 25
guidelines, the following table shows pro forma net loss and pro forma net loss
per share for the periods indicated as if the Company had adopted SFAS 123. The
following table illustrates the effect on net income per share if the
provisions of SFAS 123 had been applied. The pro forma impact of applying SFAS
123 as illustrated below will not necessarily be representative of the pro
forma impact in future years. Pro forma information is as follows (amounts in
thousands, except per share amounts): Three months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net income, as reported
    
    $
    5,460
    
    
    $
    4,891
    
    
    $
    10,680
    
    
    $
    10,253Add:
Amortization of deferred compensation included in reported net income,
net of income taxes
    
    
    344
    
    
    
    
    
    
    
    590
    
    
    
    Less:
Stock-based compensation expense computed under the Fair Value
method, net of income taxes
    
    
    (5,688
    )
    
    
    (7,797
    )
    
    
    (12,356
    )
    
    
    (14,439
    )Pro forma net income (loss)
    
    $
    116
    
    
    $
    (2,906
    )
    
    $
    (1,086
    )
    
    $
    (4,186
    )Basic net income per share of Common
Stock, as reported
    
    $
    0.11
    
    
    $
    0.10
    
    
    $
    0.22
    
    
    $
    0.21Diluted net income per share of
Common Stock, as reported
    
    $
    0.11
    
    
    $
    0.10
    
    
    $
    0.22
    
    
    $
    0.21Pro forma basic and diluted net loss per
share of Common Stock
    
    $
    (0.00
    )
    
    $
    (0.06
    )
    
    $
    (0.02
    )
    
    $
    (0.08
    )
 In
2004, 295,000 restricted shares were issued to
officers and certain key employees of ISS. These shares vest in two
installments: 50% vests two years from the grant date, and the remaining 50%
vests three years from the grant date. Upon issuance of restricted shares,
unearned compensation is recorded in stockholders equity as deferred
compensation equal to the market value of the restricted shares and is
recognized as compensation expense over the vesting period.
Total compensation expense for restricted stock awards, including the expense
for 13,000 restricted shares issued to directors in 2003, amounted to $539,000
in the second quarter of 2004 and $925,000 in the six months ended June 30,
2004. Note 2. Income Taxes The Company recorded tax provisions of $3.1 million and $3.0 million for
the three-month periods ended June 30, 2004 and 2003, respectively, and tax
provisions of $6.1 million and $6.3 million for the six-month periods ended
June 30, 2004 and 2003, respectively. While income tax expense was recorded on
domestic income, the amount of domestic taxes payable was reduced by deductions
related to the employee exercise of stock options in current and prior periods.
The tax benefit of these deductions was 7




---



##### Table of Contents



recorded as additional paid-in capital. Taxes paid generally relate to
foreign operations and certain state taxes for which net operating loss
deductions have been suspended. The effective tax rate was approximately 36% for the three and six months
ended June 30, 2004 and 38% for the three and six months ended June 30, 2003.
The effective rates differ from the statutory rates due primarily to the impact
of acquisition-related intangibles that are not deductible for income tax
purposes. As of June 30, 2004, ISS had a net operating loss carryforward of
approximately $7.5 million related to US operations. The tax benefit of this
carryforward will be recorded as additional paid-in capital as realized. There
are also approximately $8.3 million of research and development tax credit
carryforwards that expire between 2011 and 2023 and foreign tax credit
carryforwards of $2.9 million that expire between 2006 and 2008. In addition, Cobion, which was acquired by ISS in January 2004, has a net
operating loss carryforward of approximately $9.1 million. The tax value of
this loss has been recorded as a deferred tax asset and the Company will not
recognize a provisional benefit as this loss is utilized. Note 3. Business Acquisition In January 2004, ISS acquired Cobion, a privately held company based in
Kassel, Germany. Cobion provides content filtering and anti-spam technology
that protects individuals and enterprises against unwanted Web content, spam,
misuse of information and lost productivity. The Company is continuing to sell
the Cobion product on a stand-alone basis as well as including the technology
in the Companys multi-function Proventia appliance. Total cash consideration for all of the outstanding shares of Cobion and
the acquisition related fees were approximately $33.5 million. The Company
adopted a plan to restructure Cobion whereby certain Cobion employees were
terminated over a six-month period following the acquisition. As a result,
acquisition costs included the accrual of $203,000 of severance costs
associated with these terminations. As of June 30, 2004, approximately $95,000
remained in the accrual and will be paid out during the third quarter of 2004. The operating results of Cobion are included in the consolidated financial
statements of ISS from the date of acquisition. The adjusted aggregate purchase
price was allocated based on a valuation report of the Cobion intangibles as
follows (in thousands): Net tangible liabilities of Cobion
    
    $
    (2,736
    )Developed technology
    
    
    16,030Customer relationships
    
    
    516Deferred income taxes
    
    
    (2,655
    )Goodwill
    
    
    22,359$
    33,514
 The
Company is amortizing these intangible assets over their estimated
useful lives of five years for developed technology and three years for
customer relationships. The tangible assets of Cobion acquired in the merger consisted primarily
of cash, accounts receivable and fixed assets. The liabilities of Cobion
assumed in the merger consisted primarily of accounts payable, accrued expenses
and deferred revenue. The following summarizes the unaudited pro forma results of operations of
the Company for the three months and six months ended June 30, 2003, assuming
the acquisition of Cobion was concluded as of the beginning of 2003: (i)
revenues of $59.3 million and $119.0 million, respectively, (ii) net income of
$4.1 million and $8.1 million, respectively (iii) basic and diluted net income
per share of Common Stock of $.08 and $0.16, respectively. Net income and
basic and diluted net income per share of Common Stock have been adjusted to
reflect the amortization of intangibles identified above. Unaudited pro forma
results are not included for the corresponding period of 2004 as the impact of
the acquisition would have been immaterial to the consolidated results of
operations. This pro forma information is not necessarily indicative of what
combined operations would have been if ISS had control of Cobion from the
beginning of 2003. 8




---



##### Table of Contents



Note 4. Comprehensive Income The components of comprehensive income are as follows (in thousands): Three months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net income, as reported
    
    $
    5,460
    
    
    $
    4,891
    
    
    $
    10,680
    
    
    $
    10,253Change in cumulative translation adjustment
    
    
    (3,741
    )
    
    
    1,066
    
    
    
    (4,520
    )
    
    
    717Comprehensive income
    
    $
    1,719
    
    
    $
    5,957
    
    
    $
    6,160
    
    
    $
    10,970
 Note 5. Income per Share The following table sets forth the computation of basic and diluted net income
per share (amounts in thousands, except per share amounts): Three months ended
    
    Three months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Numerator:Net income
    
    $
    5,460
    
    
    $
    4,891
    
    
    $
    10,680
    
    
    $
    10,253Denominator:Denominator for basic net
income per share -  weighted
average shares
    
    
    47,654
    
    
    
    49,510
    
    
    
    48,064
    
    
    
    49,249Effect of dilutive stock options
    
    
    1,102
    
    
    
    942
    
    
    
    1,302
    
    
    
    685Denominator for diluted net
income per share - weighted
average shares
    
    
    48,756
    
    
    
    50,452
    
    
    
    49,366
    
    
    
    49,934Basic net income per share
    
    $
    0.11
    
    
    $
    0.10
    
    
    $
    0.22
    
    
    $
    0.21Diluted net income per share
    
    $
    0.11
    
    
    $
    0.10
    
    
    $
    0.22
    
    
    $
    0.21
 Note 6. Segment and Geographic Information ISS conducts business in one operating segment: providing information
security management solutions. The Company does, however, prepare operating
results for internal use on a geographic basis. These geographical based
operating costs consist of direct sales expenses, infrastructure to support its
employee and customer and partner base, supporting billing and financial
systems and a management team. Corporate expenses that are not charged directly
to the other segments include research and development, general and
administrative costs that support the global organization, amortization of
intangibles, stock-based compensation and goodwill and costs that are one-time
in nature, such as acquired in-process research and development. The accounting policies of the segments are the same as those described in
the summary of significant accounting policies. There are no inter-segment
sales. Our chief executive officer and chief financial officer evaluate
performance based on operating profit or loss from operations, and trade
accounts receivable for each segment. Other than trade accounts receivable,
assets and liabilities are not discretely allocated or reviewed by segment. In accordance with SFAS No. 131, Disclosures about Segments of an
Enterprise and Related Information, the Company has included a summary of the
segment financial information reported internally. The geographic segments are
the Americas, Europe, Middle East and Africa (EMEA), and the Asia/Pacific
region. The following table presents ISSs revenues, operating expenses and
operating income (loss) by reportable geographic segment (in thousands): As of and for the three months endedJune 30, 2004Americas
    
    EMEA
    
    Asia/Pac
    
    Unallocated
    
    TotalRevenues from external customers:Product licenses
and sales
    
    $
    18,164
    
    
    $
    6,922
    
    
    $
    3,765
    
    
    $
    
    
    
    $
    28,851
 9




---



##### Table of Contents



As of and for the three months endedJune 30, 2004Americas
    
    EMEA
    
    Asia/Pac
    
    Unallocated
    
    TotalSubscriptions
    
    
    23,519
    
    
    
    7,101
    
    
    
    3,647
    
    
    
    
    
    
    
    34,267Professional services
    
    
    3,920
    
    
    
    930
    
    
    
    1,572
    
    
    
    
    
    
    
    6,422Total revenue
    
    
    45,603
    
    
    
    14,953
    
    
    
    8,984
    
    
    
    
    
    
    
    69,540Cost of revenues:Product licenses and sales
    
    
    3,306
    
    
    
    990
    
    
    
    652
    
    
    
    
    
    
    
    4,948Subscriptions and professional
services
    
    
    8,429
    
    
    
    1,397
    
    
    
    2,720
    
    
    
    
    
    
    
    12,546Total cost of revenues
    
    
    11,735
    
    
    
    2,387
    
    
    
    3,372
    
    
    
    
    
    
    
    17,494Operating expenses
    
    
    15,539
    
    
    
    6,394
    
    
    
    2,183
    
    
    
    19,632
    
    
    
    43,748Total expenses
    
    
    27,274
    
    
    
    8,781
    
    
    
    5,555
    
    
    
    19,632
    
    
    
    61,242Segment operating income (loss)
    
    $
    18,329
    
    
    $
    6,172
    
    
    $
    3,429
    
    
    $
    (19,632
    )
    
    $
    8,298Accounts receivable, net
    
    $
    40,656
    
    
    $
    15,098
    
    
    $
    10,219
    
    
    $
    
    
    
    $
    65,973Property and equipment, net
    
    $
    30,174
    
    
    $
    1,722
    
    
    $
    5,741
    
    
    $
    
    
    
    $
    37,637
 As of and for the three months endedJune 30, 2003Americas
    
    EMEA
    
    Asia/Pac
    
    Unallocated
    
    TotalRevenues from external customers:Product licenses
and sales
    
    $
    17,002
    
    
    $
    4,248
    
    
    $
    3,099
    
    
    $
    
    
    
    $
    24,349Subscriptions
    
    
    20,434
    
    
    
    4,891
    
    
    
    2,601
    
    
    
    
    
    
    
    27,926Professional services
    
    
    4,529
    
    
    
    1,021
    
    
    
    1,300
    
    
    
    
    
    
    
    6,850Total revenue
    
    
    41,965
    
    
    
    10,160
    
    
    
    7,000
    
    
    
    
    
    
    
    59,125Cost of revenues:Product licenses and sales
    
    
    1,587
    
    
    
    77
    
    
    
    140
    
    
    
    
    
    
    
    1,804Subscriptions and professional
services
    
    
    8,301
    
    
    
    1,842
    
    
    
    2,396
    
    
    
    
    
    
    
    12,539Total cost of revenues
    
    
    9,888
    
    
    
    1,919
    
    
    
    2,536
    
    
    
    
    
    
    
    14,343Operating expenses
    
    
    14,487
    
    
    
    5,054
    
    
    
    1,454
    
    
    
    16,885
    
    
    
    37,880Total expenses
    
    
    24,375
    
    
    
    6,973
    
    
    
    3,990
    
    
    
    16,885
    
    
    
    52,223Segment operating income (loss)
    
    $
    17,590
    
    
    $
    3,187
    
    
    $
    3,010
    
    
    $
    (16,885
    )
    
    $
    6,902Accounts receivable, net
    
    $
    31,286
    
    
    $
    9,672
    
    
    $
    10,353
    
    
    $
    
    
    
    $
    51,311Property and equipment, net
    
    $
    31,040
    
    
    $
    1,986
    
    
    $
    5,792
    
    
    $
    
    
    
    $
    38,818
 As of and for the six months endedJune 30, 2004Americas
    
    MEA
    
    Asia/Pac
    
    Unallocated
    
    TotalRevenues from external customers:Product licenses
and sales
    
    $
    35,143
    
    
    $
    14,051
    
    
    $
    8,442
    
    
    $
    
    
    
    $
    57,636Subscriptions
    
    
    46,303
    
    
    
    13,692
    
    
    
    7,114
    
    
    
    
    
    
    
    67,109Professional services
    
    
    7,094
    
    
    
    1,819
    
    
    
    2,946
    
    
    
    
    
    
    
    11,859Total revenue
    
    
    88,540
    
    
    
    29,562
    
    
    
    18,502
    
    
    
    
    
    
    
    136,604Cost of revenues:Product licenses and sales
    
    
    5,782
    
    
    
    1,841
    
    
    
    1,433
    
    
    
    
    
    
    
    9,056Subscriptions and professional
services
    
    
    16,241
    
    
    
    2,658
    
    
    
    5,320
    
    
    
    
    
    
    
    24,219Total cost of revenues
    
    
    22,023
    
    
    
    4,499
    
    
    
    6,753
    
    
    
    
    
    
    
    33,275Operating expenses
    
    
    30,962
    
    
    
    13,389
    
    
    
    4,119
    
    
    
    38,908
    
    
    
    87,378Total expenses
    
    
    52,985
    
    
    
    17,888
    
    
    
    10,872
    
    
    
    38,908

    
    
    
    120,653Segment operating income (loss)
    
    $
    35,555
    
    
    $
    11,674
    
    
    $
    7,630
    
    
    $
    (38,908
    )
    
    $
    15,951Accounts receivable, net
    
    $
    40,656
    
    
    $
    15,098
    
    
    $
    10,219
    
    
    $
    
    
    
    $
    65,973Property and equipment, net
    
    $
    30,174
    
    
    $
    1,722
    
    
    $
    5,741
    
    
    $
    
    
    
    $
    37,637
 As of and for the six months endedJune 30, 2003Americas
    
    EMEA
    
    Asia/Pac
    
    Unallocated
    
    TotalRevenues from external customers:Product licenses
and sales
    
    $
    35,055
    
    
    $
    9,212
    
    
    $
    6,346
    
    
    $
    
    
    
    $
    50,613Subscriptions
    
    
    40,568
    
    
    
    9,068
    
    
    
    5,188
    
    
    
    
    
    
    
    54,824Professional services
    
    
    8,518
    
    
    
    2,058
    
    
    
    2,565
    
    
    
    
    
    
    
    13,141Total revenue
    
    
    84,141
    
    
    
    20,338
    
    
    
    14,099
    
    
    
    
    
    
    
    118,578Cost of revenues:Product licenses and sales
    
    
    3,003
    
    
    
    77
    
    
    
    165
    
    
    
    
    
    
    
    3,245Subscriptions and professional
services
    
    
    16,536
    
    
    
    3,794
    
    
    
    4,557
    
    
    
    
    
    
    
    24,887Total cost of revenues
    
    
    19,539
    
    
    
    3,871
    
    
    
    4,722
    
    
    
    
    
    
    
    28,132Operating expenses
    
    
    28,775
    
    
    
    10,144
    
    
    
    3,252
    
    
    
    33,500
    
    
    
    75,671
 10




---



##### Table of Contents



As of and for the three months endedJune 30, 2003Americas
    
    EMEA
    
    Asia/Pac
    
    Unallocated
    
    TotalTotal expenses
    
    
    48,314
    
    
    
    14,015
    
    
    
    7,974
    
    
    
    33,500
    
    
    
    103,803Segment operating income (loss)
    
    $
    35,827
    
    
    $
    6,323
    
    
    $
    6,125
    
    
    $
    (33,500
    )
    
    $
    14,775Accounts receivable, net
    
    $
    31,286
    
    
    $
    9,672
    
    
    $
    10,353
    
    
    $
    
    
    
    $
    51,311Property and equipment, net
    
    $
    31,040
    
    
    $
    1,986
    
    
    $
    5,792
    
    
    $
    
    
    
    $
    38,818
 Note 7. Commitments and Contingencies The Company and certain of its officers and directors were named as
defendants in a consolidated amended complaint that was filed in the United
States District Court for the Northern District of Georgia on October 9, 2002.
The lawsuit purported to be brought on behalf of a class of investors who
purchased the Companys stock during the period from April 5, 2001 through
August 14, 2001. The lawsuit alleged violations of the federal securities laws.
On September 3, 2003, the court dismissed, with prejudice, the consolidated
amended complaint and all rights to appeal have expired. Note 8. Exit or Disposal Activities In the fourth quarter of 2003, the Company committed to a plan of cost
reduction and exit activities through the closing of its engineering operations
in Reading, U.K. and Sydney, Australia. At December 31, 2003 the Company had accrued the following costs
associated with these exit activities: one-time termination benefits of
$152,000; contract termination costs of $184,000 and other costs of $31,000.
One-time termination benefits consisted of severance and benefits for
involuntarily terminated employees. The contract termination costs include
costs for remaining lease payments on vacated facilities and costs associated
with vacating the facility. Other costs consisted primarily of write-off of
abandoned fixed assets and the write-off of leasehold improvements related to
the vacated facilities. At June 30, 2004 all of the one-time termination benefits had been paid
out. The remaining liability at June 30, 2004 of approximately $195,000
consists primarily of contract termination costs associated with the final
settlement of the office lease in Reading, U.K. The Company expects to utilize
the remaining balance of the exit costs by December 31, 2004. 11




---



##### Table of Contents



INTERNET SECURITY SYSTEMS, INC. 
 Item 2. Managements Discussion and Analysis of Financial Condition and Results
of Operations The following Managements Discussion and Analysis of Financial Condition
and Results of Operations should be read in conjunction with the Consolidated
Financial Statements and related Notes thereto included elsewhere in this
Quarterly Report onForm 10-Q, as well as the Managements Discussion and
Analysis of Financial Condition and Results of Operations and the Consolidated
Financial Statements and Notes thereto included in our Annual Report on Form
10-K for the year ended December 31, 2003 as filed with the Securities and
Exchange Commission (SEC). Except for the historical financial information, many of the matters
discussed in this Item 2 may be considered forward-looking statements.
Forward-looking statements can be identified by the use of words such as may,
will, should, could, continue, future, potential, believe,
project,  forecast, plan, intend, seek, estimate, predict,
expect, anticipate and similar expressions, or the negative of such terms,
or other comparable terminology. Forward-looking statements also include the
assumptions underlying or relating to any of the foregoing statements. Such
forward-looking statements are not guarantees of future performance and involve
a number of risks and uncertainties. Our actual results could differ materially
from those anticipated in these forward-looking statements as a result of
various factors, including those set forth below under the caption Risk
Factors and those otherwise described from time to time in our Securities and
Exchange Commission reports filed after thisForm 10-Q. All forward-looking
statements included in thisForm 10-Qare based on information available to ISS
on the date hereof. We assume no obligation (except where required by law) to
update any forward-looking statements for any events or circumstances occurring
after the date of thisForm 10-Q. Overview We protect gateways, networks, servers and desktops against an
ever-changing spectrum of threats, with a comprehensive line of products and
services designed specifically for the enterprise, service provider, risk
management, small business and consumer markets. These threat protection
solutions go beyond basic access control to deliver multiple layers of defense
that detect, prevent and respond to threats prior to those threats causing
damage to our customers business operations. Our family of products is a critical element of an active Internet and
networking security program within todays world of global connectivity,
enabling organizations to proactively monitor, detect and respond to risks to
enterprise information. Prior to 2003, our products were exclusively software,
providing intrusion detection and vulnerability assessment solutions. In 2003,
we began to sell a new line of products called Proventia, which includes an
appliance pre-loaded and configured with our network-based software solutions
for intrusion detection and in-line intrusion prevention. Initial customer
response has been positive, with this line representing 49% of product and
license sale revenues for the first six months of 2004. We believe this new
product line is critical to our product sales growth and the ongoing
subscription revenues associated with such sales. In the fourth quarter of 2003, our product offerings expanded to include
multi-function Proventia appliances that include firewall, virtual private
network (VPN) and anti-virus protection in addition to intrusion protection.
We added content filtering and anti-spam features to this product line in the
second quarter of 2004. We believe this expanded product offering
significantly increases our market opportunity as well as our risk from broader
competition. While there have been increasing levels of sales of this
multi-function appliance since its introduction in December 2003, our
expectations for future revenue growth are dependent on successfully
penetrating both our existing intrusion protection market and new network
security markets. This product also has a different pricing model than our
traditional pricing models, which results in a more significant portion of the
sales price being deferred and recognized as subscription revenues over a
specified term. Our managed services offerings currently provide remote management of our
best-of-breed security technology, focusing on security assessment and
intrusion protection systems, and include firewalls, VPNs, anti-virus and URL
filtering software. We focus on serving as the trusted security provider to our
customers by maintaining within our existing products the latest
counter-measures to security risks, creating new innovative products based on
our customers needs and providing professional and managed services. Many factors will affect our future financial performance, especially our
ability to differentiate our offerings from competitors that include much
larger companies with greater marketing capabilities, financial resources and
brand recognition. In order to continue to create such differentiation, we
expect to continue to expand the reach of our domestic and international sales
operations through channel partners; seek acquisition candidates and alliances
with partners whose products, technologies or services capabilities are
complementary to our solutions; and improve our internal operating and
financial infrastructure in support of our strategic goals and 12




---



##### Table of Contents



objectives. At the same time, we expect to adjust our organization size in
light of changing economic conditions and maintain emphasis on controlling
current period expenses and capital expenditures. While we believe in the
long-term success of our business solutions our prospects should be considered
in light of the recent experience, risks and uncertainties that are frequently
encountered by companies serving rapidly evolving markets. See Risk Factors. Critical Accounting Policies The consolidated financial statements were prepared in conformity with
accounting principles generally accepted in the United States. As such,
management is required to make certain estimates, judgments and assumptions it
believes are reasonable based upon the information available. These estimates
and assumptions affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported amounts of revenues and
expenses during the periods presented. The significant accounting policies
which management believes are the most critical to aid in fully understanding
and evaluating our reported financial results include the following: Revenue recognition We recognize revenue in the following categories:  -
    
    Product licenses and sales, which include revenue from sales of perpetual
software licenses and products;  -
    
    Subscription revenues, which include product support and content updates,
term licenses, subscription licenses, and managed service arrangements; and  -
    
    Professional services revenues, which includes fee-based service
engagements and training. We recognize software license revenue under Statement of Position (SOP)
97-2, Software Revenue Recognition, as modified by SOP 98-9, Software Revenue
Recognition with Respect to Certain Transactions, when the following criteria
have been met:  -
    
    persuasive evidence of an arrangement exists;  -
    
    delivery has occurred or services have been rendered;  -
    
    price is fixed or determinable; and  -
    
    collection is probable. Product licenses and sales We recognize perpetual software license revenues, assuming all other
revenue recognition criteria are met, upon (1) delivery of the software and (2)
issuance of the related license, assuming that no significant vendor
obligations or customer acceptance rights exist. Where payment terms are
extended over periods greater than 12 months, revenue is recognized as such
amounts become due and payable. Revenue is also deferred when payment terms are
extended for periods less than twelve months and such sales are deemed either
not to be fixed or determinable or collection is not probable based on evaluation
of all terms of the transaction. Product sales consist primarily of appliances
sold in conjunction with ISS licensed software. These sales are recognized upon
shipment to the customer provided all other revenue recognition criteria are
met. Sales of enterprise products are generated both through direct sales to
end-users as well as through various partners, including system integrators,
value-added resellers and distributors. Revenue from product licenses
and sales revenue is recognized when the
sale has occurred for an identified end user, provided all other
revenue recognition criteria are met. At the point of delivery, the
customer has no right of return. Our historical rate of returns by customers of our products is negligible.
We offer evaluation software available via download from our website and
evaluation units for appliance-based products that allow potential customers to
see the functionality of the products on their own networks. Subscription revenues Renewable product support and content updates are separate components of
product licenses and sales. Term licenses allow customers to use our products
and receive product support coverage and content updates for a specified
period, generally 12 months. We generally invoice for product support, content
updates and term licenses at the beginning of the term and recognize revenue 13




---



##### Table of Contents



ratably over the subscription term. Security monitoring and management
services for information assets and systems are part of managed services and
associated revenues are recognized and billed as such services are provided. Historically, our appliance and software sales have been accounted for
primarily as revenue at the time of sale, with product support and content
updates generally representing between 20% and 30% of the license or product
amount. With the introduction of our Proventia multi-function appliances, the
majority of the initial price paid by the customer may be for content provided
for a specified term that will be recorded initially in deferred revenues and
recognized over the term as subscription revenue. Professional services revenues Service engagements are typically billed on either a fixed fee or
time-and-materials basis and primarily consist of security assessments of
customer networks and the development of customers security policies. These
offerings are intended to support our goal of providing products and managed
services. We prefer to have our partners provide these services where
practical. We recognize such professional services revenues as the related
services are rendered. Multiple elements arrangements Multiple element arrangements can include any combination of our products
and services listed above. When some elements are delivered prior to others in
an arrangement, all revenue is deferred until the delivery of the last element
unless all of the following exist:  -
    
    vendor specific objective evidence (VSOE) of fair value of the
undelivered elements;  -
    
    the functionality of the delivered elements is not dependent on the
undelivered elements; and  -
    
    delivery of the delivered elements represents the culmination of the
earnings process. When these criteria have been met, we allocate revenue to the delivered
software product using the residual method. Under the residual method, we
allocate discounts inherent in the arrangement entirely to the product that is
initially delivered and recognize the other elements as they are delivered
based on the VSOE, which is typically determined by the company selling those
elements separately. Allowance for doubtful accounts Our sales are global, with customers located in the Americas, Europe,
Middle East and Africa (EMEA), and Asia/Pacific regions. We perform periodic
credit evaluations of our customers financial condition and do not require
collateral. We provide for estimated credit losses as such losses become
probable. We evaluate specific accounts when we become aware of a situation
where a customer may not be able to meet its financial obligations due to
deterioration of its liquidity or financial viability, credit ratings or
bankruptcy. The allowance for doubtful accounts is established based on the
best facts available to us and is reevaluated and adjusted as additional
information is received. At June 30, 2004, the allowance for doubtful accounts
totaled $3.0 million, or 4.4% of the $69.0 million of total trade receivables.
This 4.4% allowance percentage of receivables reflects our practice to leave
accounts on our general ledger and provide reserves pending final resolution of
collectibility rather than to write-off such accounts. During the second
quarter of 2004 and 2003, we incurred bad debt expense of $240,000 and
$628,000, respectively, and during the first six months of 2004 and 2003, we
incurred bad debt expense of $529,000 and $1.0 million, respectively. While actual credit losses have historically been within managements
expectations and the provisions established, we cannot guarantee that we will
continue to experience the same credit loss rates we have in the past. If the
financial condition of our customers were to deteriorate, resulting in an
impairment of their ability to make payments, additional allowances may be
required. Impairment of goodwill and other long-lived and intangible assets We review goodwill for impairment on an annual basis or on an interim
basis whenever events or changes in circumstances indicate that the carrying
amount of an asset may not be recoverable. All other long-lived and intangible
assets are reviewed for impairment whenever events or circumstances indicate
that the carrying amount of an asset may not be recoverable. Such impairment
loss would be measured as the difference between the carrying amount of the
asset and its fair value based on the present value of 14




---



##### Table of Contents



estimated future cash flows. Significant judgment is required in the
forecasting of future operating results, which are used in the preparation of
projected cash flows. Due to uncertain market conditions and potential changes
in our strategy and products, it is possible that forecasts used to support our
intangible assets may change in the future, which could result in significant
non-cash charges that would adversely affect our results of operations. We currently have goodwill and other acquisition related intangibles of
approximately $250 million, with $195 million of goodwill related to our June
2001 acquisition of Network ICE Corporation (Network ICE) and $22 million of
goodwill related to the January 2004 acquisition of Cobion. The determination
of whether or not goodwill is impaired involves significant judgments based
upon short and long-term projections of future performance. We have concluded
that this amount is realizable based on forecasted discounted cash flows
through 2007 and on our stock market valuation. Neither method indicated that
our goodwill had been impaired and, as a result, we did not record any
impairment losses related to goodwill during the three months or six months
ended June 30, 2004. Other intangibles of approximately $22 million are
principally acquired technology from the Network ICE and Cobion acquisitions
that are a primary component in our current product offerings. Acquisitions We believe that our total solutions approach will positively impact our
revenue. This includes our products, managed services offerings, and product
content and support. While we expect the expansion of these product and service
offerings to originate primarily from internal development, our strategy
includes acquiring products, technologies and service capabilities that fit
within our strategy and could potentially accelerate the timing of the
commercial introduction of such products and technologies. On January 14, 2004, we acquired Cobion, a privately held company based in
Kassel, Germany. Cobion provides content filtering and anti-spam technology
that protects individuals and enterprises against unwanted Web content, spam,
misuse of information and lost productivity. We are continuing to sell the
Cobion product on a stand-alone basis and to OEM partners to incorporate in
their products as well as include the technology in our multi-function
Proventia appliance in 2004. ISS paid cash of approximately $33.5 million for all of the outstanding
shares of Cobion and the acquisition related fees. We also adopted a plan to
restructure Cobion whereby certain Cobion employees were terminated over a
six-month period following the acquisition. As a result, acquisition costs
included the accrual of $203,000 of severance costs associated with these
terminations. As of June 30, 2004, we had paid out the substantial portion of
the severance and will finish paying out the remaining severance of
approximately $95,000 against this accrual in the third quarter of 2004. Results of Operations The following table sets forth our consolidated historical operating
information, as a percentage of total revenues, for the periods indicated: Three months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Consolidated Statements of Operations Data:Product licenses and sales
    
    
    42
    %
    
    
    41
    %
    
    
    42
    %
    
    
    43
    %Subscriptions
    
    
    49
    %
    
    
    47
    %
    
    
    49
    %
    
    
    46
    %Professional services
    
    
    9
    %
    
    
    12
    %
    
    
    9
    %
    
    
    11
    %Total revenues
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Cost of revenues:Product licenses and sales
    
    
    7
    %
    
    
    3
    %
    
    
    6
    %
    
    
    3
    %Subscriptions and
professional services
    
    
    18
    %
    
    
    21
    %
    
    
    18
    %
    
    
    21
    %Total cost of revenues
    
    
    25
    %
    
    
    24
    %
    
    
    24
    %
    
    
    24
    %Research and development
    
    
    16
    %
    
    
    17
    %
    
    
    17
    %
    
    
    17
    %Sales and marketing
    
    
    35
    %
    
    
    36
    %
    
    
    35
    %
    
    
    36
    %General and administrative
    
    
    9
    %
    
    
    9
    %
    
    
    9
    %
    
    
    9
    %Amortization of intangibles and stock-based compensation
    
    
    3
    %
    
    
    2
    %
    
    
    3
    %
    
    
    2
    %Total costs and expenses
    
    
    88
    %
    
    
    88
    %
    
    
    88
    %
    
    
    88
    %Operating income
    
    
    12
    %
    
    
    12
    %
    
    
    12
    %
    
    
    12
    %
 15




---



##### Table of Contents



Revenues Product licenses and sales Product licenses and sales, including perpetual licenses and sales of
partner software and hardware appliances, represented 42% of total revenues for
both the three-month and six-month periods ended June 30, 2004 as compared with
41% and 43% for the three and six month periods ended June 30, 2003. Although
the percentages of total revenue remained comparable, the products making up
this revenue component have changed significantly over the last twelve months. Since the second quarter of 2003, we have offered the Proventia family of
network protection appliances that collectively provides unified,
multi-function protection capabilities designed to identify and prevent many
forms of attack with minimal user intervention. These products are designed to
operate in demanding network environments while being easy to deploy, easy to
use and centrally managed, all in an effort to make our solution more
cost-effective. In the second quarter of 2004, Proventia represented 50% of our
product and license revenues and 49% for the six-month period ended June 30,
2004. We experienced an 18% overall growth in product and license revenues to
$28.9 million over the second quarter of 2003 and a 14% overall growth in
product and license revenues to $57.6 million over the first half of 2003. Our future growth is dependent on a continuation of the positive market
response to our Proventia family of products. During 2004, we expect to extend
Proventia in software form to our server and desktop solutions. This expected
growth is critical as it represents not only product and license revenues, but
also subscription revenues from product support and content. This is
particularly important with respect to our multi-function Proventia appliances
where the majority of the product sale is software blades licensed on a
subscription basis and therefore recognized as subscription revenue over the
license period. Our present product roadmap focuses our development on product offerings
and enhancements that will provide broader Proventia appliance offerings and
continue to improve central control and manageability, easier deployment and
more refined information. We expect that this focus will make our products more
cost effective to implement and maintain and will increase the future level of
product licenses and sales. Subscriptions Subscriptions revenue represented 49% of total revenues in the three
months ended June 30, 2004 increasing from 47% of total revenues in the three
months ended June 30, 2003. This was an increase of 23% from $27.9 million in
the second quarter of 2003 to $34.3 million in the second quarter of 2004. For
the six months ended June 30, 2004, subscriptions revenue increased to 49% of
total revenues from 46% of total revenues in the six months ended June 30,
2003. On a year-to-date basis, there was an increase of 22% from $54.8 million
for the six months ended June 30, 2003 to $67.1 million for the comparable
period of 2004. Subscriptions revenue consists of product support and content updates, term
licenses of products and security-monitoring fees for our managed services
offerings. Product content and support revenues, the largest component of
subscriptions revenue, remained comparable at 31% and 32% of total revenues in
the three months ended June 30, 2004 and 2003, respectively. For the six-month
periods ended June 30, 2004 and 2003, product content and support revenues
remained at 31%. Product content and support includes hardware support of our
Proventia appliances, software updates and software blades, technical support and security content,
which are provided through contracts executed with customers for a specified
term and billed at the time of contract. Such billings are recorded as deferred
revenues on our balance sheet and amortized as subscription revenue over the
term of the contract. We expect product content and support revenues to
increase in the future as our client base that generates product content and
support revenues expands as a result of the pricing model of our multi-function
Proventia appliance. The majority of the sale amount of our multi-function
Proventia appliances is typically associated with the software blades licensed
on a subscription basis and included as subscription revenues. For the three
months ended June 30, 2004, software license blade sales exceeded the
amortization of blade sales by approximately $200,000. For the six months
ended June 30, 2004 sales of software license blades exceeded the amortization
of blades by approximately $1,565,000. Managed services revenue accounted for 13% of total revenues for both the
three months and six months ended June 30, 2004, as compared with 11% in the
corresponding periods of 2003. We believe these increases were due to a strong
demand in the market for proven, financially sound, managed security service
providers. We are marketing managed services both directly to end users and
through partners, including a number of new arrangements with integrators and
service providers that include managed services as a part of their service
offerings to their customers. We also expect sales of managed services to
continue to grow steadily as we focus our efforts on marketing offerings to new
and existing customers that meet changing needs in todays environment. 16




---



##### Table of Contents



Professional services Professional services revenue decreased both in absolute dollars and as a
percentage of total revenues from 12% in the three months ended June 30, 2003
to 9% in the three months ended June 30, 2004 and from 11% in the six months
ended June 30, 2003 to 9% in the six months ended June 30, 2004. This trend is
largely the result of our conscious effort to look to our system integration
and channel partners to serve as the primary resource to fulfill the services
and education needs of our customers. Geographic regions Geographically, we derived the majority of our revenues from sales to
customers within the Americas region. Revenues by region represented the
following percentages of total revenues for the periods indicated: Three months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Americas
    
    
    65
    %
    
    
    71
    %
    
    
    65
    %
    
    
    71
    %EMEA
    
    
    22
    %
    
    
    17
    %
    
    
    22
    %
    
    
    17
    %Asia/Pacific Rim
    
    
    13
    %
    
    
    12
    %
    
    
    13
    %
    
    
    12
    %
 While there have been changes in the proportion of revenues generated by
each region, all of the regions experienced growth in revenues when comparing
both the three and six-month periods ended June 30, 2004 and 2003. Revenues in
EMEA benefited not only from volume growth, but also from a strengthening
currency over the last twelve months, since products are primarily sold in the
Euro. The financial data for each segment can be found in Note 6 to the
Consolidated Financial Statements. Costs and Expenses Personnel Personnel and related costs represent our largest expense category. We
ended the first half of 2004 with 1,220 employees, up from 1,150 at the
beginning of the year. This increase occurred primarily from the January 2004
acquisition of Cobion. We began to use restricted stock, in addition to stock
options, as an equity component of compensation beginning in the first quarter
of 2004 and expensed $539,000 in the second quarter of 2004 and $925,000 in the
first half of 2004 in the expense category in which the recipients are
included. Cost of product licenses and sales Cost of product licenses and sales consists of several components. Costs
associated with licensing our software products are minor. The substantial
portion of our cost of product licenses and sales represents the hardware cost
of our Proventia appliances and payments to partners for their products that we
sell or integrate with our managed service offerings. This cost, as a
percentage of product licenses and sales revenue, increased from 7% in the
quarter ended June 30, 2003 to 17% in the quarter ended June 30, 2004. On a
year-to-date basis, cost of product licenses and sales increased from 6% of
product licenses and sales revenue in 2003 to 16% in 2004. The increase is due
to the introduction of the Proventia appliance line beginning in the second
quarter of 2003 and we expect the cost of product licenses and sales to
continue to increase in future periods with the continued growth of Proventia
appliance sales. Cost of subscriptions and professional services Cost of subscriptions and professional services includes the cost of our
technical support personnel who provide assistance to customers under product
support agreements, the security operations center costs of providing managed
security monitoring services and the costs related to our professional services
and training. These costs, as a percentage of subscription and professional
services revenues, decreased from 36% and 37% in the three and six months ended
June 30, 2003, respectively, to 31% in both the three and six months ended June
30, 2004 as the result of higher subscription revenues from Proventia
sales and cost efficiencies. Costs associated with our technical support personnel and our security
operations centers increased as we added personnel to handle additional
customers. We gained efficiencies in our security operations centers and
restructured our support groups to be more productive so personnel increased at
a much lower rate than revenue growth, contributing to the decrease in those
costs as a percentage of total revenues. While we continue to seek increased
productivity, we do expect to increase costs with a continued increase in
revenues in the future. 17




---



##### Table of Contents



Offsetting this increase of costs associated with our technical support
personnel and our security operations centers is a decrease in costs
commensurate with the decrease in professional services and education services
revenues Research and development Research and development expenses consist of salary and related costs of
research and development personnel, including costs for employee benefits, and
depreciation on computer equipment. These costs include those associated with
maintaining and expanding the X-Force, our internal team of security experts.
We believe our primary research and product development and managed service
offerings are important to retaining our leadership position in the market. We continue to add functionality to our product family, providing gateway,
network, server and desktop-based solutions, as well as to our security
management applications. These improvements, as well as new offerings, are
intended to provide our customers with more powerful and easier-to-use
solutions for security management across the enterprise. In the first half of 2004, we introduced the following:  
    
    Proventia G1200 and G1200-400 Intrusion Prevention Appliances,
designed specifically for highly centralized and space-limited network
environments.  
    
    Proventia M30 and M10 Multi-Function Protection Appliance, an
all-in-one appliance that identifies and blocks known and unknown
threats, as well as unwanted traffic, in a single easy-to-use and
manage device. Research and development expenses increased in absolute dollars from $10.1
million in the three months ended June 30, 2003 to $11.4 million in the three
months ended June 30, 2004 and represented 17% and 16% of total revenues,
respectively. On a year-to-date basis, these costs increased in absolute
dollars from $19.8 million in the first half of 2003 to $22.7 million in the
first half of 2004 and represented 17% of total revenues in both periods. The
increase in absolute dollars is principally due to the acquisition of Cobion
and the amortization of development source code that was licensed in the first
quarter of 2004 and is used in our Proventia products. Additionally, we
continue to streamline operations as we relocated some engineering functions
from our California development facility to Atlanta and offshore with some
further streamlining scheduled for the third quarter of 2004. While we are committed to continue our investment in X-Force research and
development capabilities, which we believe distinguishes ISS from its
competitors, we intend to seek leverage in future periods in the research and
development area while enhancing current technologies and developing new
technologies. Sales and marketing Sales and marketing expenses consist of salaries, travel expenses,
commissions, advertising, maintenance of our website, trade show expenses,
costs of recruiting sales and marketing personnel and costs of marketing
materials. Sales and marketing expenses increased in absolute dollars from
$21.0 million in the three months ended June 30, 2003 and $42.2 million in the
six months ended June 30, 2003 to $24.1 million and $48.5 million,
respectively, in the corresponding periods of 2004. As a percentage of total
revenues, sales and marketing expenses decreased from 36% in the three and six
months ended June 30, 2003 to 35% in the comparable periods of 2004. This
increase in absolute dollars is due to an increase in our overall sales
headcount. In addition, the 18% increase in product licenses and sales revenue
from the second quarter of 2003 to the comparable period of 2004 resulted in
increased commission expense. We expect to achieve leverage in our sales efforts by focusing our direct
touch sales force on large customers that are served either directly by us or
through large systems integrators. Our channel, which includes systems
integrators, value-added resellers and distributors, will continue to be of
increasing importance to us. We intend to expand the number of partners and use
their capabilities to sell to smaller companies and departments of
larger companies, as well as extend our reach to larger enterprises
through joint selling efforts. General and administrative General and administrative expenses consist of personnel-related costs for
executive, administrative, finance and human resources, internal information
systems and other support services costs, and legal, accounting and other
professional service fees. 18




---



##### Table of Contents



General and administrative expenses of $6.3 million in the second quarter
of 2004 and $12.6 million in the first half of 2004 and $5.4 million in the
second quarter of 2003 and $11.0 million in the first half of 2003 represented
9% of total revenues in all four periods. The increase in absolute dollars is
the result of increased costs associated with public company matters such as
audit fees and the incremental cost in 2004 of financial control documentation
and testing required by Section 404 of the Sarbanes-Oxley Act of 2002. Amortization We incurred amortization expense related to intangible assets and
stock-based compensation of $1.8 million in the three months ended June 30,
2004 and $1.3 million in the three months ended June 30, 2003. For the
six-month periods, amortization expense was $3.6 million in 2004 and $2.7
million in 2003. These intangible assets and stock-based compensation resulted
from acquisitions accounted for under the purchase method of accounting and are
amortized over their estimated useful lives and vesting period, respectively.
The increase is a result of the amortization of intangibles related to our
acquisition of Cobion in the first quarter of 2004. Interest income Interest
income decreased from $737,000 in the quarter ended June 30,
2003 to $464,000 in the comparable quarter of 2004 and from $1.4
million in the six months ended June 30, 2003 to $992,000 in the
comparable period of 2004. The difference in interest income results
from our decrease in yield on investment-quality commercial
paper and similar investments from approximately 1.2% in the second
quarter of 2003 to approximately .8% during the second quarter of
2004. This decrease results both from the lower average yield on
securities purchased during the period as well as from the change in
fair market value of marketable securities in anticipation of the
increase in the federal funds rate that occurred June 30, 2004. Provision for income taxes Our effective tax rate was approximately 36% for the three and six months
ended June 30, 2004 and 38% for the three and six months ended June 30, 2003.
The effective rates differ from the statutory rates due primarily to the impact
of acquisition-related intangibles that are not deductible for income tax
purposes. Liquidity and Capital Resources Our financial position remained strong through the first half of 2004. Our
cash and cash equivalents and marketable security investments were $195.3
million at June 30, 2004. Our investments in marketable securities consist
solely of highly rated debt obligations with maturities of 12 months or less. We continue to meet our working capital needs and capital equipment needs
with cash provided by operations. Cash provided by operations in the first six
months of 2004 totaled $28.1 million. The major components of cash flows
provided by operating activities were net income of $10.7 million, non-cash
depreciation and amortization expense charges of $10.4 million, income tax
benefit of $4.7 million from employee exercises of stock options, increase in
deferred revenues of $4.5 million and a decrease in net accounts receivable of
$1.4 million. An important element of our liquidity is the collection of our accounts
receivable. We measure our accounts receivable management by our days sales
outstanding (DSO). This is a measurement of accounts receivable divided by
billings in the quarter, represented by the sum of revenues plus the change in
the deferred revenues liability account balance. This measurement was 87 days
at June 30, 2004, slightly higher than our publicly stated target range of 75
to 85 days. Our net cash used in investing activities of $63.1 million in the first
six months of 2004 resulted primarily from our acquisition of Cobion. The
license for development source code used in our Proventia products was the
primary component of our capital purchases of $8.2 million. Investing
activities also included changes in our marketable securities that have quality
characteristics similar to cash equivalents, except their maturities when we
acquire them are longer than three months. The cash flow statement included the 19




---



##### Table of Contents



purchase of $40.9 million of intermediate term marketable securities,
primarily interest-bearing government obligations and commercial paper, offset
by net proceeds from the maturity of marketable securities of $19.6 million. Our financing activities used $27.1 million of cash in the first six
months of 2004. This was principally due to the repurchase of 1.9 million
shares of our common stock in the open market at an aggregate cost of $29.0
million. Since the inception of this stock repurchase plan, which expired in
July 2004, we have purchased 3.2 million shares at an average cost of $14.85
per share for a total cash outlay of approximately $47.4 million. Also, in July
2004, the Board of Directors authorized a new repurchase program to spend up to
$50 million over the next year. Also, in the first six months of 2004, the
exercise of stock options by our employees and the issuance of common stock
through our employee stock purchase plan generated funds of approximately $1.9
million. We believe our cash and cash equivalents and marketable securities will be
sufficient to meet our working capital needs and capital expenditures for the
foreseeable future. Furthermore, we are not aware of any trends, events, or
uncertainties that are reasonably likely to result in any significant change to
our liquidity. From time to time, we evaluate possible acquisition and
investment opportunities in businesses, products or technologies that are
complementary to ours. In the event we determine to pursue such opportunities,
we may use our available cash and cash equivalents and marketable securities
for this purpose. Off-Balance Sheet Arrangements Payments for certain of our operating leases are secured by two
collateralized stand-by letters of credit totaling approximately $10.3 million
at June 30, 2004. These stand-by letters of credit guarantee our payment
obligations on the leases and are renewable annually over the duration of the
applicable leases. If we default on the lease payments, the landlords can make
a claim against the letters of credit. We, in turn, would be liable to the
letter of credit issuers. Our stand-by letters of credit are collateralized by
securities worth $12.8 million at June 30, 2004. Other than these
non-cancelable operating leases, we have no off-balance sheet financing
arrangements, any relationships with structured finance or special purpose
entities, or any contractual obligations with unconsolidated entities that are
reasonably likely to impact our liquidity. Risk Factors Forward-looking statements are inherently uncertain as they are based on
various expectations and assumptions concerning future events and are subject
to known and unknown risks and uncertainties. Our forward-looking statements
contained in this Quarterly Report on Form 10-Q and elsewhere should be
considered in light of the following important risk factors. Variations from
our stated intentions or failure to achieve objectives could cause actual
results to differ from those projected in our forward-looking statements. With
respect to our Business Outlook published in our earnings press release for the
quarter ended June 30, 2004, you may continue to rely on this Business Outlook
prior to the start of our quiet period for the quarter ending September 30,
2004 (the Q3 Quiet Period), unless we have published a notice stating
otherwise. During the Q3 Quiet Period, ISS and its corporate representatives
will not comment concerning our previously published Business Outlook. During
the Q3 Quiet Period, the Companys press releases and filings with the SEC on
Forms 10-K and 10-Q should be considered historical, speaking as of a date
prior to the Q3 Quiet Period only and not subject to update by the Company.
The Q3 Quiet Period is expected to run from September 15, 2004 until financial
results for the quarter ending September 30, 2004 are expected to be released
in October 2004. There are many factors that affect ISS business and the results of its
operations, some of which are beyond ISS control. The following is a
description of some of the important factors that may cause the actual results
of ISS operations in future periods to differ materially from those currently
expected or desired. We encourage you to read this section carefully. We Operate in a Rapidly Evolving Market We operate in a new and rapidly evolving market and must, among other
things:  
    
    respond to competitive developments;
    
    continue to upgrade and expand our product and services offerings; and
    
    continue to attract, retain and motivate our employees. We cannot be certain that we will successfully address these issues. As a
result, we cannot assure our investors that we will be able to continue to
operate profitably in the future. 20




---



##### Table of Contents



We introduced our new Proventia appliance line, beginning with the A
Series, in April 2003. The G Series and M Series were introduced in the fourth
quarter of 2003. As a result of our limited history with these products, it may
be difficult to plan or project our revenues accurately. The revenue and income
potential of these products is unproven and the markets addressed by these
products are volatile. While initial reaction to these products have had a
positive impact on company results, failure to continue to gain further market
acceptance could result in revenues below our expectations and our operating
results could be adversely affected. Our Future Operating Results Will Likely Fluctuate Significantly We cannot predict our future revenues and operating results with
certainty. However, we do expect our future revenues and operating results to
fluctuate due to a combination of factors, including:  
    
    the growth in the acceptance of, and activity on, the Internet and
the world wide web, particularly by corporate, institutional and
government users;
    
    the extent to which the public perceives that unauthorized access to
and use of online information are threats to network security;
    
    customer budgets;
    
    the mix of product sales among the various products offered by ISS
and whether revenue is recognized upon sale or deferred to subsequent
periods;
    
    the volume and timing of orders, including seasonal trends in
customer purchasing;
    
    our ability to develop new and enhanced product and managed service
offerings and expand our professional services capabilities;
    
    the introduction and acceptance rate of ISS branded appliances, including increased cost of goods sold;
    
    our ability to accurately forecast and produce demanded quantities of our appliance products and models;
    
    availability of component parts of appliance products and reliance on contract manufacturers to produce such products;
    
    our ability to provide scalable managed services offerings through our partners in a cost effective manner;
    
    foreign currency exchange rates that affect our international operations;
    
    product and price competition in our markets; and
    
    general economic conditions, both domestically and in our foreign markets. We increasingly focus our efforts on sales of enterprise-wide security
solutions, which consist of our entire product suite and related professional
services, and managed security services, rather than on the sale of component
products. As a result, each sale requires substantial time and effort from our
sales and support staff. In addition, the revenues associated with particular
sales vary significantly depending on the number of products licensed by a
customer, the number of devices used by the customer and the customers
relative need for our professional services. Large individual sales, or even
small delays in customer orders, can cause significant variation in our license
revenues and results of operations for a particular period. The timing of large
orders is usually difficult to predict and, like many software and services
companies, many of our customers typically complete transactions in the last
month of a quarter. We cannot predict our operating expenses based on our past results.
Instead, we establish our spending levels based in large part on our expected
future revenues. As a result, if our actual revenues in any future period fall
below our expectations, our operating results likely will be adversely affected
because very few of our expenses vary with our revenues. Because of the factors
listed above, we believe that our quarterly and annual revenues, expenses and
operating results likely will vary significantly in the future. 21




---



##### Table of Contents



Our ability to provide timely guidance and meet the expectations of
investors with respect to our operating and financial results is impacted by
the tendency of a majority of our sales to be completed in the last month of a
quarter. We may not be able to determine whether we will experience material
deviations from guidance or expectations until the end of a quarter. Dependence on Third Party Suppliers and Manufacturers We carry little inventory of our appliance products and we rely on
suppliers to deliver necessary components to our contract manufacturers in a
timely manner based on the forecasts we provide. We currently purchase some
Proventia appliance components and contract manufacturing services from single
or limited sources. If shortages occur, supplies are interrupted, or we under
estimate demand for models, we may not be able to deliver products to our
customers and our revenue and operating results would be adversely affected.
Because our supply of hardware is based on short-term forecasts and purchase
orders, our contract manufacturers are not obligated to purchase components for
greater quantities over longer periods. We provide six-month forecasts of our
demand to our contract manufacturers. If we overestimate our requirements, our
contract manufacturers may have excess inventory, which could increase our
costs. If we underestimate our requirements, our contract manufacturers may
have an inadequate component inventory and, based on lead times, this could
interrupt manufacturing and result in delays in shipments and revenues. We Face Intense Competition in Our Market The market for network security monitoring, detection, prevention and response
solutions is intensely competitive, and we expect competition to increase in
the future. We cannot guarantee that we will compete successfully against our
current or potential competitors, especially those with significantly greater
financial resources or brand name recognition. Our chief competitors generally
fall within the following categories:  
    
    large companies, including Symantec Corp., Cisco Systems, Inc.,
Juniper Networks, Inc., and McAfee, Inc., that sell competitive products
and offerings, as well as other large software companies that have the
technical capability and resources to develop competitive products;  
    
    software or hardware network infrastructure companies like Cisco
Systems, Inc. and Juniper Networks, Inc. that could integrate features
that are similar to our products into their own products; and  
    
    relatively smaller software companies offering relatively limited applications for network and Internet security;  
    
    small and large companies with competitive offerings to components of our managed services offerings. Mergers or consolidations among these competitors, or acquisitions of
small competitors by larger companies, represent risks. For example, Symantec
Corp., Cisco Systems, Inc., McAfee, Inc., and Juniper Networks, Inc. have
acquired smaller companies which have intrusion detection or prevention
technologies during the past several years. These acquisitions will make these
entities potentially more formidable competitors to us if such products and
offerings are effectively integrated. Large companies may have advantages over
us because of their longer operating histories, greater name recognition,
larger customer bases or greater financial, technical and marketing resources.
As a result, they may be able to adapt more quickly to new or emerging
technologies and changes in customer requirements. They can also devote greater
resources to the promotion and sale of their products than we can. In addition,
these companies have reduced and could continue to reduce, the price of their
security monitoring, detection, prevention and response products and managed
security services, which increases pricing pressures within our market. Several companies currently sell software products (such as encryption,
firewall, operating system security and virus detection software) that our
customers and potential customers have broadly adopted. Some of these companies
sell products that perform the same functions as some of our products. In
addition, the vendors of operating system software or networking hardware may
enhance their products to include the same kinds of functions that our products
currently provide. The widespread inclusion of comparable features to our
software in operating system software or networking hardware could render our
products less competitive or obsolete, particularly if such features are of a
high quality. Even if security functions integrated into operating system
software or networking hardware are more limited than those of our products, a
significant number of customers may accept more limited functionality to avoid
purchasing additional products. In addition, with the introduction of our multi-function M Series
Proventia appliance, we have offerings that compete with vendors of firewalls,
VPNs, anti-virus systems, and content and spam filtering products. These
offerings are competitive with a broader 22




---



##### Table of Contents



spectrum of network security companies, as well as those that also offer
multi-function appliances or broad product suites, like Symantec Corp. For the above reasons, we may not be able to compete successfully against
our current and future competitors. Increased competition may result in price
reductions, reduced gross margins and loss of market share. We Face Rapid Technological Change in Our Industry and Frequent Introductions
of New Products Rapid changes in technology pose significant risks to us. We do not
control nor can we influence the forces behind these changes, which include:  
    
    the extent to which businesses and others seek to establish more secure networks;  
    
    the extent to which hackers and others seek to compromise secure systems;  
    
    evolving computer hardware and software standards;  
    
    changing customer requirements; and  
    
    frequent introductions of new products and product enhancements. To remain successful, we must continue to change, adapt and improve our
products in response to these and other changes in technology. Our future
success hinges on our ability to both continue to enhance our current line of
products and professional services and to introduce new products and services
that address and respond to innovations in computer hacking, computer
technology and customer requirements. We cannot be sure that we will
successfully develop and market new products that do this. Any failure by us to
timely develop and introduce new products, to enhance our current products or
to expand our professional services capabilities in response to these changes
could adversely affect our business, operating results and financial condition. Our products involve very complex technology and, as a consequence, major
new products and product enhancements require a long time to develop and test
before going to market. Because this amount of time is difficult to estimate,
we have had to delay the scheduled introduction of new and enhanced products in
the past and may have to delay the introduction of new and enhanced products in
the future. The techniques computer hackers use to gain unauthorized access to, or to
sabotage, networks and intranets are constantly evolving and increasingly
sophisticated. Furthermore, because new hacking techniques are usually not
recognized until used against one or more targets, we are unable to anticipate
most new hacking techniques. To the extent that new hacking techniques harm our
customers computer systems or businesses, affected or prospective customers
may believe that our products are ineffective, which may cause them or
prospective customers to reduce or avoid purchases of our products. Undetected Product Errors or Defects Could Result in Loss of Revenues, Delayed
Market Acceptance and Claims Against Us We offer warranties on our products, allowing the end customer to have any
defective product repaired, or to receive a replacement product for it during
the warranty period, or in certain circumstances return the product for a
refund. Our products may contain undetected errors or defects. If there is a
broad product failure across our customer base, we may decide to replace all
affected products or we may decide to refund the purchase price for defective
units. Such defects and actions may adversely affect our ability to record
revenue. Some errors are discovered only after a product has been installed and
used by end customers. Any errors discovered after commercial release could
result in loss of revenues and claims against us. We offer warranties on our 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 fix errors or other product problems that later are
identified after full deployment, or if we fail to meet our service levels for
managed security services, in addition to the consequence described above, we
could experience:  
    
    failure to achieve market acceptance;  
    
    loss of customers; 23




---



##### Table of Contents




    
    loss of or delay in revenues and loss of market share;
    
    diversion of development resources;
    
    increased service and warranty costs;
    
    legal actions by our customers; and
    
    increased insurance costs. Our Products are Complex and Are Operated in a Wide Variety of Computer
Configurations, Which Could Result in Errors or Product Failures Because we offer very complex products, undetected errors, failures or
bugs may occur when they are first introduced or when new versions are
released. Our products often are installed and used in large-scale computing
environments with different operating systems, system management software and
equipment and networking configurations, which may cause errors or failures in
our products or may expose undetected errors, failures or bugs in our products.
We discover software errors, failures and bugs in certain of our product
offerings after their introduction and have experienced delays and could
experience lost revenues during the period required to correct these errors.
Our customers computer environments are often characterized by a wide variety
of standard and non-standard configurations that make pre-release testing for
programming or compatibility errors very difficult and time-consuming. Despite
testing, errors, failures or bugs may not be found in new products or releases
after commencement of commercial shipments. Errors, failures or bugs in
products released by us could result in negative publicity, product returns,
loss of or delay in market acceptance of our products or claims by customers or
others. In addition, if an actual or perceived breach of network security occurs
in one of our end customers security systems, regardless of whether the breach
is attributable to our products, the market perception of the effectiveness of
our products could be harmed. Because the techniques used by computer hackers
to access or sabotage networks change frequently and generally are not
recognized until launched against a target, we may be unable to anticipate
these techniques. Alleviating any of these problems could require significant
expenditures of our capital and resources and could cause interruptions, delays
or cessation of our product licensing, which could cause us to lose existing or
potential customers and would adversely affect results of operations. We Might Have to Defend Lawsuits or Pay Damages in Connection With Any Alleged
or Actual Failure of Our Products and Services Because our products and services provide and monitor network security and
may protect valuable information, we could face claims for product liability,
tort or breach of warranty. Anyone who circumvents our security measures could
misappropriate the confidential information or other property of end customers
using our products, or interrupt their operations. If that happens, affected
end customers or others may sue us. In addition, we may face liability for
breaches caused by faulty installation of our products by our service and
support organizations. Provisions in our contracts relating to warranty
disclaimers and liability limitations may be unenforceable. Some courts, for
example, have found contractual limitations of liability in standard computer
and software contracts 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 coverage may be unavailable on acceptable terms or at all. Risks Associated with Our Global Operations The expansion of our international operations includes our presence in
dispersed locations throughout the world, including throughout EMEA and the
Asia/Pacific and Latin America regions. Our international presence and
expansion exposes us to risks not present in our U.S. operations, such as:  
    
    the difficulty in managing an organization spread over various
countries located across the world;
    
    compliance with, and unexpected changes in, a wide range of complex
regulatory requirements in countries where we do business;
    
    duties and tariffs imposed on importation of our products in other
jurisdictions where other manufacturers may not bear those same costs;
    
    increased financial accounting and reporting burdens;
    
    potentially adverse tax consequences; 24




---



##### Table of Contents




    
    fluctuations in foreign currency exchange rates resulting in losses
or gains from transactions and expenses denominated in foreign
currencies;
    
    reduced protection for intellectual property rights in some countries;
    
    reduced protection for enforcement of creditor and contractual rights in some countries; and
    
    import and export license requirements and restrictions on the import
and export of certain technology, especially encryption technology and
trade restrictions. Despite these risks, we believe that we must continue to expand our
operations in international markets to support our growth. To this end, we
intend to establish additional foreign sales operations, expand our existing
offices, hire additional personnel, expand our international sales channels and
customize our products for local markets. If we fail to execute this strategy,
our international sales growth will be limited. Our Networks, Products and Services May be Targeted by Hackers Like other companies, our websites, networks, information systems,
products and services may be targets for sabotage, disruption or
misappropriation by hackers. As a leading network security solutions company,
we are a high profile target. Although we believe we have sufficient controls
in place to prevent disruption and misappropriation, and to respond to such
situations, we expect these efforts by hackers to continue. If these efforts
are successful, our operations, reputation and sales could be adversely
affected. We Must Successfully Integrate Acquisitions As part of our growth strategy, we have and may continue to acquire or
make investments in companies with products, technologies or professional
services capabilities complementary to our solutions. When engaging in
acquisitions, we could encounter difficulties in assimilating or completing the
development of the technologies, new personnel and operations into our company.
These difficulties may disrupt our ongoing business, distract our management
and employees, increase our expenses and adversely affect our results of
operations. These difficulties could also include accounting requirements, such
as impairment charges related to goodwill or other intangible assets or
expensing in-process research and development costs. We cannot be certain that
we will successfully overcome these risks with respect to any future
acquisitions or that we will not encounter other problems in connection with
our recent or any future acquisitions. In addition, any future acquisitions may
require us to incur debt or issue equity securities. The issuance of equity
securities could dilute the investment of our existing stockholders. Our Proprietary Rights May be Difficult to Enforce We rely primarily on copyright, trademark, patent and trade secrets laws,
confidentiality procedures and contractual provisions to protect our
proprietary rights. We have obtained one United States patent and have a number
of patent applications pending, as well as numerous trademarks and trademark
applications pending. There can be no assurance that patents will be issued
from pending applications, or that claims allowed on any patents will be
sufficiently broad to protect our technology. There can be no assurance that
any issued patents will not be challenged, invalidated or circumvented, or that
any rights granted under these patents will actually provide competitive
advantages to us. Despite our efforts to protect our proprietary rights,
unauthorized parties may attempt to copy aspects of our products or to obtain
and use information that we regard as proprietary. Policing unauthorized use of
our products is difficult. While we cannot determine the extent to which piracy
of our software products occurs, we expect software piracy to be a persistent
problem. In addition, the laws of some foreign countries do not protect our
proprietary rights to as great an extent as do the laws of the United States,
and many foreign countries do not enforce these laws as diligently as U.S.
government agencies and private parties. If we are unable to protect our
proprietary rights to the totality of the features in our software and products
(including aspects of our software and products protected other than by patent
rights), we may find ourselves at a competitive disadvantage to others who need
not incur the additional expense, time and effort required to create the
innovative products that have enabled us to be successful. We May Be Found to Infringe the Proprietary Rights of Others Third parties may assert claims or initiate litigation related to
exclusive patent, copyright, trademark and other intellectual property rights
to technologies that are relevant to our business. Because of the large number
of patents in the Internet, networking, security and software fields, the
secrecy of some pending patents and the rapid rate of issuance of new patents,
it is not economically practical (or 25




---



##### Table of Contents



even possible) to determine in advance whether a product (or any of its
components) infringe or will infringe the patent rights of others. Third party
asserted claims and/or initiated litigation can include claims against us or
our manufacturers, suppliers, or customers, alleging infringement of
proprietary rights with respect to our existing or future products (or
components of those products). Regardless of the merit of these claims, they
can be time-consuming, result in costly litigation and diversion of technical
and management personnel, or require us to develop a non-infringing technology
or enter into license agreements. There can be no assurance that licenses will
be available on acceptable terms and conditions, if at all, in these
circumstances, or that any indemnification that might be available to us would
be adequate to cover our costs of defense. Furthermore, because of the
potential for large judgments, which are not necessarily predictable, it is not
unusual to find even arguably unmeritorious claims settled for significant
funds. If any infringement or other intellectual property claim made against us
by a third party is successful, or if we fail to develop non-infringing
technology or license the proprietary rights on commercially reasonable terms
and conditions, our business, operating results, financial condition and
liquidity could be materially and adversely affected. We Must Continue to Attract and Retain Personnel in a Competitive Marketplace We believe that our future success will depend in part on our ability to
recruit and retain highly skilled management, sales, marketing and technical
personnel. To accomplish this, we believe that we must provide personnel with a
competitive compensation package, including stock options, restricted stock or
similar incentive stock awards. Increases in shares available for issuance
under our incentive stock plans and new incentive stock plans require
stockholder approval in many cases, and institutional stockholders, or
stockholders generally, may not approve future plans or increases. Our current
incentive stock plan expires in September 2005 and we believe that sufficient
shares are available for issuance under that plan to meet our needs until it
expires. We currently expect to propose a new incentive stock plan to
stockholders at our annual stockholders meeting in 2005. Additionally, the
accounting industry has recently determined that corporations will include a
compensation expense in their statement of operations relating to the issuance
of employee stock options. This may become effective in calendar year 2005. As
a result, we may decide to issue fewer stock options and may be impaired in our
efforts to attract and retain necessary personnel. Conversely, issuing a
comparable number of stock options could adversely impact our results of
operations. Some Provisions in the ISS Certificate of Incorporation and Bylaws Make a
Takeover of ISS Difficult Our certificate of incorporation and bylaws contain provisions that could
have the effect of making it more difficult for a third party to acquire, or of
discouraging a third party from attempting to acquire, control of ISS. These
provisions:  
    
    establish a classified board of directors;  
    
    create preferred stock purchase rights that grant to holders of
common stock the right to purchase shares of Series A Junior Preferred
Stock in the event that a third party acquires 20% or more of the voting
power of our outstanding common stock;  
    
    prohibit the right of our stockholders to act by written consent;  
    
    limit calling special meetings of stockholders; and  
    
    impose a requirement that holders of 66 2/3% of the outstanding shares of common stock are required to amend the provisions relating to he classification of our board of directors and action by written consent of stockholders. 
 Item 3. Quantitative and Qualitative Disclosures About Market Risk We have no material changes to the disclosure on this matter made in our
Annual Report on Form 10-K for the year ended December 31, 2003. 
 Item 4. Controls and Procedures Our management, with the participation of the Chief Executive Officer and
Chief Financial Officer, evaluated the effectiveness of our disclosure controls
and procedures as of the end of the period covered by this quarterly report.
Based on such evaluation, these officers have concluded that, as of such date,
our disclosure controls and procedures were effective to provide reasonable
assurance that information required to be disclosed in the reports the Company
files or submits under the Securities Exchange Act of 1934 is recorded,
processed, summarized and reported on a timely basis. 26




---



##### Table of Contents



There have not been any changes in the Companys internal control over
financial reporting during the quarter ended June 30, 2004 that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting. 
 PART II. OTHER INFORMATION 
 Item 1. Legal Proceedings The Company and certain of its officers and directors were named as
defendants in a consolidated amended complaint that was filed in the United
States District Court for the Northern District of Georgia on October 9, 2002.
The lawsuit purported to be brought on behalf of a class of investors who
purchased the Companys stock during the period from April 5, 2001 through
August 14, 2001. The lawsuit alleged violations of the federal securities laws.
On September 3, 2003, the court dismissed, with prejudice, the consolidated
amended complaint and all rights to appeal have expired 
 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities (e) The following table provides information about purchases by the Company of
its common stock during the three months ended June 30, 2004: All such
purchases were made in open-market transactions pursuant to a repurchase plan
publicly announced on July 18, 2002 under which the Company has been authorized
by the Board to purchase up to $50 million. The plan terminated on July 14,
2004 and no further purchases can be made under that plan. Through June 30,
2004, the Company had purchased approximately 3.2 million shares at an
aggregate cost of approximately $47.4 million. Issuer Purchases of Equity Securities Total Number ofShares Purchased
    
    Approximate DollarCumulatively as
    
    Value of SharesPart of Publicly
    
    that May Yet BeTotal Number of
    
    Average Price Paid
    
    Announced Plans or
    
    Purchased Under thePeriod
    
    Shares Purchased
    
    Per Share
    
    Programs
    
    Plans or Programs4/1/04-4/30/04
    
    
    160,000
    
    
    $
    14.50
    
    
    
    1,843,000
    
    
    $
    22,734,0005/1/04-5/31/04
    
    
    850,000
    
    
    $
    14.37
    
    
    
    2,693,000
    
    
    $
    10,451,0006/1/04-6/30/04
    
    
    500,000
    
    
    $
    15.75
    
    
    
    3,193,000
    
    
    $
    2,575,000
 
 Item 4. Submission of Matters to a Vote of Security Holders The Annual Meeting of Stockholders of Internet Security Systems, Inc. was
held on Monday, May 24, 2004. The following two directors were elected to serve a three-year term ending
in the year 2007: (a) Robert E. Davoli, 43,315,528 votes for and 2,312,293
votes withheld, and (b) Christopher W. Klaus, 44,531,928 votes for and
1,095,893 votes withheld. 
 Item 6. Exhibits and Reports on Form 8-K (a)
    
    Exhibits.
    
    
    3.1
    
    
    Restated Certificate of Incorporation (filed as Exhibit 3.1 to
the Companys Quarterly Report on Form 10-Q, dated November
14, 2000 and incorporated by reference herein).3.2
    
    
    Bylaws (filed as Exhibit 3.2 to the Companys Registration
Statement on Form S-1, Registration No. 373-44529 and
incorporated by reference herein).3.3
    
    
    Certificate of Designations of Series A Junior Participating
Preferred Stock dated July 24, 2002 (filed as Exhibit 3.3 to
the Companys Annual Report on Form 10-K, filed March 28, 2003
and incorporated by reference herein).
 27




---



##### Table of Contents



4.1
    
    
    Specimen Common Stock certificate (filed as Exhibit 4.3 to the
Companys Registration Statement on Form S-8, Registration No.
333-100954, filed November 1, 2002 and incorporated by
reference herein).4.2
    
    
    Form of Rights Certificate (filed as Exhibit 4.2 to the
Companys Current Report on Form 8-K filed July 24, 2002 and
incorporated by reference herein.)4.3
    
    
    See Exhibits 3.1 and 3.2 for provisions of the Certificate of
Incorporation and Bylaws of the Company defining the rights of
holders of the Companys Common Stock.4.4
    
    
    1999 Network ICE Stock Option Plan, incorporated by reference
to Exhibit 4.1 to Form S-8, Registration No. 333-62658, filed
on June 8, 2001.4.5
    
    
    Restated 1995 Stock Incentive Plan (as amended and restated as
of May 23, 2001) incorporated by reference to Exhibit 4.2 to
Form S-8, Registration No. 333-62658, filed June 8, 2001.4.6
    
    
    Netrex, Inc. 1998 Stock Plan incorporated by reference to
Exhibit 99.15 to Form S-8, Registration Statement No.
333-89563, filed October 22, 1999.4.7
    
    
    vCIS, Inc. 2001 Stock Plan incorporated by reference to
Exhibit 4.1 to Form S-8, Registration Statement No.
333-100954, filed November 1, 2002.11
    
    
    Computation of Per Share Earnings *31.1
    
    
    Certification of principal executive officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    
    Certification of principal financial officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    
    Certification pursuant to 18 U.S.C. Section 1350, as adapted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    
    Certification pursuant to 18 U.S.C. Section 1350, as adapted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*
    
    
    Data required by SFAS No. 128, Earnings Per Share, is
provided in Note 5 to the consolidated financial statements in
this report
 (b) Reports on Form 8-K. ISS furnished the following reports on Form 8-K during the reporting
period:  
    
    On April 20, 2004 ISS furnished a report on Form 8-K pursuant to Item
12 thereof relating to a press release regarding its financial results
for the quarter ended March 31, 2004 and providing its Business Outlook
for the quarter ending June 30, 2004 and fiscal year ending December 31,
2004. 28




---



##### Table of Contents



29




---



##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. INTERNET SECURITY SYSTEMS, INC.(Registrant)Date: August 9, 2004
    
    By /s/ Richard MacchiaSenior Vice President Finance and Administrationand Chief Financial Officer (on behalf of registrantand as principal financial officer)
 30