**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

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**FORM 10-Q**

** **

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**(Mark One)**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

**For the quarterly period ended June 30, 2006**

 

**OR**

 

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 

 

**For the transition period from                              to                    **

**CommissionFile Number 000-23655**

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**INTERNET SECURITY SYSTEMS, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

**6303BARFIELD ROAD, ATLANTA, GEORGIA 30328**(Address ofprincipal executive offices)

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

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Indicate by check markwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes  x   No  o

Indicate by a check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act.

Largeaccelerated filer   x            Acceleratedfiler   o            Non-acceleratedfiler   o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes  o   No  x

Indicate the number of sharesoutstanding of each of the registrant’s classes of common stock, as of thelatest practicable date.
| **Title of  each class of common stock** |       | **Number  of Shares Outstanding as of August 1, 2006** |
|------------------------------------------|------------|--------------------------------------------------------|
| Common stock,  $0.001 par value          | ** ** | 43,815,478                                             |

 

 

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##### **1.1.1.A   Table of Contents**

|                                              | ** ** | ** **                                                                                                                   | ** ** | **PAGE  NUMBER** |
|----------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------|------------|------------------|
|                                         | ** ** | **PART  I — FINANCIAL INFORMATION**                                                                                     |       |             |
|                                         |       |                                                                                                                         |       |             |
| Item 1                                  |       | Consolidated Financial Statements (unaudited):                                                                               |       |             |
|                                         |       |                                                                                                                         |       |             |
|                                         |       | Consolidated Balance Sheets at June 30, 2006  (unaudited) and December 31, 2005                                              |       | 3                |
|                                         |       |                                                                                                                         |       |             |
|                                         |       | Consolidated Statements of Operations for the three  months and six months ended June 30, 2006 and June 30, 2005 (unaudited) |       | 4                |
|                                         |       |                                                                                                                         |       |             |
|                                         |       | Consolidated Statements of Cash Flows for the six  months ended June 30, 2006 and June 30, 2005 (unaudited)             |       | 5                |
|                                         |       |                                                                                                                         |       |             |
|                                         |       | Notes to Consolidated Financial Statements                                                                                   |       | 6                |
|                                         |       |                                                                                                                         |       |             |
| Item 2                                       |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                                  |       | 15               |
|                                         |       |                                                                                                                         |       |             |
| Item 3                                       |       | Quantitative and Qualitative Disclosures about Market  Risk                                                                  |       | 23               |
|                                         |       |                                                                                                                         |       |             |
| Item 4                                       |       | Controls and Procedures                                                                                                      |       | 24               |
|                                         |       |                                                                                                                         |       |             |
|                                         | ** ** | **PART II - OTHER  INFORMATION**                                                                                             |       |             |
|                                         |       |                                                                                                                         |       |             |
| Item  1                                      |       | Legal  Proceedings                                                                                                           |       | 24               |
|                                         |       |                                                                                                                         |       |             |
| Item 1A                                      |       | Risk Factors                                                                                                                 |       | 25               |
|                                         |       |                                                                                                                         |       |             |
| Item 2                                       |       | Unregistered Sale of Equity Securities and Use of  Proceeds                                                                  |       | 30               |
|                                         |       |                                                                                                                         |       |             |
| Item 4                                       |       | Submission of Matters to a Vote of Security Holders                                                                          |       | 31               |
|                                         |       |                                                                                                                         |       |             |
| Item 6                                       |       | Exhibits                                                                                                                     |       | 31               |
|                                         |       |                                                                                                                         |       |             |
| EX-31.1 SECTION 302 CERTIFICATION OF THE CEO |       |                                                                                                                         |
|                                         |       |                                                                                                                         |       |             |
| EX-31.2 SECTION 302 CERTIFICATION OF THE CFO |       |                                                                                                                         |
|                                         |       |                                                                                                                         |       |             |
| EX-32.1 SECTION 906 CERTIFICATION OF THE CEO |       |                                                                                                                         |
|                                         |       |                                                                                                                         |       |             |
| EX-32.2 SECTION 906 CERTIFICATION OF THE CFO |       |                                                                                                                         |
|                                              |            |                                                                                                                              |            |                  |  |  |

 

2

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**PARTI. FINANCIAL INFORMATION**

**Item 1.Consolidated Financial Statements**

**INTERNETSECURITY SYSTEMS, INC.****CONSOLIDATED BALANCE SHEETS**(amounts in thousands, except share and per share amounts)
| ** **                                                                                                                      | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                      | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| ** **                                                                                                                      | ** ** | **(unaudited)**   | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                      | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                 |       |              |       |                  |       |
| Cash and cash  equivalents                                                                                                      |       | $                 | 177,122    |                  | $          | 238,893 |   |
| Marketable securities                                                                                                           |       | 42,681            |       | —                |       |
| Accounts receivable,  less allowance for doubtful accounts of $4,130 and $3,574 in 2006 and 2005,  respectively                 |       | 78,950            |       | 87,769                |       |
| Inventory                                                                                                                       |       | 6,321             |       | 2,852                 |       |
| Prepaid expenses and  other current assets                                                                                      |       | 13,080            |       | 9,656                 |       |
| Total current assets                                                                                                            |       | 318,154           |       | 339,170               |       |
|                                                                                                                            |       |              |       |                  |       |
| Property and equipment:                                                                                                         |       |              |       |                  |       |
| Computer equipment and  software                                                                                                |       | 72,279            |       | 60,365                |       |
| Office furniture and  equipment                                                                                                 |       | 18,191            |       | 17,797                |       |
| Leasehold improvements                                                                                                          |       | 21,083            |       | 20,948                |       |
|                                                                                                                            |       | 111,553           |       | 99,110                |       |
| Less accumulated  depreciation                                                                                                  |       | 75,027            |       | 67,754                |       |
|                                                                                                                            |       | 36,526            |       | 31,356                |       |
|                                                                                                                            |       |              |       |                  |       |
| Restricted cash  equivalents and marketable securities                                                                          |       | 9,200             |       | 8,600                 |       |
| Goodwill, less  accumulated amortization of $27,381                                                                             |       | 221,439           |       | 220,224               |       |
| Other intangible  assets, less accumulated amortization of $31,189 and $27,490 in 2006 and  2005, respectively                  |       | 8,122             |       | 10,913                |       |
| Other assets                                                                                                                    |       | 8,209             |       | 8,381                 |       |
|                                                                                                                            |       |                   |       |                       |       |
| Total assets                                                                                                                    |       | $                 | 601,650    |                  | $          | 618,644 |   |
|                                                                                                                            |       |                   |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                  | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current liabilities:                                                                                                            |       |              |       |                  |       |
| Accounts payable                                                                                                                |       | $                 | 11,580     |                  | $          | 11,261 |   |
| Accrued expenses                                                                                                                |       | 26,164            |       | 35,019                |       |
| Deferred revenues                                                                                                               |       | 76,803            |       | 74,577                |       |
| Total current  liabilities                                                                                                      |       | 114,547           |       | 120,857               |       |
| Long-term deferred  revenues                                                                                                    |       | 8,697             |       | 7,067                 |       |
| Other non-current liabilities                                                                                                   |       | 195               |       | 202                   |       |
| Commitments and  contingencies                                                                                                  |       |              |       |                  |       |
| Minority interest                                                                                                               |       | 4,813             |       | 4,378                 |       |
|                                                                                                                            |       |              |       |                  |       |
| Stockholders’ equity:                                                                                                      |       |              |       |                  |       |
| Preferred stock, $.001  par value, 20,000,000 shares authorized, none issued or outstanding                                     |       | —            |       | —                |       |
| Common stock, $.001 par  value, 120,000,000 shares authorized, 52,872,000 and 52,204,000 issued in  2006 and 2005, respectively |       | 53                |       | 52                    |       |
| Additional paid-in  capital                                                                                                     |       | 535,027           |       | 524,105               |       |
| Deferred compensation                                                                                                           |       | —            |       | (1,830                | )          |
| Accumulated other  comprehensive income                                                                                         |       | 4,084             |       | 1,058                 |       |
| Retained earnings                                                                                                               |       | 100,359           |       | 87,089                |       |
| Treasury stock, at cost  (9,080,000 and 7,129,000 shares in 2006 and 2005, respectively)                                        |       | (166,125          | )          | (124,334              | )          |
| Total stockholders’  equity                                                                                                |       | 473,398           |       | 486,140               |       |
|                                                                                                                            |       |              |       |                  |       |
| Total liabilities and stockholders’ equity                                                                                 |       | $                 | 601,650    |                  | $          | 618,644 |   |

 

*Seeaccompanying notes*

3

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**INTERNET SECURITY SYSTEMS, INC.CONSOLIDATED STATEMENTS OF OPERATIONS**(amounts in thousands, except per share amounts)(unaudited)
| ** **                                      | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                       |       |                                            |       |                                          |       |   |   |   |   |
| Product licenses and sales                      |       | $                                               | 33,447     |                                          | $          | 33,613 |   | $ | 66,136 |   | $ | 65,883 |   |
| Subscriptions                                   |       | 43,358                                          |       | 39,852                                        |       | 86,056 |   | 78,690 |   |
| Professional services                           |       | 5,907                                           |       | 5,635                                         |       | 11,281 |   | 11,319 |   |
|                                            |       | 82,712                                          |       | 79,100                                        |       | 163,473 |   | 155,892 |   |
| Costs and expenses:                             |       |                                            |       |                                          |       |   |   |   |   |
| Cost of  revenues:                              |       |                                            |       |                                          |       |   |   |   |   |
| Product licenses and sales                      |       | 7,996                                           |       | 6,152                                         |       | 14,804 |   | 12,537 |   |
| Amortization of acquired technology             |       | 1,501                                           |       | 1,756                                         |       | 3,221 |   | 3,542 |   |
| Subscriptions and professional services         |       | 14,472                                          |       | 13,167                                        |       | 28,021 |   | 26,325 |   |
| Total cost of revenues                          |       | 23,969                                          |       | 21,075                                        |       | 46,046 |   | 42,404 |   |
| Operating expenses:                             |       |                                            |       |                                          |       |   |   |   |   |
| Research and development                        |       | 12,406                                          |       | 10,985                                        |       | 25,100 |   | 21,276 |   |
| Sales and marketing                             |       | 30,033                                          |       | 27,537                                        |       | 58,127 |   | 53,646 |   |
| General and administrative                      |       | 8,350                                           |       | 7,302                                         |       | 16,659 |   | 14,646 |   |
| Amortization of other intangibles               |       | 42                                              |       | 42                                            |       | 82 |   | 86 |   |
|                                            |       | 74,800                                          |       | 66,941                                        |       | 146,014 |   | 132,058 |   |
|                                            |       |                                            |       |                                          |       |   |   |   |   |
| Operating income                                |       | 7,912                                           |       | 12,159                                        |       | 17,459 |   | 23,834 |   |
|                                            |       |                                            |       |                                          |       |   |   |   |   |
| Interest income                                 |       | 1,828                                           |       | 1,253                                         |       | 3,795 |   | 2,312 |   |
| Other income  (expense), net                    |       | 123                                             |       | (476                                          | )          | (240 | ) | (1,015 | ) |
| Gain on issuance  of subsidiary stock           |       | 19                                              |       | 71                                            |       | 63 |   | 134 |   |
| Income before  income taxes                     |       | 9,882                                           |       | 13,007                                        |       | 21,077 |   | 25,265 |   |
| Provision for  income taxes                     |       | 3,662                                           |       | 4,746                                         |       | 7,807 |   | 9,159 |   |
| Net income                                      |       | $                                               | 6,220      |                                          | $          | 8,261 |   | $ | 13,270 |   | $ | 16,106 |   |
| Basic net income  per share of Common Stock     |       | $                                               | 0.14       |                                          | $          | 0.18 |   | $ | 0.30 |   | $ | 0.36 |   |
| Diluted net  income per share of Common Stock   |       | $                                               | 0.14       |                                          | $          | 0.18 |   | $ | 0.29 |   | $ | 0.34 |   |
|                                            |       |                                            |       |                                          |       |   |   |   |   |
| Weighted average shares  and equivalent shares: |       |                                            |       |                                          |       |   |   |   |   |
| Basic net income per share of Common Stock      |       | 44,035                                          |       | 45,243                                        |       | 44,285 |   | 45,284 |   |
| Diluted net  income per share of Common Stock   |       | 44,762                                          |       | 47,178                                        |       | 45,260 |   | 47,314 |   |

 

*Seeaccompanying notes*

4

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**INTERNETSECURITY SYSTEMS, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS**(amounts in thousands)(unaudited)
| ** **                                                                         | ** ** | **Six months ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| **Operating activities**                                                           |       |                                          |       |   |   |
| Net income                                                                         |       | $                                             | 13,270     |   | $ | 16,106 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                          |       |   |   |
| Depreciation                                                                       |       | 7,017                                         |       | 5,355 |   |
| Amortization of  intangibles                                                       |       | 3,303                                         |       | 3,628 |   |
| Stock-based  compensation expense                                                  |       | 7,313                                         |       | 1,053 |   |
| Income tax  benefit from exercise of stock options                                 |       | 480                                           |       | 945 |   |
| Accretion of  discount on marketable securities                                    |       | 31                                            |       | (562 | ) |
| Minority  interest                                                                 |       | 572                                           |       | 61 |   |
| Gain on issuance  of subsidiary stock                                              |       | (63                                           | )          | (134 | ) |
| Changes in assets and  liabilities, excluding the effects of acquisitions:         |       |                                          |       |   |   |
| Accounts receivable                                                                |       | 10,460                                        |       | 7,192 |   |
| Inventory                                                                          |       | (3,429                                        | )          | (848 | ) |
| Prepaid expenses and other assets                                                  |       | (2,854                                        | )          | 2,808 |   |
| Accounts payable and accrued expenses                                              |       | (9,852                                        | )          | 3,206 |   |
| Deferred revenues                                                                  |       | 2,334                                         |       | (3,977 | ) |
|                                                                               |       |                                          |       |   |   |
| Net cash  provided by operating activities                                         |       | 28,582                                        |       | 34,833 |   |
|                                                                               |       |                                          |       |   |   |
| **Investing activities**                                                           |       |                                          |       |   |   |
| Acquisitions,  net of cash received                                                |       | —                                        |       | (764 | ) |
| Purchases of  marketable securities                                                |       | (48,581                                       | )          | (56,923 | ) |
| Net proceeds  from maturity of marketable securities                               |       | 7,749                                         |       | 60,136 |   |
| Net proceeds  from sales of marketable securities                                  |       | —                                        |       | 29,750 |   |
| Additions to cash  equivalents in restricted cash and marketable securities        |       | (2,480                                        | )          | — |   |
| Purchases of  property, equipment, and software                                    |       | (12,052                                       | )          | (3,229 | ) |
| Issuance of  (dividend from) subsidiary stock                                      |       | (74                                           | )          | 357 |   |
|                                                                               |       |                                               |       |  |   |
| Net cash  provided by (used in) investing activities                               |       | (55,438                                       | )          | 29,327 |   |
|                                                                               |       |                                          |       |   |   |
| **Financing activities**                                                           |       |                                          |       |   |   |
| Proceeds from  exercise of stock options                                           |       | 4,450                                         |       | 4,800 |   |
| Proceeds from  issuance of common stock                                            |       | —                                        |       | 732 |   |
| Purchases of  treasury stock                                                       |       | (41,791                                       | )          | (18,349 | ) |
| Excess tax  benefits from stock option exercises                                   |       | 510                                           |       | — |   |
|                                                                               |       |                                          |       |   |   |
| Net cash (used  in) financing activities                                           |       | (36,831                                       | )          | (12,817 | ) |
|                                                                               |       |                                               |       |   |   |
| Foreign currency  impact on cash                                                   |       | 1,916                                         |       | (3,427 | ) |
|                                                                               |       |                                               |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                              |       | (61,771                                       | )          | 47,916 |   |
| Cash and cash  equivalents at beginning of period                                  |       | 238,893                                       |       | 140,148 |   |
|                                                                               |       |                                          |       |   |   |
| Cash and cash  equivalents at end of period                                        |       | $                                             | 177,122    |   | $ | 188,064 |   |
|                                                                               |       |                                          |       |   |   |
| **Supplemental cash flow  disclosure**                                             |       |                                          |       |   |   |
| Income taxes  paid                                                                 |       | $                                             | 15,651     |   | $ | 3,509 |   |

 

*Seeaccompanying notes*

5

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**INTERNET SECURITY SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(unaudited)**

**Note1.   Significant Accounting Policies**

*Basis of Presentation*

The consolidated financial statements of InternetSecurity Systems, Inc. (“ISS” or the “Company”) as of June 30, 2006 and for thethree and six months ended June 30, 2006 and 2005 are unaudited and, in theopinion of management, contain all adjustments, consisting of normal recurringitems, necessary for the fair presentation of the financial position and resultsof operations of the Company for the interim periods. The consolidatedfinancial statements include the accounts of the Company and its majority-ownedsubsidiaries. The consolidated balance sheet at December 31, 2005 has beenderived from the audited financial statements at that date but does not includeall of the footnotes required by U.S. generally accepted accounting principlesfor complete financial statements.

These consolidated financial statements should be readin conjunction with the Consolidated Financial Statements and Notes theretoincluded in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2005. The results of operations for the three and six months endedJune 30, 2006 are not necessarily indicative of the results to be expected forthe entire year. All significant intercompany accounts and transactions havebeen eliminated. Certain prior year amounts have been reclassified to conformto current year presentation.

The preparation of financial statements and related disclosuresin conformity with U.S. generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the amounts reportedin the financial statements and accompanying notes. Actual results will differfrom those estimates, and such differences may be material to the consolidatedfinancial statements.

*Goodwilland Intangibles*

     Goodwilland intangible assets are comprised of the following, as of the dates indicated(in thousands): 
| ** **                    | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| ** **                    | ** ** | **Gross**         | ** ** | ** **            | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **Carrying**      | ** ** | **Accumulated**       | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** |
| ** **                    | ** ** | **Amount**        | ** ** | **Amortization**      | ** ** | **Amount** | ** ** | **Amortization** | ** ** |
| Goodwill                      |       | $                 | 248,820    |                  | $          | (27,381 | ) | $ | 247,605 |   | $ | (27,381 | ) |
| Amortized intangible  assets: |       |              |       |                  |       |   |   |   |   |
| Core technology               |       | $                 | 3,853      |                  | $          | (3,756 | ) | $ | 3,853 |   | $ | (3,483 | ) |
| Developed  technology         |       | 33,416            |       | (25,482               | )          | 32,537 |   | (22,158 | ) |
| Customer  relationships       |       | 2,042             |       | (1,951                | )          | 2,013 |   | (1,849 | ) |
| Total                         |       | $                 | 39,311     |                  | $          | (31,189 | ) | $ | 38,403 |   | $ | (27,490 | ) |

 

The change in the carrying amounts of goodwill anddeveloped technology from December 31, 2005 to June 30, 2006 was theresult of currency translation adjustments for goodwill related to theacquisition of Cobion, a German content filtering and anti-spam provider.

We amortize intangibleassets over their estimated useful lives of eight years for core technology,five years for developed technology and three years for customer relationships.Amortization related to core technology and developed technology is classifiedas a component of cost of revenues. Amortization expense of intangible assetsis as follows (in thousands):

|                         | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **              | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Core technology         |       | $                                               | 152        |                                          | $          | 120 |   | $ | 273 |   | $ | 240 |   |
| Developed  technology   |       | 1,349                                           |       | 1,636                                         |       | 2,948 |   | 3,302 |   |
| Customer  relationships |       | 42                                              |       | 42                                            |       | 82 |   | 86 |   |
| Total                   |       | $                                               | 1,543      |                                          | $          | 1,798 |   | $ | 3,303 |   | $ | 3,628 |   |

 

6

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The estimatedfuture amortization expense of intangible assets as of June 30, 2006 is asfollows (in thousands): 

|                                | ** ** | **Amount** | ** ** |
|--------------------------------|------------|------------|------------|
| Year ending  December 31, |       |       |       |
| 2006 (six  months)             |       | $          | 1,750      |   |
| 2007                           |       | 3,125      |       |
| 2008                           |       | 3,125      |       |
| 2009                           |       | 122        |       |
| Total                          |       | $          | 8,122      |   |

 

*Accountingfor stock-based compensation*

On January 1,2006, we adopted Statement of Financial Accounting Standards No. 123 (revised2004), *Share-Based Payment,*(“SFAS No. 123(R)”),which requires the measurement of compensation expense for all share-basedpayment awards made to employees and directors based on estimated fair valueson date of grant and recognition of compensation over the service period forawards expected to vest. SFAS No. 123(R) supersedes our previous accountingunder Accounting Principles Board Opinion No. 25, *Accountingfor Stock Issued to Employees*(“APB No. 25”) and revises guidance inSFAS No. 123, *Accounting for Stock-Based Compensation*,(“SFAS No. 123”), for periods beginning in fiscal 2006. On March 29, 2005, theSEC published Staff Accounting Bulletin (“SAB”) No. 107, which provides theStaff’s views on a variety of matters relating to stock-based payments. We haveapplied the provisions of SAB 107 in our adoption of SFAS No. 123(R).

We adopted SFASNo. 123(R) using the modified prospective method, and accordingly, prior periodresults have not been restated, and do not include, the impact of SFAS No.123(R). The fair value of restricted stock is determined based on the number ofshares granted and the quoted price of our common stock; the fair value ofstock options is determined using the Black-Scholes valuation model, which isconsistent with our valuation techniques previously utilized for options infootnote disclosures required under SFAS No. 123. Such value is recognized asexpense over the service period, net of estimated forfeitures, using thestraight-line single option method under SFAS No. 123(R). SFAS No. 123(R)requires forfeitures to be estimated at the time of grant and revised, ifnecessary, in subsequent periods if actual forfeitures differ from thoseestimates. In our pro forma information required under SFAS No. 123 for theperiods prior to fiscal 2006, we accounted for forfeitures as they occurred.

Stock-basedcompensation expense for the three months ended June 30, 2006 was $3,978,000which consisted of expense related to employee stock options of $3,496,000 andexpense related to restricted stock of $482,000. Stock-based compensationexpense for the three months ended June 30, 2005 was $480,000, all related torestricted stock awards. Tax benefits recognized in the income statementrelated to stock-based compensation arrangements was $1,472,000 and $175,000for the three months ended June 30, 2006 and 2005, respectively.

Stock-basedcompensation expense for the six months ended June 30, 2006 was $7,313,000which consisted of expense related to employee stock options of $6,426,000 andexpense related to restricted stock of $887,000. Stock-based compensationexpense for the six months ended June 30, 2005 was $1,053,000, all related torestricted stock awards. Tax benefits recognized in the income statementrelated to stock-based compensation arrangements was $2,706,000 and $382,000for the six months ended June 30, 2006 and 2005, respectively.

Tax benefitsresulting from stock-based compensation deductions in excess of amountsreported for financial reporting purposes were $510,000 for the six monthsending June 30, 2006. Prior to the adoption of SFAS No. 123(R), cash retainedas a result of tax deductions relating to stock-based compensation waspresented in operating cash flows, along with other tax cash flows, inaccordance with the provisions of Emerging Issues Task Force (“EITF”) Issue No.00-15, *Classification in the Statement of Cash Flows ofthe Income Tax Benefit Received by a Company upon Exercise of a NonqualifiedEmployee Stock Option.* SFAS No. 123(R) supersedes EITF No. 00-15,amends SFAS No. 95, *Statement of Cash Flows*,and requires tax benefits relating to excess stock-based compensationdeductions to be prospectively presented in the statement of cash flows asfinancing cash inflows.

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

7

----

 

Theapplication of SFAS No. 123(R) has the following effect on the three and sixmonth periods ending June 30, 2006 reported amounts relative to amounts thatwould have been reported using the intrinsic value method under previousaccounting (in thousands, except per share amounts).
| **Three months ended  June 30, 2006** | ** ** | **Using  Previous  Accounting** | ** ** | **SFAS  123(R)  Impact** | ** ** | **As  Reported** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------|------------|--------------------------|------------|------------------|------------|
| Total revenues                                            |       | $                               | 82,712     |                     | $          | —           |       | $ | 82,712 |   |
| Cost of revenues:                                         |       |                            |       |                     |       |             |       |
| Product and  licenses sales                               |       | 7,972                           |       | 24                       |       | 7,996            |       |
| Amortization of  acquired technology                      |       | 1,501                           |       | —                   |       | 1,501            |       |
| Subscriptions  and professional services                  |       | 14,031                          |       | 441                      |       | 14,472           |       |
| Total costs of  revenues                                  |       | 23,504                          |       | 465                      |       | 23,969           |       |
| Research and  development                                 |       | 11,511                          |       | 895                      |       | 12,406           |       |
| Sales and  marketing                                      |       | 28,876                          |       | 1,157                    |       | 30,033           |       |
| General and  administrative                               |       | 7,371                           |       | 979                      |       | 8,350            |       |
| Amortization of  other intangibles                        |       | 42                              |       | —                   |       | 42               |       |
|                                                      |       | 71,304                          |       | 3,496                    |       | 74,800           |       |
| Operating income                                          |       | 11,408                          |       | (3,496                   | )          | 7,912            |       |
| Other, net                                                |       | 1,970                           |       | —                   |       | 1,970            |       |
| Income before  income taxes                               |       | 13,378                          |       | (3,496                   | )          | 9,882            |       |
| Provision for  income taxes                               |       | 4,958                           |       | 1,296                    |       | 3,662            |       |
| Net income                                                |       | $                               | 8,420      |                     | $          | (2,200           | )          | $ | 6,220 |   |
| Basic net income  per share of Common Stock               |       | $                               | 0.19       |                     | $          | (0.05            | )          | $ | 0.14 |   |
| Dilutive net  income per share of Common Stock            |       | $                               | 0.19       |                     | $          | (0.05            | )          | $ | 0.14 |   |

 
| **Six months ended  June 30, 2006** | ** ** | **Using  Previous  Accounting** | ** ** | **SFAS  123(R)  Impact** | ** ** | **As  Reported** | ** ** |
|---------------------------------------------------------|------------|---------------------------------|------------|--------------------------|------------|------------------|------------|
| Total revenues                                          |       | $                               | 163,473    |                     | $          | —           |       | $ | 163,473 |   |
| Cost of  revenues:                                      |       |                            |       |                     |       |             |       |
| Product and  licenses sales                             |       | 14,766                          |       | 38                       |       | 14,804           |       |
| Amortization of  acquired technology                    |       | 3,221                           |       | —                   |       | 3,221            |       |
| Subscriptions  and professional services                |       | 27,224                          |       | 797                      |       | 28,021           |       |
| Total costs of  revenues                                |       | 45,211                          |       | 835                      |       | 46,046           |       |
| Research and  development                               |       | 23,402                          |       | 1,698                    |       | 25,100           |       |
| Sales and  marketing                                    |       | 55,984                          |       | 2,143                    |       | 58,127           |       |
| General and  administrative                             |       | 14,909                          |       | 1,750                    |       | 16,659           |       |
| Amortization of  other intangibles                      |       | 82                              |       | —                   |       | 82               |       |
|                                                    |       | 139,588                         |       | 6,426                    |       | 146,014          |       |
| Operating income                                        |       | 23,885                          |       | (6,426                   | )          | 17,459           |       |
| Other, net                                              |       | 3,618                           |       | —                   |       | 3,618            |       |
| Income before  income taxes                             |       | 27,503                          |       | (6,426                   | )          | 21,077           |       |
| Provision for  income taxes                             |       | 10,187                          |       | 2,380                    |       | 7,807            |       |
| Net income                                              |       | $                               | 17,316     |                     | $          | (4,046           | )          | $ | 13,270 |   |
| Basic net income  per share of Common Stock             |       | $                               | 0.39       |                     | $          | (0.09            | )          | $ | 0.30 |   |
| Dilutive net  income per share of Common Stock          |       | $                               | 0.38       |                     | $          | (0.09            | )          | $ | 0.29 |   |
| Cash flow from  operating activities                    |       | $                               | 29,092     |                     | $          | (510             | )          | $ | 28,582 |   |
| Cash flow from  financing activities                    |       | $                               | (37,341    | )                        | $          | 510              |       | $ | (36,831 | ) |

 

8

----

 

*Gain on issuance of subsidiaryshares*

The gain on issuance ofsubsidiary shares results from Internet Security Systems KK, our Asia/Pacificsubsidiary (“ISS KK”), issuing shares related to the exercise of ISS KK stockoptions. In 2006, ISS KK has issued 243 shares at an average exercise price ofapproximately $450 per share. Our ownership percentage of the subsidiaryremained at 87% at June 30, 2006. Deferred income taxes have been provided inthe period in which the gain is recognized.

**Note2. Income Taxes**

     TheCompany recorded tax provisions of $3.7 million and $4.7 million forthe three-month periods ended June 30, 2006 and 2005, and tax provisions of$7.8 million and $9.2 million for the six-month periods ended June 30, 2006 and2005, respectively. The effective tax rate was approximately 37% for the threeand six months ended June 30, 2006 and approximately 36.5% for the three andsix months ended June 30, 2005. The effective rates differ from the statutoryrates due to the impact of acquisition-related intangibles and certainoperating expenses that are not deductible for income tax purposes as well asfederal and state tax credits.

##### **Note3. Business Acquisition**

     In August 2002, InternetSecurity Systems KK (“ISS KK”), our Asia-Pacific subsidiary, acquired adistributor in Singapore, TriSecurity Holdings Pte Ltd. (“TriSecurity”). TriSecuritywas the sole distributor for ISS KK in Southeast Asia, including India, and itsbusiness was almost exclusively focused on ISS solutions. This acquisitionprovides our Asia-Pacific subsidiary direct support capabilities for theircustomers in Southeast Asia and allows ISS KK to expand its capabilities inthis growing market. The consideration consisted of 1,000 shares of ISS KKstock and approximately $1.2 million of cash. Goodwill of approximately $4.0million related to the purchase was recorded. During the first quarter of 2003,ISS KK amended the agreement and agreed to make payment of 490 shares of ISS KKin each of the first quarters of 2004 and 2005, relating to annual contingentconsideration payments defined in the 2002 purchase agreement. Due toregulatory issues, the agreement was amended prior to the 2004 payment to makethe 2004 and 2005 payments in cash in lieu of shares. Additional considerationof $764,000 and $498,000 was paid in February 2005 and 2004, respectively,based on the fair market value of the 490 shares, and is reflected in goodwill.

**Note4. Comprehensive Income**

     Thecomponents of comprehensive income are as follows (in thousands):
| ** **                                   | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|----------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net income, as  reported                     |       | $                                               | 6,220      |                                          | $          | 8,261 |   | $ | 13,270 |   | $ | 16,106 |   |
| Change in  cumulative translation adjustment |       | 1,839                                           |       | (3,834                                        | )          | 3,026 |   | (7,993 | ) |
| Comprehensive  income                        |       | $                                               | 8,059      |                                          | $          | 4,427 |   | $ | 16,296 |   | $ | 8,113 |   |

 

**Note5. Income per Share**

The following table sets forth the computation ofbasic and diluted net income per share (amounts in thousands, except per shareamounts):
| ** **                                                                                   | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Numerator:                                                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Net income                                                                                   |       | $                                               | 6,220      |                                          | $          | 8,261 |   | $ | 13,270 |   | $ | 16,106 |   |
|                                                                                         |       |                                            |       |                                          |       |   |   |   |   |
| Denominator:                                                                                 |       |                                            |       |                                          |       |   |   |   |   |
| Denominator for basic net income per share—weighted  average shares                     |       | 44,035                                          |       | 45,243                                        |       | 44,285 |   | 45,284 |   |
| Effect of dilutive stock options                                                             |       | 727                                             |       | 1,935                                         |       | 975 |   | 2,030 |   |
| Denominator for  diluted net income per share — weighted average shares and equivalents |       | 44,762                                          |       | 47,178                                        |       | 45,260 |   | 47,314 |   |
| Basic net income per share                                                                   |       | $                                               | 0.14       |                                          | $          | 0.18 |   | $ | 0.30 |   | $ | 0.36 |   |
| Diluted net income per share                                                                 |       | $                                               | 0.14       |                                          | $          | 0.18 |   | $ | 0.29 |   | $ | 0.34 |   |

 

9

----

 

Optionsaggregating 6,264,000 and 3,579,000 in the three months ended June 30, 2006 and2005, respectively, and 5,241,000 and 3,553,000 in the six months ended June30, 2006 and 2005, respectively, were not included in the computation ofdiluted income per share because the options’ exercise price was greater thanthe average market price of the common shares, and their impact would have beenanti-dilutive.

**Note 6.   Stock option plans**

The InternetSecurity Systems, Inc. 2005 Stock Incentive Plan (“the Plan”) consists ofequity programs that provide for the granting of qualified or non-qualifiedstock options, the issuance of restricted stock, the granting of restrictedstock units, and the automatic option and restricted stock grant program. Underthe terms of the plan the exercise price of options granted shall not be lessthan the fair market value on the date of grant, the options have a maximumterm of seven years and generally vest over a four-year period. Stock issuedunder the Plan generally vests over a period of service or attainment ofspecified performance objectives. The automatic option and restricted stockgrant program is available to the non-employee members of the Company’s boardof directors. At June 30, 2006 there were 5,929,000 shares reserved for futureissuance under the Plan. An additional 80,000 shares have been reserved fornon-statutory options issued in 1997 to non-employee directors.

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

|                                                           | ** ** | **Three months ended  June 30,** | ** ** |
|-----------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                | ** ** | **2006**                                        | ** ** | **2005** | ** ** |
| Expected life  (years)                                    |       | 4.6                                             |       | 4.6 |   |
| Risk free  interest rate                                  |       | 5.0                                             | %          | 3.83 | % |
| Expected volatility                                       |       | 33                                              | %          | 41 | % |
| Expected  dividend yield                                  |       | —                                          |       | — |   |
| Weighted-average fair  value per share of options granted |       | $                                               | 8.14       |   | $ | 6.40 |   |
|                                                           |            |                                                 |            |  |  |  |  |

 

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

A summary of ISS’stock option activity is as follows (number of options in thousands):

|                                 | ** ** | **Six months ended  June 30, 2006** | ** ** |
|---------------------------------|------------|---------------------------------------------------------|------------|
| ** **                      | ** ** | ** **                                              | ** ** | **Weighted** | ** ** |
| ** **                      | ** ** | ** **                                              | ** ** | **Average** | ** ** |
| ** **                      | ** ** | **Number of**                                      | ** ** | **Exercise** | ** ** |
| ** **                      | ** ** | **Shares**                                              | ** ** | **Price** | ** ** |
| Outstanding at  January 1, 2006 |       | 9,327                                                   |       | $ | 21.93 |   |
| Granted                         |       | 717                                                     |       | 21.46 |   |
| Exercised                       |       | (296                                                    | )          | 15.02 |   |
| Canceled:                       |       |                                                    |       |   |   |
| Forfeited                       |       | (192                                                    | )          | 17.46 |   |
| Expired                         |       | (116                                                    | )          | 32.35 |   |
| Outstanding at  June 30, 2006   |       | 9,440                                                   |       | $ | 22.07 |   |
| Exercisable at June 30,  2006   |       | 5,948                                                   |       | $ | 23.60 |   |

 

The aggregateintrinsic value of options outstanding and exercisable was $22.5 million and$17.2 million as of June 30, 2006 and 

10

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$41.0 million and $24.5million as of June 30, 2005, respectively. The total intrinsic value of optionsexercised during the six months ended June 30, 2006 and 2005 was $2.4 millionand $3.3 million, respectively. Unrecognized non-cash stock compensationexpense related to unvested options outstanding as of June 30, 2006 was approximately$22.6 million and will be recorded over the remaining vesting period of fouryears.

The followingtable summarizes information about stock options outstanding at June 30, 2006(option amounts in thousands):
| ** **                                  | ** ** | **Options Outstanding** | ** ** | **Options Fully  Vested and Exercisable** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                  | ** ** | **Number of**           | ** ** | **Weighted**                                             | ** ** | ** ** | ** ** | **Number** | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | **Options**                  | ** ** | **Average**                                              | ** ** | **Weighted** | ** ** | **Exercisable** | ** ** | **Weighted** | ** ** |
| ** **                                  | ** ** | **Outstanding at**      | ** ** | **Remaining**                                            | ** ** | **Average** | ** ** | **At** | ** ** | **Average** | ** ** |
| ** **                                  | ** ** | **June 30,**            | ** ** | **Contractual**                                          | ** ** | **Exercise** | ** ** | **June 30,** | ** ** | **Exercise** | ** ** |
| **Range of Exercise Prices** | ** ** | **2006**                     | ** ** | **Life**                                                 | ** ** | **Price** | ** ** | **2006** | ** ** | **Price** | ** ** |
|                                        |       |                         |       |                                                     |       |   |   |   |   |   |   |
| $.08-9.11                                   |       | 211                          |       | 2.79                                                     |       | $ | 5.46 |   | 211 |   | $ | 5.46 |   |
| $10.00-19.98                                |       | 4,313                        |       | 5.84                                                     |       | 14.60 |   | 2,968 |   | 14.32 |   |
| $20.03-29.44                                |       | 3,210                        |       | 5.84                                                     |       | 21.98 |   | 1,063 |   | 21.69 |   |
| $30.63-39.75                                |       | 1,059                        |       | 5.41                                                     |       | 33.04 |   | 1,059 |   | 33.04 |   |
| $49.81-85.63                                |       | 647                          |       | 4.21                                                     |       | 59.81 |   | 647 |   | 59.82 |   |
|                                        |       | 9,440                        |       | 5.61                                                     |       | $ | 22.07 |   | 5,948 |   | $ | 23.60 |   |

 

Directors,officers and certain key employees of ISS were issued 411,000 and 56,000restricted shares in the six months ended June 30, 2006 and the year-endedDecember 31, 2005, respectively. In 2005, 33,000 restricted shares werereturned prior to vesting. The shares issued to directors vest quarterly overtwo years. There are two vesting schedules for shares issued to officers andcertain key employees: (i) generally 50% vests two years from the grant date,and the remaining 50% vests three years from the grant date; and (ii) certainother awards cliff vest at seven years with accelerated vesting at the end ofthree years if certain performance targets are achieved.

| Restricted stock summary             | ** ** | **Restricted  Stock** | ** ** | **Weighted-  Average  Grant-Date  Fair Value** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|-----------------------------------------------------|------------|
| Nonvested  restricted stock at January 1, 2006 |       | 283,350               |       | $                                                   | 18.60      |   |
| Granted                                        |       | 410,700               |       | 21.67                                               |       |
| Vested                                         |       | (125,625              | )          | 17.93                                               |       |
| Forfeited                                      |       | (12,625               | )          | 18.11                                               |       |
| Nonvested restricted  stock at June 30, 2006   |       | 555,800               |       | $                                                   | 20.99      |   |

 

The total fairvalue of restricted stock which vested during the six months ended June 30,2006 and 2005 was $2.6 million and $0, respectively. Unrecognized non-cashstock compensation expense related to unvested restricted stock outstanding asof June 30, 2006 was approximately $8.2 million and will be recorded over theremaining vesting period of approximately 2 years.

Stock-basedcompensation for 2005 was determined using the intrinsic value method. The followingtable provides supplemental information for the three and six months ended June30, 2005 as if stock-based compensation had been computed under SFAS No. 123 (inthousands, except per share amounts):

|                                                                                                    | ** ** | **Three months  ended June 30,  2005** | ** ** | **Six months  ended June 30,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Net income, as  reported                                                                           |       | $                                                     | 8,261      |                                                | $          | 16,106 |   |
| Add: Stock-based  compensation included in reported net income, net of income taxes                |       | 305                                                   |       | 672                                                 |       |
| Less:  Stock-based compensation expense computed under the fair value method, net of  income taxes |       | (3,457                                                | )          | (7,595                                              | )          |
| Pro forma net  income                                                                              |       | $                                                     | 5,109      |                                                | $          | 9,183 |   |
| Basic net income  per share of Common Stock                                                        |       |                                                  |       |                                                |       |
| As reported                                                                                        |       | $                                                     | 0.18       |                                                | $          | 0.36 |   |
| Pro forma                                                                                          |       | $                                                     | 0.11       |                                                | $          | 0.20 |   |
| Diluted net  income per share of Common Stock                                                      |       |                                                  |       |                                                |       |
| As reported                                                                                        |       | $                                                     | 0.18       |                                                | $          | 0.34 |   |
| Pro forma                                                                                          |       | $                                                     | 0.11       |                                                | $          | 0.20 |   |

 

11

----

 

**Note 7.   Segment and GeographicInformation**

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

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

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

The following tablepresents ISS’s revenues, operating expenses and operating income (loss) byreportable geographic segment (in thousands):
| ** **                                             | ** ** | **Americas** | ** ** | **EMEA**   | ** ** | **Asia/Pacific** | ** ** | **Unallocated** | ** ** | **Total**  | ** ** |
|--------------------------------------------------------|------------|--------------|------------|------------|------------|------------------|------------|-----------------|------------|------------|------------|
| **As of  or for the three months ended June 30, 2006** | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| Revenues from  external customers:                     | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| Product licenses and sales                             |       | $            | 18,369     |       | $          | 8,506            |       | $               | 6,572      |       | $          | — |   | $ | 33,447 |   |
| Subscriptions                                          |       | 26,673       |       | 10,222     |       | 6,463            |       | —          |       | 43,358     |       |
| Professional services                                  |       | 4,452        |       | 463        |       | 992              |       | —          |       | 5,907      |       |
| Total revenue                                          |       | 49,494       |       | 19,191     |       | 14,027           |       | —          |       | 82,712     |       |
| Cost of  revenues:                                     |       |         |       |       |       |             |       |            |       |       |       |
| Product licenses and sales                             |       | 4,234        |       | 1,940      |       | 1,264            |       | 558             |       | 7,996      |       |
| Amortization of acquired technology                    |       | —       |       | —     |       | —           |       | 1,501           |       | 1,501      |       |
| Subscriptions and professional services                |       | 9,764        |       | 1,216      |       | 3,014            |       | 478             |       | 14,472     |       |
| Total cost of revenues                                 |       | 13,998       |       | 3,156      |       | 4,278            |       | 2,537           |       | 23,969     |       |
| Operating  expenses                                    |       | 18,335       |       | 8,759      |       | 2,939            |       | 20,798          |       | 50,831     |       |
| Total expenses                                         |       | 32,333       |       | 11,915     |       | 7,217            |       | 23,335          |       | 74,800     |       |
| Segment operating  income (loss)                       |       | $            | 17,161     |       | $          | 7,276            |       | $               | 6,810      |       | $          | (23,335 | ) | $ | 7,912 |   |
| Accounts  receivable, net                              |       | $            | 46,585     |       | $          | 17,727           |       | $               | 14,638     |       | $          | — |   | $ | 78,950 |   |
| Property and  equipment, net                           |       | $            | 27,547     |       | $          | 4,216            |       | $               | 4,493      |       | $          | — |   | $ | 36,256 |   |
| ** **                                             | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| **As of  or for the three months ended June 30, 2005** | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| ** **                                             | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| Revenues from  external customers:                     | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| Product licenses and sales                             |       | $            | 20,492     |       | $          | 7,789            |       | $               | 5,332      |       | $          | — |   | $ | 33,613 |   |
| Subscriptions                                          |       | 25,261       |       | 9,305      |       | 5,286            |       | —          |       | 39,852     |       |
| Professional services                                  |       | 3,856        |       | 606        |       | 1,173            |       | —          |       | 5,635      |       |
| Total revenue                                          |       | 49,609       |       | 17,700     |       | 11,791           |       | —          |       | 79,100     |       |
|                                                   |       |         |       |       |       |             |       |            |       |       |       |
| Cost of  revenues:                                     | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| Product licenses and sales                             |       | 3,676        |       | 1,103      |       | 998              |       | 375             |       |       |       |
| Amortization of acquired technology                    |       | —       |       | —     |       | —           |       | 1,756           |       |       |       |
| Subscriptions and professional services                |       | 9,453        |       | 1,154      |       | 2,527            |       | 33              |       | 13,167     |       |
| Total cost of revenues                                 |       | 13,129       |       | 2,257      |       | 3,525            |       | 2,164           |       | 21,075     |       |
| Operating  expenses                                    |       | 16,805       |       | 8,269      |       | 2,463            |       | 18,329          |       | 45,866     |       |
| Total expenses                                         |       | 29,934       |       | 10,526     |       | 5,988            |       | 20,493          |       | 66,941     |       |
| Segment  operating income (loss)                       |       | $            | 19,675     |       | $          | 7,174            |       | $               | 5,803      |       | $          | (20,493 | ) | $ | 12,159 |   |
| Accounts  receivable, net                              |       | $            | 39,428     |       | $          | 18,615           |       | $               | 10,118     |       | $          | — |   | $ | 68,161 |   |
| Property and equipment,  net                           |       | $            | 25,080     |       | $          | 1,696            |       | $               | 4,920      |       | $          | — |   | $ | 31,696 |   |

 

12

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| ** **                                           | ** ** | **Americas** | ** ** | **EMEA**   | ** ** | **Asia/Pacific** | ** ** | **Unallocated** | ** ** | **Total**  | ** ** |
|------------------------------------------------------|------------|--------------|------------|------------|------------|------------------|------------|-----------------|------------|------------|------------|
| **As of or for the six months  ended June 30, 2006** | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| Revenues from external  customers:                   | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| Product licenses and sales                           |       | $            | 38,641     |       | $          | 15,242           |       | $               | 12,253     |       | $          | — |   | $ | 66,136 |   |
| Subscriptions                                        |       | 53,901       |       | 19,667     |       | 12,488           |       | —          |       | 86,056     |       |
| Professional services                                |       | 8,138        |       | 879        |       | 2,264            |       | —          |       | 11,281     |       |
| Total revenue                                        |       | 100,680      |       | 35,788     |       | 27,005           |       | —          |       | 163,473    |       |
| Cost of revenues:                                    | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| Product licenses and sales                           |       | 8,042        |       | 3,382      |       | 2,381            |       | 999             |       | 14,804     |       |
| Amortization of acquired technology                  |       | —       |       | —     |       | —           |       | 3,221           |       | 3,221      |       |
| Subscriptions and professional services              |       | 19,177       |       | 2,283      |       | 5,707            |       | 854             |       | 28,021     |       |
| Total cost of revenues                               |       | 27,219       |       | 5,665      |       | 8,088            |       | 5,074           |       | 46,046     |       |
| Operating  expenses                                  |       | 36,505       |       | 16,148     |       | 5,474            |       | 41,841          |       | 99,968     |       |
| Total expenses                                       |       | 63,724       |       | 21,813     |       | 13,562           |       | 46,915          |       | 146,014    |       |
| Segment  operating income (loss)                     |       | $            | 36,956     |       | $          | 13,975           |       | $               | 13,443     |       | $          | (46,915 | ) | $ | 17,459 |   |
| Accounts  receivable, net                            |       | $            | 46,585     |       | $          | 17,727           |       | $               | 14,638     |       | $          | — |   | $ | 78,950 |   |
| Property and  equipment, net                         |       | $            | 27,547     |       | $          | 4,216            |       | $               | 4,493      |       | $          | — |   | $ | 36,256 |   |
| ** **                                           | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| **As of or for the six months  ended June 30, 2005** | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| Revenues from external  customers:                   | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| Product licenses and sales                           |       | $            | 39,550     |       | $          | 14,596           |       | $               | 11,737     |       | $          | — |   | $ | 65,883 |   |
| Subscriptions                                        |       | 50,019       |       | 18,453     |       | 10,218           |       | —          |       | 78,690     |       |
| Professional services                                |       | 7,419        |       | 1,073      |       | 2,827            |       | —          |       | 11,319     |       |
| Total revenue                                        |       | 96,988       |       | 34,122     |       | 24,782           |       | —          |       | 155,892    |       |
| ** **                                           | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| Cost of revenues:                                    | ** ** | ** **   | ** ** | ** ** | ** ** | ** **       | ** ** | ** **      | ** ** | ** ** | ** ** |
| Product licenses and sales                           |       | 7,347        |       | 2,317      |       | 2,123            |       | 750             |       | 12,537     |       |
| Amortization of acquired technology                  |       | —       |       | —     |       | —           |       | 3,542           |       | 3,542      |       |
| Subscriptions and professional services              |       | 18,453       |       | 2,448      |       | 5,358            |       | 66              |       | 26,325     |       |
| Total cost of revenues                               |       | 25,800       |       | 4,765      |       | 7,481            |       | 4,358           |       | 42,404     |       |
| Operating  expenses                                  |       | 32,752       |       | 15,987     |       | 4,906            |       | 36,009          |       | 89,654     |       |
| Total expenses                                       |       | 58,552       |       | 20,752     |       | 12,387           |       | 40,367          |       | 132,058    |       |
| Segment operating  income (loss)                     |       | $            | 38,436     |       | $          | 13,370           |       | $               | 12,395     |       | $          | (40,367 | ) | $ | 23,834 |   |
| Accounts  receivable, net                            |       | $            | 39,428     |       | $          | 18,615           |       | $               | 10,118     |       | $          | — |   | $ | 68,161 |   |
| Property and equipment,  net                         |       | $            | 25,080     |       | $          | 1,696            |       | $               | 4,920      |       | $          | — |   | $ | 31,696 |   |

 

Revenuesfor each service included in Subscriptions are as follows:
| ** **                   | ** ** | **For the Three Months Ended June 30,** | ** ** | **For the Six Months Ended June 30** | ** ** |
|------------------------------|------------|-----------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                                              | ** ** | **2005**                                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Product content  and support |       | $                                                                     | 29,952     |                                                               | $          | 25,611 |   | $ | 58,350 |   | $ | 50,684 |   |
| Managed security  services   |       | 11,718                                                                |       | 11,488                                                             |       | 23,533 |   | 22,276 |   |
| Other                        |       | 2,048                                                                 |       | 2,753                                                              |       | 4,173 |   | 5,730 |   |
| Total Subscription  Revenues |       | $                                                                     | 43,358     |                                                               | $          | 39,852 |   | $ | 86,056 |   | $ | 78,690 |   |

 

**Note8.   Commitments and Contingencies**

Our sales agreements with customers generally containinfringement indemnity provisions. We have not previously incurred costs tosettle claims or pay awards under these indemnification obligations. We haveonly incurred costs to defend ISS to date. As a result, we believe theestimated fair value of these obligations is nominal. Accordingly, we have noliabilities recorded for these agreements as of June 30, 2006. In addition, wewarrant that our software products will perform in all material respects inaccordance with our standard published specifications in effect at the time ofdelivery of the licensed products to the customer for ninety days. We alsowarrant that for one year after shipment, all hardware will be free fromdefects in materials and workmanship under normal authorized use, consistentwith the instructions contained in the product documentation. Additionally, wewarrant that our services will be performed consistent with generally acceptedindustry standards or specific service levels through completion of the agreedupon 

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services. While these generally continue to be theperformance warranties, there are variations arising from custom contracts. Wehave not incurred significant recurring expense under our product or servicewarranties and hardware warranties are covered by the manufacturer warranties.As a result, we believe the estimated fair value of these agreements isnominal. Accordingly, we have no liabilities recorded for these agreements asof June 30, 2006.

Payments for certain operating leases for our officespace are secured by collateralized standby letters of credit totaling$7.9 million at June 30, 2006. These standby letters of creditguarantee payments on certain lease obligations and are renewed annually unlesscancelled by either party. The lease obligations have terms that expire atvarious dates through 2013. The beneficiary of the standby letters of creditcan draw on the letters of credit if we default on the related leaseobligation. Each standby letter of credit is collateralized by securities. AtJune 30, 2006, $9.2 million of cash and marketable securities arepledged as collateral and are shown on the balance sheet as restricted cash andmarketable securities.

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

**Note9.   Recently Issued Accounting Standards**

In July 2006, theFASB issued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes—an interpretation of FASB StatementNo. 109*(“FIN 48”), which clarifies the accounting foruncertainty in tax positions. This Interpretation requires that we recognize inour financial statements, the impact of a tax position, if that position ismore likely than not of being sustained on audit, based on the technical meritsof the position. FIN 48 seeks to reduce the diversity in practice associatedwith certain aspects of the recognition and measurement related to accountingfor income taxes. The provisions of FIN 48 will be effective for ISS as of thebeginning of fiscal 2007, with the cumulative effect of the change inaccounting principle recorded as an adjustment to opening retained earnings. Weare currently evaluating the impact of adopting FIN 48 on the ConsolidatedFinancial Statements.

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

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

*Except for the historical financialinformation, many of the matters discussed in this Form 10-Q may beconsidered “forward-looking” statements. Forward-looking statements can be identifiedby the use of words such as “may,” “should,” “could,” “continue,” “future,” “potential,”“believe,” “project,” “plan,” “intend,” “seek,” “estimate,” “predict”, “expect”,“anticipate” and similar expressions, or the negative of such terms, or othercomparable terminology.  Forward-looking statements also include theassumptions underlying or relating to any of the foregoing statements. Such forward-looking statements are not guarantees of future performance andinvolve a number of risks and uncertainties.  Our actual results coulddiffer materially from those anticipated in these forward-looking statements asa result of various factors, including those set forth below under the caption “RiskFactors” and those otherwise described from time to time in our Securities andExchange Commission reports filed after this Form 10-Q . Allforward-looking statements included in this Form 10-Q are based oninformation available to us on the date hereof.  We assume no obligation(except where required by law) to update any forward-looking statements for anyevents or circumstances occurring after the date of this Form 10-Q.*

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

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

**Overview**

We focus on providing enterprise-wide pre-emptiveprotection of networks and computers.  Weprovide such protection with our comprehensive line of products andservices.  These include a product familyconsisting of network and host intrusion prevention, network anomaly detection,integrated security appliances, desktop protection and vulnerability assessmentand protection; ISS’ SiteProtector centralized management system; and ISS’Managed Security Services and Professional Security Services.  The integrated security appliance includes,in addition to intrusion prevention, firewalls, virtual private networkfeatures, anti-virus protection, content filtering, e-mail security, andanti-spam technology.

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

We currently plan to continue to develop the ProventiaEnterprise Security Platform by further automating enterprise security policyand delivering it within the context of existing IT processes.

Our managed services offerings currently provideremote management of our best-of-breed security technology, focusing onsecurity assessment and intrusion detection, intrusion prevention and desktopprotection systems, and include firewalls, VPNs, anti-virus and URL filteringsoftware. We focus on serving as the trusted security provider to our customersby maintaining within our existing products the latest counter-measures tosecurity risks, creating new innovative products based on our customers’ needsand providing professional and managed services.

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

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**CriticalAccounting Policies**

The consolidated financial statements were prepared inconformity with U.S. generally accepted accounting principles (“GAAP”).  As such, management is required to makecertain estimates, judgments and assumptions it believes are reasonable basedupon the information available.  Theseestimates and assumptions affect the reported amounts of assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the periods presented. Actual results may differ significantly from these estimates underdifferent assumptions, judgments, or conditions.  The significant accounting policies whichmanagement believes are the most critical to aid in fully understanding andevaluating our reported financial results include the following:

***Revenue recognition***

We recognize revenue in the following categories:

·     *Product licenses andsales,* which include revenue from sales of perpetual softwarelicenses and products;

·                    *Subscription revenues,*which consists of customer support, including content updates and technicalsupport, term licenses, subscription licenses and managed servicearrangements; and

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

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

·                    persuasiveevidence of an arrangement exists;

·                    deliveryhas occurred or services have been rendered;

·                    priceis fixed or determinable; and

·                    collectionis probable.

*Productlicenses and sales*

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

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

Sales of products are generated both through directsales to end-users as well as through various partners, including systemintegrators, value-added resellers and distributors.  Revenue from product licenses and sales isrecognized when the sale has occurred for an identified end-user, provided allother revenue recognition criteria are met. At the point of delivery, the customer has no right of return.  We offer evaluation software available viadownload from our website and evaluation units for appliance-based productsthat allow potential customers to see the functionality of the products ontheir own networks prior to purchase.

*Subscription revenues*

Subscription revenues consist of renewable customersupport, term licenses, and security monitoring and management services.  Renewable customer support is a separateelement of sales of perpetual software licenses and products.  Term licenses allow customers to use ourproducts and receive product support coverage and content updates for aspecified period, generally twelve months. We generally invoice for customer support and term licenses at thebeginning of the term and recognize revenue ratably over the subscriptionterm.  Security monitoring and managementservices for information assets and systems are part of managed services andassociated revenues are recognized as such services are rendered.

Historically, our software and intrusion preventionappliance sales have been accounted for primarily as revenue at the time ofsale, with product support and content updates generally representing between20% and 30% of the related license or product amount.  Prior to the second quarter of 2005, themajority of the initial price paid by the customer for certain Proventiaintegrated security appliance models was for selected content updates(sometimes referred to as “blades”), which customers acquired for a specifiedterm.  That initial price was recognizedover such term as subscription revenue. During the second quarter of 2005, we changed the pricing model for ourProventia integrated security appliances to our historical model under whichcustomers acquire the appliance bundled with most content blades, with theprice recorded as product revenue at the time of sale, and pay annual customersupport fees at an average rate of 22% of the related product price.  This change did not have a material impact onour results for the quarter as the integrated security appliance representedonly 3% of product licenses and sales revenue, which approximated thepercentage of quarterly product licenses and sales that it had historicallyrepresented since introduced in late 2003, under the prior pricing model.

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*Professional services revenues*

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

*Multiple element arrangements*

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

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

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

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

We recognize the difference between the totalarrangement fee and the amount deferred for the undelivered elements asrevenues by allocating revenue to the delivered products, licensesand services using the residual method. Under the residual method, we allocate discounts inherent in thearrangement to products and customer support associated with products that areinitially delivered and recognize the other elements as they are deliveredbased on the VSOE of fair value, which is determined based on transactionswhere the company sells those elements separately.  We determine fair value of the undeliveredelements based on historical evidence of our stand-alone sales of theseelements to third parties.

*Allowance for doubtful accounts*

Our sales areglobal, with customers located in the Americas, Europe, the Middle East, andAfrica (“EMEA”), and Asia/Pacific regions. We perform periodic creditevaluations of our customer’s financial condition and do not requirecollateral. We provide for estimated credit losses as such losses becomeprobable. We evaluate specific accounts when we become aware of a situationwhere a customer may not be able to meet its financial obligations due todeterioration of its liquidity or financial viability, credit ratings orbankruptcy. The allowance for doubtful accounts is established based on thebest facts available to us and is reevaluated and adjusted as additionalinformation is received.  At June 30,2006, the allowance for doubtful accounts totaled $4.1 million, or 4.9% ofthe $83.1 million of total trade receivables. This 4.9% allowance ofreceivables reflects our practice to leave accounts on our general ledger andprovide reserves pending final resolution of collectibility rather than towrite-off such accounts.

Our bad debtexpense for the quarter ended June 30, 2006 amounted to $488,000 compared to$241,000 in the corresponding period of 2005 and $818,000 and $386,000 duringthe first six months of 2006 and 2005, respectively.

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

*Impairment of goodwill and otherlong-lived and intangible assets*

We review goodwill for impairment on an annual basisor on an interim basis whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable.  All otherlong-lived and intangible assets are reviewed for impairment whenever events orcircumstances indicate that the carrying amount of an asset may not berecoverable.  Such impairment loss would be measured as the differencebetween the carrying amount of the asset and its fair value based on the presentvalue of estimated future cash flows.  Significant judgment is required inthe forecasting of future operating results, which are used in the preparationof projected cash flows.  Due to uncertain market conditions and potentialchanges in our strategy and products, it is possible that forecasts used tosupport our intangible assets may change in the future, which could result insignificant non-cash charges that would adversely affect our results ofoperations.

We currently havegoodwill and other acquisition related intangibles, net of accumulatedamortization, of approximately $230 million, with $195 million ofgoodwill related to our June 2001 acquisition of Network ICE Corporation (“NetworkICE”) and approximately $20 million of goodwill related to the January 2004acquisition of Cobion, AG (“Cobion”).  The determination of whether or notgoodwill is impaired involves significant judgments based upon short andlong-term projections of future performance.  We have concluded that thisamount is realizable based on forecasted discounted cash flows through 2009 andon our stock market valuation.  Neither method indicated that our goodwillhad been impaired and, as a result, we did not record any impairment lossesrelated to goodwill during the quarter ended June 30, 2006.  Otherintangibles of approximately $8 million are principally acquiredtechnology from the Network ICE and Cobion acquisitions that are components inour current product offerings.

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*Stock-based compensation*

As of January 1, 2006, we adopted SFAS 123(R), whichrequires us to measure compensation cost for stock awards at fair value andrecognize compensation over the service period for awards expected tovest.  The estimation of stock awardsthat will ultimately vest requires judgment, and to the extent actual resultsor updated estimates differ from our current estimates, such amounts will berecorded as a cumulative adjustment in the period estimates are revised.  We consider many factors when estimating awardsexpected to vest including type of awards, employee class, and our historicalexperience.  Actual results, and futurechanges in estimates, may differ substantially from our current estimates.

We use the Black-Scholes option pricing model todetermine the fair value of our stock options. The determination of the fair value of stock-based awards using anoption pricing model is affected by our stock price as well as assumptionsregarding a number of complex and subjective variables.  Changes in the input assumptions canmaterially affect the fair value estimate of our stock options. Thoseassumptions include estimating:

·                    the expected volatility of themarket price of our common stock over the expected term;

·                    the expected term of the award;

·                    the risk free interest rateexpected during the option term; and

·                    the expected dividends to be paid.

We have reviewed each of these assumptions carefullyand determined our best estimate for these variables.  Of these assumptions, the expected volatilityof our common stock is the most difficult to estimate since it is based onexpected performance of our common stock. We use the implied volatility of publicly traded options for our commonstock to estimate expected volatility. An increase in the expected volatility, expected term, and risk freeinterest rate, all will cause an increase in compensation expense.  The dividend yield on our common stock isassumed to be zero since we do not pay dividends and have no current plans todo so in the future.

* Recently Issued AccountingStandards*

 In July2006, the FASB issued FASB Interpretation No. 48, *Accounting for Uncertainty in Income Taxes—an interpretation of FASBStatement No. 109*(“FIN 48”), which clarifies the accountingfor uncertainty in tax positions. This Interpretation requires that werecognize in our financial statements, the impact of a tax position, if thatposition is more likely than not of being sustained on audit, based on thetechnical merits of the position. FIN 48 seeks to reduce the diversity inpractice associated with certain aspects of the recognition and measurementrelated to accounting for income taxes. The provisions of FIN 48 will be effective for ISS as of the beginningof fiscal 2007, with the cumulative effect of the change in accountingprinciple recorded as an adjustment to opening retained earnings. We arecurrently evaluating the impact of adopting FIN 48 on the ConsolidatedFinancial Statements.

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**Resultsof Operation****s**

 Thefollowing table sets forth our consolidated historical operating information,as a percentage of total revenues, for the periods indicated:
| ** **                                                | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-----------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Consolidated Statements of  Operations Data:**          | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Product licenses and  sales                               |       | 41                                              | %          | 43                                            | %          | 40 | % | 42 | % |
| Subscriptions                                             |       | 52                                              | %          | 50                                            | %          | 53 | % | 51 | % |
| Professional services                                     |       | 7                                               | %          | 7                                             | %          | 7 | % | 7 | % |
|                                                      |       |                                            |       |                                          |       |   |   |   |   |
| Total revenues                                            |       | 100                                             | %          | 100                                           | %          | 100 | % | 100 | % |
|                                                      |       |                                            |       |                                          |       |   |   |   |   |
| Cost of revenues:                                         |       |                                            |       |                                          |       |   |   |   |   |
| Product licenses and  sales                               |       | 10                                              | %          | 8                                             | %          | 9 | % | 7 | % |
| Amortization of  acquired technology                      |       | 2                                               | %          | 2                                             | %          | 2 | % | 2 | % |
| Subscriptions and  professional services                  |       | 17                                              | %          | 17                                            | %          | 17 | % | 17 | % |
|                                                      |       |                                            |       |                                          |       |   |   |   |   |
| Total cost of revenues                                    |       | 29                                              | %          | 27                                            | %          | 28 | % | 27 | % |
| Research and  development                                 |       | 15                                              | %          | 14                                            | %          | 15 | % | 14 | % |
| Sales and marketing                                       |       | 36                                              | %          | 35                                            | %          | 36 | % | 35 | % |
| General and  administrative                               |       | 10                                              | %          | 9                                             | %          | 10 | % | 9 | % |
| Amortization of  intangibles and stock-based compensation |       | —                                          | %          | —                                        | %          | — | % | — | % |
|                                                      |       |                                            |       |                                          |       |   |   |   |   |
| Total costs and  expenses                                 |       | 90                                              | %          | 85                                            | %          | 89 | % | 85 | % |
|                                                      |       |                                            |       |                                          |       |   |   |   |   |
| Operating income                                          |       | 10                                              | %          | 15                                            | %          | 11 | % | 15 | % |

 

**Revenues**

*Productlicenses and sales*

Since the second quarter of 2003, we have offered theProventia family of network protection appliances that collectively providesunified, multi-function protection capabilities designed to identify andprevent many forms of attack with minimal user intervention. These products aredesigned to operate in demanding network environments while being easy todeploy, easy to use and centrally managed, all in an effort to make oursolution more cost-effective. The market response has been dramatic as sales ofProventia appliances grew from 23% of product license and sales revenues in itsyear of introduction to 78% in the second quarter of 2006.

Product licensesand sales in the three and six months ended June 30, 2006 of $33.4 million and$66.1 million, respectively, were consistent with product licenses and sales inthe three and six months ended June 30, 2005 of $33.6 million and $65.9million, respectively. Increases in intrusion prevention appliances were offsetby a decrease in legacy software revenue and intrusion detection appliances.Proventia appliances grew to 78% of product license and sales in the secondquarter of 2006 from 67% of product license and sales in the second quarter of2005. For the six months ended June 30, 2006 Proventia appliances increased to74% of total product license and sales revenues compared to 65% in the sixmonths ended June 30, 2005. Product licenses and sales decreased slightly to41% of total revenues in the second quarter of 2006 compared to 43% in thecorresponding period of 2005 due to the growth of subscription revenues whileproduct license and sales revenues remained level.

We believe ourfuture growth is dependent on a continuation of the positive market response toour Proventia family of products.  Ourpresent product roadmap also focuses on product offerings and enhancements thatwill continue to improve central control and manageability, easier deploymentand more refined information as well as broader Proventia appliance offerings.We expect that this focus will continue to make our products more costeffective to implement and maintain the goal of increasing the future level ofproduct licenses and sales.  Thisexpected growth is critical as it represents not only product and licenserevenues, but also subscription revenues from product support and contentupdates.

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*Subscriptions*

Subscriptionrevenues consist of product support and content updates, security-monitoringfees for managed services offerings, and term licenses of products.  Subscriptions grew 9% in the second quarterof 2006 compared to the second quarter of 2005, increasing to $43.4 millionfrom $39.9 million. Subscriptions revenue represented 52% of total revenues inthe second quarter of 2006 compared to 50% in the second quarter of 2005.  On a year-to-date basis subscription revenuesincreased 9% to $86.1 million in 2006 from $78.7 million in 2005.

For both thesecond quarter and first half of 2006, the largest component of subscriptionrevenues, product content and support, increased to 36% of total revenues from32% in the corresponding periods of 2005. Product content and support includeshardware support of our Proventia appliances, software updates, technicalsupport and security content that includes advisory updates from X-Force, ourinternal team of security experts. Product content and support are provided toour customers through contracts executed with customers for a specified termand billed at the time of contract.  Suchbillings are recorded as deferred revenues on our balance sheet and amortizedas subscriptions revenue over the term of the contract.  The increase of our product content andsupport revenues in the future is dependent on continued success with productsales and maintenance renewals.

Managed servicesrevenues increased 2% from the second quarter of 2005 and 6% on an annualbasis.  Managed services revenues were14% of total revenues in the three and six months ended June 30, 2006, comparedwith 15% in the three months ended June 30, 2005 and 14% for the six monthsended June 30, 2005. We are marketing managed services both directly to end usersand through partners, including through a number of new arrangements withintegrators and service providers that include managed services as a part oftheir service offerings to their customers.

*Professionalservices*

Professional servicesrevenues increased to $5.9 million in the three months ended June 30, 2006 from$5.6 million in the three months ended June 30, 2005.  Professional services revenues were $11.3million in both the six months ended June 30, 2006 and 2005. We continue tofocus on high-value offerings that utilize our X-Force expertise, and look toour system integration and channel partners to serve as the primary resource tofulfill the services and education needs of our customers.

*Geographicregions*

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

|                  | ** ** | **Three months  ended  June 30,** | ** ** | **Six months  ended  June 30,** | ** ** |
|------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|
| ** **       | ** ** | **2006**                                    | ** ** | **2005**                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
| Americas         |       | 60                                          | %          | 63                                        | %          | 62 | % | 62 | % |
| EMEA             |       | 23                                          | %          | 22                                        | %          | 22 | % | 22 | % |
| Asia/Pacific Rim |       | 17                                          | %          | 15                                        | %          | 16 | % | 16 | % |

 

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

**Costsand Expenses**

*Personnel*

Personnel and related costs represent our largestexpense category.  We ended the secondquarter of 2006 with 1,285 employees, up approximately 6% from the secondquarter of 2005. The majority of headcount growth occurred in engineering,quota-carrying sales personnel, sales support, and managed security servicesoperations. Our headcount has fluctuated between approximately 1,150 and 1,285over the last 3 years as we acquired and integrated acquisitions andcontinually refined our business targets in light of economic conditions duringthese years.

On January 1, 2006we adopted SFAS No. 123(R), and as required we have recorded stock-basedcompensation expense starting in the first quarter of 2006. Previously we hadaccounted for stock options under APB No. 25, and as permitted, we had notrecorded stock-based compensation expense for our options. We adopted SFAS No.123(R) using the modified prospective method, and accordingly, prior periodresults have not been restated, and do not include, the impact of SFAS No.123(R). Total stock-based compensation expense related to the expensing ofstock options was approximately $3.5 million and $6.4 million in the three andsix months ended June 30, 2006, respectively, or  4.2% and 3.9% of total revenues,respectively. This expense has affected the

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comparability of currentresults to the prior three- and six-month periods for the majority of ourexpense categories as it has been recorded in the expense line in which therecipients of the options are placed. Unrecognized non-cash stock compensation expense related to unvestedoptions outstanding as of June 30, 2006 was approximately $22.6 million andwill be recorded over the remaining vesting period of four years.

We began to userestricted stock, in addition to stock options, as an equity component ofcompensation beginning in the first quarter of 2004.  We incurred $0.5 million and$0.9 million of compensation expense in the three and six months endedJune 30, 2006, respectively, and $0.5 million and $1.1 million of compensationexpense in the three and six months ended June 30, 2005, respectively. Werecorded these restricted stock charges in the expense categories in which therecipients are placed.  Unrecognizednon-cash stock compensation expense related to unvested restricted stockoutstanding as of June 30, 2006 was approximately $8.2 million and will berecorded over the remaining vesting period of approximately four years.

###### *Cost ofproduct licenses and sales*

The substantialportion of our cost of product licenses and sales represents the hardware costof our Proventia appliances. Costs associated with licensing our softwareproducts are minor.  As a percentage ofproduct licenses and sales revenues, these costs increased to 24% in thequarter ended June 30, 2006 from 18% in the quarter ended June 30, 2005.  On a year-to-date basis, cost of productlicenses and sales increased to 22% of product licenses and sales revenue in2006 from 19% in 2005. We also purchased development source code in the firstquarter of 2006 and in 2004, which is being amortized as cost of products soldover its estimated useful life of four years. These increases in the costs as apercentage of the related revenues resulted from an increase in Proventiaappliance revenues, which grew approximately 16% on a quarterly and 14% on a year-to-datebasis in 2006 compared to 2005.

We incurredamortization expense related to core and developed technology that was recordedas a result of acquisitions accounted for under the purchase method ofaccounting of approximately $1.5 million in the three months ended June 30,2006; $1.8 million in the three months ended June 30, 2005; $3.2 million in thesix months ended June 30, 2006; and $3.5 million in the six months ended June30, 2005.

*Cost ofsubscriptions and professional services*

Cost of subscriptions and professional services includes thecost of our technical support personnel who provide assistance to customersunder product support agreements, the security operations center (“SOC”) costsof providing managed security monitoring services, and the costs related to ourprofessional services and training. These costs were $14.5 million in the threemonths ended June 30, 2006 and $13.2 million in the three months ended June 30,2005. In the six months ended June 30, 2006 these costs were $28.0 millioncompared to $26.3 million in the corresponding period of 2005.  Stock-based compensation expense with the adoptionof SFAS No. 123(R) accounted for approximately $0.4 million of the increase inthe quarter comparison and approximately $0.8 million in the year-to-datecomparison. The remaining increase is primarily related to additional personnelto handle additional customers. As a percentage of subscription andprofessional services revenues, these costs were approximately 29% for allperiods presented.

Costs associated with our technical support personnel and oursecurity operations centers increased each year in 2005, 2004 and 2003 as weadded personnel to handle additional customers. We gained efficiencies in ourSOCs and restructured our support groups to be more productive so personnelincreased at a lower rate than revenue growth, contributing to those costsremaining the same as a percentage of total revenues even with the addition ofstock-based compensation expense in 2006. Additionally, our appliances typically require less technical supporteffort than our software products.  Whilewe continue to seek increased productivity, we do expect increase in costs witha continued increase in revenues in the future.

*Researchand development*

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

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

Research anddevelopment expenses increased $1.4 million to $12.4 million in the threemonths ended June 30, 2006 from $11.0 million in the three months endedJune 30, 2005. On a year-to-date basis, these costs increased $3.8 million to$25.1 million in the first half of 2006 from $21.3 million in the first half of2005. Approximately $0.9 million and $1.7 million of the quarter and year todate increase, respectively, was related to stock options expense with theadoption of SFAS No. 123(R). The remaining increase

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was a result ofadditional engineering headcount as we continue to invest in our productofferings. Research and development expenses were 15% of total revenues for thethree and six months ended June 30, 2006 compared to 14% for the three and sixmonths ended June 30, 2005. The additional stock option expense with theadoption of SFAS No. 123(R) contributed to the increase in this percentage.

While we arecommitted to continue our investment in X-Force research and developmentcapabilities, which we believe distinguishes ISS from its competitors, weintend to seek leverage in future periods in the research and development areawhile enhancing current technologies and developing new technologies.

*Salesand marketing*

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

Sales andmarketing expenses increased approximately $2.5 million to $30.0 millionin the three months ended June 30, 2006 from $27.5 million in the three monthsended June 30, 2005. The implementation of SFAS 123(R) on January 1, 2006 addedapproximately $1.2 million (approximately 1.5% of total revenues) of stockoption expense in the three months ended March 31, 2006.  In the six months ended June 30, 2006 salesand marketing increased approximately $4.5 million to $58.1 million from $53.6million in the six months ended June 30, 2005. Approximately $2.1 million ofthe increase was a result of stock option expense with the adoption of SFAS No.123(R). We added quota-carrying headcount and sales support, but gainedleverage from our sales force as we continue to increase the percentage ofsales fulfilled through our partner sales channel.

We expect tocontinue to achieve leverage in our sales efforts by focusing our direct salesforce on large customers that are served either directly by us or through largesystems integrators. We believe our partner sales channel, which includessystems integrators, value-added resellers and distributors, will continue tobe of increasing importance to us, measured quantitatively by an increasinglevel of product revenue originating through it.  This channel represented approximately 81% ofour sales in the second quarter of 2006 as compared to 75% in 2005. We intendto use its capabilities in the future to reach larger customers through jointselling efforts and to reach departmental and small companies.

*Generaland administrative*

General andadministrative expenses consist of personnel-related costs for executive,administrative, finance and human resources, internal information systems andother support services costs, and legal, accounting and other professionalservice fees.  General and administrativeexpenses were $8.4 million in the second quarter of 2006 and $16.7 million inthe first half of 2006 compared with $7.3 million in the second quarter of 2005and $14.6 million in the first half of 2005. The largest increase wasapproximately $1.0 million and $1.8 million for the three and six months endedJune 30, 2006, respectively, for the expensing of stock options due to theadoption of SFAS 123(R) on January 1, 2006.

*Interestincome*

Interest incomeincreased to $1.8 million in the quarter ended June 30, 2006 from $1.3 millionin the comparable quarter of 2005 and to $3.8 million in the six months endedJune 30, 2006 from $2.3 million in the six months ended June 30, 2005.  These increases were due to a higher yield oninvestment-quality commercial paper and similar investments of approximately3.9% for the 2006 periods compared to 2.9% in the second quarter of 2005 and2.6% in the first half of 2005.

*Otherincome (expense), net*

Other income(expense) consists primarily of minority interest expense and foreign exchangegains or losses.  Minority interestexpense was $240,000 and $572,000 for the three and six months ended June 30,2006 compared to $51,000 and $61,000 for the corresponding periods of 2005.Foreign exchange gains were $364,000 and $341,000 in the three and six monthsended June 30, 2006, compared to losses of $445,000 and $980,000 for thecorresponding periods in 2005.

*Gain onissuance of subsidiary shares*

The gain on issuance ofsubsidiary shares results from Internet Security Systems KK, our Asia/Pacificsubsidiary (“ISS KK”), issuing shares related to the exercise of ISS KK stockoptions. In 2006, ISS KK has issued 243 shares at an average exercise price ofapproximately $450 per share.  Ourownership percentage of the subsidiary remained at 87% at June 30, 2006.  Deferred income taxes have been provided inthe period in which the gain is recognized.

*Provisionfor income taxes*

Oureffective tax rate was approximately 37% for the three and six months ended June30, 2006 and approximately 36.5% for

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the three and six monthsended June 30, 2005. The effective rates differ from the Federal statutory ratedue primarily to certain operating expenses that are not deductible for incometax purposes, state income taxes, foreign operations taxed at different ratesand Federal tax credits.

**Liquidityand Capital Resources**

Our financialposition remained strong through the first six months of 2006. Our cash andcash equivalents and marketable security investments were $219.8 million atJune 30, 2006. Our investments in marketable securities consisted solely ofhighly rated debt obligations with maturities of twelve months or less.

We continue tomeet our working capital needs and capital equipment needs with cash providedby operations. Cash provided by operations in the first six months of 2006totaled $28.6 million. The major components of cash flows provided by operatingactivities were net income of $13.2 million, non-cash depreciation andamortization expense charges of $10.3 million, non-cash stock-basedcompensation expense of $7.3 million, a decrease in accounts receivable of$10.5 million, an increase in deferred revenue of $2.3 million, offset by anincrease in inventory of $3.4 million, an increase in prepaid expenses andother assets of $2.9 million, and a decrease in accounts payable and accruedexpenses of $9.9 million (primarily for the payment of income taxes).

An importantelement of our liquidity is the collection of our accounts receivable. Wemeasure our accounts receivable management by our day’s sales outstanding (“DSO”).This is a measurement of accounts receivable divided by billings in thequarter, represented by the sum of revenues plus the change in the deferredrevenues liability account balance. This measurement was 85 days at June30, 2006, within our target range of 75 to 85 days.

Our net cash usedin investing activities was $55.4 million in the first six months of2006.  Investing activities includedchanges in our marketable securities that have quality characteristics similarto cash equivalents, except their maturities when we acquire them are longerthan three months. The cash flow statement included the purchase of $48.6million of intermediate term marketable securities, primarily interest-bearinggovernment obligations and commercial paper, offset by net proceeds from thematurity and sales of marketable securities of $7.7 million. Also includedin cash flow from investing was the purchase of $12.1 million of property,equipment, and acquired source code due to continued investment in our businessand infrastructure.

Our financingactivities used $36.8 million of cash in the first six months of2006.  This was principally due to therepurchase of $2.0 million shares of our common stock in the open market at anaggregate cost of $41.8 million. The previous stock repurchase plan expired inJuly 2006 and we are currently considering a replacement program.  Since the inception of the stock repurchaseprograms, we have purchased 9.1 million shares at an average cost of$18.30 per share for a total cash outlay of approximately$166.1 million.  Also, in the firstsix months of 2006, the exercise of stock options by our employees generatedfunds of approximately $4.5 million.

At June 30, 2006, we had $219.8 million of cashand cash equivalents. An additional $9.2 million of cash equivalents andmarketable securities are pledged as collateral for stand-by letters of creditrelated to the operating leases of our facilities and are shown on the balancesheet as restricted marketable securities and cash equivalents. We believe thatsuch cash and cash equivalents and marketable securities will be sufficient tomeet our working capital needs and capital expenditures for the foreseeablefuture. Furthermore, we are not aware of any trends, events, or uncertaintiesthat are reasonably likely to result in any significant change to ourliquidity.

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

###### *Off-Balance Sheet Arrangements*

Payments for certain operating leases for our officespace are secured by collateralized standby letters of credit totaling$7.9 million at June 30, 2006. These standby letters of credit guaranteepayments on certain lease obligations and are renewed annually unless cancelledby either party. The lease obligations have terms that expire at various datesthrough 2013.  The beneficiary of thestandby letters of credit can draw on the letters of credit if we default onthe related lease obligation.  Eachstandby letter of credit is collateralized by securities. At June 30, 2006,$9.2 million of cash and marketable securities are pledged as collateraland are shown on the balance sheet as restricted cash and marketablesecurities.

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

ISS is subject to foreign exchange risk as a result ofexposures to changes in currency exchange rates. Our foreign operations are,for the most part, naturally hedged against exchange rate fluctuations sincethe majority of revenues and expenses of each foreign

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affiliateare denominated in the same currency. Therefore, we do not engage in formalhedging activities, but we do periodically review the potential impact of thisrisk to ensure that the risk of significant potential losses remains minimal.As a result, an unfavorable change in the exchange rate for any particularforeign subsidiary would result in lower revenues and expenses with regards tooperating results, and lower assets and liabilities with regards to the balancesheet.

The Company’s operating results are affected bychanges in exchange rates between the U.S. Dollar and the Euro and theJapanese Yen. When the U.S. Dollar strengthens against these foreigncurrencies, the value of our reporting currency revenues decreases. When theU.S. Dollar weakens, the value of our reporting currency revenuesincreases.  Since much of ourinternational operating expenses are also incurred in local currencies, whichis the foreign subsidiaries functional currency, the impact of exchange rateson net income or loss is relatively less than the impact on revenue. Althoughour operating and pricing strategies take into account changes in exchangerates over time, our results of operations may be affected significantly in theshort term by fluctuations in foreign currency exchange rates. A fluctuation of10% in the average exchange rates of the Euros and Japanese Yen relative to theUS dollar for the three and six months ending June 30, 2006 and 2005 wouldhave resulted in increases or decreases in operating income of approximately$1.4 million, $2.7 million in 2006, respectively, and $1.3 million and$2.6 million in 2005, respectively, from the reported operating income.

During the three and six month periods ended June 30,2006, the Company recorded a net foreign exchange gains of $364,000 and$341,000. The nature and extent of the foreign currency risk faced by theCompany depends on many factors that cannot be accurately predicted. Thesefactors include significant changes in foreign currency market conditions, theCompany’s inability to match foreign currency denominated revenues with costsdenominated in the same currency, and changes in the amount or mix of revenuesdenominated in various foreign currencies. As a result of material unforeseenchanges in these factors, the Company’s foreign currency risk could have agreater impact on the Company’s results of operations in the future.

**Item 4.Controls and Procedures**

*Disclosure Controls andProcedures*

ISS maintainsdisclosure controls and procedures that are designed to ensure that informationrequired to be disclosed in ISS’ Securities Exchange Act reports is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission’s rules and forms, and that such informationis accumulated and communicated to ISS’ management, including the ChiefExecutive Officer and Chief Financial Officer, as appropriate, to allow timelydecisions regarding required disclosure. No system of controls, no matter howwell designed and operated, can provide absolute assurance that the objectivesof the system of controls are met, and no evaluation of controls can provideabsolute assurance that the system of controls has operated effectively in allcases. Our disclosure controls and procedures however are designed to providereasonable assurance that the objectives of disclosure controls and proceduresare met.

Our ChiefExecutive Officer and Chief Financial Officer have evaluated the effectivenessof ISS’ disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act) as of the end of the period coveredby this report. Based on such evaluation, such officers have concluded that, asof the end of the period covered by this report, ISS’ disclosure controls andprocedures were effective.

**Changes in Internal Control Over Financial Reporting**

There have not been any changes in ISS’ internalcontrol over financial reporting during the quarter ended June 30, 2006 thathave materially affected, or are reasonably likely to materially affect, suchcontrols.

**PARTII. OTHER INFORMATION**

**Item 1.Legal Proceedings**

On August 17,2004, the Company’s Georgia operating subsidiary filed in the United StatesDistrict Court for the Northern District of Georgia a declaratory judgmentaction (the “Georgia Action”) against SRI International, Inc. (“SRI”). Theaction seeks the court’s declaration that our products and services do notinfringe any valid claim of five patents held by SRI and seeks declaration thatcertain claims of those patents are invalid. On August 26, 2004, SRI filedin the United States District Court for Delaware a complaint against theCompany and Symantec Corporation (the “Delaware Action”). The complaint in theDelaware Action alleges that our SiteProtector and Proventia products infringeupon claims of two of the five patents at issue in the Georgia Action. TheDelaware Action seeks unspecified damages and injunctive relief. OnApril 25, 2005, SRI filed an amended complaint adding the Company’sGeorgia operating subsidiary as a separate defendant to the Delaware Action.The Company and its subsidiary answered SRI’s amended complaint on May 23,2005, denying that they infringe the two patents asserted by SRI and assertingcounterclaims seeking a declaration from the Delaware court that the five SRIpatents are not infringed, and are invalid and unenforceable. On June 9,2005, the Georgia court transferred the Georgia Action to the United StatesDistrict Court for the District of Delaware. The transferred action wasconsolidated with the Delaware Action. On June 13, 2005, SRI answered thecounterclaims asserted by the Company and

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its subsidiary, denyingthat the five patents are not infringed, invalid, and unenforceable. OnAugust 5, 2005, SRI granted to the Company a covenant never to sue theCompany, its distributors, customers, licensees or end users, for damages orany other form of legal or equitable relief based on or arising out of thealleged infringement of one of the five patents-in-suit as a result of themanufacture, use, sale, offer for sale, importation, maintenance, support orservicing of any Company product or service existing on or before the effectivedate. The parties are currently engaged in discovery on the remaining claims,and trial has been scheduled to begin on or about October 30, 2006. Weintend to defend the Delaware Action vigorously and believe we have meritoriousdefenses and counterclaims.

**Item 1A.Risk Factors**

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

***We Operate in aRapidly Evolving Market***

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

·       respondto competitive developments;

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

·       continueto attract, retain and motivate our employees.

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

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

***Our FutureOperating Results Will Likely Fluctuate Significantly***

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

·       theextent to which the public perceives that unauthorized access to and use ofonline information are threats to network security;

·       customerbudgets;

·       themix of product sales among the various products offered by ISS and whetherrevenue is recognized upon sale or deferred to subsequent periods;

·       thevolume and timing of orders and deliveries, including seasonal trends incustomer purchasing;

·       ourability to develop and timely introduce new and enhanced product and managedservice offerings;

·       newregulations requiring changes to products and the availability of compliantproducts in a timely manner;

·       theintroduction and acceptance rate of new ISS branded appliances, includingrelated increased cost of goods sold;

·       disruptionin the sales cycle and supply chain management due to product introductions;

·       ourability to accurately forecast and produce demanded quantities of our applianceproducts and models;

·       availabilityof component parts of appliance products and reliance on contract manufacturersto produce such products;

·       ourability to provide scalable managed services offerings in a cost effectivemanner;

·       foreigncurrency exchange rates that affect our international operations;

·       whetherenterprises consolidate their security platforms with fewer vendors and whetherISS benefits from this;

·       productand price competition in our markets; and

·       generaleconomic conditions, both domestically and in our foreign markets.

We focus our direct sales efforts on enterprise-widesecurity solutions, which consist of our entire product suite, professionalservices, and managed security services, rather than on the sale of componentproducts. As a result, each sale requires substantial time and effort from oursales and support staff. In addition, the revenues associated with particularsales vary significantly depending on the number of products acquired by acustomer and the number of devices used by the customer. Large individualsales, or even small

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delaysin customer orders, can cause significant variation in our license revenues andresults of operations for a particular period. The timing of large orders isusually difficult to predict and, like many software-based technologycompanies, many of our customers typically complete transactions in the lastmonth of a quarter.

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

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

***Dependence on ThirdParty Suppliers and Manufacturers***

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

***We Face IntenseCompetition in Our Market***

The market for network security monitoring, detection,prevention and response solutions is intensely competitive, and we expectcompetition to increase in the future. We cannot guarantee that we will competesuccessfully against our current or potential competitors, especially thosewith significantly greater financial resources or brand name recognition. Ourchief competitors generally fall within the following categories:

·       largecompanies, including Symantec Corporation, Cisco Systems, Inc., JuniperNetworks, Inc., 3Com Corporation, Check Point Software Technologies, LTD,and McAfee, Inc., that sell competitive products and offerings, as well asother large software companies that have the technical capability and resourcesto develop competitive products;

·       softwareor hardware network infrastructure companies like Cisco Systems, Inc.,3Com Corporation, and Juniper Networks, Inc. that could integrate featuresthat are similar to our products into their own products;

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

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

Mergers or consolidations among these competitors, oracquisitions of small competitors by larger companies, represent risks. Forexample, Symantec Corporation., Cisco Systems, Inc., McAfee, Inc.,3Com Corporation, and Juniper Networks, Inc. have acquired during the pastseveral years smaller companies, which have network security technologies.These acquisitions will make these entities potentially more formidablecompetitors to us if such products and offerings are effectively integrated.Large companies may have advantages over us because of their longer operatinghistories, greater name recognition, larger customer bases or greaterfinancial, technical and marketing resources. As a result, they may be able toadapt more quickly to new or emerging technologies and changes in customerrequirements. They can also devote greater resources to the promotion and saleof their products than we can. In addition, these companies have reduced andcould continue to reduce, the price of their security monitoring, detection,prevention and response products and managed security services, which increasespricing pressures within our market.

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

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

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

***We Face RisksAssociated with Governmental Contracting***

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

·       Procurement—Contractingwith public sector customers is highly competitive and can be expensive andtime-consuming, often requiring that we incur significant upfront time andexpense without any assurance that we will win a contract;

·       Budgetary Constraints andCycles—Demand and payment for our products and services are impacted by publicsector budgetary cycles and funding availability, with funding reductions ordelays adversely impacting public sector demand for our products and services;

·       Modification orCancellation of Contracts—Public sector customers often have contractual orother legal rights to terminate current contracts for convenience or due to adefault. If a contract is cancelled for convenience, which can occur if thecustomer’s product needs change, we may only be able to collect for productsand services delivered prior to termination. If a contract is cancelled becauseof default, we may only be able to collect for products and alternativeproducts and services;

·       GovernmentalAudits—National governments and other state and local agencies routinelyinvestigate and audit government contractors’ administrative processes. Theymay audit our performance and pricing and review our compliance with applicablerules and regulations. If they find that we improperly allocated costs,they may require us to refund those costs or may refuse to pay us foroutstanding balances related to the improper allocation. An unfavorable auditcould result in a reduction of revenue, and may result in civil or criminalliability if the audit uncovers improper or illegal activities.

***We Face RapidTechnological Change in Our Industry and Frequent Introductions of New Products***

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

·       the extent to whichbusinesses and others seek to establish more secure networks;

·       the extent to which hackersand others seek to compromise secure systems;

·       evolving computer hardwareand software standards;

·       changing customerrequirements; and

·       frequent introductions ofnew products and product enhancements.

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

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

We are increasing ourinvestment in engineering and customer support activities and these investmentsmay achieve delayed, or lower than expected, benefits which could harm ouroperating results. We intend to continue to add personnel and other resourcesto our engineering and customer support functions as we continue developingadvanced technologies. We are likely to recognize the costs associated withthese investments earlier than some of the anticipated benefits and the returnon these investments may be lower, or may develop more slowly, than we expect.If we do not achieve the benefits anticipated from these investments, or if theachievement of these benefits is delayed, our expected operating results may beadversely affected.

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

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***Undetected Product Errors or Defects CouldResult in Loss of Revenues, Delayed Market Acceptance and Claims Against Us***

We offer warranties on our products, allowing the endcustomer to have any defective product repaired, or to receive a replacementproduct for it during the warranty period, or in certain circumstances returnthe product for a refund. Our products may contain undetected errors ordefects. If there is a broad product failure across our customer base, we maydecide to replace all affected products or we may decide to refund the purchaseprice for defective units. Such defects and actions may adversely affect ourability to record revenue. Some errors are discovered only after a product hasbeen installed and used by end customers. Any errors discovered aftercommercial release could result in loss of revenues and claims against us.

We offer warranties on our service levels for managedsecurity services. If we do not meet warranties, the customer generally mayobtain credits for service.

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

·       failure to achieve marketacceptance;

·       loss of customers;

·       loss of or delay inrevenues and loss of market share;

·       diversion of developmentresources;

·       increased service andwarranty costs;

·       legal actions by ourcustomers; and

·       increased insurance costs.

***Our Products are Complex and Are Operatedin a Wide Variety of Computer Configurations, Which Could Result in Errors orProduct Failures***

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

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

***We Might Have to Defend Lawsuits or PayDamages in Connection With Any Alleged or Actual Failure of Our Products andServices***

Because our products and services provide and monitornetwork security and may protect valuable information, we could face claims forproduct liability, tort or breach of warranty. Anyone who circumvents oursecurity measures could misappropriate the confidential information or otherproperty of end customers using our products, or interrupt their operations. Ifthat happens, affected end customers or others may sue us. In addition, we mayface liability for breaches caused by faulty installation of our products byour service and support organizations. Provisions in our contracts relating towarranty disclaimers and liability limitations may be unenforceable. Some courts,for example, have found contractual limitations of liability in standardcomputer and software contracts to be unenforceable in some circumstances.Defending a lawsuit, regardless of its merit, could be costly and could divertmanagement attention. Our business liability insurance coverage may beinadequate or future coverage may be unavailable on acceptable terms or at all.

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***Risks Associatedwith Our Global Operations***

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

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

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

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

·       increased financialaccounting and reporting burdens;

·       potentially adverse taxconsequences;

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

·       reduced protection forintellectual property rights in some countries;

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

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

Despite these risks, we believe that we must continueto expand our operations in international markets to support our growth. Tothis end, we intend to establish additional foreign sales operations, expandour existing offices, hire additional personnel, expand our international saleschannels and customize our products for local markets. If we fail to executethis 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 securitysolutions company, we are a high profile target. Although we believe we havesufficient controls in place to prevent disruption and misappropriation, and torespond to such situations, we expect these efforts by hackers to continue. Ifthese efforts are successful, our operations, reputation and sales could beadversely affected.

***We MustSuccessfully Integrate Acquisitions***

As part of our growth strategy, we have and maycontinue to acquire or make investments in companies with products,technologies or professional services capabilities complementary to oursolutions. When engaging in acquisitions, we could encounter difficulties inassimilating or completing the development of the technologies, new personneland operations into our company. These difficulties may disrupt our ongoingbusiness, distract our management and employees, increase our expenses andadversely affect our results of operations. These difficulties could alsoinclude accounting requirements, such as impairment charges related to goodwillor other intangible assets or expensing in-process research and developmentcosts. We cannot be certain that we will successfully overcome these risks withrespect to any future acquisitions or that we will not encounter other problemsin connection with our recent or any future acquisitions. In addition, anyfuture acquisitions may require us to incur debt or issue equity securities.The issuance of equity securities could dilute the investment of our existingstockholders.

***We Have Authorized the Use of a SubstantialAmount of Our Cash for the Repurchase of Our Shares, and This Use of FundsMay Limit Our Ability to Complete Other Transactions or to Pursue OtherBusiness Initiatives.***

ISS has historically used significant amounts of cashin share repurchase programs to repurchase outstanding shares of our commonstock. Repurchase programs generally use a significant portion of cashreserves. Use of cash in this manner could limit our future flexibility tocomplete acquisitions of businesses or technology or other transactions.

***Our ProprietaryRights May be Difficult to Enforce***

We rely primarily on copyright, trademark, patent andtrade secrets laws, confidentiality procedures and contractual provisions toprotect our proprietary rights. We hold several United States patents, oneTaiwanese patent, and have a number of patent applications pending. We alsohold numerous United States and foreign trademarks and have a number oftrademark applications pending. There can be no assurance that patents will beissued from pending applications, or that claims allowed on any patents will besufficiently broad to protect our technology. There can be no assurance thatany issued patents will not be challenged, invalidated or circumvented, or thatany rights granted under these patents will actually provide competitiveadvantages to us. Despite our efforts to protect our proprietary rights,unauthorized parties may attempt to copy aspects of our products or to obtainand use information that we regard as proprietary. Policing unauthorized use ofour products is difficult. While we cannot determine the extent to which piracy

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of our software products occurs, we expect softwarepiracy to be a persistent problem. In addition, the laws of some foreigncountries do not protect our proprietary rights to as great an extent as do thelaws of the United States, and many foreign countries do not enforce these lawsas diligently as U.S. government agencies and private parties. If we areunable to protect our proprietary rights to the totality of the features in oursoftware and products (including aspects of our software and products protectedother than by patent rights), we may find ourselves at a competitivedisadvantage to others who need not incur the additional expense, time andeffort required to create the innovative products that have enabled us to besuccessful.

***We May BeFound to Infringe the Proprietary Rights of Others***

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

***Some Provisions inthe ISS Certificate of Incorporation and Bylaws Make a Takeover of ISSDifficult***

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

·       establish a classifiedboard of directors;

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

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

·       limit calling specialmeetings of stockholders; and

·       impose a requirement thatholders of 66 2¤3% of the outstanding sharesof common stock are required to amend the provisions relating to theclassification of our board of directors and action by written consent ofstockholders.

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

The following table provides information about purchases by the Company of its common stock during the three months ended June 30, 2006.  All such purchases were made in open-market transactions pursuant to a repurchase plan publicly announced on July 27, 2005.  Under this repurchase plan, the Company was authorized by the Board to repurchase up to $100 million of its outstanding common stock over the 12 months ending July 19, 2006.  This plan has now terminated and no further purchases can be made under it or any of the previous repurchases plans.  We are currently considering a replacement program.  Through June 30, 2006, the Company had purchased approximately 9.1 million shares at an aggregate cost of approximately $166.1 million under the current and prior repurchase plans.

**Issuer Purchases of Equity Securities**
| ** **     | ** ** | ** **               | ** ** | ** **             | ** ** | **Total Number of**          | ** ** | **Approximate Dollar**        | ** ** |
|----------------|------------|--------------------------|------------|------------------------|------------|----------------------------------------|------------|------------------------------------|------------|
| ** **     | ** ** | ** **               | ** ** | ** **             | ** ** | **Shares Purchased**              | ** ** | **Value of Shares**      | ** ** |
| ** **     | ** ** | **Total Number**    | ** ** | **Average Price** | ** ** | **As Part of Publicly** | ** ** | **That May Yet Be** | ** ** |
| ** **     | ** ** | **of Shares ** | ** ** | **Paid**               | ** ** | **Announced Plans or**       | ** ** | **Purchased Under the**  | ** ** |
| **Period**     | ** ** | **Purchased**            | ** ** | **Per Share**     | ** ** | **Programs**                           | ** ** | **Plans or Programs**    | ** ** |
| 4/1/06-4/30/06 |       | 20,000                   |       | $                      | 22.55      |                                   | 20,000     |                               | $          | 54,318,000 |   |
| 5/1/06-5/31/06 |       | 797,000                  |       | $                      | 21.05      |                                   | 797,000    |                               | $          | 37,541,000 |   |
| 6/1/06-6/30/06 |       | 546,000                  |       | $                      | 19.91      |                                   | 546,000    |                               | $          | 26,670,000 |   |

 

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**Item 3.Defaults Upon Senior Securities**

**None.**

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

The Annual Meetingof Stockholders of Internet Security Systems, Inc. was held on Friday, May 26,2006.

The followingthree directors were elected to serve a three-year term ending in the year2008: (a) Thomas E. Noonan, 42,081,047 votes for and 745,350 votes withheld,(b) Sam Nunn, 41,255,250 votes for and 1,571,152 votes withheld, and (c) David N.Strohm, 39,540,250 votes for and 3,286,147 votes withheld. Directors continuingin office are Robert E. Davoli, Christopher W. Klaus, Richard S. Bodman, andKevin J. O’Connor.

**Item 5.Other Information**

**None.**

**Item 6. Exhibits**
| 11**  |   | — |   | Computation of Per Share Earnings                                                                                                       |
|-------|--------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------|
| 31.1* |   | — |   | Certification of principal executive officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                           |
| 31.2* |   | — |   | Certification of principal financial officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                           |
| 32.1* |   | — |   | Certification Pursuant to 18 U.S.C.  Section 1350. as Adopted Pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002 |
| 32.2* |   | — |   | Certification Pursuant to 18 U.S.C.  Section 1350. as Adopted Pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002 |

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*                    Identifiesthose filed exhibits with this Form 10-Q.

**             Datarequired by SFAS No. 128, “Earnings Per Share”, is provided inNote 5 to the consolidated financial statements in this report.

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                       |   |   | INTERNET SECURITY SYSTEMS, INC.                      |
|-----------------------|--------|--------|------------------------------------------------------|
|                  |   |   | (Registrant)                                         |
|                  |   |   |                                                 |
| Date: August 4,  2006 | By     |   | /s/ Raghavan Rajaji                                  |
|                  |   |   | Senior Vice President Finance and Administration     |
|                  |   |   | and Chief Financial Officer (on behalf of registrant |
|                  |   |   | and as principal financial officer)                  |

 

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