##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-Q (Mark One)[X]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended September 30, 2004OR[   ]
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934For the transition period from  to
 Commission File Number 000-23655 INTERNET SECURITY SYSTEMS, INC. (Exact name of registrant as specified in its charter) DELAWARE
(State or jurisdiction of
incorporation or organization)
    
    58-2362189
(I.R.S. Employer
Identification No.)
 6303 BARFIELD ROAD, ATLANTA, GEORGIA 30328
(Address of principal executive offices) Registrants telephone number, including area code (404) 236-2600 Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [   ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [   ] Indicate the number of shares outstanding of each of the registrants
classes of common stock, as of the latest practicable date. Number of SharesOutstandingTitle of each class of common stock
    
    as of October 29, 2004Common stock, $0.001 par value
    
    45,859,041




---



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




---



##### Table of Contents



PART I. FINANCIAL INFORMATION 
 Item 1. Consolidated Financial Statements INTERNET SECURITY SYSTEMS, INC. 
 CONSOLIDATED BALANCE SHEETS
  September 30,
    
    December 31,2004
    
    2003(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    114,756
    
    
    $
    184,551Marketable securities
    
    
    73,859
    
    
    
    53,630Accounts receivable, less allowance for doubtful accounts of $3,228 and $2,755, respectively
    
    
    66,521
    
    
    
    66,588Inventory
    
    
    1,224
    
    
    
    750Prepaid expenses and other current assets
    
    
    10,408
    
    
    
    10,732Total current assets
    
    
    266,768
    
    
    
    316,251Property and equipment:Computer equipment and software
    
    
    56,055
    
    
    
    45,261Office furniture and equipment
    
    
    22,250
    
    
    
    21,311Leasehold improvements
    
    
    21,620
    
    
    
    21,67499,925
    
    
    
    88,246Less accumulated depreciation
    
    
    64,293
    
    
    
    52,42735,632
    
    
    
    35,819Restricted cash and marketable securities
    
    
    12,760
    
    
    
    12,760Goodwill, less accumulated amortization of $27,381
    
    
    222,563
    
    
    
    201,303Other intangible assets, less accumulated amortization of $18,857 and $13,499, respectively
    
    
    20,199
    
    
    
    9,728Other assets
    
    
    8,926
    
    
    
    5,421Total assets
    
    $
    566,848
    
    
    $
    581,282LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    5,958
    
    
    $
    5,145Accrued expenses
    
    
    24,328
    
    
    
    26,092Deferred revenues
    
    
    59,580
    
    
    
    55,271Total current liabilities
    
    
    89,866
    
    
    
    86,508Other non-current liabilities
    
    
    6,444
    
    
    
    2,573Deferred revenues, less current portion
    
    
    9,069
    
    
    
    5,858Commitments and contingencies Stockholders equity:Preferred stock, $.001 par value, 20,000,000 shares authorized, none issued or outstanding
    
    
    
    
    
    
    Common stock, $.001 par value, 120,000,000 shares authorized, 50,455,000 and 49,841,000
issued, respectively
    
    
    50
    
    
    
    50Additional paid-in capital
    
    
    490,505
    
    
    
    475,062Deferred compensation
    
    
    (3,887
    )
    
    
    (92
    )Accumulated other comprehensive income
    
    
    3,396
    
    
    
    7,452Retained earnings
    
    
    39,342
    
    
    
    22,251Treasury stock, at cost (4,601,000 and 1,310,000 shares, respectively)
    
    
    (67,937
    )
    
    
    (18,380
    )Total stockholders equity
    
    
    461,469
    
    
    
    486,343Total liabilities and stockholders equity
    
    $
    566,848
    
    
    $
    581,282
 See accompanying notes




---



##### Table of Contents



INTERNET SECURITY SYSTEMS, INC. 
 CONSOLIDATED STATEMENTS OF OPERATIONS
 
 Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Revenues:Product licenses and sales
    
    $
    31,241
    
    
    $
    25,545
    
    
    $
    88,877
    
    
    $
    76,158Subscriptions
    
    
    35,819
    
    
    
    28,211
    
    
    
    102,928
    
    
    
    83,035Professional services
    
    
    5,673
    
    
    
    6,331
    
    
    
    17,532
    
    
    
    19,47272,733
    
    
    
    60,087
    
    
    
    209,337
    
    
    
    178,665Costs and expenses:Cost of revenues:Product licenses and sales
    
    
    6,110
    
    
    
    2,407
    
    
    
    15,166
    
    
    
    5,652Subscriptions and professional services
    
    
    12,278
    
    
    
    11,784
    
    
    
    36,497
    
    
    
    36,671Total cost of revenues
    
    
    18,388
    
    
    
    14,191
    
    
    
    51,663
    
    
    
    42,323Research and development
    
    
    11,093
    
    
    
    10,496
    
    
    
    33,790
    
    
    
    30,288Sales and marketing
    
    
    24,653
    
    
    
    21,113
    
    
    
    73,123
    
    
    
    63,284General and administrative
    
    
    7,173
    
    
    
    5,428
    
    
    
    19,766
    
    
    
    16,407Amortization of other intangibles and
stock-based compensation
    
    
    1,791
    
    
    
    1,317
    
    
    
    5,409
    
    
    
    4,04663,098
    
    
    
    52,545
    
    
    
    183,751
    
    
    
    156,348Operating income
    
    
    9,635
    
    
    
    7,542
    
    
    
    25,586
    
    
    
    22,317Interest income
    
    
    699
    
    
    
    610
    
    
    
    1,691
    
    
    
    1,990Minority interest
    
    
    (126
    )
    
    
    (168
    )
    
    
    (537
    )
    
    
    (270
    )Other income
    
    
    3
    
    
    
    68
    
    
    
    220
    
    
    
    101Foreign currency exchange gain
    
    
    9
    
    
    
    28
    
    
    
    14
    
    
    
    497Income before income taxes
    
    
    10,220
    
    
    
    8,080
    
    
    
    26,974
    
    
    
    24,635Provision for income taxes
    
    
    3,809
    
    
    
    3,045
    
    
    
    9,883
    
    
    
    9,347Net income
    
    $
    6,411
    
    
    $
    5,035
    
    
    $
    17,091
    
    
    $
    15,288Basic net income per share of Common Stock
    
    $
    0.14
    
    
    $
    0.10
    
    
    $
    0.36
    
    
    $
    0.31Diluted net income per share of Common Stock
    
    $
    0.14
    
    
    $
    0.10
    
    
    $
    0.35
    
    
    $
    0.31Weighted average shares:Basic
    
    
    46,267
    
    
    
    49,142
    
    
    
    47,460
    
    
    
    49,123Diluted
    
    
    47,225
    
    
    
    49,884
    
    
    
    48,650
    
    
    
    49,773
 See accompanying notes




---



##### Table of Contents



INTERNET SECURITY SYSTEMS, INC. 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 
 Nine months endedSeptember 30,2004
    
    2003Operating activitiesNet income
    
    $
    17,091
    
    
    $
    15,288Adjustments to reconcile net income to net cash provided by operating activities:Depreciation
    
    
    11,866
    
    
    
    10,742Amortization of other intangibles and stock-based compensation
    
    
    5,409
    
    
    
    4,046Accretion of discount on marketable securities
    
    
    31
    
    
    
    172Minority interest
    
    
    537
    
    
    
    270Deferred compensation expense
    
    
    1,467
    
    
    
    Income tax benefit from exercise of stock options
    
    
    7,385
    
    
    
    8,146Gain on issuance of subsidiary stock
    
    
    (367
    )
    
    
    (127
    )Changes in assets and liabilities, excluding the effects of acquisitions:Accounts receivable
    
    
    829
    
    
    
    (805
    )Inventory
    
    
    (474
    )
    
    
    527Prepaid expenses and other assets
    
    
    (3,166
    )
    
    
    (1,996
    )Accounts payable and accrued expenses
    
    
    (1,964
    )
    
    
    136Deferred revenues
    
    
    5,035
    
    
    
    (1,195
    )Net cash provided by operating activities
    
    
    43,679
    
    
    
    35,204Investing activitiesAcquisitions, net of cash received
    
    
    (34,022
    )
    
    
    Purchases of marketable securities
    
    
    (64,465
    )
    
    
    (52,284
    )Net proceeds from maturity of marketable securities
    
    
    44,205
    
    
    
    49,977Release of restricted cash and marketable securities
    
    
    
    
    
    
    565Purchases of property and equipment
    
    
    (11,227
    )
    

    
    (6,653
    )Net proceeds from issuance of subsidiary stock
    
    
    433
    
    
    
    189Net cash used in investing activities
    
    
    (65,076
    )
    
    
    (8,206
    )Financing activitiesProceeds from exercise of stock options
    
    
    1,936
    
    
    
    439Proceeds from employee stock purchase plan
    
    
    1,417
    
    
    
    1,609Purchases of treasury stock
    
    
    (49,557
    )
    
    
    (9,454
    )Net cash used in financing activities
    
    
    (46,204
    )
    
    
    (7,406
    )Foreign currency impact on cash
    
    
    (2,194
    )
    
    
    3,088Net increase (decrease) in cash and cash equivalents
    
    
    (69,795
    )
    
    
    22,680Cash and cash equivalents at beginning of period
    
    
    184,551
    
    
    
    148,317Cash and cash equivalents at end of period
    
    $
    114,756
    
    
    $
    170,997Supplemental cash flow disclosureIncome taxes paid
    
    $
    2,800
    
    
    $
    1,302
 See accompanying notes




---



##### Table of Contents



INTERNET SECURITY SYSTEMS, INC. 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 Note 1. Significant Accounting Policies Basis of Presentation The consolidated financial statements of Internet Security Systems, Inc.
(ISS or the Company) as of September 30, 2004 and for the three months and
nine months ended September 30, 2004 and 2003 are unaudited and, in the opinion
of management, contain all adjustments, consisting of normal recurring items,
necessary for the fair presentation of the financial position and results of
operations of the Company for the interim periods. The consolidated financial
statements include the accounts of the Company and its majority-owned
subsidiaries. The consolidated balance sheet at December 31, 2003 has been
derived from the audited financial statements at that date but does not include
all of the footnotes required by U.S. generally accepted accounting principles
for complete financial statements. These consolidated financial statements should be read in conjunction with
the Consolidated Financial Statements and Notes thereto included in the
Companys Annual Report on Form 10-K for the year ended December 31, 2003. The
results of operations for the three months and nine months ended September 30,
2004 are not necessarily indicative of the results to be expected for the
entire year. All significant intercompany accounts and transactions have been
eliminated. Certain prior period amounts have been reclassified to conform to current
period presentation. The preparation of financial statements and related disclosures in
conformity with U.S. generally accepted accounting principles requires
management to make estimates and assumptions that affect the amounts reported
in the financial statements and accompanying notes. Actual results may differ
from those estimates, and such differences may be material to the consolidated
financial statements. Goodwill and Intangibles Goodwill and intangible assets are comprised of the following, as of the
dates indicated (in thousands): September 30, 2004
    
    December 31, 2003Gross
    
    
    
    
    
    GrossCarrying
    
    Accumulated
    
    Carrying
    
    AccumulatedAmount
    
    Amortization
    
    Amount
    
    AmortizationGoodwill
    
    $
    249,944
    
    
    $
    (27,381
    )
    
    $
    228,684
    
    
    $
    (27,381
    )Amortized intangible assets:Core technology
    
    
    3,853
    
    
    
    (2,882
    )
    
    
    3,853
    
    
    
    (2,521
    )Developed technology
    
    
    33,143
    
    
    
    (14,303
    )
    
    
    17,808
    
    
    
    (9,576
    )Customer relationships
    
    
    2,060
    
    
    
    (1,672
    )
    
    
    1,566
    
    
    
    (1,402
    )Total
    
    $
    39,056
    
    
    $
    (18,857
    )
    
    $
    23,227
    
    
    $
    (13,499
    )
 The changes in the carrying amounts of goodwill and other intangibles from
December 31, 2003 to September 30, 2004 were primarily a result of the purchase
of Cobion AG (Cobion) (see Note 3) and additional consideration related to a
2002 acquisition of TriSecurity Holdings Pte Ltd., resulting in approximately
$22.3 million of goodwill and $16.5 million of other intangibles recorded
during the first quarter of 2004. The remaining fluctuation is the result of
currency translation adjustments. The Company amortizes intangible assets over their estimated useful lives
of eight years for core technology, five years for developed technology, three
to six years for work force and three years for customer relationships.
Amortization expense of intangible assets is as follows (in thousands): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Core technology
    
    $
    121
    
    
    $
    122
    
    
    $
    361
    
    
    $
    361Developed technology
    
    
    1,646
    
    
    
    902
    
    
    
    4,727
    
    
    
    2,722Work force
    
    
    
    
    
    
    108
    
    
    
    
    
    
    
    326Customer relationships
    
    
    45
    
    
    
    109
    
    
    
    269
    
    
    
    327Total
    
    $
    1,812
    
    
    $
    1,241
    
    
    $
    5,357
    
    
    $
    3,736




---



##### Table of Contents



Additional amortization expense totaling $375,000 in the third quarter of
2004 and $1.1 million in the nine months ending September 30, 2004 related to
the purchase of a software license used in certain of the Companys products is
included in research and development expense. The estimated future amortization expense of intangible assets as of
September 30, 2004 is as follows (in thousands): AmountYear ending December 31,2004 (three months)
    
    $
    1,7752005
    
    
    7,1012006
    
    
    4,9932007
    
    
    3,0522008 & thereafter
    
    
    3,278Total
    
    $
    20,199
 Stock-Based Compensation Statement of Financial Accounting Standard 123, Accounting for
Stock-Based Compensation(SFAS 123), as amended by SFAS 148, Accounting for
Stock-Based Compensation  Transition and Disclosure,establishes accounting
and reporting standards for stock-based employee compensation plans. As
permitted by SFAS 123, ISS continues to account for stock-based compensation in
accordance with Accounting Principles Board Opinion No. 25, Accounting for
Stock Issued to Employees(APB 25), and has elected the pro forma disclosure
alternative of SFAS 123. Although SFAS 123 allows the Company to continue to follow APB 25
guidelines, the following table shows pro forma net income (loss) and
pro forma net income (loss) per share for the periods indicated as if the Company had adopted SFAS 123. The
pro forma impact of applying SFAS 123 as illustrated below will not necessarily
be representative of the pro forma impact in future years. Pro forma
information is as follows (amounts in thousands, except per share amounts): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net income, as reported
    
    $
    6,411
    
    
    $
    5,035
    
    
    $
    17,091
    
    
    $
    15,288Add: Amortization of
deferred compensation
included in reported net
income, net of income
taxes
    
    
    384
    
    
    
    
    
    
    
    986
    
    
    
    Less: Stock-based
compensation expense
computed under the Fair
Value method, net of
income taxes
    
    
    (5,996
    )
    
    
    (7,424
    )
    
    
    (18,364
    )
    
    
    (21,626
    )Pro forma net income (loss)
    
    $
    799
    
    
    $
    (2,389
    )
    
    $
    (287
    )
    
    $
    (6,338
    )Basic net income per share
of Common Stock, as
reported
    
    $
    0.14
    
    
    $
    0.10
    
    
    $
    0.36
    
    
    $
    0.31Diluted net income per
share of Common Stock, as
reported
    
    $
    0.14
    
    
    $
    0.10
    
    
    $
    0.35
    
    
    $
    0.31Pro forma basic and
diluted net income (loss)
per share of Common Stock
    
    $
    0.02
    
    
    $
    (0.05
    )
    
    $
    (0.01
    )
    
    $
    (0.13
    )




---



##### Table of Contents



On March 31, 2004, the FASB issued its Exposure Draft, Share-Based Payment,
which is a proposed amendment to SFAS No.123, Accounting for Stock-Based
Compensation. The amendment would require all share-based payments to
employees, including grants of employee stock options, to be recognized in the
income statement based on their fair values. The FASB expects to issue a final
amendment late in 2004. On October 13, 2004, the FASB decided that the final
amendment would be effective for public companies for any interim or annual
period beginning after June 15, 2005, though early adoption would be
encouraged, provided that financial statements for periods prior to the
effective date have not been issued. In 2004, 306,000 restricted shares have been issued to directors, officers and
certain key employees of ISS. The shares issued to directors vest when the
Company holds its annual stockholders meeting in 2005 and the shares issued to
officers and certain key employees vest in two installments: 50% vests two
years from the grant date, and the remaining 50% vests three years from the
grant date. Upon issuance of restricted shares, unearned compensation is
recorded in stockholders equity as deferred compensation equal to the market
value of the restricted shares and is recognized as compensation expense over
the vesting period. Total compensation expense for restricted stock awards
amounted to $613,000 in the third quarter of 2004 and $1.6 million in the nine
months ended September 30, 2004. Note 2. Income Taxes The Company recorded tax provisions of $3.8 million and $3.0 million for
the three-month periods ended September 30, 2004 and 2003, respectively, and
tax provisions of $9.9 million and $9.3 million for the nine-month periods
ended September 30, 2004 and 2003, respectively. While income tax expense was
recorded on domestic income, the amount of domestic taxes payable was reduced
by deductions related to the exercise of employee stock options in current and
prior periods. The tax benefit of these deductions was
recorded as additional paid-in capital. Taxes paid generally relate to foreign
operations and certain state taxes for which net operating loss deductions have
been suspended or fully utilized. The effective tax rate was approximately 37% for the three and nine months
ended September 30, 2004 and 38% for the three and nine months ended September
30, 2003. The effective rates differ from the statutory rates due to the impact
of acquisition-related intangibles and certain operating expenses that are not
deductible for income tax purposes as well as federal and state tax credits. As of September 30, 2004, ISS had fully utilized its net operating loss
carryforward related to US operations. The company has approximately $7.9
million of research and development tax credit carryforwards that expire
between 2011 and 2023 and foreign tax credit carryforwards of $2.4 million that
expire between 2006 and 2008. In addition, Cobion, which was acquired by ISS in January 2004, has a net
operating loss carryforward of approximately $9.1 million. The tax value of
this loss has been recorded as a deferred tax asset and the Company will not
reduce its total income tax expense as this loss is utilized. Note 3. Business Acquisition In January 2004, ISS acquired Cobion, a privately held company based in
Kassel, Germany. Cobion provides content filtering and anti-spam technology
that protects individuals and enterprises against unwanted Web content, spam,
misuse of information and lost productivity. The Company is continuing to sell
the Cobion product on a stand-alone basis and to OEM partners to incorporate in
their products as well as including the technology in the Companys
multi-function Proventia appliance. Total cash consideration for all of the outstanding shares of Cobion and
the acquisition related fees were approximately $33.5 million. The Company
adopted a plan to restructure Cobion whereby certain Cobion employees were
terminated over a six-month period following the acquisition. As a result,

acquisition costs included the accrual of $203,000 of severance costs
associated with these terminations. The Company has paid out the majority of
the severance and will finish paying out the remaining severance in the fourth
quarter of 2004 against the accrual of approximately $95,000 remaining at
September 30, 2004. The operating results of Cobion are included in the consolidated financial
statements of ISS from the date of acquisition. The aggregate purchase price
was allocated based on a valuation report of the Cobion intangibles as follows
(in thousands): Net tangible liabilities of Cobion
    
    $
    (2,736
    )Developed technology
    
    
    16,030Customer relationships
    
    
    516Deferred income taxes
    
    
    (2,655
    )Goodwill
    
    
    22,359$
    33,514




---



##### Table of Contents



The Company is amortizing these intangible assets over their estimated
useful lives of five years for developed technology and three years for
customer relationships. The tangible assets of Cobion acquired in the merger consisted primarily
of cash, accounts receivable and fixed assets. The liabilities of Cobion
assumed in the merger consisted primarily of accounts payable, accrued expenses
and deferred revenue. The following summarizes the unaudited pro forma results of operations of
the Company for the three months and nine months ended September 30, 2003,
assuming the acquisition of Cobion was concluded as of the beginning of 2003:
(i) revenues of $60.4 million and $179.4 million, respectively, (ii) net income
of $4.2 million and $12.3 million, respectively (iii) basic and diluted net
income per share of Common Stock of $.08 and $0.17, respectively. Net income
and basic and diluted net income per share have been adjusted to reflect the
amortization of intangibles identified above. Unaudited pro forma results are
not included for the corresponding period of 2004 as the impact of the
acquisition would have been immaterial to the consolidated results of
operations. This pro forma information is not necessarily indicative of what
combined operations would have been if ISS had control of Cobion from the
beginning of 2003. Note 4. Comprehensive Income The components of comprehensive income are as follows (in thousands): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net income, as reported
    
    $
    6,411
    
    
    $
    5,035
    
    
    $
    17,091
    
    
    $
    15,288Change in cumulative translation adjustment
    
    
    464
    
    
    
    2,635
    
    
    
    (4,056
    )
    
    
    3,352Comprehensive income
    
    $
    6,875
    
    
    $
    7,670
    
    
    $
    13,035
    
    
    $
    18,640
 Note 5. Income per Share The following table sets forth the computation of basic and diluted net income
per share (amounts in thousands, except per share amounts): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Numerator:Net income
    
    $
    6,411
    
    
    $
    5,035
    
    
    $
    17,091
    
    
    $
    15,288Denominator:Denominator for basic net
income per share - weighted
average shares
    
    
    46,267
    
    
    
    49,142
    
    
    
    47,460
    
    
    
    49,123Effect of dilutive stock options
    
    
    958
    
    
    
    742
    
    
    
    1,190
    
    
    
    650Denominator for diluted net
income per share - weighted
average shares
    
    
    47,225
    
    
    
    49,884
    
    
    
    48,650
    
    
    
    49,773Basic net income per share
    
    $
    0.14
    
    
    $
    0.10
    
    
    $
    0.36
    
    
    $
    0.31Diluted net income per share
    
    $
    0.14
    
    
    $
    0.10
    
    
    $
    0.35
    
    
    $
    0.31




---



##### Table of Contents



Note 6. Segment and Geographic Information ISS conducts business in one operating segment: providing information
security management solutions. However, the Company does prepare operating
results for internal use on a geographic basis. These geographical based
operating costs consist of direct sales expenses, infrastructure to support its
employee and customer and partner base, supporting billing and financial
systems and a management team. Corporate expenses that are not charged directly
to the other segments include research and development, general and
administrative costs that support the global organization, amortization of
intangibles, stock-based compensation and goodwill and costs that are one-time
in nature, such as acquired in-process research and development. The accounting policies of the segments are the same as those described in
the summary of significant accounting policies. There are no inter-segment
sales. Our chief executive officer and chief financial officer evaluate
performance based on operating profit or loss from operations, and trade
accounts receivable for each segment. Other than trade accounts receivable,
assets and liabilities are not discretely allocated or reviewed by segment. In accordance with SFAS No. 131, Disclosures about Segments of an
Enterprise and Related Information, the Company has included a summary of the
segment financial information reported internally. The geographic segments are
the Americas, Europe, Middle East and Africa (EMEA), and the Asia/Pacific
region. The following table presents ISSs revenues, operating expenses and
operating income (loss) by reportable geographic segment (in thousands): As of and for the three months endedSeptember 30, 2004Americas
    
    EMEA
    
    Asia/Pac
    
    Unallocated
    
    TotalRevenues from external customers:Product licenses and sales
    
    $
    19,375
    
    
    $
    6,117
    
    
    $
    5,749
    
    
    $
    
    
    
    $
    31,241Subscriptions
    
    
    23,826
    
    
    
    8,095
    
    
    
    3,898
    
    
    
    
    
    
    
    35,819Professional services
    
    
    3,769
    
    
    
    758
    
    
    
    1,146
    
    
    
    
    
    
    
    5,673Total revenue
    
    
    46,970
    
    
    
    14,970
    
    
    
    10,793
    
    
    
    
    
    
    
    72,733Cost of revenues:Product licenses and sales
    
    
    4,105
    
    
    
    870
    
    
    
    1,135
    
    
    
    
    
    
    
    6,110Subscriptions and professional services
    
    
    8,621
    
    
    
    1,302
    
    
    
    2,355
    
    
    
    
    
    
    
    12,278Total cost of revenues
    
    
    12,726
    
    
    
    2,172
    
    
    
    3,490
    
    
    
    
    
    
    
    18,388Operating expenses
    
    
    15,707
    
    
    
    6,745
    
    
    
    2,201
    
    
    
    20,057
    
    
    
    44,710Total expenses
    
    
    28,433
    
    
    
    8,917
    
    
    
    5,691
    
    
    
    20,057
    
    
    
    63,098Segment operating income (loss)
    
    $
    18,537
    
    
    $
    6,053
    
    
    $
    5,102
    
    
    $
    (20,057
    )
    
    $
    9,635Accounts receivable, net
    
    $
    38,980
    
    
    $
    14,769
    
    
    $
    12,772
    
    
    $
    
    
    
    $
    66,521Property and equipment, net
    
    $
    28,542
    
    
    $
    1,604
    
    
    $
    5,486
    
    
    $
    
    
    
    $
    35,632
 As of and for the three months endedSeptember 30, 2003Americas
    
    EMEA
    
    Asia/Pac
    
    Unallocated
    
    TotalRevenues from external customers:Product licenses and sales
    
    $
    16,853
    
    
    $
    4,584
    
    
    $
    4,108
    
    
    $
    
    
    
    $
    25,545Subscriptions
    
    
    20,600
    
    
    
    5,044
    
    
    
    2,567
    
    
    
    
    
    
    
    28,211Professional services
    
    
    3,621
    
    
    
    1,277
    
    
    
    1,433
    
    
    
    
    
    
    
    6,331Total revenue
    
    
    41,074
    
    
    
    10,905
    
    
    
    8,108
    
    
    
    
    
    
    
    60,087Cost of revenues:Product licenses and sales
    
    
    1,779
    
    
    
    276
    
    
    
    352
    
    
    
    
    
    
    
    2,407Subscriptions and professional services
    
    
    8,070
    
    
    
    1,634
    
    
    
    2,080
    
    
    
    
    
    
    
    11,784Total cost of revenues
    
    
    9,849
    
    
    
    1,910
    
    
    
    2,432
    
    
    
    
    
    
    
    14,191Operating expenses
    
    
    14,419
    
    
    
    4,885
    
    
    
    1,809
    
    
    
    17,241
    
    
    
    38,354Total expenses
    
    
    24,268
    
    
    
    6,795
    
    
    
    4,241
    
    
    
    17,241
    
    
    
    52,545Segment operating income (loss)
    
    $
    16,806
    
    
    $
    4,110
    
    
    $
    3,867
    
    
    $
    (17,241
    )
    
    $
    7,542Accounts receivable, net
    
    $
    36,499
    
    
    $
    10,455
    
    
    $
    10,551
    
    
    $
    
    
    
    $
    57,505Property and equipment, net
    
    $
    29,929
    
    
    $
    1,664
    
    
    $
    6,037
    
    
    $
    
    
    
    $
    37,630




---



##### Table of Contents



As of and for the nine months endedSeptember 30, 2004Americas
    
    EMEA
    
    Asia/Pac
    
    Unallocated
    
    TotalRevenues from external customers:Product licenses and sales
    
    $
    54,519
    
    
    $
    20,168
    
    
    $
    14,190
    
    
    $
    
    
    
    $
    88,877Subscriptions
    
    
    70,128
    
    
    
    21,788
    
    
    
    11,012
    
    
    
    
    
    
    
    102,928Professional services
    
    
    10,863
    
    
    
    2,577
    
    
    
    4,092
    
    
    
    
    
    
    
    17,532Total revenue
    
    
    135,510
    
    
    
    44,533
    
    
    
    29,294
    
    
    
    
    
    
    
    209,337Cost of revenues:Product licenses and sales
    
    
    9,887
    
    
    
    2,711
    
    
    
    2,568
    
    
    
    
    
    
    
    15,166Subscriptions and professional services
    
    
    24,862
    
    
    
    3,960
    
    
    
    7,675
    
    
    
    
    
    
    
    36,497Total cost of revenues
    
    
    34,749
    
    
    
    6,671
    
    
    
    10,243
    
    
    
    
    
    
    
    51,663Operating expenses
    
    
    46,669
    
    
    
    20,134
    
    
    
    6,320
    
    
    
    58,965
    
    
    
    132,088Total expenses
    
    
    81,418
    
    
    
    26,805
    
    
    
    16,563
    
    
    
    58,965
    
    
    
    183,751Segment operating income (loss)
    
    $
    54,092
    
    
    $
    17,728
    
    
    $
    12,731
    
    
    $
    (58,965
    )
    
    $
    25,586Accounts receivable, net
    
    $
    38,980
    
    
    $
    14,769
    
    
    $
    12,772
    
    
    $
    
    
    
    $
    66,521Property and equipment, net
    
    $
    28,542
    
    
    $
    1,604
    
    
    $
    5,486
    
    
    $
    
    
    
    $
    35,632
 As of and for the nine months endedSeptember 30, 2003Americas
    
    EMEA
    
    Asia/Pac
    
    Unallocated
    
    TotalRevenues from external customers:Product licenses and sales
    
    $
    51,908
    
    
    $
    13,796
    
    
    $
    10,454
    
    
    $
    
    
    
    $
    76,158Subscriptions
    
    
    61,168
    
    
    
    14,112
    
    
    
    7,755
    
    
    
    
    
    
    
    83,035Professional services
    
    
    12,139
    
    
    
    3,335
    
    
    
    3,998
    
    
    
    
    
    
    
    19,472Total revenue
    
    
    125,215
    
    
    
    31,243
    
    
    
    22,207
    
    
    
    
    
    
    
    178,665Cost of revenues:Product licenses and sales
    
    
    4,782
    
    
    
    353
    
    
    
    517
    
    
    
    
    
    
    
    5,652Subscriptions and professional services
    
    
    24,606
    
    
    
    5,428
    
    
    
    6,637
    
    
    
    
    
    
    
    36,671Total cost of revenues
    
    
    29,388
    
    
    
    5,781
    
    
    
    7,154
    
    
    
    
    
    
    
    42,323Operating expenses
    
    
    43,194
    
    
    
    15,029
    
    
    
    5,061
    
    
    
    50,741
    
    
    
    114,025Total expenses
    
    
    72,582
    
    
    
    20,810
    
    
    
    12,215
    
    
    
    50,741
    
    
    
    156,348Segment operating income (loss)
    
    $
    52,633
    
    
    $
    10,433
    
    
    $
    9,992
    
    
    $
    (50,741
    )
    
    $
    22,317Accounts receivable, net
    
    $
    36,499
    
    
    $
    10,455
    
    
    $
    10,551
    
    
    $
    
    
    
    $
    57,505Property and equipment, net
    
    $
    29,929
    
    
    $
    1,664
    
    
    $
    6,037
    
    
    $
    
    
    
    $
    37,630




---



##### Table of Contents



Note 7. Commitments and Contingencies The Company and certain of its officers and directors were named as
defendants in a consolidated amended complaint that was filed in the United
States District Court for the Northern District of Georgia on October 9, 2002.
The lawsuit purported to be brought on behalf of a class of investors who
purchased the Companys stock during the period from April 5, 2001 through
August 14, 2001. The lawsuit alleged violations of the federal securities laws.
On September 3, 2003, the court dismissed, with prejudice, the consolidated
amended complaint and all rights to appeal expired in May 2004. On August 17, 2004, the Company filed in the United States District Court
for the Northern District of Georgia a declaratory judgment action (the
Georgia Action) against SRI International, Inc. (SRI). The action seeks the
courts declaration that the Companys products and services do not infringe
any valid claim of five patents held by SRI and seeks declaration that certain
claims of those patents are invalid. SRI has filed a motion to dismiss the
action, which the Company has opposed. On August 26, 2004, SRI filed in the
United States District Court for Delaware a complaint against the Company and
Symantec Corporation (the Delaware Action). The complaint in the Delaware
Action alleges that the Companys SiteProtector and Proventia products infringe
upon claims of two of the five patents at issue in the Georgia Action. The
Delaware Action seeks unspecified damages and injunctive relief. The Company
has filed a motion to dismiss the Delaware Action, which SRI has opposed. Note 8. Exit or Disposal Activities In the fourth quarter of 2003, the Company committed to a plan of cost
reduction and exit activities through the closing of its engineering operations
in Reading, U.K. and Sydney, Australia. At December 31, 2003 the Company had accrued the following costs
associated with these exit activities: one-time termination benefits of
$152,000; contract termination costs of $184,000; and other costs of $31,000.
One-time termination benefits consisted of severance and benefits for
involuntarily terminated employees. The contract termination costs include
costs for remaining lease payments on vacated facilities and costs associated
with vacating the facility. Other costs consisted primarily of write-off of
abandoned fixed assets and the write-off of leasehold improvements related to
the vacated facilities. At June 30, 2004 all of the one-time termination benefits had been paid
out. The remaining liability, related to contract termination costs associated
with vacating the facility, at September 30, 2004 totaled approximately
$82,000. 
 Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations The following Managements Discussion and Analysis of Financial Condition
and Results of Operations should be read in conjunction with the Consolidated
Financial Statements and related Notes thereto included elsewhere in this
Quarterly Report onForm 10-Q, as well as the Managements Discussion and
Analysis of Financial Condition and Results of Operations and the Consolidated
Financial Statements and Notes thereto included in our Annual Report on Form
10-K for the year ended December 31, 2003 as filed with the Securities and
Exchange Commission (SEC). Except for the historical financial information, many of the matters
discussed in this Item 2 may be considered forward-looking statements.
Forward-looking statements can be identified by the use of words such as may,
will, should, could, continue, future, potential, believe,
project,  forecast, plan, intend, seek, estimate, predict,
expect, anticipate, view and similar expressions, or the negative of such
terms, or other comparable terminology. Forward-looking statements also include
the assumptions underlying or relating to any of the foregoing statements. Such
forward-looking statements are not guarantees of future performance and involve
a number of risks and uncertainties. Our actual results could differ materially
from those anticipated in these forward-looking statements as a result of
various factors, including those set forth below under the caption Risk
Factors and those otherwise described from time to time in our SEC reports
filed after thisForm 10-Q. All forward-looking statements included in this
Form 10-Q are based on information available to ISS on the date hereof. We
assume no obligation (except
where required by law) to update any forward-looking statements for any events
or circumstances occurring after the date of thisForm 10-Q.




---



##### Table of Contents



Overview We protect gateways, networks, servers and desktops against an
ever-changing spectrum of threats, with a comprehensive line of products and
services designed specifically for the enterprise, service provider, risk
management, small business and consumer markets. These threat protection
solutions go beyond basic access control to deliver multiple layers of defense
that detect, prevent and respond to threats prior to those threats causing
damage to our customers business operations. Our family of products is a critical element of an active Internet and
networking security program within todays world of global connectivity,
enabling organizations to proactively monitor, detect, prevent and respond to
risks to enterprise information. Prior to 2003, our products were exclusively
software, providing intrusion detection and vulnerability assessment solutions.
In the second quarter of 2003, we began to sell a new line of products called
Proventia, which includes an appliance pre-loaded and configured with our
network-based software solutions for intrusion detection and intrusion
prevention. Initial customer response has been positive, with this line
representing 61% of product and license sales in the third quarter of 2004 and
53% of product and license sale revenues for the first nine months of 2004. We
believe this new product line is critical to our product sales growth and the
ongoing subscription revenues associated with such sales. In the fourth quarter of 2003, our product offerings expanded to include
multi-function Proventia appliances that include content referred to as
software blades. This included firewall, virtual private network (VPN) and
anti-virus protection in addition to intrusion protection. We added content
filtering and anti-spam blades to this product line in the second quarter of
2004. We believe this expanded product offering significantly increases our
market opportunity as well as our risk from broader competition. While there
have been increasing levels of sales of this multi-function appliance since its
introduction in December 2003, our expectations for future revenue growth are
dependent on successfully penetrating both our existing intrusion protection
market and new network security markets. Our managed services offerings currently provide remote management of our
best-of-breed security technology, focusing on security assessment and
intrusion protection systems, and also include firewalls, VPNs, anti-virus and
URL filtering software. We focus on serving as the trusted security provider to
our customers by maintaining within our existing products the latest
counter-measures to security risks, creating new innovative products based on
our customers needs and providing professional and managed services. Many factors will affect our future financial performance, especially our
ability to differentiate our offerings from competitors that include much
larger companies with greater marketing capabilities, financial resources and
brand recognition. In order to continue to create such differentiation, we
expect to continue to expand the reach of our domestic and international sales
operations through channel partners; seek acquisition candidates and alliances
with partners whose products, technologies or services capabilities are
complementary to our solutions; and improve our internal operating and
financial infrastructure in support of our strategic goals and
objectives. At the same time, we expect to adjust our organization size in
light of changing economic conditions and maintain emphasis on controlling
current period expenses and capital expenditures. While we believe in the
long-term success of our business solutions, our prospects should be considered
in light of recent experience and the risks and uncertainties that are
frequently encountered by companies serving rapidly evolving markets. See Risk
Factors. Critical Accounting Policies The consolidated financial statements were prepared in conformity with
U.S. generally accepted accounting principles. As such, management is required
to make certain estimates, judgments and assumptions it believes are reasonable
based upon the information available. These estimates and assumptions affect
the reported amounts of assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the periods
presented. The significant accounting policies which management believes are
the most critical to aid in fully understanding and evaluating our reported
financial results include the following: Revenue recognition We recognize revenue in the following categories:  -
    
    Product licenses and sales, which include revenue from sales of perpetual software licenses and products;-
    
    Subscription revenues, which include product support and content updates, term licenses, subscription
licenses and managed service arrangements; and-
    
    Professional services revenues, which includes fee-based service engagements and training. We recognize software license revenue under Statement of Position (SOP)
97-2, Software Revenue Recognition, as modified by SOP 98-9, Software Revenue
Recognition with Respect to Certain Transactions, when the following criteria
have been met:  -
    
    persuasive evidence of an arrangement exists;-
    
    delivery has occurred or services have been rendered;-
    
    price is fixed or determinable; and-
    
    collection is probable.




---



##### Table of Contents



Product licenses and sales We recognize perpetual software license revenues, assuming all other
revenue recognition criteria are met, upon (1) delivery of the software and (2)
issuance of the related license, assuming that no significant vendor
obligations or customer acceptance rights exist. Where payment terms are
extended over periods greater than 12 months, revenue is recognized as such
amounts become due and payable. Revenue is also deferred when payment terms are
extended for periods less than twelve months and such sales are deemed either
not to be fixed or determinable or collection is not probable based on
evaluation of all terms of the transaction. Product sales consist primarily of appliances sold in conjunction with ISS
licensed software. These sales are recognized upon shipment to the customer
provided all other revenue recognition criteria are met. Sales of enterprise products are generated both through direct sales to
end-users as well as through various partners, including system integrators,
value-added resellers and distributors. Revenue from product licenses and sales
revenue is recognized when the sale has occurred for an identified end user,
provided all other revenue recognition criteria are met. At the point of
delivery, the customer has no right of return. Our historical rate of returns by customers of our products is negligible.
We offer evaluation software available via download from our website and
evaluation units for appliance-based products that allow potential customers to
see the functionality of the products on their own networks. Subscription revenues Renewable product support and content updates are separate components of
product licenses and sales. Term licenses allow customers to use our products
and receive product support coverage and content updates for a specified
period, generally 12 months. We generally invoice for product support, content
updates and term licenses at the beginning of the term and recognize revenue
ratably over the subscription term. Security monitoring and management services
for information assets and systems are part of managed services and associated
revenues are recognized and billed as such services are provided. Historically, our appliance and software sales have been accounted for
primarily as revenue at the time of sale, with product support and content
updates generally representing between 20% and 30% of the license or product
amount. With the introduction of our Proventia multi-function appliances, the
majority of the initial price paid by the customer for certain models may be
for content provided for a specified term that will be recorded initially in
deferred revenues and recognized over the term as subscription revenue. Professional services revenues Service engagements are typically billed on either a fixed fee or
time-and-materials basis and primarily consist of security assessments of
customer networks and the development of customers security policies. These
offerings are intended to support our goal of providing products and managed
services. We prefer to have our partners provide these services where
practical. We recognize such professional services revenues as the related
services are rendered. Multiple elements arrangements Multiple element arrangements can include any combination of our products
and services listed above. When some elements are delivered prior to others in
an arrangement, all revenue is deferred until the delivery of the last element
unless all of the following exist:  
    
    vendor specific objective evidence (VSOE) of fair value of the undelivered elements;
    
    the functionality of the delivered elements is not dependent on the undelivered elements; and
    
    delivery of the delivered elements represents the culmination of the earnings process. When these criteria have been met, we allocate revenue to the delivered
software product using the residual method. Under the residual method, we
allocate discounts inherent in the arrangement to products and product support
and content updates associated with products that are initially delivered and
recognize the other elements as they are delivered based on the VSOE, which is
typically determined by the company selling those elements separately. Allowance for doubtful accounts Our sales are global, with customers located in the Americas, Europe,
Middle East and Africa (EMEA), and Asia/Pacific regions.




---



##### Table of Contents



We perform periodic credit evaluations of our customers financial condition
and do not require collateral. We provide for estimated credit losses as such
losses become probable. We evaluate specific accounts when we become aware of a
situation where a customer may not be able to meet its financial obligations
due to deterioration of its liquidity or financial viability, credit ratings or
bankruptcy. The allowance for doubtful accounts is established based on the
best facts available to us and is reevaluated and adjusted as additional
information is received. At September 30, 2004, the allowance for doubtful
accounts totaled $3.2 million, or 4.6% of the $69.7 million of total trade
receivables. This 4.6% allowance percentage of receivables reflects our
practice to leave accounts on our general ledger and provide reserves pending
final resolution of collectibility rather than to write-off such accounts.
During the third quarter of 2004 and 2003, we incurred bad debt expense of
$527,000 and $317,000, respectively, and during the first nine months of 2004
and 2003, we incurred bad debt expense of $1.1 million and $1.4 million,
respectively. While actual credit losses have historically been within managements
expectations and the provisions established, we cannot guarantee that we will
continue to experience the same credit loss rates we have in the past. If the
financial condition of our customers were to deteriorate, resulting in an
impairment of their ability to make payments, additional allowances may be
required. Impairment of goodwill and other long-lived and intangible assets We review goodwill for impairment on an annual basis or on an interim
basis whenever events or changes in circumstances indicate that the carrying
amount of an asset may not be recoverable. All other long-lived and intangible
assets are reviewed for impairment whenever events or circumstances indicate
that the carrying amount of an asset may not be recoverable. Such impairment
loss would be measured as the difference between the carrying amount of the
asset and its fair value based on the present value of estimated future cash
flows. Significant judgment is required in the forecasting of future operating
results, which are used in the preparation of projected cash flows. Due to
uncertain market conditions and potential changes in our strategy and products,
it is possible that forecasts used to support our intangible assets may change
in the future, which could result in significant non-cash charges that would
adversely affect our results of operations. We currently have goodwill and other acquisition related intangibles of
approximately $250 million, with $195 million of goodwill related to our June
2001 acquisition of Network ICE Corporation (Network ICE) and $22 million of
goodwill related to the January 2004 acquisition of Cobion, a privately held
company based in Kassel, Germany. The determination of whether or not goodwill
is impaired involves significant judgments based upon short and long-term
projections of future performance. We have concluded that this amount is
realizable based on forecasted discounted cash flows through 2007 and on our
stock market valuation. Neither method indicated that our goodwill had been
impaired and, as a result, we did not record any impairment losses related to
goodwill during the three months or nine months ended September 30, 2004. Other
intangibles of approximately $22 million are principally acquired technology
from the Network ICE and Cobion acquisitions that are a primary component in
our current product offerings. Acquisitions We believe that our total solutions approach will positively impact our
revenue. This includes our products, managed services offerings, and product
content and support. While we expect the expansion of these product and service
offerings to originate primarily from internal development, our strategy
includes acquiring products, technologies and service capabilities that fit
within our strategy and could potentially accelerate the timing of the
commercial introduction of such products and technologies. In January 2004, we acquired Cobion. Cobion provides content filtering and
anti-spam technology that protects individuals and enterprises against unwanted
Web content, spam, misuse of information and lost productivity. We are
continuing to sell the Cobion product on a stand-alone basis and to OEM
partners to incorporate in their products, as well as including the technology
in our multi-function Proventia appliance. ISS paid cash of approximately $33.5 million for all of the outstanding
shares of Cobion and the acquisition related fees. We also adopted a plan to
restructure Cobion whereby certain Cobion employees were terminated over a
six-month period following the acquisition. As a result, acquisition costs
included the accrual of $203,000 of severance costs associated with these
terminations. The Company has paid out the majority of the severance and will
finish paying out the remaining severance in the fourth quarter of 2004 against
the accrual of approximately $95,000 remaining at September 30, 2004.




---



##### Table of Contents



Results of Operations The following table sets forth our consolidated historical operating
information, as a percentage of total revenues, for the periods indicated: Three months
    
    Nine monthsended
    
    endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Consolidated Statements of Operations Data:Product licenses and sales
    
    
    43
    %
    
    
    43
    %
    
    
    43
    %
    
    
    43
    %Subscriptions
    
    
    49
    %
    
    
    47
    %
    
    
    49
    %
    
    
    46
    %Professional services
    
    
    8
    %
    
    
    10
    %
    
    
    8
    %
    
    
    11
    %Total revenues
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Cost of revenues:Product licenses and sales
    
    
    8
    %
    
    
    4
    %
    
    
    7
    %
    
    
    3
    %Subscriptions and professional services
    
    
    17
    %
    
    
    20
    %
    
    
    18
    %
    
    
    21
    %Total cost of revenues
    
    
    25
    %
    
    
    24
    %
    
    
    25
    %
    
    
    24
    %Research and development
    
    
    15
    %
    
    
    17
    %
    
    
    16
    %
    
    
    17
    %Sales and marketing
    
    
    34
    %
    
    
    35
    %
    
    
    35
    %
    
    
    35
    %General and administrative
    
    
    10
    %
    
    
    9
    %
    
    
    9
    %
    
    
    9
    %Amortization of intangibles and stock-based compensation
    
    
    3
    %
    
    
    2
    %
    
    
    3
    %
    
    
    2
    %Total costs and expenses
    
    
    87
    %
    
    
    87
    %
    
    
    88
    %
    
    
    87
    %Operating income
    
    
    13
    %
    
    
    13
    %
    
    
    12
    %
    
    
    13
    %
 Revenues Product licenses and sales Product licenses and sales, including perpetual licenses and sales of
partner software and hardware appliances, have represented 43% of total
revenues for the three-month and nine-month periods ended September 30, 2003
and 2004. Although the percentages of total revenue remained comparable, the
products making up this revenue component have changed significantly over these
periods. Since the second quarter of 2003, we have offered the Proventia family of
network protection appliances that collectively provides unified,
multi-function protection capabilities designed to identify and prevent many
forms of attack with minimal user intervention. These products are designed to
operate in demanding network environments while being easy to deploy, easy to
use and centrally managed, all in an effort to make our solution more
cost-effective. In the third quarter of 2004, Proventia represented 61% of our
product and license revenues and 53% for the nine-month period ended September
30, 2004. We experienced a 22% overall growth in product and license revenues
to $31.2 million over the third quarter of 2003 and a 17% overall growth in
product and license revenues to $88.9 million over the first nine months of
2003. Our future growth is dependent on a continuation of the positive market
response to our Proventia family of products. Over the next twelve months, we
expect to extend Proventia in software form to our server and desktop
solutions. This expected growth is critical as it represents not only product
and license revenues, but also subscription revenues from product support and
content, including software blades for certain of our multi-function Proventia
appliances, licensed on a subscription basis, and therefore recognized as
subscription revenue over the license period. Our present product roadmap focuses our development on product offerings
and enhancements that will provide broader Proventia appliance offerings and
continue to improve central control and manageability, ease deployment and
refine information provided. We expect that this focus will make our products
more cost effective to implement and maintain and will increase the future
level of product licenses and sales. Subscriptions Subscriptions revenue consists of product support and content updates,
term licenses of products and security-monitoring fees for our managed services
offerings. Subscriptions revenue represented 49% of total revenues in the three
months ended September 30, 2004 increasing from 47% of total revenues in the
three months ended September 30, 2003. This increase from $28.2 million in the
third quarter of 2003 to $35.8 million in the third quarter of 2004 represents
growth of 27%. For the nine months ended September 30, 2004, subscriptions
revenue increased to 49% of total revenues from 46% of total revenues in the
nine months ended September 30, 2003. On a year-to-date basis, there was an
increase of 24% from $83.0 million for the nine months ended September 30, 2003
to $102.9 million for the comparable period of 2004. Product content and support revenues, the largest component of
subscriptions revenue, remained comparable at 31% and 32% of total revenues in
the three months ended September 30, 2004 and 2003, respectively. For the
nine-month periods ended September 30, 2004 and 2003, product content and
support revenues remained at 31% of total revenues. Product content and support
includes hardware support of our Proventia appliances, software updates and
software blades, technical support and security content, which are provided
through contracts executed with customers for a specified term and billed at
the time of contract. Such billings are recorded as deferred revenues on our
balance sheet and amortized as subscription revenue over the term of the
contract. We expect product




---



##### Table of Contents



content and support revenues to increase in the future as our client base
that generates product content and support revenues expands and a higher
percentage of the total contract value is deferred. This is due to a higher
percentage deferral for Proventia appliance sales than our software sales and
the sale of software blades on certain models of our multi-function Proventia
appliances on a subscription basis. Software license blade sales exceeded
subscription revenues from blade sales by approximately $200,000 for the three
months ended September 30, 2004 and by approximately $1.4 million for the nine
months ended September 31, 2004. Managed services revenue accounted for 13% of total revenues for both the
three months and nine months ended September 30, 2004, as compared with 12% in
the three months ended September 30, 2003, and 11% in the nine months ended
September 30, 2003. We believe these increases were due to a strong demand in
the market for proven, financially sound, managed security service providers.
We are marketing managed services both directly to end users and through
partners, including a number of new arrangements with integrators and service
providers that include managed services as a part of their service offerings to
their customers. We also expect sales of managed services to continue to grow
steadily as we focus our efforts on marketing offerings to new and existing
customers that meet changing needs in todays environment. Professional services Professional services revenue decreased both in absolute dollars and as a
percentage of total revenues from 10% in the three months ended September 30,
2003 to 8% in the three months ended September 30, 2004 and from 11% in the
nine months ended September 30, 2003 to 8% in the nine months ended September
30, 2004. This trend is largely the result of our conscious effort to look to
our system integration and channel partners to serve as the primary resource to
fulfill the services and education needs of our customers. Geographic regions Geographically, we derived the majority of our revenues from sales to
customers within the Americas region. Revenues by region represented the
following percentages of total revenues for the periods indicated: Three months
    
    Nine monthsended
    
    endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Americas
    
    
    64
    %
    
    
    69
    %
    
    
    65
    %
    
    
    70
    %EMEA
    
    
    21
    %
    
    
    18
    %
    
    
    21
    %
    
    
    18
    %Asia/Pacific Rim
    
    
    15
    %
    
    
    13
    %
    
    
    14
    %
    
    
    12
    %
 While there have been changes in the proportion of revenues generated by
each region, all of the regions experienced growth in revenues when comparing
both the three and nine-month periods ended September 30, 2004 and 2003.
Revenues in EMEA benefited not only from volume growth, but also from a
strengthening currency when comparing 2004 to 2003 since products are primarily
sold in the Euro. The financial data for each segment can be found in Note 6 to
the Consolidated Financial Statements. Costs and Expenses Personnel Personnel and related costs represent our largest expense category. We
ended the first nine months of 2004 with just under 1,200 employees, up from
1,150 at the beginning of the year. While there have been numerous minor
adjustments within the organization during 2004, this increase occurred
primarily from the January 2004 acquisition of Cobion. We began to use restricted stock, in addition to stock options, as an
equity component of compensation beginning in the first quarter of 2004 and
expensed $613,000 in the third quarter of 2004 and $1.6 million in the first
nine months of 2004 in the expense category in which the recipients are
included. Cost of product licenses and sales Cost of product licenses and sales consists of several components. Costs
associated with licensing our software products are minor. The substantial
portion of our cost of product licenses and sales represents the hardware cost
of our Proventia appliances and payments to vendors for their products that we
sell or integrate with our managed service offerings. This cost increased in
both dollars and as a percentage of product licenses and sales revenue. It
increased from 9% in the quarter ended September 30, 2003 to 20% in the quarter
ended September 30, 2004. On a year-to-date basis, cost of product licenses and
sales increased from 7% of product licenses and sales revenue in 2003 to 17% in
2004. This increase was primarily due to the introduction of the Proventia
appliance line beginning in the second quarter of 2003. Cost of product
licenses and sales will continue to increase in future periods assuming
Proventia appliance sales continue to grow.




---



##### Table of Contents



Cost of subscriptions and professional services Cost of subscriptions and professional services includes the cost of our
technical support personnel who provide assistance to customers under product
support agreements, the security operations center costs of providing managed
security monitoring services and the costs related to our professional services
and training. These costs, as a percentage of subscription and professional
services revenues, decreased from 34% and 36% in the three and nine months
ended September 30, 2003, respectively, to 30% in both the three and nine
months ended September 30, 2004. Increased cost efficiencies allowed these
expenses to remain relatively flat during periods of increasing subscription
revenues from Proventia sales. Costs associated with our technical support personnel and our security
operations centers increased as we added personnel to handle additional
customers. We gained efficiencies in our security operations centers and
restructured our support groups to be more productive so personnel increased at
a much lower rate than revenue growth, contributing to the decrease in those
costs as a percentage of total revenues. While we continue to seek increased
productivity, we expect to increase costs with a continued increase in revenues
in the future. Offsetting this increase of costs associated with our technical support
personnel and our security operations centers is a decrease in costs
commensurate with the decrease in professional services and education services
revenues. Research and development Research and development expenses consist of salary and related costs of
research and development personnel, including costs for employee benefits, and
depreciation on computer equipment. These costs include those associated with
maintaining and expanding the X-Force, our internal team of security experts.
We believe our primary research and product development and managed service
offerings are important to retaining our leadership position in the market. We continue to add functionality to our product family, providing gateway,
network, server and desktop-based solutions, as well as to our security
management applications. These improvements, as well as new offerings, are
intended to provide our customers with more powerful and easier-to-use
solutions for security management across the enterprise. Examples of product
introductions in the first nine months of 2004 include the following:  
    
    Proventia G1200 and G1200-400 Intrusion Prevention Appliances,
designed specifically for highly centralized and space-limited network
environments.
    
    Proventia M30 and M10 Multi-Function Protection Appliances, an
all-in-one appliance that identifies and blocks known and unknown
threats, as well as unwanted traffic, in a single easy-to-use and
manage device. Research and development expenses increased in absolute dollars from $10.5
million in the three months ended September 30, 2003 to $11.1 million in the
three months ended September 30, 2004, but decreased from 17% to 15% of total
revenues for these periods. On a year-to-date basis, these costs increased in
absolute dollars from $30.3 million in the first nine months of 2003 to $33.8
million in the first nine months of 2004 and decreased from 17% of total
revenues in 2003 to 16% in 2004. The increase in absolute dollars is
principally due to the acquisition of Cobion and the amortization of
development source code that was licensed in the first quarter of 2004 and is
used in our Proventia products. Additionally, we continue to streamline
operations as we relocated some engineering functions from our California
development facility to Atlanta and offshore. While we are committed to continue our investment in X-Force research and
development capabilities, which we believe distinguishes ISS from its
competitors, we intend to seek leverage in future periods in the research and
development area while enhancing current technologies and developing new
technologies. Sales and marketing Sales and marketing expenses consist of salaries, travel expenses,
commissions, advertising, maintenance of our website, trade show expenses,
costs of recruiting sales and marketing personnel and costs of marketing
materials. Sales and marketing expenses increased in absolute dollars from
$21.1 million in the three months ended September 30, 2003
and $63.3 million in
the nine months ended September 30, 2003 to $24.7 million and $73.1 million,
respectively, in the corresponding periods of 2004. As a percentage of total
revenues, sales and marketing expenses decreased from 35% in the three months
ended September 30, 2003 to 34% in the three months ended September 30, 2004.
On a year-to-date basis, sales and marketing expenses were 35% of total
revenues for both 2003 and 2004. These increases in absolute dollars are due to
an increase in our overall sales headcount and higher variable commission
expense associated with higher product licenses and sales revenues. We expect to achieve leverage in our sales efforts in the future by
focusing our direct sales force on large customers that are served either
directly by us or through large systems integrators. Our channel, which
includes systems integrators, value-added resellers and distributors, will
continue to be of importance to us, measured quantitatively by an increasing
level of product revenue originating through the channel. During the quarter
ended September 30, 2004 the channel represented 73% of our quarterly sales, as
compared to 60% in the prior year quarter. We intend to expand the number of
partners and use their capabilities to sell to smaller companies and
departments of larger companies, as well as extend our reach to larger
enterprises through joint selling efforts.




---



##### Table of Contents



General and administrative General and administrative expenses consist of personnel-related costs for
executive, administrative, finance and human resources, internal information
systems and other support services costs, and legal, accounting and other
professional service fees. General and administrative expenses of $7.2 million in the third quarter
of 2004 and $5.4 million in the third quarter of 2003 represented 10% and 9% of
total revenues, respectively. On a year-to-date basis, general and
administrative expenses totaled $19.8 million in 2004 and $16.4 million in 2003
representing 9% of total revenues in both periods. The use of outside resources
to assist in the design and execution of control testing related to financial
control compliance work required by Sarbanes Oxley was the primary contributor
to this increase. We expect Section 404 will continue to represent a
significant effort and cost to the company in the fourth quarter of 2004 and in
2005 to a lesser degree. Amortization We incurred amortization expense related to intangible assets and
stock-based compensation of $1.8 million in the three months ended September
30, 2004 and $1.3 million in the three months ended September 30, 2003. For the
nine-month periods, amortization expense was $5.4 million in 2004 and $4.0
million in 2003. These intangible assets and stock-based compensation resulted
from acquisitions accounted for under the purchase method of accounting and are
amortized over their estimated useful lives and vesting period, respectively.
The increase is a result of the amortization of intangibles related to our
acquisition of Cobion in the first quarter of 2004. Interest income Interest income increased from $610,000 in the quarter ended September 30,
2003 to $699,000 in the comparable quarter of 2004 due to an increase in the
yield on investment-quality commercial paper and similar investments from
approximately 1.0% in the third quarter of 2003 to approximately 1.4% during the
third quarter of 2004. Interest income for the nine months ended September 30,
2004 totaled $1.7 million as compared to $2.0 million in the nine months ended
September 30, 2003. This decrease results from the lower average yield on
securities purchased during the period. Provision for income taxes Our effective tax rate was approximately 37% for the three and nine months
ended September 30, 2004 and 38% for the three and nine months ended September
30, 2003. The effective rates differ from the statutory rates due to the impact
of acquisition-related intangibles and certain operating expenses that are not
deductible for income tax purposes as well as federal and state tax credits. Liquidity and Capital Resources Our financial position remained strong through the first nine months of
2004. Our cash and cash equivalents and marketable security investments were
$188.6 million at September 30, 2004. Our investments in marketable securities
consist solely of highly rated debt obligations with maturities of 12 months or
less. We continue to meet our working capital needs and capital equipment needs
with cash provided by operations. Cash provided by operations in the first nine
months of 2004 totaled $43.7 million. The major components of cash flows
provided by operating activities were net income of $17.1 million, non-cash
depreciation and amortization expense charges of $17.3 million, income tax
benefit of $7.4 million from exercises of employee stock options and an
increase in deferred revenues of $5.0 million. An important element of our liquidity is the collection of our accounts
receivable. We measure our accounts receivable management by our days sales
outstanding (DSO). This is a measurement of accounts receivable divided by
billings in the quarter, represented by the sum of revenues plus the change in
the deferred revenues liability account balance. This measurement was 82 days
at September 30, 2004, within our target range of 75 to 85 days. Our net cash used in investing activities of $65.1 million in the first
nine months of 2004 resulted primarily from our acquisition of Cobion. The
license of development source code used in our Proventia products was more than
half of our capital purchases of $11.2 million. Investing activities also
included changes in our marketable securities that have quality characteristics
similar to cash equivalents, except their maturities when we acquire them are
longer than three months. The cash flow statement included the purchase of
$64.5 million of intermediate term marketable securities, primarily
interest-bearing government obligations and commercial paper, offset by net
proceeds from the maturity of marketable securities of $44.2 million. Our financing activities used $46.2 million of cash in the first nine
months of 2004. This was principally due to the repurchase of 3.3 million
shares of our common stock in the open market at an aggregate cost of $50.0
million. The original stock repurchase plan expired in July 2004 and a new
repurchase program to repurchase up to $50 million of our common stock through
July 2005 was authorized by the Board of Directors in July 2004. Since the
inception of the stock repurchase plans, we have purchased 4.6 million shares
at an average cost of $14.76 per share for a total cash outlay of approximately
$67.9 million. Also, in the first nine months of 2004, the exercise of stock
options by our employees and the issuance of common stock through our employee
stock purchase plan generated funds of approximately $3.4 million. We believe our cash and cash equivalents and marketable securities will be
sufficient to meet our working capital needs and capital expenditures for the
foreseeable future. Furthermore, we are not aware of any trends, events, or
uncertainties that are reasonably likely to result in any significant change to
our liquidity. From time to time, we evaluate possible acquisition and
investment opportunities in




---



##### Table of Contents



businesses, products or technologies that are complementary to ours. In the
event we determine to pursue such opportunities, we may use our available cash
and cash equivalents and marketable securities for this purpose. Off-Balance Sheet Arrangements Payments for certain of our operating leases are secured by two
collateralized stand-by letters of credit totaling approximately $10.3 million
at September 30, 2004. These stand-by letters of credit guarantee our payment
obligations on the leases and are renewable annually over the duration of the
applicable leases. If we default on the lease payments, the landlords can make
a claim against the letters of credit. We, in turn, would be liable to the
letter of credit issuers. Our stand-by letters of credit are collateralized by
securities worth $12.8 million at September 30, 2004. Other than these
non-cancelable operating leases, we have no off-balance sheet financing
arrangements, any relationships with structured finance or special purpose
entities, or any contractual obligations with unconsolidated entities that are
reasonably likely to impact our liquidity. Risk Factors Forward-looking statements are inherently uncertain as they are based on
various expectations and assumptions concerning future events and are subject
to known and unknown risks and uncertainties. Our forward-looking statements
contained in this Quarterly Report on Form 10-Q and elsewhere should be
considered in light of the following important risk factors. Variations from
our stated intentions or failure to achieve objectives could cause actual
results to differ from those projected in our forward-looking statements. With
respect to our Business Outlook published in our earnings press release for the
quarter ended September 30, 2004, you may continue to rely on this Business
Outlook prior to the start of our quiet period for the quarter ending December
31, 2004 (the Q4 Quiet Period), unless we have published a notice stating
otherwise. During the Q4 Quiet Period, ISS and its corporate representatives
will not comment concerning our previously published Business Outlook. During
the Q4 Quiet Period, the Companys press releases and filings with the SEC on
Forms 10-K and 10-Q should be considered historical, speaking as of a date
prior to the Q4 Quiet Period only and not subject to update by the Company. The
Q4 Quiet Period is expected to run from December 15, 2004 until financial
results for the quarter ending December 31, 2004 are released. There are many factors that affect ISS business and the results of its
operations, some of which are beyond ISS control. The following is a
description of some of the important factors that may cause the actual results
of ISS operations in future periods to differ materially from those currently
expected or desired. We encourage you to read this section carefully. We Operate in a Rapidly Evolving Market We operate in a rapidly evolving market and must, among other things:  
    
    respond to competitive developments;
    
    continue to upgrade and expand our product and services offerings; and
    
    continue to attract, retain and motivate our employees. We cannot be certain that we will successfully address these issues. As a
result, we cannot assure our investors that we will be able to continue to
operate profitably in the future. We introduced our new Proventia appliance line in April 2003 that includes
intrusion prevention and multi-function security protection. Given our limited
history with these products, it may be difficult to plan or project our
revenues accurately in the future. While initial reaction to these products
have had a positive impact on company results, failure to continue to gain
further market acceptance could result in revenues below our expectations and
our operating results could be adversely affected. Our Future Operating Results Will Likely Fluctuate Significantly We cannot predict our future revenues and operating results with
certainty. However, we do expect our future revenues and operating results to
fluctuate due to a combination of factors, including:  
    
    the growth in the acceptance of, and activity on, the Internet and the world wide web, particularly by corporate,
institutional and government users;
    
    the extent to which the public perceives that unauthorized access to and use of online information are threats to
network security;
    
    customer budgets;
    
    the mix of product sales among the various products offered by ISS and whether revenue is recognized upon sale or
deferred to subsequent periods;
    
    the volume and timing of orders, including seasonal trends in customer purchasing;




---



##### Table of Contents




    
    our ability to develop new and enhanced product and managed service offerings and expand our professional services
capabilities;
    
    the introduction and acceptance rate of ISS branded appliances, including increased cost of goods sold;
    
    our ability to accurately forecast and produce demanded quantities of our appliance products and models;
    
    availability of component parts of appliance products and reliance on contract manufacturers to produce such products;
    
    our ability to provide scalable managed services offerings in a cost effective manner;
    
    foreign currency exchange rates that affect our international operations;
    
    product and price competition in our markets; and
    
    general economic conditions, both domestically and in our foreign markets. We focus our efforts on sales of enterprise-wide security solutions, which
consist of our entire product suite and related professional services, and
managed security services, rather than on the sale of component products. As a
result, each sale requires substantial time and effort from our sales and
support staff. In addition, the revenues associated with particular sales vary
significantly depending on the number of products licensed by a customer, the
number of devices used by the customer and the customers relative need for our
professional services. Large individual sales, or even small delays in customer
orders, can cause significant variation in our license revenues and results of
operations for a particular period. The timing of large orders is usually
difficult to predict and, like many software and services companies, many of
our customers typically complete transactions in the last month of a quarter. We cannot predict our operating expenses based on our past results.
Instead, we establish our spending levels based in large part on our expected
future revenues. As a result, if our actual revenues in any future period fall
below our expectations, our operating results likely will be adversely affected
because very few of our expenses vary with our revenues. Because of the factors
listed above, we believe that our quarterly and annual revenues, expenses and
operating results likely will vary significantly in the future. Our ability to provide timely guidance and meet the expectations of
investors with respect to our operating and financial results is affected by
the tendency of a majority of our sales to be completed in the last month of a
quarter. We may not be able to determine whether we will experience material
deviations from guidance or expectations until the end of a quarter. Dependence on Third Party Suppliers and Manufacturers We carry little inventory of our appliance products and we rely on
suppliers to deliver necessary components to our contract manufacturers in a
timely manner based on the forecasts we provide. We currently purchase some
Proventia appliance components and contract manufacturing services from single
or limited sources. If shortages occur, supplies are interrupted, or we
underestimate demand for models, we may not be able to deliver products to our
customers and our revenue and operating results would be adversely affected.
Because our supply of hardware is based on short-term forecasts and purchase
orders, our contract manufacturers are not obligated to purchase components for
greater quantities over longer periods. We provide six-month forecasts of our
demand to our contract manufacturers. If we overestimate our requirements, our
contract manufacturers may have excess inventory, which could increase our
costs. If we underestimate our requirements, our contract manufacturers may
have an inadequate component inventory and, based on lead times, this could
interrupt manufacturing and result in delays in shipments and revenues. We Face Intense Competition in Our Market The market for network security monitoring, detection, prevention and
response solutions is intensely competitive, and we expect competition to
increase in the future. We cannot guarantee that we will compete successfully
against our current or potential competitors, especially those with
significantly greater financial resources or brand name recognition. Our chief
competitors generally fall within the following categories:  
    
    large companies, including Symantec Corp., Cisco Systems, Inc., Juniper Networks, Inc., and McAfee, Inc.,
that sell competitive products and offerings, as well as other large software companies that have the
technical capability and resources to develop competitive products;
    
    software or hardware network infrastructure companies like Cisco Systems, Inc. and Juniper Networks, Inc.
that could integrate features that are similar to our products into their own products;
    
    smaller software companies offering relatively limited applications for network and Internet security; and
    
    small and large companies with competitive offerings to components of our managed services offerings. Mergers or consolidations among these competitors, or acquisitions of
small competitors by larger companies, represent risks. For




---



##### Table of Contents



example, Symantec Corp., Cisco Systems, Inc., McAfee, Inc., and Juniper
Networks, Inc. have acquired during the past several years smaller companies
which have intrusion detection or prevention technologies. These acquisitions
will make these entities potentially more formidable competitors to us if such
products and offerings are effectively integrated. Large companies may have
advantages over us because of their longer operating histories, greater name
recognition, larger customer bases or greater financial, technical and
marketing resources. As a result, they may be able to adapt more quickly to new
or emerging technologies and changes in customer requirements. They can also
devote greater resources to the promotion and sale of their products than we
can. In addition, these companies have reduced and could continue to reduce,
the price of their security monitoring, detection, prevention and response
products and managed security services, which increases pricing pressures
within our market. Several companies currently sell software products (such as encryption,
firewall, operating system security and virus detection software) that our
customers and potential customers have broadly adopted. Some of these companies
sell products that perform the same functions as some of our products. In
addition, the vendors of operating system software or networking hardware may
enhance their products to include the same kinds of functions that our products
currently provide. The widespread inclusion of comparable features to our
software in operating system software or networking hardware could render our
products less competitive or obsolete, particularly if such features are of a
high quality. Even if security functions integrated into operating system
software or networking hardware are more limited than those of our products, a
significant number of customers may accept more limited functionality to avoid
purchasing additional products. In addition, with the introduction of our multi-function Proventia
appliance, we have offerings that compete with vendors of firewalls, VPNs,
anti-virus systems, and content and spam filtering products. These offerings
are competitive with a broader spectrum of network security companies, as well
as those that also offer multi-function appliances or broad product suites,
like Symantec Corp. For the above reasons, we may not be able to compete successfully against
our current and future competitors. Increased competition may result in price
reductions, reduced gross margins and loss of market share. We Face Rapid Technological Change in Our Industry and Frequent Introductions
of New Products Rapid changes in technology pose significant risks to us. We do not
control nor can we influence the forces behind these changes, which include:  
    
    the extent to which businesses and others seek to establish more secure networks;
    
    the extent to which hackers and others seek to compromise secure systems;
    
    evolving computer hardware and software standards;
    
    changing customer requirements; and
    
    frequent introductions of new products and product enhancements. To remain successful, we must continue to change, adapt and improve our
products in response to these and other changes in technology. Our future
success hinges on our ability to both continue to enhance our current line of
products and professional services and to introduce new products and services
that address and respond to innovations in computer hacking, computer
technology and customer requirements. We cannot be sure that we will
successfully develop and market new products that do this. Any failure by us to
timely develop and introduce new products, to enhance our current products or
to expand our professional services capabilities in response to these changes
could adversely affect our business, operating results and financial condition. Our products involve very complex technology and, as a consequence, major
new products and product enhancements require a long time to develop and test
before going to market. Because this amount of time is difficult to estimate,
we have had to delay the scheduled introduction of new and enhanced products in
the past and may have to delay the introduction of new and enhanced products in
the future. The techniques computer hackers use to gain unauthorized access to, or to
sabotage, networks and intranets are constantly evolving and increasingly
sophisticated. Furthermore, because new hacking techniques are usually not
recognized until used against one or more targets, we are unable to anticipate
most new hacking techniques. To the extent that new hacking techniques harm our
customers computer systems or businesses, affected or prospective customers
may believe that our products are ineffective, which may cause them or
prospective customers to reduce or avoid purchases of our products. Undetected Product Errors or Defects Could Result in Loss of Revenues, Delayed
Market Acceptance and Claims Against Us We offer warranties on our products, allowing the end customer to have any
defective product repaired, or to receive a replacement product for it during
the warranty period, or in certain circumstances return the product for a
refund. Our products may contain undetected errors or defects. If there is a
broad product failure across our customer base, we may decide to replace all
affected products or we may decide to refund the purchase price for defective
units. Such defects and actions may adversely affect our ability to record
revenue. Some errors are discovered only after a product has been installed and
used by end customers. Any errors discovered after commercial release could
result in loss of revenues and claims against us.




---



##### Table of Contents



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




---



##### Table of Contents



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




---



##### Table of Contents



for large judgments, which are not necessarily predictable, it is not unusual
to find even arguably unmeritorious claims settled for significant funds. If
any infringement or other intellectual property claim made against us by a
third party is successful, or if we fail to develop non-infringing technology
or license the proprietary rights on commercially reasonable terms and
conditions, our business, operating results, financial condition and liquidity
could be materially and adversely affected. We Must Continue to Attract and Retain Personnel in a Competitive Marketplace We believe that our future success will depend in part on our ability to
recruit and retain highly skilled management, sales, marketing and technical
personnel. To accomplish this, we believe that we must provide personnel with a
competitive compensation package, including stock options, restricted stock or
similar incentive stock awards. Increases in shares available for issuance
under our incentive stock plans and new incentive stock plans require
stockholder approval in many cases, and institutional stockholders, or
stockholders generally, may not approve future plans or increases. Our current
incentive stock plan expires in September 2005 and we believe that sufficient
shares are available for issuance under that plan to meet our needs until it
expires. We currently expect to propose a new incentive stock plan to
stockholders at our annual stockholders meeting in 2005. Additionally, current
proposed accounting standards would require corporations to include
compensation expense in their statement of operations relating to the issuance
of employee stock options. As a result, we may decide to issue fewer stock
options and may be impaired in our efforts to attract and retain necessary
personnel. Conversely, issuing a comparable number of stock options could
adversely impact our results of operations. Some Provisions in the ISS Certificate of Incorporation and Bylaws Make a
Takeover of ISS Difficult Our certificate of incorporation and bylaws contain provisions that could
have the effect of making it more difficult for a third party to acquire, or of
discouraging a third party from attempting to acquire, control of ISS. These
provisions:  
    
    establish a classified board of directors;
    
    create preferred stock purchase rights that grant to holders of common
stock the right to purchase shares of Series A Junior Preferred Stock
in the event that a third party acquires 20% or more of the voting
power of our outstanding common stock;
    
    prohibit the right of our stockholders to act by written consent;
    
    limit calling special meetings of stockholders; and
    
    impose a requirement that holders of 66 2/3% of the outstanding shares
of common stock are required to amend the provisions relating to the
classification of our board of directors and action by written consent
of stockholders. 
 Item 3. Quantitative and Qualitative Disclosures About Market Risk We have no material changes to the disclosure on this matter made in our
Annual Report on Form 10-K for the year ended December 31, 2003. 
 Item 4. Controls and Procedures Our management, with the participation of the Chief Executive Officer and
Chief Financial Officer, evaluated the effectiveness of our disclosure controls
and procedures as of the end of the period covered by this quarterly report.
Based on such evaluation, these officers have concluded that, as of such date,
our disclosure controls and procedures were effective to provide reasonable
assurance that information required to be disclosed in the reports the Company
files or submits under the Securities Exchange Act of 1934 is recorded,
processed, summarized and reported on a timely basis. There have not been any changes in the Companys internal control over
financial reporting during the quarter ended September 30, 2004 that have
materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting. 
 PART II. OTHER INFORMATION 
 Item 1. Legal Proceedings The Company and certain of its officers and directors were named as defendants
in a consolidated amended complaint that was filed in the United States
District Court for the Northern District of Georgia on October 9, 2002. The
lawsuit purported to be brought on behalf of a class of investors who purchased
the Companys stock during the period from April 5, 2001 through August 14,
2001. The lawsuit alleged violations of the federal securities laws. On
September 3, 2003, the court dismissed, with prejudice, the consolidated
amended complaint and all rights to appeal expired in May 2004. On August 17, 2004, the Company filed in the United States District Court for
the Northern District of Georgia a declaratory judgment action (the Georgia
Action) against SRI International, Inc. (SRI). The action seeks the courts
declaration that the Companys products and services do not infringe any valid
claim of five patents held by SRI and seeks declaration that certain claims of
those




---



##### Table of Contents



patents are invalid. SRI has filed a motion to dismiss the action, which the
Company has opposed. On August 26, 2004, SRI filed in the United States
District Court for Delaware a complaint against the Company and Symantec
Corporation (the Delaware Action). The complaint in the Delaware Action
alleges that the Companys SiteProtector and Proventia products infringe upon
claims of two of the five patents at issue in the Georgia Action. The Delaware
Action seeks unspecified damages and injunctive relief. The Company has filed a
motion to dismiss the Delaware Action, which SRI has opposed. 
 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of
Equity Securities (e) The following table provides information about purchases by the Company of
its common stock during the three months ended September 30, 2004: All such
purchases were made in open-market transactions pursuant to a repurchase plan
publicly announced on July 21, 2004. Under this repurchase plan, the Company
has been authorized by the Board to repurchase up to $50 million of its
outstanding common stock over the 12 months ending July 19, 2005. The Company
had a prior repurchase plan in place that terminated on July 14, 2004 and no
further purchases can be made under that plan. Through September 30, 2004, the
Company had purchased approximately 4.6 million shares at an aggregate cost of
approximately $67.9 million under the current and prior repurchase plans. Issuer Purchases of Equity Securities Total Number ofShares Purchased
    
    Approximate Dollaras
    
    Value of SharesTotal Number
    
    Average Price
    
    Part of Publicly
    
    that May Yet Beof
    
    Paid
    
    Announced Plans or
    
    Purchased Under thePeriod
    
    Shares Purchased
    
    Per Share
    
    Programs
    
    Plans or Programs7/1/04-7/31/04
    
    
    176,000
    
    
    $
    14.96
    
    
    
    176,000
    
    
    $
    47,362,0008/1/04-8/31/04
    
    
    898,000
    
    
    $
    14.16
    
    
    
    898,000
    
    
    $
    34,657,0009/1/04-9/30/04
    
    
    334,000
    
    
    $
    15.45
    
    
    
    334,000
    
    
    $
    29,489,000
 
 Item 6. Exhibits  3.1
    
    Restated Certificate of Incorporation (filed as
Exhibit 3.1 to the Companys Quarterly Report on
Form 10-Q, dated November 14, 2000 and incorporated
by reference herein).3.2
    
    Bylaws (filed as Exhibit 3.2 to the Companys
Registration Statement on Form S-1, Registration
No. 373-44529 and incorporated by reference
herein).3.3
    
    Certificate of Designations of Series A Junior
Participating Preferred Stock dated July 24, 2002
(filed as Exhibit 3.3 to the Companys Annual
Report on Form 10-K, filed March 28, 2003 and
incorporated by reference herein).4.1
    
    Specimen Common Stock certificate (filed as Exhibit 4.3 to the Companys Registration Statement on Form S-8,
Registration No. 333-100954, filed November 1, 2002 and incorporated by reference herein).4.2
    
    Form of Rights Certificate (filed as Exhibit 4.2 to the Companys Current Report on Form 8-K filed July 24,
2002 and incorporated by reference herein.)4.3
    
    See Exhibits 3.1 and 3.2 for provisions of the Certificate of Incorporation and Bylaws of the Company
defining the rights of holders of the Companys Common Stock.4.4
    
    1999 Network ICE Stock Option Plan, incorporated by reference to Exhibit 4.1 to Form S-8, Registration No.
333-62658, filed on June 8, 2001.4.5
    
    Restated 1995 Stock Incentive Plan (as amended and restated as of May 23, 2001) incorporated by reference to
Exhibit 4.2 to Form S-8, Registration No. 333-62658, filed June 8, 2001.4.6
    
    Netrex, Inc. 1998 Stock Plan incorporated by reference to Exhibit 99.15 to Form S-8, Registration Statement
No. 333-89563, filed October 22, 1999.4.7
    
    vCIS, Inc. 2001 Stock Plan incorporated by reference to Exhibit 4.1 to Form S-8, Registration Statement No.
333-100954, filed November 1, 2002.




---



##### Table of Contents



11
    
    Computation of Per Share Earnings *31.1
    
    Certification of principal executive officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of principal financial officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification pursuant to 18 U.S.C. Section 1350, as adapted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.32.2
    
    Certification pursuant to 18 U.S.C. Section 1350, as adapted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.*
    
    Data required by SFAS No. 128, Earnings Per Share, is provided in Note 5 to the consolidated financial
statements in this report




---



##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. INTERNET SECURITY SYSTEMS, INC.(Registrant)Date: November 1, 2004
    
    By /s/ Richard MacchiaSenior Vice President Finance and Administration
and Chief Financial Officer (on behalf of registrant
and as principal financial officer)