##### Table of Contents






UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549






FORM 10-Q

(Mark One)

|                                                     |  |                                                                                         
|---------------------------------------------------- |  | ----------------------------------------------------------------------------------------
|(Box with an X)                                      |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934  
|                                                    
|                                                    
|                                                    
|                                                    
|For the quarterly period ended September 30, 2001   
|                                                    
|                                                    
|                                                    
|                                                    
|OR                                                  
|                                                    
|                                                    
|                                                    
|                                                    
|(Empty Ballot Box)                                   |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
|                                                    
|                                                    
|                                                    
|                                                    
|For the transition period from
                  
to

Commission File Number 0-23655

INTERNET SECURITY SYSTEMS, INC.
(Exact name of registrant as specified in its charter)

|                                                         |  |                                     
|-------------------------------------------------------- |  | ------------------------------------
|DELAWARE                                                 |  | 58-2362189                          
|                                                        
|                                                        
|                                                        
|                                                        
|(State or jurisdiction of
incorporation or organization) |  | (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

NOT APPLICABLE(Former name, former address and former fiscal year, if changed since last report.)

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  (Ballot Box with an X)     No  (Empty Ballot Box)

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

|                               |  |                                                     |            | 
|------------------------------ |  | --------------------------------------------------- | ---------- | 
|Title of each class            |  | Number of Shares Outstanding
as of November 5, 2001
|                               |  |                                                    
|Common Stock, $0.001 par value |  |                                                     | 47,784,423 | 










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TABLE OF CONTENTS



|                             |                                                                                              |                                            |  |  |  |  |  | 
|---------------------------- | -------------------------------------------------------------------------------------------- | ------------------------------------------ |  |  |  |  |  | 
|PART I FINANCIAL INFORMATION
|                             | ITEM I                                                                                      
|                             |                                                                                              | CONSOLIDATED BALANCE SHEETS               
|                             |                                                                                              | CONSOLIDATED STATEMENTS OF OPERATIONS     
|                             |                                                                                              | CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                             |                                                                                              | NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|                             | ITEM 2 MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|                             | ITEM 3. Quantitative and Qualitative Disclosures about Market Risk                          
|PART II OTHER INFORMATION   
|                             | ITEM 1. Legal Proceedings                                                                   
|                             | ITEM 6. Exhibits and Reports on Form 8-K                                                    
|SIGNATURES                  



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##### Table of Contents






PART IFINANCIAL INFORMATION



ITEM 1



INTERNET SECURITY SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(amounts in thousands, except per share amounts)

|                                                                                    |                                                                                                                                     |                                            |         |         |         |               |        |              |         |  |  | 
|----------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------- | ------- | ------- | ------------- | ------ | ------------ | ------- |  |  | 
|                                                                                    |                                                                                                                                     |                                            |         |         |         | September 30, |        | December 31,
|                                                                                    |                                                                                                                                     |                                            |         |         |         | 2001          |        | 2000        
|                                                                                    |                                                                                                                                     |                                            |         |         |         |               |        |             
|                                                                                    |                                                                                                                                     |                                            |         |         |         | (unaudited)   |        |              |         | 
|ASSETS                                                                              |                                                                                                                                     |                                            |         |         |         |               |        |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|Current assets:                                                                     |                                                                                                                                     |                                            |         |         |         |               |        |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Cash and cash equivalents                                                                                                           |                                            | $       | 87,823  |         |               | $      | 66,210       |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Marketable securities                                                                                                               |                                            |         | 58,398  |         |               |        | 65,938       |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Accounts receivable, less allowance for doubtful accounts of
$1,942 and $1,188, respectively                                        |                                            |         | 58,334  |         |               |        | 56,358       |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Inventory                                                                                                                           |                                            |         | 2,128   |         |               |        | 2,275        |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Prepaid expenses and other current assets                                                                                           |                                            |         | 9,970   |         |               |        | 5,717        |        
|                                                                                    |                                                                                                                                     |                                            |         |         |         |               |        |             
|                                                                                    |                                                                                                                                     | Total current assets                       |         |         | 216,653 |               |        |              | 196,498 | 
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|Property and equipment:                                                             |                                                                                                                                     |                                            |         |         |         |               |        |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Computer equipment                                                                                                                  |                                            |         | 30,143  |         |               |        | 20,199       |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Office furniture and equipment                                                                                                      |                                            |         | 18,321  |         |               |        | 9,958        |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Leasehold improvements                                                                                                              |                                            |         | 16,284  |         |               |        | 6,609        |        
|                                                                                    |                                                                                                                                     |                                            |         |         |         |               |        |             
|                                                                                    |                                                                                                                                     |                                            | 64,748  |         |         |               | 36,766 |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Less accumulated depreciation                                                                                                       |                                            |         | 22,087  |         |               |        | 13,673       |        
|                                                                                    |                                                                                                                                     |                                            |         |         |         |               |        |             
|                                                                                    |                                                                                                                                     |                                            | 42,661  |         |         |               | 23,093 |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|Restricted marketable securities                                                    |                                                                                                                                     |                                            | 12,500  |         |         |               | 12,500 |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|Goodwill, less accumulated amortization of $16,472 and $876,
respectively           |                                                                                                                                     |                                            | 207,968 |         |         |               | 3,167  |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|Other intangibles, less accumulated amortization of $3,442 and $1,500,
respectively |                                                                                                                                     |                                            | 20,924  |         |         |               | 3,346  |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|Other assets                                                                        |                                                                                                                                     |                                            | 5,750   |         |         |               | 1,636  |             
|                                                                                    |                                                                                                                                     |                                            |         |         |         |               |        |             
|                                                                                    | Total assets                                                                                                                        |                                            | $       | 506,456 |         |               | $      | 240,240      |        
|                                                                                    |                                                                                                                                     |                                            |         |         |         |               |        |             
|LIABILITIES AND STOCKHOLDERS EQUITY                                                |                                                                                                                                     |                                            |         |         |         |               |        |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|Current liabilities:                                                                |                                                                                                                                     |                                            |         |         |         |               |        |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Accounts payable                                                                                                                    |                                            | $       | 3,157   |         |               | $      | 4,200        |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Accrued expenses                                                                                                                    |                                            |         | 14,242  |         |               |        | 15,490       |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Deferred revenues                                                                                                                   |                                            |         | 48,295  |         |               |        | 31,675       |        
|                                                                                    |                                                                                                                                     |                                            |         |         |         |               |        |             
|                                                                                    |                                                                                                                                     | Total current liabilities                  |         |         | 65,694  |               |        |              | 51,365  | 
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|Other non-current liabilities                                                       |                                                                                                                                     |                                            | 1,518   |         |         |               | 486    |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|Commitments and contingencies                                                       |                                                                                                                                     |                                            |        |         |         |               |       |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|Stockholders equity:                                                               |                                                                                                                                     |                                            |         |         |         |               |        |             
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Preferred stock, $.001 par value, 20,000,000 shares authorized,
none issued or outstanding                                          |                                            |         |        |         |               |        |             |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Common stock, $.001 par value, 120,000,000 shares
authorized, 47,708,000 and 42,415,000 shares issued and
outstanding, respectively |                                            |         | 48      |         |               |        | 42           |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Additional paid-in capital                                                                                                          |                                            |         | 431,096 |         |               |        | 172,985      |        
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Deferred compensation                                                                                                               |                                            |         | (2,869  | )       |               |        | (86          | )      
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Accumulated other comprehensive loss                                                                                                |                                            |         | (67     | )       |               |        | (745         | )      
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                   
|                                                                                    | Retained earnings                                                                                                                   |                                            |         | 11,036  |         |               |        | 16,193       |        
|                                                                                    |                                                                                                                                     |                                            |         |         |         |               |        |             
|                                                                                    |                                                                                                                                     | Total stockholders equity                 |         |         | 439,244 |               |        |              | 188,389 | 
|                                                                                    |                                                                                                                                     |                                            |         |         |         |               |        |             
|                                                                                    |                                                                                                                                     | Total liabilities and stockholders equity |         | $       | 506,456 |               |        | $            | 240,240 | 
|                                                                                    |                                                                                                                                     |                                            |         |         |         |               |        |             

3



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##### Table of Contents






INTERNET SECURITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(amounts in thousands, except per share amounts)
(unaudited)

|                                                    |                                                          |                                         |         |                    |        |                   |        |        |       |      |         |        |        |   |         |        |        | 
|--------------------------------------------------- | -------------------------------------------------------- | --------------------------------------- | ------- | ------------------ | ------ | ----------------- | ------ | ------ | ----- | ---- | ------- | ------ | ------ | - | ------- | ------ | ------ | 
|                                                    |                                                          |                                         |         | Three months ended |        | Nine months ended
|                                                    |                                                          |                                         |         | September 30,      |        | September 30,    
|                                                    |                                                          |                                         |         |                    |        |                  
|                                                    |                                                          |                                         |         | 2001               |        | 2000              |        | 2001   |       | 2000
|                                                    |                                                          |                                         |         |                    |        |                   |        |        |       |     
|Revenues:                                           |                                                          |                                         |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Product licenses and sales                               |                                         | $       | 27,435             |        |                   | $      | 31,770 |       |      | $       | 91,699 |        |   | $       | 82,879 |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Subscriptions                                            |                                         |         | 17,663             |        |                   |        | 10,938 |       |      |         | 48,259 |        |   |         | 28,564 |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Professional services                                    |                                         |         | 7,636              |        |                   |        | 9,079  |       |      |         | 25,641 |        |   |         | 23,852 |       
|                                                    |                                                          |                                         |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|                                                    |                                                          |                                         | 52,734  |                    |        |                   | 51,787 |        |       |      | 165,599 |        |        |   | 135,295 |       
|                                                   
|                                                   
|                                                   
|                                                   
|Costs and expenses:                                 |                                                          |                                         |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Cost of revenues:                                        |                                         |         |                    |        |                   |        |        |       |      |         |        |        |   |         |        |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    |                                                          | Product licenses and sales              |         |                    | 1,401  |                   |        |        | 6,525 |      |         |        | 11,552 |   |         |        | 16,222 | 
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    |                                                          | Subscriptions and professional services |         |                    | 12,788 |                   |        |        | 9,884 |      |         |        | 38,083 |   |         |        | 25,214 | 
|                                                    |                                                          |                                         |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|                                                    | Total cost of revenues                                   |                                         |         | 14,189             |        |                   |        | 16,409 |       |      |         | 49,635 |        |   |         | 41,436 |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Research and development                                 |                                         |         | 9,276              |        |                   |        | 8,449  |       |      |         | 26,531 |        |   |         | 22,817 |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Sales and marketing                                      |                                         |         | 23,449             |        |                   |        | 17,406 |       |      |         | 68,996 |        |   |         | 47,348 |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | General and administrative                               |                                         |         | 5,509              |        |                   |        | 3,429  |       |      |         | 15,105 |        |   |         | 9,804  |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Write-off of lease obligation                            |                                         |         |                   |        |                   |        |       |       |      |         | 1,072  |        |   |         |       |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Charge for in-process research and
development           |                                         |         |                   |        |                   |        |       |       |      |         | 2,910  |        |   |         |       |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Amortization of goodwill                                 |                                         |         | 11,393             |        |                   |        | 41     |       |      |         | 15,597 |        |   |         | 41     |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Amortization of intangibles and stock based
compensation |                                         |         | 2,213              |        |                   |        | 248    |       |      |         | 3,451  |        |   |         | 744    |       
|                                                    |                                                          |                                         |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|                                                    |                                                          |                                         | 66,029  |                    |        |                   | 45,982 |        |       |      | 183,297 |        |        |   | 122,190 |       
|                                                   
|Operating income (loss)                             |                                                          |                                         | (13,295 | )                  |        |                   | 5,805  |        |       |      | (17,698 | )      |        |   | 13,105  |       
|                                                   
|                                                   
|                                                   
|                                                   
|Interest income, net                                |                                                          |                                         | 1,524   |                    |        |                   | 2,253  |        |       |      | 5,274   |        |        |   | 6,191   |       
|                                                   
|                                                   
|                                                   
|                                                   
|Minority interest                                   |                                                          |                                         | (156    | )                  |        |                   |       |        |       |      | (156    | )      |        |   |        |       
|                                                   
|                                                   
|                                                   
|                                                   
|Other income, including Japan IPO gain              |                                                          |                                         | 13,620  |                    |        |                   |       |        |       |      | 15,258  |        |        |   |        |       
|                                                   
|                                                   
|                                                   
|                                                   
|Foreign currency exchange loss                      |                                                          |                                         | (163    | )                  |        |                   | (463   | )      |       |      | (445    | )      |        |   | (494    | )     
|                                                    |                                                          |                                         |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|Income before income taxes                          |                                                          |                                         | 1,530   |                    |        |                   | 7,595  |        |       |      | 2,233   |        |        |   | 18,802  |       
|                                                   
|                                                   
|                                                   
|                                                   
|Provision for income taxes                          |                                                          |                                         | 7,618   |                    |        |                   | 2,740  |        |       |      | 7,390   |        |        |   | 6,796   |       
|                                                    |                                                          |                                         |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|Net income (loss)                                   |                                                          | $                                       | (6,088  | )                  |        | $                 | 4,855  |        |       | $    | (5,157  | )      |        | $ | 12,006  |       
|                                                    |                                                          |                                         |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|Basic net income (loss) per share of Common
Stock   |                                                          | $                                       | (0.13   | )                  |        | $                 | 0.12   |        |       | $    | (0.12   | )      |        | $ | 0.29    |       
|                                                    |                                                          |                                         |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|Diluted net income (loss) per share of Common
Stock |                                                          | $                                       | (0.13   | )                  |        | $                 | 0.11   |        |       | $    | (0.12   | )      |        | $ | 0.27    |       
|                                                    |                                                          |                                         |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|Weighted average shares:                            |                                                          |                                         |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|                                                   
|                                                   
|                                                   
|                                                   
|                                                    | Basic                                                    |                                         |         | 47,693             |        |                   |        | 41,984 |       |      |         | 44,764 |        |   |         | 41,752 |       
|                                                    |                                                          |                                         |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       
|                                                    | Diluted                                                  |                                         |         | 47,693             |        |                   |        | 45,099 |       |      |         | 44,764 |        |   |         | 45,039 |       
|                                                    |                                                          |                                         |         |                    |        |                   |        |        |       |      |         |        |        |   |         |       

4



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##### Table of Contents






INTERNET SECURITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(amounts in thousands)
(unaudited)

|                                                 |                                                                                   |                                                          |                                           |         |                   |        |         |         |         |        | 
|------------------------------------------------ | --------------------------------------------------------------------------------- | -------------------------------------------------------- | ----------------------------------------- | ------- | ----------------- | ------ | ------- | ------- | ------- | ------ | 
|                                                 |                                                                                   |                                                          |                                           |         | Nine months ended
|                                                 |                                                                                   |                                                          |                                           |         | September 30,    
|                                                 |                                                                                   |                                                          |                                           |         |                  
|                                                 |                                                                                   |                                                          |                                           |         | 2001              |        | 2000   
|                                                 |                                                                                   |                                                          |                                           |         |                   |        |        
|OPERATING ACTIVITIES                             |                                                                                   |                                                          |                                           |         |                   |        |         |        
|                                                
|                                                
|                                                
|                                                
|Net income                                       |                                                                                   | $                                                        | (5,157                                    | )       |                   | $      | 12,006  |        
|                                                
|                                                
|                                                
|                                                
|                                                 | Adjustments to reconcile net income to net cash provided
by operating activities: |                                                          |                                           |         |                   |        |         |         |        
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                   | Depreciation                                             |                                           |         | 8,135             |        |         |         | 4,358   |       
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                   | Amortization of goodwill                                 |                                           |         | 15,597            |        |         |         | 279     |       
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                   | Amortization of intangibles and stock based compensation |                                           |         | 3,451             |        |         |         | 504     |       
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                   | Accretion of discount on marketable securities           |                                           |         | 175               |        |         |         | (1,309  | )     
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                   | Charge for in-process research and development           |                                           |         | 2,910             |        |         |         |        |       
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                   | Other non-cash items                                     |                                           |         | 67                |        |         |         | 117     |       
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                   | Income tax benefit from exercise of stock options        |                                           |         | 9,398             |        |         |         | 4,985   |       
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                   | Gain
on IPO of Japan subsidiary                          |                                           |         | (13,620           | )      |         |         |        |       
|                                                
|                                                
|                                                
|                                                
|                                                 | Changes in assets and liabilities, excluding the effects of
acquisitions:         |                                                          |                                           |         |                   |        |         |         |        
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                   | Accounts receivable                                      |                                           |         | 1,271             |        |         |         | (14,845 | )     
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                   | Inventory                                                |                                           |         | 147               |        |         |         | (919    | )     
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                   | Prepaid expenses and other assets                        |                                           |         | (6,723            | )      |         |         | (2,195  | )     
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                   | Accounts payable and accrued expenses                    |                                           |         | (4,937            | )      |         |         | 5,782   |       
|                                                
|                                                
|                                                
|                                                
|                                                 |                                                                                   | Deferred revenues                                        |                                           |         | 8,059             |        |         |         | 8,441   |       
|                                                 |                                                                                   |                                                          |                                           |         |                   |        |         |        
|                                                 |                                                                                   |                                                          | NET CASH PROVIDED BY OPERATING ACTIVITIES |         |                   | 18,773 |         |         |         | 17,204 | 
|                                                
|                                                
|                                                
|                                                
|INVESTING ACTIVITIES                             |                                                                                   |                                                          |                                           |         |                   |        |         |        
|                                                
|                                                
|                                                
|                                                
|                                                 | Acquisitions, net of cash received                                                |                                                          |                                           | (7,495  | )                 |        |         | (1,262  | )      
|                                                
|                                                
|                                                
|                                                
|                                                 | Net proceeds from maturity of marketable securities                               |                                                          |                                           | 105,492 |                   |        |         | 45,861  |        
|                                                
|                                                
|                                                
|                                                
|                                                 | Purchases of marketable securities                                                |                                                          |                                           | (98,127 | )                 |        |         | (98,529 | )      
|                                                
|                                                
|                                                
|                                                
|                                                 | Purchases of property and equipment                                               |                                                          |                                           | (26,683 | )                 |        |         | (9,212  | )      
|                                                
|                                                
|                                                
|                                                
|                                                 | Gain
on IPO of Japan subsidiary                                                   |                                                          |                                           | (13,620 | )                 |        |         |       
|                                                 |                                                                                   |                                                          |                                           |         |                   |        |         |        
|                                                 |                                                                                   | NET CASH USED IN INVESTING ACTIVITIES                    |                                           |         | (13,193           | )      |         |         | (63,142 | )     
|                                                
|                                                
|                                                
|                                                
|FINANCING ACTIVITIES                             |                                                                                   |                                                          |                                           |         |                   |        |         |        
|                                                
|                                                
|                                                
|                                                
|                                                 | Payments on long-term debt and capital leases                                     |                                                          |                                           |        |                   |        |         | (827    | )      
|                                                
|                                                
|                                                
|                                                
|                                                 | Proceeds from exercise of stock options                                           |                                                          |                                           | 13,105  |                   |        |         | 3,681   |        
|                                                
|                                                
|                                                
|                                                
|                                                 | Proceeds from issuance of common stock                                            |                                                          |                                           | 2,250   |                   |        |         | 1,633   |        
|                                                 |                                                                                   |                                                          |                                           |         |                   |        |         |        
|                                                 |                                                                                   | NET CASH PROVIDED BY FINANCING ACTIVITIES                |                                           |         | 15,355            |        |         |         | 4,487   |       
|                                                
|                                                
|                                                
|                                                
|Foreign currency impact on cash                  |                                                                                   |                                                          | 678                                       |         |                   |        | (46     | )      
|                                                 |                                                                                   |                                                          |                                           |         |                   |        |         |        
|Net increase in cash and cash equivalents        |                                                                                   |                                                          | 21,613                                    |         |                   |        | (41,497 | )      
|                                                
|                                                
|                                                
|                                                
|Cash and cash equivalents at beginning of period |                                                                                   |                                                          | 66,210                                    |         |                   |        | 70,090  |        
|                                                 |                                                                                   |                                                          |                                           |         |                   |        |         |        
|Cash and cash equivalents at end of period       |                                                                                   | $                                                        | 87,823                                    |         |                   | $      | 28,593  |        
|                                                 |                                                                                   |                                                          |                                           |         |                   |        |         |        
|                                                
|                                                
|                                                
|                                                
|SUPPLEMENTAL CASH FLOW DISCLOSURE                |                                                                                   |                                                          |                                           |         |                   |        |         |        
|                                                
|                                                
|                                                
|                                                
|Interest paid                                    |                                                                                   | $                                                        |                                          |         |                   | $      | 50      |        
|                                                 |                                                                                   |                                                          |                                           |         |                   |        |         |        

5



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##### Table of Contents






INTERNET SECURITY SYSTEMS, INC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Significant Accounting Policies

The accompanying consolidated financial statements of Internet Security
Systems, Inc. (ISS or the Company) should be read in conjunction with the
Companys consolidated financial statements for the year ended December 31,
2000.

ISS is focused on maintaining the latest security threat and vulnerability
checks within existing products and creating new products and services that are
consistent with the Companys mission of providing security management
solutions. This approach entails continuous security risk monitoring and
response to develop an active and informed network security policy.

The accompanying consolidated financial statements are unaudited; however,
in the opinion of management, they include all normal recurring adjustments
necessary for a fair presentation of the consolidated financial position of ISS
at September 30, 2001 and the consolidated results of its operations and cash
flows for the three month and nine month periods ended September 30, 2001 and
2000. Results of operations reported for interim periods are not necessarily
indicative of results for the entire year.

The consolidated balance sheet at December 31, 2000 has been derived from
the audited financial statements at that date but does not include all the
footnotes required by accounting principles generally accepted in the United
States for complete financial statements.

Revenue Recognition

ISS recognizes its perpetual license revenue upon (i) delivery of software
or, if the customer has evaluation software, delivery of the software key, and
(ii) issuance of the related license, assuming no significant vendor
obligations or customer acceptance rights exist. For perpetual license
agreements, when payment terms extend over periods greater than twelve months,
revenue is recognized as such amounts are billable. Product sales consist of
(i) appliances sold in conjunction with ISS licensed software and (ii) software
developed by third party-partners, combined in some instances with associated
hardware appliances and partner maintenance services. These sales are
recognized upon shipment to the customer.

Subscriptions revenues include maintenance, term licenses and security
monitoring services. Annual renewable maintenance is a separate component of
perpetual license agreements for which the revenue is recognized ratably over
the maintenance contract term. Term licenses allow customer use of the product
and maintenance for a specified period, generally twelve months, for which
revenues are also recognized ratably over the contract term. Security
monitoring services of information assets and systems are a part of managed
services and are recognized as such services are provided. Professional
services revenues, including consulting and training, are recognized as such
services are performed.

Cost of Revenues

Cost of revenues includes the costs of products and services. Cost of
products represents the cost of product sales, which are incurred upon
recognition of the associated product revenues. Cost of services includes the
cost of ISSs technical support group who provide assistance to customers with
maintenance agreements, the operations center costs of providing managed
services and the costs related to the Companys professional services and
training.

6



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##### Table of Contents



INTERNET SECURITY SYSTEMS, INC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. Business Combination

On June 5, 2001, ISS completed the acquisition of Network ICE Corporation,
a privately held corporation based in San Mateo, California (Network ICE).
Network ICE is a leading developer of desktop intrusion protection technology
and highly scalable security management systems. ISS acquired all of the assets
of Network ICE, including all of its plant, equipment and other physical
property, which assets will continue to be used in the business of Network ICE.
ISS issued approximately 4,311,000 shares of ISS common stock for all of the
outstanding Network ICE common stock. ISS also assumed all of the outstanding
Network ICE stock options, which totaled approximately 289,000 shares of ISS
common stock. Each outstanding share of Network ICE common stock, no par value,
and each share of Network ICE common stock issuable upon exercise of
outstanding stock options of Network ICE was converted into the right to
receive 0.13529 shares of ISS common stock, par value $0.001 per share. The
combined total of the common stock issued, options assumed and acquisition
costs was approximately $237.6 million based on the average closing price of
ISS common stock on the merger agreement date of April 30, 2001 and the two
days before and after. Acquisition costs of approximately $8 million consist
primarily of financial advisory, legal and accounting fees.

The merger was accounted for as a purchase and, accordingly, the operating
results of Network ICE are included in the consolidated financial statements of
ISS from the date of acquisition. Substantially all of the aggregate purchase
price of $237.6 million was allocated to identified intangibles, including
in-process research and development, developed technology, customer
relationships, deferred compensation related to stock options assumed and
goodwill.

The aggregate purchase price was allocated based on a valuation report
from an independent appraisal of the Network ICE intangibles and in-process
research and development as follows:

|                                    |  |   |             |  
|----------------------------------- |  | - | ----------- | -
|Net liabilities of Network ICE      |  | $ | (4,020,000  | )
|                                   
|                                   
|                                   
|                                   
|In-process research and development |  |   | 2,910,000   |  
|                                   
|                                   
|                                   
|                                   
|Customer relationships              |  |   | 2,490,000   |  
|                                   
|                                   
|                                   
|                                   
|Technology                          |  |   | 17,030,000  |  
|                                   
|                                   
|                                   
|                                   
|Deferred income taxes               |  |   | (7,418,000  | )
|                                   
|                                   
|                                   
|                                   
|Deferred compensation               |  |   | 6,231,000   |  
|                                   
|                                   
|                                   
|                                   
|Goodwill                            |  |   | 220,398,000 |  
|                                    |  |   |             |  
|                                    |  | $ | 237,621,000 |  
|                                    |  |   |             |  

The tangible assets of Network ICE acquired in the merger consisted
primarily of cash, accounts receivable and fixed assets. The liabilities of
Network ICE assumed in the merger consisted primarily of accounts payable and
accrued expenses and deferred revenue.

In-process research and development of approximately $2.9 million had not
reached technological feasibility based on identifiable technological risk
factors, which indicated that even though successful completion was expected,
it was not assured as of the acquisition date and was immediately charged to
operations. Accordingly, under current accounting standards, such amount was
expensed.

To determine the value of the developed technology, the expected future
cash flow attributable to all existing technology was discounted, taking into
account the risks related to the characteristics and applications of the
technology, existing and future markets and assessments of the life cycle stage
of the technology. The analysis resulted in a valuation of approximately $17
million for developed technology, which has reached technological feasibility
and therefore was capitalizable. The amount allocated to technology is being
amortized over the estimated useful life of 5 years.

7



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##### Table of Contents



INTERNET SECURITY SYSTEMS, INC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Customer relationships were based on the identifiable revenue stream in
the future that is related specifically to historical sales made to existing
customers. The amount allocated to customer relationships of approximately $2.5
million is being amortized over the estimated useful life of 3 years.

All unvested Network ICE options assumed by ISS were included in the
purchase price based on their fair value; however, the portion of the intrinsic
value of the unvested options that will be deemed to be earned over the
remaining vesting period of those options has been allocated to deferred
compensation and will be amortized over the remaining vesting period. The fair
value of the options assumed was based on the Black-Scholes option pricing
model using the following assumptions: fair market value of the underlying
shares, which were based on the average of the closing price of ISSs common
stock on the agreement date of April 30, 2001 and for the two days before and
after April 30, 2001; expected life of two years for vested options and five
years for unvested options; expected volatility of 1.29; no expected dividend
yield; and risk-free interest rate of 5.34%. The value of the deferred
compensation of approximately $6.2 million was derived using the guidance of
Financial Accounting Standards Board Interpretation number 44.

The purchase price in excess of tangible assets and identifiable
intangible assets has been allocated to goodwill and totaled approximately
$219.2 million and is being amortized over the estimated useful life of 5
years. The following table summarizes pro forma results of operations as if the
acquisition of Network ICE was concluded as of the beginning of the periods
presented. This pro forma information is not necessarily indicative of what
combined operations would have been if ISS had control of such combined
businesses for the periods presented.

The adjustments to the historical data reflect the following (i)
amortization of goodwill and intangibles, (ii) write off of in-process research
and development, and (iii) deferred stock compensation.

|                                                     |  |                   |         |      |  |   |         |  
|---------------------------------------------------- |  | ----------------- | ------- | ---- |  | - | ------- | -
|                                                     |  | Nine months ended
|                                                     |  | September 30,    
|                                                     |  |                  
|Amounts in thousands, except per share amounts       |  | 2001              |         | 2000
|                                                     |  |                   |         |     
|Revenue                                              |  | $                 | 171,361 |      |  | $ | 141,361 |  
|                                                    
|                                                    
|                                                    
|                                                    
|Net loss                                             |  | $                 | (31,545 | )    |  | $ | (30,909 | )
|                                                    
|                                                    
|                                                    
|                                                    
|Basic and diluted net loss per share of Common Stock |  | $                 | (.66    | )    |  | $ | (.67    | )

3. Nonrecurring income and expense items

Pretax income for the three and nine months ended September 30, 2001
includes a subsidiary IPO gain of $13,620,000 from an initial public offering
on the Japan over-the-counter market by the Companys subsidiary responsible
for Asia and Pacific Rim operations. Proceeds of the IPO were retained by the
subsidiary. Pretax income for the nine months ended September 30, 2001, also
includes a non-recurring other income item of $1.6 million generated from the
sale of approximately 2% of the outstanding shares of our Asia-Pacific
subsidiary in March 2001 to employees and key partners. The IPO will provide
more visibility of this operation in its marketplace and has provided funds for
the expansion of the business in this market. In anticipation of the IPO,
options for approximately 2% of the subsidiarys stock were granted as a means
of key employee retention. The price for the shares and exercise price for
options were established based on a valuation of the subsidiary by an
independent appraisal firm. The gains reported on the IPO and the previous sale
of shares represents the difference between proceeds received for the shares
sold and the underlying basis in the shares, less the minority interest in such
gains.

In the quarter ended March 31, 2001, the Company recorded a $1.1 million
write-off of the remaining lease obligation on vacated Atlanta office space as
a result of the relocation of Atlanta personnel to new leased corporate
headquarters. This non-recurring expense originated in the first quarter of
2001 as available subleased space in the

8



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##### Table of Contents



area grew substantially as the result of layoffs, closures and
consolidations, diminishing the prospects of subleasing the old space.

4. Income taxes

The Company recorded a tax provision of $7.6 million for the quarter ended
September 30, 2001 and a tax provision of $7.4 million for the nine months
ended September 30, 2001. As required under APB Opinion No. 28, Interim
Financial Reporting, the Company has estimated its effective annual income tax
rate to be (20)% and provided for taxes on year to date earnings from normal
operations at this rate. The Company accrued an additional tax provision of
36% of the gain from the IPO of the Japan subsidiary to provide for taxes
payable upon the distribution of funds to the Company. As of September 30,
2001, ISS had a net operating loss carryforward of approximately $89 million.
The tax benefit of this carryforward will be recorded as additional
paid-in-capital as realized. There are also approximately $3.0 million of
research and development tax credit carryforwards that expire between 2011 and
2021.

5. Comprehensive income (loss)

The components of comprehensive income (loss), net of tax, are as follows
(in thousands):

|                                                                                                                         |  |                    |        |                   |  |      |       |      |  |   |        |   |  |   |        |  
|------------------------------------------------------------------------------------------------------------------------ |  | ------------------ | ------ | ----------------- |  | ---- | ----- | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                                                                         |  | Three months ended |        | Nine months ended
|                                                                                                                         |  | September 30,      |        | September 30,    
|                                                                                                                         |  |                    |        |                  
|                                                                                                                         |  | 2001               |        | 2000              |  | 2001 |       | 2000
|                                                                                                                         |  |                    |        |                   |  |      |       |     
|Net income (loss)                                                                                                        |  | $                  | (6,088 | )                 |  | $    | 4,855 |      |  | $ | (5,157 | ) |  | $ | 12,006 |  
|                                                                                                                        
|                                                                                                                        
|                                                                                                                        
|                                                                                                                        
|Change in cumulative translation adjustment,
net of a tax provision (benefit) of $387, $64,
$244 and ($17), respectively |  |                    | 687    |                   |  |      | 114   |      |  |   | 434    |   |  |   | (63    | )
|                                                                                                                         |  |                    |        |                   |  |      |       |      |  |   |        |   |  |   |        |  
|Comprehensive income (loss)                                                                                              |  | $                  | (5,401 | )                 |  | $    | 4,969 |      |  | $ | (4,723 | ) |  | $ | 11,943 |  
|                                                                                                                         |  |                    |        |                   |  |      |       |      |  |   |        |   |  |   |        |  

9



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##### Table of Contents



INTERNET SECURITY SYSTEMS, INC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

6. Income (Loss) per share

The computation of net income (loss) per share is as follows (amounts in
thousands, except per share amounts):

|                                     |                                                                        |   |                    |        |                   |   |      |        |      |   |       |        |   |   |      |        | 
|------------------------------------ | ---------------------------------------------------------------------- | - | ------------------ | ------ | ----------------- | - | ---- | ------ | ---- | - | ----- | ------ | - | - | ---- | ------ | 
|                                     |                                                                        |   | Three months ended |        | Nine months ended
|                                     |                                                                        |   | September 30,      |        | September 30,    
|                                     |                                                                        |   |                    |        |                  
|                                     |                                                                        |   | 2001               |        | 2000              |   | 2001 |        | 2000
|                                     |                                                                        |   |                    |        |                   |   |      |        |     
|Basic net income (loss) per share:   |                                                                        |   |                    |        |                   |   |      |        |      |   |       |        |   |   |      |       
|                                    
|                                    
|                                    
|                                    
|                                     | Net income (loss)                                                      |   | $                  | (6,088 | )                 |   | $    | 4,855  |      |   | $     | (5,157 | ) |   | $    | 12,006 | 
|                                    
|                                    
|                                    
|                                    
|                                     | Weighted average number of common shares
outstanding during the period |   |                    | 47,693 |                   |   |      | 41,984 |      |   |       | 44,764 |   |   |      | 41,752 | 
|                                     |                                                                        |   |                    |        |                   |   |      |        |      |   |       |        |   |   |      |       
|Basic net income (loss) per share    |                                                                        | $ | (0.13              | )      |                   | $ | 0.12 |        |      | $ | (0.12 | )      |   | $ | 0.29 |       
|                                     |                                                                        |   |                    |        |                   |   |      |        |      |   |       |        |   |   |      |       
|Diluted net income (loss) per share: |                                                                        |   |                    |        |                   |   |      |        |      |   |       |        |   |   |      |       
|                                    
|                                    
|                                    
|                                    
|                                     | Net income (loss)                                                      |   | $                  | (6,088 | )                 |   | $    | 4,855  |      |   | $     | (5,157 | ) |   | $    | 12,006 | 
|                                    
|                                    
|                                    
|                                    
|                                     | Weighted average number of common shares
outstanding during the period |   |                    | 47,693 |                   |   |      | 41,984 |      |   |       | 44,764 |   |   |      | 41,752 | 
|                                    
|                                    
|                                    
|                                    
|                                     | Dilutive stock options                                                 |   |                    |       |                   |   |      | 3,115  |      |   |       |       |   |   |      | 3,287  | 
|                                     |                                                                        |   |                    |        |                   |   |      |        |      |   |       |        |   |   |      |       
|                                     | Total shares for purpose of calculating diluted
net income per share   |   |                    | 47,693 |                   |   |      | 45,099 |      |   |       | 44,764 |   |   |      | 45,039 | 
|                                     |                                                                        |   |                    |        |                   |   |      |        |      |   |       |        |   |   |      |       
|Diluted net income (loss) per share  |                                                                        | $ | (0.13              | )      |                   | $ | 0.11 |        |      | $ | (0.12 | )      |   | $ | 0.27 |       
|                                     |                                                                        |   |                    |        |                   |   |      |        |      |   |       |        |   |   |      |       

Options aggregating 881,461 and 1,343,884 for the three months and nine months
ended September 30, 2001, respectively, are not included in the above
calculation as they are antidilutive.

7. Recent Accounting Pronouncements

In July, 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standard No. 142, (SFAS 142), Goodwill and
Other Intangible Assets. Under SFAS 142, goodwill and indefinite lived
intangible assets are no longer amortized, but are reviewed annually (or more
frequently if impairment indicators arise) for impairment. Separable intangible
assets that are not deemed to have an indefinite life will continue to be
amortized over their useful lives. Companies are required to immediately adopt
the amortization provisions of SFAS 142 as it relates to goodwill and
intangible assets acquired after June 30, 2001. With respect to goodwill and
intangible assets acquired prior to July 1, 2001, companies are required to
adopt SFAS 142 in their fiscal year beginning after December 15, 2001. The
Company anticipates adopting SFAS 142 in accordance with the provisions of the
statement. SFAS 142 may not be applied retroactively. Substantially all of the
Companys goodwill balance of $208.0 million as of September 30, 2001, was
recorded in June of 2001, in conjunction with the acquisition of Network ICE.
The goodwill balance is being amortized over five years. The impact of the
adoption as it relates to goodwill, which exists currently, is to eliminate
amortization of goodwill expense beginning with the year ending December 31,
2002.

8. Contingencies

Beginning on September 28, 2001, the Company and certain of its officers
and directors were named as defendants in several lawsuits alleging violations
of the federal securities laws, including Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934, as amended, and Rule 10(b)-5, thereunder. As
of this time, four such actions have been filed in the United States District
Court for the Northern District of Georgia. The complaints, which are
substantially similar in nature, purport to be brought on behalf of a
class of investors who purchased the Companys stock during the period from
April 5, 2001 through July 2, 2001 (the Class Period). The complaints
generally allege that the Company and the individual defendants violated the
anti-fraud provisions of the federal securities laws and caused the Companys
stock to trade at artificially high prices by making misrepresentations
relating to the Companys financial condition and prospects during the Class
Period. The complaints seek damages in an unspecified amount. The Company
anticipates that all four of these actions, along with any other similar
actions which may hereafter be filed, will be consolidated into a single case.
No answer or other responsive papers are yet due from the defendants. The
Company believes that the actions are without merit and intends to defend the
actions vigorously.

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##### Table of Contents






ITEM 2

INTERNET SECURITY SYSTEMS, INC.
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the Consolidated
Financial Statements and related Notes thereto included elsewhere in this
Quarterly Report on Form 10-Q. Except for the historical financial information,
the matters discussed in this Quarterly Report on Form 10-Q may be considered
forward-looking statements. Such statements include declarations regarding
our intent, belief or current expectations. Such forward-looking statements are
not guarantees of future performance and involve a number of risks and
uncertainties. Actual results may differ materially from those indicated by
such forward-looking statements. Among the important factors that could cause
actual results to differ materially from those indicated by such
forward-looking statements are the risk factors in this Quarterly Report on
Form 10-Q, as well as the risk factors identified in the Annual Report on Form
10-K for the year ended December 31, 2000 as filed with the Securities and
Exchange Commission and available at their Web site at www.sec.gov.

OVERVIEW

We are a leading global provider of security management solutions for
protecting digital business assets. Our continuous lifecycle approach to
information security protects distributed computing environments, such as
internal corporate networks, inter-company networks and electronic commerce
environments, from attacks, misuse and security policy violations, while
ensuring the confidentiality, privacy, integrity and availability of
proprietary information. We deliver an end-to-end security management solution
through our SAFEsuite security management platform coupled with
around-the-clock remote security monitoring through our managed services
offerings. Our SAFEsuite family of products is a critical element of an active
Internet and networking security program within todays world of global
connectivity, enabling organizations to proactively monitor, detect and respond
to risks to enterprise information. Our managed services offerings currently
provide remote management of the industrys best-of-breed security technology
including firewalls, VPNs, anti-virus and URL filtering software, security
assessment and intrusion detection systems. 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.

We generate a majority of our revenues from our SAFEsuite family of
products in the form of perpetual licenses and subscriptions, and sales of
best-of-breed technology products developed by our partners. We recognize
perpetual license revenues from ISS developed products upon delivery of
software or, if the customer has evaluation software, delivery of the software
key and 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 are billable. Product sales consist of (i) appliances sold in
conjunction with ISS licensed software and (ii) software developed by
third-party suppliers, combined in some instances with associated hardware
appliances and supplier maintenance services. These sales are recognized upon
shipment to the customer.

Annual renewable maintenance is a separate component of each perpetual
license agreement for ISS products, with revenue recognized ratably over the
maintenance term. Subscription revenues include maintenance, term licenses, and
managed service arrangements. Term licenses allow customers to use our products
and receive maintenance coverage for a specified period, generally 12 months.
We recognize revenues from these term agreements ratably over the subscription
term. Security monitoring services of information assets and systems are part
of managed services and revenues are recognized as such services are provided.
Professional services revenues include consulting services and training.
Consulting services, typically billed on a fixed price or time-and-materials
basis, assist in the successful deployment of our products within customer
networks, the development of customers security policies and the assessment of
security policy decisions. We recognize such professional services revenues as
the related services are rendered.

We believe that our total solutions approach will grow each of our revenue
categories. This includes our products and managed services offerings, as well
as maintenance and professional services and training. While we

11



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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 that
potentially accelerate the timing of the commercial introduction of such
products and technologies.

We have experienced significant revenue growth year-after-year, although
our quarter ended June 30, 2001 represented a decrease from the previous
quarter. This was our first quarterly decrease over the last five years in
measuring sequential quarterly revenues. Due to the decrease in revenues for
the quarter ended June 30, 2001, we resized our operations during the third
quarter of 2001, resulting in personnel reductions and decreases in
various operating expenses, with emphasis also on controlling discretionary
spending and capital expenditures. As a result, the third quarter results
showed significant improvement with only modest revenue growth from the second
quarter. Many factors affect financial performance, and past performance is no
assurance of similar future performance. We expect, in the long-term, to
continue to expand our domestic and international sales and marketing
operations; increase our investment in product development including our
proprietary threat and vulnerability database and managed services
capabilities; seek acquisition candidates with products, technologies or
services capabilities complimentary to our solutions; and improve our internal
operating and financial infrastructure in support of our strategic goals and
objectives. While we believe in the long-term success of our business
solutions, our prospects must be considered in light of the recent experience,
risks and difficulties that are frequently encountered by companies in new and
rapidly evolving markets. See Risk Factors.

RESULTS OF OPERATIONS

The following table sets forth certain consolidated historical operating
information, as a percentage of total revenues, for the periods indicated:

|                                                         |  |                    |     |                   |  |      |     |      |  |  |     |    |  |  |     |   | 
|-------------------------------------------------------- |  | ------------------ | --- | ----------------- |  | ---- | --- | ---- |  |  | --- | -- |  |  | --- | - | 
|                                                         |  | Three months ended |     | Nine months ended | 
|                                                         |  | September 30,      |     | September 30,     | 
|                                                         |  |                    |     |                   | 
|                                                         |  | 2001               |     | 2000              |  | 2001 |     | 2000 | 
|                                                         |  |                    |     |                   |  |      |     |      | 
|Product licenses and sales                               |  |                    | 52  | %                 |  |      | 61  | %    |  |  | 55  | %  |  |  | 61  | % | 
|                                                        
|                                                        
|                                                        
|                                                        
|Subscriptions                                            |  |                    | 34  | %                 |  |      | 21  | %    |  |  | 29  | %  |  |  | 21  | % | 
|                                                        
|                                                        
|                                                        
|                                                        
|Professional services                                    |  |                    | 14  | %                 |  |      | 18  | %    |  |  | 16  | %  |  |  | 18  | % | 
|                                                         |  |                    |     |                   |  |      |     |      |  |  |     |    |  |  |     |  
|Total revenues                                           |  |                    | 100 | %                 |  |      | 100 | %    |  |  | 100 | %  |  |  | 100 | % | 
|                                                         |  |                    |     |                   |  |      |     |      |  |  |     |    |  |  |     |  
|Cost of product licenses and sales                       |  |                    | 3   | %                 |  |      | 13  | %    |  |  | 7   | %  |  |  | 12  | % | 
|                                                        
|                                                        
|                                                        
|                                                        
|Cost of subscriptions and
professional services          |  |                    | 24  | %                 |  |      | 19  | %    |  |  | 23  | %  |  |  | 19  | % | 
|                                                        
|                                                        
|                                                        
|                                                        
|Research and development                                 |  |                    | 18  | %                 |  |      | 16  | %    |  |  | 16  | %  |  |  | 17  | % | 
|                                                        
|                                                        
|                                                        
|                                                        
|Sales and marketing                                      |  |                    | 44  | %                 |  |      | 34  | %    |  |  | 42  | %  |  |  | 35  | % | 
|                                                        
|                                                        
|                                                        
|                                                        
|General and administrative                               |  |                    | 10  | %                 |  |      | 7   | %    |  |  | 9   | %  |  |  | 7   | % | 
|                                                        
|                                                        
|                                                        
|                                                        
|Write-off of lease obligation                            |  |                    |    |                   |  |      |    |      |  |  | 1   | %  |  |  |    |   | 
|                                                        
|                                                        
|                                                        
|                                                        
|Charge for in-process research
and development           |  |                    |    |                   |  |      |    |      |  |  | 2   | %  |  |  |    |   | 
|                                                        
|                                                        
|                                                        
|                                                        
|Amortization of goodwill                                 |  |                    | 22  | %                 |  |      |    |      |  |  | 9   | %  |  |  |    |   | 
|                                                        
|                                                        
|                                                        
|                                                        
|Amortization of intangibles and
stock based compensation |  |                    | 4   | %                 |  |      | 1   | %    |  |  | 2   | %  |  |  | 1   | % | 
|                                                         |  |                    |     |                   |  |      |     |      |  |  |     |    |  |  |     |  
|                                                        
|                                                        
|                                                        
|                                                        
|Total costs and expenses                                 |  |                    | 125 | %                 |  |      | 90  | %    |  |  | 111 | %  |  |  | 91  | % | 
|                                                         |  |                    |     |                   |  |      |     |      |  |  |     |    |  |  |     |  
|Operating income (loss)                                  |  |                    | (25 | )%                |  |      | 10  | %    |  |  | (11 | )% |  |  | 9   | % | 
|                                                         |  |                    |     |                   |  |      |     |      |  |  |     |    |  |  |     |  

REVENUES

Our total revenues increased 2% to $52.7 million for the three months
ended September 30, 2001 and 22% to $165.6 million for the nine months ended
September 30, 2001 as compared with the same periods in the prior year. Product
licenses and sales, including perpetual licenses and sales of partner software
and hardware appliances, continued to be the primary source of revenue
generation at 52% of total revenues for the three month period ended September
30, 2001 as compared to 61% for the corresponding period in 2000. Product
licenses and sales represented 55% of total revenues for the nine-month period
ended September 30, 2001 as compared to 61% for the same period in

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2000. The decrease in product and license sales as a percentage of total
revenues is due primarily to the decrease in the sales of
third-party products.

We made several changes that impacted the level of sales of third-party
products. Primarily, this movement away from direct sales of third party
products was a conscious effort to simplify our business by focusing on our own
ISS solutions. The business of selling third party products arose from our
Netrex acquisition in 1999. Although we have de-emphasized sales of third party
products, we continue it as part of our managed security services offerings.
Additionally, we modified our agreement with Nokia, a maker of appliances that
work in conjunction with ISS RealSecure software and certain Checkpoint
software. We previously purchased and resold these Nokia appliances with ISS
RealSecure software, but now the sale of the Nokia appliances occurs primarily
through Nokia resellers, with the sale of ISS RealSecure software directly by
us or through our resellers to our customers. This change lowered our sales
because the Nokia appliances component of sales is now occurring through Nokia
resellers.

License sales are generated both through a direct sales force and through
resellers. When our resellers generate sales, revenues are recognized when the
end user sale has occurred, which is identified through electronic delivery of
a software key that is necessary to operate the product.

In the third quarter of 2001, 71% of our revenues were generated from
customers in the Americas, while 15% were generated from EMEA customers and 14%
from Asia and Pacific Rim customers. This compares to 79% in the Americas, 13%
in EMEA and 8% in the Asia and Pacific Rim for the third quarter of 2000. This
trend is the same on a year-to-date basis as continued international
geographic expansion combined with the reduction of third party product sales
which were almost exclusively in the Americas produces a more globally balanced
company.

We continue to add functionality to our SAFEsuite product family,
 providing
network, server and desktop based solutions, and our security management
applications. In the second quarter of 2001, the acquisition of Network ICE
added desktop intrusion detection and highly scalable security management
systems to the family. Additionally, we announced our pervasive protection
platform strategy to converge intrusion detection and security assessment
technologies into one system for enhanced accuracy and simplified management.
In the third quarter, we released several enhancements to our product offerings
that included our pervasive protection platform strategy and incorporated some
technology from the Network ICE product set. These improvements as well as
planned new offerings provide our customers with more powerful and
easier-to-use solutions for security management across the enterprise.

Subscription revenues grew 61% from $10.9 million in the three months
ended September 30, 2000 to $17.7 million in the three months ended September
30, 2001. This represents an increase from 21% of total revenues in the third
quarter of 2000 to 34% of total revenues in the third quarter of 2001. On a
year to date basis, subscriptions revenue represented 29% of total revenues in
the nine months ended September 30, 2001 as compared to 21% in the nine months
ended September 30, 2000. Subscription revenues consist of maintenance, term
licenses of product usage and security-monitoring fees for managed services
offerings. While all components of subscription revenues grew, the increase was
primarily due to maintenance, the largest component, and managed services,
which had the highest growth percentage. Managed services, a relatively newer
business for us, grew to 7% of total revenues in the third quarter of 2001.

Professional services revenue decreased 16% from $9.1 million for the
three months ended September 30, 2000 to $7.6 million for the three months
ended September 30, 2001, representing 14% of total revenues for the quarter
ended September 30, 2001 as compared to 18% for the corresponding quarter in
2000. For the nine months ended September 30, 2001, professional services
revenue increased 8% from $23.9 million for the nine months ended September 30,
2000 to $25.6 million for the nine months ended September 30, 2001. The
decrease in the third quarter comparison is evidence of reduced customer
spending as entities curtailed these discretionary costs in the quarter. We
further contributed to this decline with a narrowing of our consulting offerings to
focus on services that directly contribute to our pervasive protection platform
strategy. This focus extends to training where the decline is attributable to courses
related to third-party products as courses dedicated to ISS solutions continue
to exhibit good demand.

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COSTS AND EXPENSES

In the quarter ended September 30, 2001, we resized the business as the
result of disappointing sales results in the quarter ended June 30, 2001. This
included personnel reductions in all areas of the business and decreases in various operating expenses, with
emphasis also on controlling discretionary spending and capital expenditures.
The severance costs, contract termination and office consolidation costs
incurred in the quarter related to these activities are included in the
appropriate expense categories and totaled approximately $2.1 million.

Cost of revenues

Cost of revenues consists of several components. Substantially all of the
cost of product licenses and sales represents payments to partners for their
products that we integrate with our products or directly sell to our customers
in providing a single solution source. Costs associated with licensing our
products are minor. Costs of product revenues as a percentage of total revenues
decreased from 13% for the three months ended September 30, 2000 to 3% for the
comparable period in 2001. For the nine months ended September 30, 2001, cost
of product revenues represented 7% of total revenues as compared to 12% in the
corresponding period of 2000. As explained in our discussion of license and
product sales revenues, this decrease was primarily the result of a reduction
in sales of third party products.

Cost of subscription and services includes the cost of our technical
support personnel who provide assistance to customers under maintenance
agreements, the security operations center (SOC) costs of providing managed
security monitoring services and the costs related to consulting and training.
These costs represented 19% of total revenues for the three-month period ended
September 30, 2000 and increased to 24% for the comparable period in 2001. On a
year-to-date basis, these costs represented 19% of total revenues for the nine
months ended September 30, 2000 and 23% for the nine months ended September 30,
2001. The percentage increase is partially the result of investment in
automated systems and personnel resources for our Asia/Pacific SOC for
contracted business, which began in the third quarter and in our United States
SOC to handle anticipated growth. We also added professional services
capabilities and more automated technical support programs over the last year.
With the decrease in professional services revenues in the third quarter of
2001, we have taken actions to reduce personnel in the consulting and training
groups to achieve appropriate gross margins at expected revenue levels.

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
dedicated to understanding, documenting and coding new vulnerability checks,
real-time threats and attack signatures and developing solutions to address
global security issues. We increased these expenditures, as we
perceived primary research and product development and managed service offerings
as essential ingredients for retaining our leadership position in the market.
We also increased the number of our development personnel focused on our
best-of-breed products, enterprise applications, managed services offerings and
research for future product offerings, including the addition of approximately
20 engineers from the June 2001 Network ICE acquisition. Accordingly, research
and development expenses increased from $8.4 million in the three months ended
September 30, 2000 to $9.3 million in the three months ended September 30,
2001. As a percentage of total revenues, research and development expenses
increased from 16% for the three months ended September 30, 2000 to 18% for the
corresponding period in 2001. On a year-to-date basis, research and development
expenses increased from $22.8 million in the nine months ended September 30,
2000 to $26.5 million in the nine months ended September 30, 2001. As a
percentage of revenues, these costs decreased from 17% for the nine months
ended September 30, 2000 to 16% for the nine months ended September 30, 2001.
We have begun to integrate the Network ICE technologies into our technologies
under the leadership of our Vice President of Engineering and Development, the
former chief executive officer of Network ICE. Our personnel
reduction actions in the quarter ended September 30, 2001
included our development group, and we expect these costs to
decrease as a percentage of revenues in future quarters through
controlled growth relative to our planned revenue expansion.

Sales and marketing

Sales and marketing expenses consist primarily 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. In the quarter ended September 30, 2001, sales and
marketing expenses were $23.4 million or 44% of total revenues, compared to
$17.4 million or 34% of total revenues in the quarter ended September 30, 2000.
For the nine months ended September 30, sales and marketing expenses increased
from $47.3 million in 2000 to $69.0

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million in 2001 and as a percentage of revenues from 35% in 2000 to 42% in
2001. This higher percentage was partially due to lower third-party sales,
which consume only minor sales effort and expense. The balance of the increase
was a larger number of sales and marketing personnel compared to the prior year
periods and the cost of severance in the quarter related to the reduction of
personnel in the third quarter.

General and administrative

General and administrative expenses in the quarter ended September 30,
2001 increased to $5.5 million or 10% of total revenues from $3.4 million or 7%
of total revenues in the third quarter of 2000. For the nine months ended
September 30, general and administrative expenses increased as a percentage of
revenues from 7% in 2000 to 9% in 2001. General and administrative expenses
consist of: personnel-related costs for executive, administrative, finance and
human resources; information systems and other support services costs; and
legal, accounting and other professional service fees. The increase in these
expenses is attributable to our efforts, through additional employees and
systems, to enhance managements ability to obtain and analyze information
about our domestic and international operations and to support a larger
employee base. Ongoing expenses in this area were reduced in the third quarter
as the organization matched expenditures to the current spending environment;
at the same time, the quarter included severance, contract termination and office
consolidation costs that caused total general and administrative expenses to
increase.

In the quarter ended March 31, 2001, we completed the relocation of our
Atlanta personnel into our new corporate headquarters, incurring expenses
associated with the move and also recording a $1.1 million write-off of the
remaining lease obligation on our previous Atlanta headquarters office space.
This non-recurring expense originated in the first quarter of 2001, as
available subleased space in the area grew substantially in the quarter as the
result of layoffs, closures and consolidations, dimming the prospects of
subleasing our old space.

Charge for in-process research and development and amortization

Expenses for the nine-month period ended September 30, 2001 included a
$2.9 million charge for the write-off of in-process research and development
costs associated with the Network ICE acquisition in June 2001. In-process
research and development had not reached technological feasibility based on
identifiable technological risk factors which indicated that even though
successful completion was expected, it was not assured at the acquisition date
and was immediately charged to operations.

Goodwill amortization for the quarter ended September 30, 2001 was $11.4
million. Under the recently issued Financial Accounting Standards for Business
Combinations and Goodwill and Other Intangible Assets, beginning January 1
2002, goodwill will no longer be amortized but will be subject to periodic
tests for impairment.

Amortization of intangibles and stock-based compensation totaled $2.2
million for the quarter ended September 30, 2001. Amortization of other
intangibles includes amortization of technology and customer relationships.
Such amounts aggregated approximately $1.3 million in the quarter ended September
30, 2001 and also include amortization of compensation charges related to
unvested stock options of approximately $0.9 million in the quarter ended September
30, 2001. All unvested Network ICE options assumed by ISS were included in the
purchase price based on their fair value; however, the portion of the intrinsic
value of the unvested options that was deemed to be earned over the remaining
vesting period of those options has been allocated to deferred compensation and
will be amortized over the remaining vesting period.

Other income

Other income for the three and nine months ended September 30, 2001
includes a subsidiary IPO gain of $13.6 million from an initial public offering
on the Japan over-the-counter market by the Companys subsidiary responsible
for Asia and Pacific Rim operations. Other income for the nine months ended
September 30, 2001 also includes a non-recurring other income item of $1.6
million generated from the sale of approximately 2% of the outstanding shares
of our Asia-Pacific subsidiary in March 2001 to employees and key
partners. We believe that the IPO will provide  more visibility of this operation in its marketplace as well as
funds for the expansion of the business in this market. In anticipation of the
IPO, options were granted in the subsidiary as a means of key employee
retention. The price for the shares and exercise price for options was
established based on a valuation of the subsidiary by an independent appraisal

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firm. These gains represent the difference between proceeds received and
the underlying basis in the stock less the minority interesting such gains.

Net interest income decreased from $2.3 million in the quarter ended
September 30, 2000 to $1.5 million in the comparable quarter of 2001, primarily
due to declining interest rates. This is a continuation of a trend for the
first nine months of 2001 as interest income decreased for this period from
$6.2 million in 2000 to $5.3 million in 2001.

Income taxes

Provision for income tax was approximately 500% of pre-tax net income for
the quarter ended September 30, 2001 and 330% of pre-tax net income for the
nine months ended September 30, 2001. This compares with income tax expense of
36% of pre-tax net income for the quarter and nine-month periods ended
September 30, 2000. Under APB Opinion No. 28, Interim Financial Reporting, we
are required to estimate the annual effective income tax rate each time an
interim report is issued. As a result of the acquisition of Network ICE during
the second quarter of 2001, we will be expensing approximately $26.3 million of
goodwill amortization during the calendar year 2001 that will not be deductible
for income tax purposes. As of June 30, 2001, we estimated the annual
effective income tax rate for the calendar year 2001 to be (32)%. We now
expect the annual effective income tax rate for the 2001 calendar year to be
(20)% of pre-tax net income or loss for normal operations. In addition, we
have accrued taxes at a 36% rate on the Japan IPO gain. While income taxes
expense was recorded on domestic operations, taxes payable were reduced by
deductions related to stock options. The tax benefit for the use of these
stock option deductions was recorded to additional paid-in-capital.

Net Income (loss)

We recorded a net loss of $6.1 million or $.13 loss per share in the
quarter ended September 30, 2001 compared to net income of $4.9 million or $.12
per share in the comparable period in 2000. The net loss of $5.2 million for
the nine months ended September 30, 2001 was also a significant decrease from
net income of $12.0 million for the comparable period in 2000.

The decrease was partially due to the non-cash charges related to the June
2001 acquisition of Network ICE. Excluding these non-cash acquisition related
amortization expenses, we had operating income in the quarter ended September
30, 2001 of $.3 million and net income of $1.0 million. This met our goal of
restoring the profitability of the Company, even while including in
the operating costs the nonrecurring
severance, contract termination and office consolidation costs of $2.1 million.

LIQUIDITY AND CAPITAL RESOURCES

Net cash provided by
operations in the first nine months of 2001 was $18.8
million. It included a net loss of $5.2 million, depreciation of $8.1 million,
acquisition related amortization and in-process research and development write
off of $20.4 million, and an income tax benefit from employee exercises of
stock options of $9.4 million. Cash provided by operations has
been adjusted to reflect the gain on the IPO of our Japan
subsidiary as an investing activity.

Investing activities in the first nine months of 2001 include the purchase
of $98.1 million of marketable securities, primarily commercial paper, offset
by net proceeds from the maturity of marketable securities of $105.5 million.
These assets have quality characteristics similar to cash equivalents except
their maturities are longer than three months. We also invested in equipment
totaling $26.7 million as we provided existing and new personnel with the
computer hardware and software environment necessary to perform their job
functions and incurred leasehold improvement costs for our new headquarters.

Our financing activities provided $15.4 million of cash in the nine months
ended September 30, 2001, which consisted primarily of proceeds from the
exercise of stock options by our employees and also from the issuance of common
stock through our Employee Stock Purchase Plan.

As of September 30, 2001, we had $146.2 million of cash and cash
equivalents and marketable securities, consisting primarily of money market
accounts and commercial paper carrying the highest investment grade rating. We
believe that such cash and cash equivalents and marketable securities will be
sufficient to meet our working capital needs and capital expenditures for the
foreseeable future. From time to time we evaluate possible acquisition and

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investment opportunities in businesses, products or technologies that are
complimentary to ours. In the event we determine to pursue such opportunities,
we may use our available cash and cash equivalents. Pending such uses, we will
continue to invest our available cash in investment grade, interest-bearing
investments.

Additionally, we have restricted marketable securities of $12.5 million
securing a $10 million letter of credit issued in connection with our
commitment to a long-term lease of our Atlanta corporate facilities.

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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
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. Except as otherwise required by law, we undertake no obligation to
update publicly any forward-looking statements contained in this Quarterly
Report on Form 10-Q for any reason, even if new information becomes available
or other events occur in the future.

We Have Only Recently Achieved Profitability

We began operations in 1994 and achieved profitability beginning in 1999
and continuing through the first quarter of 2001. We attribute the loss in the
second quarter of 2001 (excluding amortization and charges associated with the
Network ICE acquisition) primarily to customers reduced technology spending in
our core markets. We adjusted our expense levels to return to profitability
(excluding amortization and charges associated with the Network ICE
acquisition) in the third quarter of 2001. We also recognize that we operate in
a new and rapidly evolving market and must, among other things:



| |  |  | respond to competitive developments;                                  
| | - |  | ----------------------------------------------------------------------
|
| |  |  | continue to upgrade and expand our product and services offerings; and
|
| |  |  | continue to attract, retain and motivate our employees.               

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

Our Future Operating Results Will Likely Fluctuate Significantly

Our future
revenues and operating results will likely deviate from our guidance
and expectations, and may differ materially. We 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;                  
|
| |  |  | the volume and timing of orders, including seasonal trends in customer purchasing and customer budgetary priorities;                                 
|
| |  |  | our ability to develop new and enhanced product and managed service offerings and expand our professional services
capabilities;                     
|
| |  |  | our ability to provide scalable managed services offerings through our partners in a cost effective manner;                                          
|
| |  |  | foreign currency exchange rates that affect our international operations;                                                                            
|
| |  |  | product and price competition in our markets;                                                                                                        
|
| |  |  | general economic conditions, both domestically and in our foreign markets; and                                                                       

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| |  |  | adequacy of personnel resources to fulfill sales.
| | - |  | -------------------------------------------------

We increasingly focus our efforts on sales of enterprise-wide security
solutions, which consist of our entire product suite and related professional
services, and managed security services, rather than on the sale of component
products. As a result, each sale may require additional 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
revenues and results of operations for a particular period. The timing of
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 establish our spending levels based in large part on our expected
future revenues instead of on our past results. 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, industry analysts and brokerage firms with respect to our operating
and financial results is impacted by the tendency of a majority of our sales to
be completed in the last month of a quarter. We may not be able to determine
whether we will experience material deviations from guidance or expectations
until the end of a quarter.

We Face Intense Competition in Our Market

The market for network security monitoring, detection 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 one of five categories:



| |  |  | internal information technology departments of our customers and the
consulting firms that assist them in formulating security systems;                                                                                                                                                           
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | relatively smaller software companies offering relatively limited
applications for network and Internet security;                                                                                                                                                                                 
|
| |  |  | large companies, including Symantec Corp., Cisco Systems, Inc.,
Network Associates, Inc. and Bindview Development Corp., 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 companies like Cisco Systems, Inc. that could
integrate features that are similar to our products into their own
products; 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, would make such combined entities more
formidable competitors to us. 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 and response products and managed security
services, which increases pricing pressures within our market.

19



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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 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 software, a
significant number of customers may accept more limited functionality to avoid
purchasing additional software.

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 products and product
enhancements 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 customers may believe that
our products are ineffective, which may cause them or prospective customers to
reduce or avoid purchases of our products.

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 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

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amortization of goodwill or in-process
research and development expense. We cannot be certain that we will
successfully overcome these risks with respect to any of our recent or 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.

We Must Attract and Retain Adequate Personnel Resources

We endeavor to employ personnel resources to correspond with our expected
future revenues. In the third quarter of 2001, we reduced our overall personnel resources to
reflect the expected decrease in revenues from prior quarters. At the
same time, we continued to hire where growth was continuing to occur
and expect to continue to hire in future periods.
Personnel resources could be
insufficient to fulfill unanticipated demand and we believe our future success
in an improving market will depend in part on our ability to recruit and retain
highly skilled engineering, technical, consulting, marketing, sales and
management personnel. To accomplish this, we believe we must continue to
provide competitive compensation.

Risks Associated with Our Global Operations

The expansion of our international operations includes our presence in
dispersed locations throughout the world, including throughout Europe 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;                                        
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | unexpected changes in regulatory requirements in countries where we do business;                                                          
|
| |  |  | excess taxation due to overlapping tax structures;                                                                                        
|
| |  |  | fluctuations in foreign currency exchange rates; and                                                                                      
|
| |  |  | export license requirements and restrictions on the 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
situations, we expect these efforts by hackers to continue. If these efforts
are successful, our operations, reputation and sales could be adversely
affected.

We Depend on Our Intellectual
Property Rights and Use Licensed Technology

We rely primarily on copyright and
trademark laws, trade secrets,
confidentiality procedures and contractual provisions to protect our
proprietary rights. We have obtained one United States patent and have
a number of patent applications under review. We also believe that the
technological and creative skills of our personnel, new product developments,
frequent product enhancements, our name recognition, our professional services
capabilities and delivery of reliable product maintenance are essential to
establishing and maintaining our technology leadership position. We cannot
assure you that our competitors will not independently develop technologies
that are similar to ours.

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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.




ITEM 3.Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Sensitivity

The primary objective of our investment activities is to preserve
principal while at the same time maximizing the income we receive from our
investments without significantly increasing risk. Some of the securities in
which we have invested may be subject to market risk. This means that a change
in prevailing interest rates may cause the principal amount of the investment
to fluctuate. For example, if we hold a security that was issued with a fixed
interest rate at the then-prevailing rate and the prevailing interest rate
later rises, the principal value of our investment will probably decline. To
minimize this risk, we maintain our portfolio of cash equivalents and
marketable securities in a variety of relatively short-term investments,
including commercial paper and overnight repurchase agreements. As of September
30, 2001, $29,704,000 of our securities had maturities more than 90 days after
September 30, 2001.

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PART II

OTHER INFORMATION




ITEM 1.Legal Proceedings

Beginning on September 28, 2001, the Company and certain of its officers and
directors were named as defendants in several lawsuits alleging violations of
the federal securities laws, including Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934, as amended, and Rule 10(b)-5, thereunder. As
of this time, four such actions have been filed in the United States District
Court for the Northern District of Georgia. The complaints, which are
substantially similar in nature, purport to be brought on behalf of a class of
investors who purchased the Companys stock during the period from April 5,
2001 through July 2, 2001 (the Class Period). The complaints generally
allege that the Company and the individual defendants violated the anti-fraud
provisions of the federal securities laws and caused the Companys stock to
trade at artificially high prices by making misrepresentations relating to the
Companys financial condition and prospects during the Class Period. The
complaints seek damages in an unspecified amount. The Company anticipates that
all four of these actions, along with any other similar actions which may
hereafter be filed, will be consolidated into a single case. No answer or
other responsive papers are yet due from the defendants. The Company believes
that the actions are without merit and intends to defend the actions vigorously.




ITEM 6.Exhibits and Reports on Form 8-K

|    |  |                                                               
|--- |  | --------------------------------------------------------------
|(a) |  | Exhibits                                                      
|   
|   
|   
|   
|    |  | None                                                          
|   
|   
|   
|   
|(b) |  | Reports on Form 8-K.                                          
|   
|   
|   
|   
|    |  | ISS filed no reports on Form 8-K during this reporting period.

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INTERNET SECURITY SYSTEMS, INC.
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 13, 2001 |  | By /s/ Richard Macchia                                            
|                        |  |                                                                   
|                        |  | Chief Financial Officer
Principal Financial and Accounting Officer

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