INTRUSION INC - 10-Q Quarterly Report

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

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FORM 10-Q

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[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2002

OR

[ ] 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 0-20191
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INTRUSION INC.
(Exact name of Registrant as specified in its charter)

DELAWARE 75-1911917
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

1101 EAST ARAPAHO ROAD, RICHARDSON, TEXAS 75081
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(Address of principal executive offices)
(Zip Code)

(972) 234-6400
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(Registrant's telephone number, including area code)

NOT APPLICABLE
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Former name, 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 X No
--- ---

The number of shares outstanding of the Registrant's Common Stock, $0.01 par
value, on July 31, 2002 was 20,646,425.

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INTRUSION INC.

INDEX

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PART I - FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS.

INTRUSION INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par value amounts)

See accompanying notes.

3

INTRUSION INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)

See accompanying notes.

4

INTRUSION INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

See accompanying notes.

5

INTRUSION INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. Description of Business

We develop, market and support a family of security software and
appliances that address vital security issues facing organizations deploying
business applications over the Internet or internally via Intranets. We
currently provide e-security solutions including intrusion detection systems,
virtual private network appliances and firewall appliances.

We market and distribute our products through a direct sales force to
end-users, distributors and by numerous domestic and international system
integrators, service providers and value-added resellers. Our end-user customers
include high-technology, manufacturing, telecommunications, retail,
transportation, health care, insurance, entertainment, utilities and energy
companies, government agencies, financial institutions, and academic
institutions.

Our company was organized in Texas in September 1983 and reincorporated
in Delaware in October 1995. For more than 15 years, we provided local area
networking equipment and were known as Optical Data Systems or ODS Networks. On
April 17, 2000, we announced plans to sell, or otherwise dispose of, our
networking divisions, which included our Essential Communications division and
our local area networking assets. In accordance with these plans, we have
accounted for these businesses as discontinued operations. On June 1, 2000, we
changed our name from ODS Networks, Inc. to Intrusion.com, Inc., and our NASDAQ
ticker symbol from ODSI to INTZ to reflect our focus on e-security solutions. On
November 1, 2001, we changed our name from Intrusion.com, Inc. to Intrusion Inc.

Our principal executive offices are located at 1101 E. Arapaho Road,
Richardson, Texas 75081, and our telephone number is (972) 234-6400. References
to "we", "us", "our" or "Intrusion Inc." refer to Intrusion Inc. and its
subsidiaries.

2. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with generally accepted accounting principles
for interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. The December 31, 2001 balance sheet was
derived from audited financial statements, but does not include all the
disclosures required by generally accepted accounting principles. However, we
believe that the disclosures are adequate to make the information presented not
misleading. In our opinion, all the adjustments (consisting of normal recurring
adjustments) considered necessary for fair presentation have been included. The
results of operations for the three and six month periods ending June 30, 2002
are not necessarily indicative of the results that may be achieved for the full
fiscal year or for any future period. The condensed consolidated financial
statements included herein should be read in conjunction with the consolidated
financial statements and notes thereto included in the Company's annual report
on Form 10-K for the year ended December 31, 2001.

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Goodwill represents the excess purchase price over the fair market
value of the net assets acquired. Net goodwill at June 30, 2002 was $354
thousand. We adopted Financial Accounting Standards ("FAS") Board Statements No.
141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets,
effective January 1, 2002. Under these new rules, goodwill and intangible assets
deemed to have indefinite lives will no longer be amortized, but will be subject
to annual impairment tests in accordance with the Statements. Accordingly, there
has been no amortization of goodwill recorded effective January 1, 2002.
Further, adoption of the impairment provision of FAS 142 had no material impact
on our financial statements for the quarter ended June 30, 2002. The impact on
operations is as follows:

3. Inventories (In thousands)

4. Income Taxes

Our effective tax rate for the quarter ended June 30, 2002 was 11.6%,
compared to 4.0% for the quarter ended June 30, 2001. Our effective tax rate for
the six months ended June 30, 2002 was 5.5%, compared to 5.9% for the six months
ended June 30, 2001. During the quarter ended June 30, 2002, an ongoing Internal
Revenue Service audit was settled favorably; we therefore recorded a benefit to
reverse income taxes payable previously accrued. We will recognize the benefit
of our remaining net operating loss carryforwards when we generate taxable
income or otherwise can be assured that such net operating loss carryforwards
can be utilized.

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5. Earnings per Share (In thousands, except per share amounts) (Unaudited)

Total weighted stock options outstanding at June 30, 2002 and June 30,
2001 that are not included in the diluted earnings per share computation due to
the antidilutive effect are 2.2 million and 2.3 million for the three months
ended June 30, 2002 and June 30, 2001, respectively, and 2.1 million and 2.2
million for the six months ended June 30, 2002 and June 30, 2001, respectively.
Such options are excluded due to our incurring net losses during these periods.

6. Comprehensive Income

There are no significant differences between net loss and comprehensive
loss for the three months and six months ended June 30, 2002 and 2001.

7. Discontinued Operations

In March 2002 we sold the assets of our last remaining discontinued
operation, our Essential Communications division, for $1 million, generating a
gain of $0.4 million, which we have shown as a gain from discontinued operations
in the accompanying financial statements. Terms of the sale included
transferring $0.7 million in net property, plant and equipment, $0.1 million in
current liabilities and product maintenance obligations, of which $0.4 million
was recorded in deferred revenue at December 31, 2001. Included in the gain on
the sale of Essential is a $0.3 million reserve to terminate an office lease,
which is the equivalent of 2 years' lease and maintenance of the facility.
Successful termination for less than 2 years will result in a greater gain on
disposition of Essential. Termination for more than $0.3 million will reduce the
gain on disposition of Essential. The contractual

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term of the lease runs through February 2009 and remaining contractual lease
payments total $1.1 million at June 30, 2002.

During the first quarter of 2001, we closed the sale of our legacy
local area networking division generating a gain of $2.1 million which was
used to reduce the estimated net realizable value of the net assets of
Essential.

The following represents a summary of assets and liabilities classified
as discontinued operations(In thousands):

The following represents a summary of gains and losses from
discontinued operations (In thousands)(Unaudited):

9

8. Commitments and Contingencies

We are subject to legal proceedings and claims that arise in the
ordinary course of business. We do not believe that the outcome of these matters
will have a material adverse affect on our consolidated financial position,
operating results or cash flows. However, there can be no assurance such legal
proceedings will not have a material impact.

On March 22, 2002, Morgan Newton Company, L.P. ("Morgan Newton") filed
suit against us in Dallas County District Court, Case No. DV02-02339-C, alleging
claims for breach of contract, promissory estoppel, and fraud. The claims arise
out of an alleged oral representation to Morgan Newton concerning a request for
quotation for the purchase of a large amount of Morgan Newton's products. Morgan
Newton has not specified the amount of damages it is seeking in the lawsuit, but
it is possible that it may be seeking damages in excess of $2 million, or more.
In addition to actual damages, Morgan Newton is also seeking attorney's fees and
punitive damages. On April 22, 2002, we filed our response to Morgan Newton's
lawsuit, generally denying all claims and asserting certain affirmative
defenses. As of this time, preliminary discovery is underway.

Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

This report contains forward-looking statements, within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934, that involve risks and uncertainties, such as statements
concerning: the difficulties in forecasting future sales caused by current
economic and market conditions, the effect of military actions on government and
corporate spending on information security products, the impact of our cost
reduction programs, the difficulties and uncertainties in successfully
developing and introducing new products, our ability to continue to meet
operating expenses through current cash flow or additional financings, the
continuance and strength of our relationship with Check Point, the highly
competitive market for our products, difficulties in accurately estimating
market growth, the consolidation of the information security industry, the
impact of changing economic conditions, business conditions in the information
security industry, our ability to manage acquisitions effectively, our ability
to manage discontinued operations effectively, the impact of market peers and
their products as well as risks concerning future technology and others
identified in our Annual Report on Form 10-K and other Securities and Exchange
Commission filings. Such forward-looking statements are generally accompanied by
words such as "plan," "estimate," "expect," "believe," "should," "would,"
"could," "anticipate," "may" or other words that convey uncertainty of future
events or outcomes. These forward-looking statements and other statements made
elsewhere in this report are made in reliance on the Private Securities
Litigation Reform Act of 1995. The section below entitled "Factors That May
Affect Future Results of Operations" sets forth and incorporates by reference
certain factors that could cause actual future results of the company to differ
materially from these statements.

OVERVIEW

We develop, market and support a family of security software and
appliances that address vital security issues facing organizations deploying
business applications over the Internet or internally via Intranets. We

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currently provide e-security solutions including intrusion detection systems,
virtual private network appliances and firewall appliances. On June 1, 2000, we
changed our name from ODS Networks, Inc. to Intrusion.com Inc. and our NASDAQ
ticker symbol from ODSI to INTZ to reflect our focus on e-security solutions. On
November 1, 2001, we changed our name from Intrusion.com, Inc. to Intrusion Inc.
During the second quarter of 2000, we announced our plan to sell, or otherwise
dispose of, our networking divisions which included our Essential Communications
division and our local area networking assets and began accounting for these
networking divisions as discontinued operations.

The following management's discussion and analysis of financial
condition and results of operations pertains only to our continuing operations
unless otherwise disclosed. Certain prior year information has been reclassified
to conform with the current presentation.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Management's discussion and analysis of financial condition and results
of operations are based upon our consolidated financial statements, which have
been prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosure of contingent assets and
liabilities. On an on-going basis, we evaluate our estimates, including those
related to product returns, bad debts, inventories, intangible assets, income
taxes, warranty obligations, restructuring, maintenance contracts and
contingencies. We base our estimates on historical experience and on various
other assumptions that are believed to be reasonable under the circumstances,
the results of which form the basis for making judgments about the carrying
values of assets and liabilities that are not readily apparent from other
sources. Actual results may differ from these estimates under different
assumptions or conditions.

We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our consolidated
financial statements.

REVENUE RECOGNITION

We generally recognize product revenue upon shipment of product. We
accrue for estimated warranty costs, sales returns and other allowances at the
time of shipment based on our experience. Revenue from maintenance contracts is
deferred and recognized over the contractual period the services are performed.
To date, warranty costs and sales returns have not been material. There is a
risk that technical issues on new products could result in unexpected warranty
costs and returns.

We recognize software revenue from the licensing of our software
products in accordance with Statement of Position ("SOP") No. 97-2 "Software
Revenue Recognition" and SOP 98-9 "Modification of 97-2, Software Revenue
Recognition, with respect to certain transactions" whereby revenue from the
licensing of our products is not recognized until all four of the following have
been met: i) execution of a written purchase order, license agreement or
contract; ii) shipment of the product has occurred; iii) the license fee is
fixed and determinable; and iv) collectibility is probable. The Company defers
and recognizes maintenance and support revenue over the term of the contract
period, which is generally one year.

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We have signed distribution agreements with distributors in the United
States, Europe and Asia. In general, these relationships are non-exclusive.
Distributors typically maintain an inventory of our products. Under these
agreements, we provide certain protection to the distributors for their
inventory of our products for price reductions as well as products that are
slow-moving or have been discontinued by us. Recognition of sales to
distributors and related gross profits are deferred until the merchandise is
resold by the distributors. However, since we have legally sold the inventory to
the distributor and we no longer have care, custody or control over the
inventory, we recognize the trade accounts receivable and reduce inventory
related to the sale at the time of shipment to the distributor. Revenue, offset
by deferred cost of sales, is included in deferred revenue in the accompanying
financial statements.

ALLOWANCE FOR DOUBTFUL ACCOUNTS

We maintain allowances for doubtful accounts for estimated losses
resulting from the inability of our customers to make required payments. If the
financial condition of our customers were to deteriorate, resulting in an
impairment of their ability to make payments, additional allowances may be
required.

INVENTORY

We write down our inventory for estimated obsolescence or unmarketable
inventory equal to the difference between the cost of inventory and the
estimated market value based upon assumptions about future demand and market
conditions. If actual market conditions are less favorable than those projected
by management, additional inventory write-downs may be required.

DISCONTINUED OPERATIONS

In the second quarter of 2000, we discontinued our networking
operations and accordingly have shown the networking operations as discontinued
in the accompanying financial statements.

During the first quarter of 2001, we closed the sale of our legacy
local area networking division generating a gain of $2.1 million which was used
to reduce the estimated net realizable value of the net assets of our Essential
Communications division.

In March 2002 we sold the assets of Essential, our last remaining
discontinued operation, for $1 million, generating a gain of $0.4 million, which
we have shown as a gain from discontinued operations in the accompanying
financial statements. Terms of the sale included transferring $0.7 million in
net property, plant and equipment, $0.1 million in current liabilities and
product maintenance obligations, of which $0.4 million was recorded in deferred
revenue at December 31, 2001. Included in the gain on the sale of Essential is a
$0.3 million reserve to terminate an office lease, which is the equivalent of 2
years' lease and maintenance of the facility. Successful termination for less
than 2 years will result in a greater gain on disposition of Essential.
Termination for more than $0.3 million will reduce the gain on disposition of
Essential. The contractual term of the lease runs through February 2009 and
remaining contractual lease payments total $1.1 million at June 30, 2002.

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RESULTS OF OPERATIONS

The following table sets forth, for the periods indicated, certain
financial data as a percentage of net sales. The period to period comparison of
financial results is not necessarily indicative of future results.

NET SALES. Net sales for the quarter and six months ended June 30, 2002
decreased to $1.5 million and $4.0 million, respectively, compared to $4.5
million and $9.8 million, respectively, for the same periods of 2001 primarily
due to the decline in sales of our transition products including SecureCom. Our
SecureNet Pro intrusion detection and PDS security appliance

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families of products were also negatively affected by the current difficult
economic environment and the slowdown in information technology security
spending by many corporations.

EXPORT SALES. Export sales for the quarter and six months ended June
30, 2002 decreased to $0.5 million and $1.2 million, respectively, compared to
$1.7 million and $2.9 million, respectively, for the same period of 2001 as
sales from our SecureNet Pro intrusion detection product family, PDS security
appliance family and other security product lines declined. Export sales may
vary as a percentage of net sales in the future.

CONCENTRATION OF SALES. Sales to TRW Systems & Information Technology
("TRW") for the quarter and six months ended June 30, 2001 were 10.3% and 11.8%.
In addition, a portion of our sales to TRW and other corporations were for
products resold by those organizations to various agencies of the U.S.
Government. There were no significant concentrations of sales (i.e. greater than
10%) during the first six months of 2002.

GROSS PROFIT. Gross profit was $0.3 million or 22.0% of net sales for
the quarter ended June 30, 2002, compared to $0.1 million or 1.2% of net sales
for the quarter ended June 30, 2001. For the six months ended June 30, 2002,
gross profit increased to $1.1 million or 28.3% of net sales compared to $.9
million or 8.9% of net sales for the same period in the prior year. Gross profit
margins as a percentage of net sales were up for the quarter and six months
ended June 30, 2002 primarily because of the change in product mix from lower
margin hardware products to higher margin intrusion detection products.

Gross profit as a percentage of net sales is impacted by several
factors, including shifts in product mix, changes in channels of distribution,
sales volume, fluctuations in manufacturing costs, pricing strategies, and
fluctuations in sales of integrated third-party products.

SALES AND MARKETING. Sales and marketing expenses decreased to $3.2
million for the quarter ended June 30, 2002, compared to $6.5 million for the
quarter ended June 30, 2001. Sales and marketing expenses decreased to $7.1
million for the six months ended June 30, 2002 compared to $14.5 million for the
same period of 2001. Sales and marketing expenses decreased in the quarter and
six months ended June 30, 2002, compared to the same periods of 2001, primarily
due to the reorganization of our sales and marketing departments and other cost
reduction initiatives. We expect sales and marketing expenses to continue to
decline in the third quarter of 2002, in comparison to the second quarter of
2002. Sales and marketing expenses may vary as a percentage of net sales in the
future.

RESEARCH AND DEVELOPMENT. Research and development expenses decreased
to $1.5 million for the quarter ended June 30, 2002, compared to $3.3 million
for the quarter ended June 30, 2001. Research and development costs for the six
months ended June 30, 2002 decreased to $3.4 million compared to $7.5 million
for the same period in 2001. Research and development costs are expensed in the
period incurred. Research and development expenses decreased in the quarter and
six months ended June 30, 2002, compared to the same periods in 2001 as we
reduced headcount in our engineering department to accommodate the decline in
information technology spending and as we focused more of our development
efforts on our core security products, SecureNet Pro and PDS security
appliances, while reducing efforts on our other security

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products. Research and development expenses may vary as a percentage of net
sales in the future.

GENERAL AND ADMINISTRATIVE. General and administrative expenses
decreased to $0.6 million for the quarter ended June 30, 2002, compared to $1.0
million for the quarter ended June 30, 2001. General and administrative expensed
decreased to $1.3 million for the six months ending June 30, 2002, compared to
$2.8 million for the six months ending June 30, 2001. General and administrative
expenses decreased in the quarter and six months ending June 30, 2002 compared
to the same periods of 2001, primarily due to restructuring activities in 2001
and 2002 and other cost reduction initiatives. It is expected that general and
administrative expenses will continue to decrease in the third quarter of 2002,
in comparison to the second quarter of 2002. General and administrative expense
may vary as a percentage of net sales in the future.

AMORTIZATION. Amortization expenses decreased to $0.2 million for the
quarter ended June 30, 2002, compared to $0.3 million for the quarter ended June
30, 2001. Amortization expenses for the six months ended June 30, 2002 decreased
to $0.4 million compared to $0.7 million for the same period in 2001.
Amortization expenses decreased in the quarter and six month period ended June
30, 2002, compared with the same periods in 2001, as a result of the June 30,
2001 write off of certain impaired intangible assets and intellectual properties
acquired from Science Applications International Corporate ("SAIC") in 1998 and
the discontinuance of the amortization of goodwill effective January 1, 2002.
Absent subsequent acquisitions, all future amortization will continue to be
associated with only identifiable intangibles acquired from MimeStar, Inc. and
will be approximately $0.2 million per quarter.

RESTRUCTURING CHARGES. Restructuring charges of $.2 million for 2002
consists of severance expense related to additional streamlining of our
organization. In June 2001, we recorded a charge of $4.0 million for
restructuring costs and other special charges consisting primarily of a $3.1
million impairment charge related to intangible assets of our SecurityAnalyst
and SecureEnterprise product lines and $0.8 million for severance as a result of
reductions in our workforce.

INTEREST. Net interest income decreased to $0.1 million for the quarter
ended June 30, 2002, compared to $0.4 million for the same period in 2001. Net
interest income decreased to $0.2 million for the six months ended June 30,
2002, compared to $1.2 million for the six months ended June 30, 2001. The net
interest income decreases were primarily due to the reduced overall cash
balances resulting from operating losses. Net interest income may vary in the
future based on our cash flow and rate of return on investments.

INCOME TAXES. Our effective tax rate for the quarter ended June 30,
2002 was 11.6%, compared to 4.0% for the quarter ended June 30, 2001. Our
effective tax rate for the six months ended June 30, 2002 was 5.5%, compared to
5.9% for the six months ended June 30, 2001. During the quarter ended June 30,
2002, an ongoing Internal Revenue Service audit was settled in our favor.
Therefore, we recorded a benefit to reverse income taxes payable previously
accrued. We will recognize the benefit of our remaining net operating loss
carryforwards when we generate taxable income or otherwise can be assured that
such net operating loss carryforwards can be utilized.

15

LIQUIDITY AND CAPITAL RESOURCES

Our principal source of liquidity at June 30, 2002 is $8.8 million of
cash and cash equivalents and $6.8 million of short-term investments. As of June
30, 2002, working capital was $17.4 million compared to $25.2 million as of
December 31, 2001.

Cash used in continuing operations for the six months ended June 30,
2002 was $5.3 million, primarily due to an operating loss from continuing
operations of $10.5 million, offset by a decrease in income taxes receivable,
accounts receivable and inventories. Future fluctuations in inventory balances,
accounts receivable and accounts payable will be dependent upon several factors,
including, but not limited to, quarterly sales, our strategy in building
inventory in advance of receiving orders from customers, and the accuracy of our
forecasts of product demand and component requirements.

Net cash used in investing activities of continuing operations in the
six months ended June 30, 2002 was $2.2 million, which consisted primarily of
the net proceeds from the maturities and purchases of available for sale
securities.

Cash provided by financing activities of continuing operations in the
six months ended June 30, 2002 was $30 thousand, which was primarily the result
of the issuance of common stock upon the exercise of employee stock options.

Net cash provided by discontinued operations in the six months ended
June 30, 2002 was $0.5 million, which consisted primarily of the net proceeds of
the sale of the assets of our Essential Communications division.

At June 30, 2002, the Company did not have any material commitments for
capital expenditures.

During the six months ended June 30, 2002, the Company funded its
operations through the use of cash and cash equivalents.

Although we believe we have sufficient cash resources to finance our
operations and expected capital expenditures for the remainder of 2002, the
sufficiency of our cash resources may depend to a certain extent on general
economic, financial, competitive or other factors beyond our control. Moreover,
despite actions to reduce our costs and improve our profitability, we expect our
operating losses and net operating cash outflows to continue during 2002. As a
result, we may not be able to achieve the revenue and gross margin objectives
necessary to achieve positive cash flow or profitability without obtaining
additional financing. We do not currently have any arrangements for financing,
and we may not be able to secure additional debt or equity financing on terms
acceptable to us, or at all, at the time when we need such funding. If our
business does not generate sufficient cash flow from operations and sufficient
future financings are not available, we may not be able to operate or grow our
business, pay our expenses when due or fund our other liquidity needs.

We intend to explore the possible acquisitions of businesses, products
and technologies that are complementary to our existing business. We are
continuing to identify and prioritize additional security technologies which we
may wish to develop, either internally or through the licensing or acquisition
of products from third parties. While we engage from time to

16

time in discussions with respect to potential acquisitions, there can be no
assurances that any such acquisitions will be made or that we will be able to
successfully integrate any acquired business. In order to finance such
acquisitions, it may be necessary for us to raise additional funds through
public or private financings. Any equity or debt financings, if available at
all, may be on terms which are not favorable to us and, in the case of equity
financings, may result in dilution to our stockholders.

FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS

Numerous factors may affect our business and future results of
operations. These factors include, but are not limited to, current economic and
market conditions, the effect of military actions on government and corporate
spending on information security products, technological changes, competition
and market acceptance, acquisitions, product transitions, timing of orders,
manufacturing and suppliers, reliance on outsourcing vendors and other partners,
intellectual property and licenses, third-party products, dependence on
government customers, international operations, intellectual property issues,
liquidity and cash resources and effects of restructuring plans and cost
reductions. The discussion below addresses some of these and other factors. For
a more thorough discussion of these and other factors that may affect our
business and future results, see the discussion under the caption "Factors That
May Affect Future Results of Operations" in our Annual Report on Form 10-K for
the year ended December 31, 2001.

TECHNOLOGICAL CHANGES. The market for our products is characterized by
frequent product introductions, rapidly changing technology and continued
evolution of new industry standards. The market for security products requires
our products to be compatible and interoperable with products and architectures
offered by various vendors, including other security products, networking
products, workstation and personal computer architectures and computer and
network operating systems. Our success will depend to a substantial degree upon
our ability to develop and introduce in a timely manner new products and
enhancements to our existing products that meet changing customer requirements
and evolving industry standards. The development of technologically advanced
products is a complex and uncertain process requiring high levels of innovation
as well as the accurate anticipation of technological and market trends. There
can be no assurance that we will be able to identify, develop, manufacture,
market and support new or enhanced products successfully in a timely manner.
Further, we or our competitors may introduce new products or product
enhancements that shorten the life cycle of or make obsolete our existing
product lines, any of which could have a material adverse effect on our
business, operating results and financial condition.

MARKET ACCEPTANCE. We are pursuing a strategy to increase the
percentage of our revenue generated through indirect sales channels including
distributors, value added resellers, system integrators, original equipment
manufacturers and managed service providers. There can be no assurance that our
products will gain market acceptance in these indirect sales channels. Further,
competition among security companies to sell products through these indirect
sales channels could result in significant price competition and reduced profit
margins.

We are also pursuing a strategy to further differentiate our product
line by introducing complementary security products and incorporating new
technologies into our existing product line. There can be no assurance that

17

we will successfully introduce these products or that such products will gain
market acceptance. We anticipate competition from networking companies,
network security companies and others in each of our product lines. We
anticipate that profit margins will vary among our product lines and that
product mix fluctuations could have an adverse effect on our overall profit
margins.

DISCONTINUED OPERATIONS. In the second quarter of 2000, we discontinued
our networking operations and accordingly have shown the networking operations
as discontinued in the accompanying financial statements.

In March 2002 we sold the assets of our last remaining discontinued
operation, Essential Communications division, for $1 million generating a gain
of $0.4 million. Included in the gain on the sale of Essential is a $0.3 million
reserve to terminate the lease which is the equivalent of 2 years' lease and
maintenance of the facility. Successful termination for less than 2 years will
result in a greater gain on disposition of Essential. Termination for more than
$0.3 million will reduce the gain on disposition of Essential. The contractual
term of the lease runs through February 2009 and remaining contractual lease
payments total $1.1 million at June 30, 2002.

ACQUISITIONS. Symantec, ISS, Cisco, Enterasys, NFR, Nokia, Celestix,
IBM, Compaq and other competitors have recently acquired several security
companies with complementary technologies, and we anticipate that such
acquisitions will continue in the future. These acquisitions may permit such
competitors to accelerate the development and commercialization of broader
product lines and more comprehensive solutions than we currently offer. In the
past, we have relied upon a combination of internal product development and
partnerships with other security vendors to provide competitive solutions to
customers. Certain of the recent and future acquisitions by our competitors may
have the effect of limiting our access to commercially significant technologies.
Further, the business combinations and acquisitions in the security industry are
creating companies with larger market shares, customer bases, sales forces,
product offerings and technology and marketing expertise. There can be no
assurance that we will be able to compete successfully in such an environment.

We have made acquisitions in the past, and we may, in the future,
acquire or invest in additional companies, business units, product lines, or
technologies to accelerate the development of products and sales channels
complementary to our existing products and sales channels. Acquisitions involve
numerous risks, including: difficulties in assimilation of operations,
technologies, and products of the acquired companies; risks of entering markets
in which we have no or limited direct prior experience and where competitors in
such markets have stronger market positions; the potential loss of key employees
of the acquired company; and the diversion of our attention from normal daily
operation of our business. There can be no assurance that any other acquisition
or investment will be consummated or that such acquisition or investment will be
realized.

PRODUCT TRANSITIONS. Once current security products have been in the
market place for a period of time and begin to be replaced by higher performance
products (whether of our design or a competitor's design), we expect the net
sales of such products to decrease. In order to achieve revenue growth in the
future, we will be required to design, develop and successfully commercialize
higher performance products in a timely manner.

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There can be no assurance that we will be able to introduce new products and
gain market acceptance quickly enough to avoid adverse revenue transition
patterns during current or future product transitions. Nor can there be any
assurance that we will be able to respond effectively to technological
changes or new product announcements by competitors, which could render
portions of our inventory obsolete.

MANUFACTURING AND SUPPLIERS. Our operational strategy relies on
outsourcing of product assembly and certain other operations. There can be no
assurance that we will effectively manage our third-party contractors or that
these contractors will meet our future requirements for timely delivery of
products of sufficient quality and quantity. Further, we intend to introduce a
number of new products and product enhancements in 2002 that will require that
we rapidly achieve volume production of those new products by coordinating our
efforts with those of our suppliers and contractors. The inability of the
third-party contractors to provide us with adequate supplies of high-quality
products could cause a delay in our ability to fulfill orders and could have an
adverse effect on our business, operating results and financial condition.

All of the materials used in our products are purchased under contracts
or purchase orders with third parties. While we believe that many of the
materials used in the production of our products are generally readily available
from a variety of sources, certain components such as microprocessors and mother
boards are available from one or a limited number of suppliers. The lead times
for delivery of components vary significantly and can exceed twelve weeks for
certain components. If we fail to forecast our requirements accurately for
components, we may experience excess inventory or shortages of certain
components that could have an adverse effect on our business and operating
results. Further, any interruption in the supply of any of these components, or
the inability to procure these components from alternative sources at acceptable
prices within a reasonable time, could have an adverse effect on our business
and operating results.

INTELLECTUAL PROPERTY AND LICENSES. There are many patents held by
companies which relate to the design and manufacture of data security systems.
Potential claims of infringement could be asserted by the holders of those
patents. We could incur substantial costs in defending ourself and our customers
against any such claim regardless of the merits of such claims. In the event of
a successful claim of infringement, we may be required to obtain one or more
licenses from third parties. There can be no assurance that we could obtain the
necessary licenses on reasonable terms.

SUFFICIENCY OF CASH FLOW. As of June 30, 2002, we had cash, cash
equivalents and investments in the amount of approximately $15.6 million, down
from approximately $20.4 million as of December 31, 2001. Although we believe we
have sufficient cash resources to finance our operations and expected capital
expenditures for the remainder of 2002, the sufficiency of our cash resources
may depend to a certain extent on general economic, financial, competitive or
other factors beyond our control. Moreover, despite actions to reduce our costs
and improve our profitability, we expect our operating losses and net operating
cash outflows to continue during 2002. As a result, we may not be able to
achieve the revenue and gross margin objectives necessary to achieve positive
cash flow or profitability without obtaining additional financing. We do not
currently have any arrangements for financing, and we may not be able to secure
additional debt or equity financing on terms acceptable to us, or at all, at the
time when we need such

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funding. If our business does not generate sufficient cash flow from
operations and sufficient future financings are not available, we may not be
able to operate or grow our business, pay our expenses when due or fund our
other liquidity needs.

DEPENDENCE ON CHECK POINT TECHNOLOGIES. A large percentage of our sales
are represented by our PDS family of security appliances which are integrated
with Check Point Software Technologies' market-leading virtual private network
and firewall security software. We expect the percentage of sales represented by
these products to increase in the future. Although we are a certified appliance
partner of Check Point and our PDS products have received certification from
Check Point, we have no long-term agreement or exclusive relationship with Check
Point. As a result, the loss or significant change in our relationship with
Check Point, the failure of future PDS products to receive Check Point
certification, the business failure of Check Point or its acquisition by or of
one of our competitors, and the loss of market share of Check Point or market
acceptance of its products could each have a material adverse effect on our
business, financial condition and results of operations.

THIRD-PARTY PRODUCTS. We believe that it is beneficial to work with
third parties with complementary technologies to broaden the appeal of our
security products. These alliances allow us to provide integrated solutions to
our customers by combining our developed technology with third-party products.
As we also compete with these technology partners in certain segments of the
market, there can be no assurance that we will have access to all of the
third-party products that may be desirable or necessary in order to offer fully
integrated solutions to our customers.

INTERNATIONAL OPERATIONS. International sales represented 33.9% and
31.1% of total revenues for the quarter and six months ended June 30, 2002,
respectively, compared to 38.2% and 29.1% of total revenues for the same periods
in 2001. We expect to continue to derive a large percentage of our revenues from
our international operations in the future. Our international operations may be
affected by changes in demand resulting from fluctuations in currency exchange
rates and local purchasing practices, including seasonal fluctuations in demand,
as well as by risks such as increases in duty rates, difficulties in
distribution, regulatory approvals and other constraints upon international
trade. Our sales to foreign customers are subject to export regulations. In
particular, certain sales of our data security products require clearance and
export licenses from the U.S. Department of Commerce under these regulations.
Any inability to obtain such clearances or any required foreign regulatory
approvals on a timely basis could have a material adverse effect on our
operating results.

IMPACT OF GOVERNMENT CUSTOMERS. $0.1 million or 8.1% and $0.5 million
or 12.0% of revenue in the quarter and six months ended June 30, 2002,
respectively, was derived from sales to the U.S. government, either directly by
Intrusion or through system integrators and other resellers compared to $0.9
million or 20.9% and $2.6 million or 27.0% of revenue for the same periods in
2001. We expect to continue to derive a significant portion of our revenue in
the future from sales to the U.S. government. Sales to the government present
risks in addition to those involved in sales to commercial customers, including
potential disruptions due to appropriation and spending patterns and the
government's reservation of the right to cancel contracts and purchase orders
for its convenience.

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EFFECTS OF RECENT TERRORIST ATTACKS AND MILITARY ACTIONS. Terrorist
attacks in the United States on September 11, 2001, as well as military actions
or other events occurring in response or in connection to them, including future
terrorist attacks against United States targets, actual conflicts involving the
United States or it allies or military or trade disruptions could impact our
operations, including by:

o reducing government or corporate spending on network security
products;

o increasing the cost and difficulty in obtaining materials or
shipping products; and

o affecting our ability to conduct business internationally.

Should such events occur, our business, operating results and financial
condition could be materially and adversely affected.

RESTRUCTURING AND COST REDUCTIONS. We implemented a restructuring plan
in 2001 and April 2002. The objective of our restructuring plan was to reduce
our cost structure to a sustainable level that is consistent with the current
macroeconomic environment. We also implemented other strategic initiatives
designed to strengthen our operations. These plans involved, among other things,
reductions in our workforce and facilities, aligning our organization around our
business objectives, realignment of our sales force and changes in our sales
management. The workforce reductions could result in temporary reduced
productivity of our remaining employees. Additionally, our customers and
prospects may delay or forgo purchasing our products due to a perceived
uncertainty caused by the restructuring and other changes. Failure to achieve
the desired results of our initiatives could seriously harm our business,
results of operations and financial condition.

GENERAL. Sales of our products fluctuate, from time to time, based on
numerous factors, including customers' capital spending levels and general
economic conditions. While certain industry analysts believe that there is a
significant market for data security products, there can be no assurance as to
the rate or extent of the growth of such market or the potential adoption of
alternative technologies. Currently, capital spending for information technology
products, including security products is being adversely affected by uncertain
economic conditions. Future declines in data security product sales as a result
of general economic conditions, adoption of alternative technologies or any
other reason could have a material adverse effect on our business, operating
results and financial condition.

Due to the factors noted above and in "Management's Discussion and
Analysis of Financial Condition and Results of Operations", our future earnings
and common stock price may be subject to significant volatility, particularly on
a quarterly basis. Past financial performance should not be considered a
reliable indicator of future performance and investors should not use historical
trends to anticipate results or trends in future periods. Any shortfall in
revenue and earnings from the levels anticipated by securities analysts could
have an immediate and significant effect on the trading price of our common
stock in any given period. Also, we participate in a highly dynamic industry
which often results in volatility of our common stock price.

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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

FOREIGN EXCHANGE. Revenue originating outside the U.S. in the quarters
ended June 30, 2002, 2001 and 2000 was 33.9%, 38.2% and 22.2% of total revenues,
respectively. Revenue originating outside the U.S. in the six months ended June
30, 2002, 2001 and 2000 was 31.1%, 29.1% and 14.1% of total revenues,
respectively. International sales are made mostly from our foreign sales
subsidiaries in the local countries and are typically denominated in U.S.
dollars. These subsidiaries incur most of their expenses in the local currency.

Our international business is subject to risks typical of an international
business, including, but not limited to: differing economic conditions, changes
in political climate, differing tax structures, other regulations and
restrictions and foreign exchange rate volatility. Accordingly, our future
results could be materially adversely affected by changes in these or other
factors. The effect of foreign exchange rate fluctuations on us in 2002, 2001
and 2000 was not material.

INTEREST RATES. We invest our cash in a variety of financial
instruments, including bank time deposits, fixed rate obligations of
corporations, municipalities, and state and national governmental entities and
agencies. These investments are denominated in U.S. dollars. Cash balances in
foreign currencies overseas are operating balances and are invested in
short-term time deposits of the local operating bank.

Interest income on our investments is carried in "Interest income,
net". We account for our investment instruments in accordance with Statement of
Financial Accounting Standards No. 115, "Accounting for Certain Investments in
Debt and Equity Securities" ("SFAS 115"). All of the cash equivalents and
short-term investments are treated as available-for-sale under SFAS 115.

Investments in fixed rate interest earning instruments carry a degree
of interest rate risk. Fixed rate securities may have their fair market value
adversely impacted due to a rise in interest rates. Due in part to these
factors, our future investment income may fall short of expectations due to
changes in interest rates or we may suffer losses in principal if forced to sell
securities which have seen a decline in market value due to changes in interest
rates. Our investment securities are held for purposes other than trading. The
weighted-average interest rate on investment securities at June 30, 2002 was
6.9%. The fair value of investments held at June 30, 2002 approximated amortized
cost.

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PART II - OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS.

We are subject to legal proceedings and claims that arise in the
ordinary course of business. We do not believe that the outcome of
those matters will have a material adverse affect on our
consolidated financial position, operating results or cash flows.
However, there can be no assurance such legal proceedings will not
have a material impact.

On March 22, 2002, Morgan Newton Company, L.P. ("Morgan Newton")
filed suit against us in Dallas County District Court, Case No.
DV02-02339-C, alleging claims for breach of contract, promissory
estoppel, and fraud. The claims arise out of an alleged oral
representation to Morgan Newton concerning a request for quotation
for the purchase of a large amount of Morgan Newton's products.
Morgan Newton has not specified the amount of damages it is seeking
in the lawsuit, but it is possible that Morgan Newton may be
seeking damages in excess of $2 million, or more. In addition to
actual damages, Morgan Newton is also seeking attorney's fees and
punitive damages. On April 22, 2002, we filed our response to
Morgan Newton's lawsuit, generally denying all claims and asserting
certain affirmative defenses. As of this time, preliminary
discovery is underway.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Annual Meeting of Stockholders was held on April 25, 2002, at
the Holiday Inn Richardson Select in Richardson, Texas. The
following is a brief description of each matter voted upon by
stockholders, including a number of votes cast for, against, or
withheld with regard to each matter of nominee.

(1) Election of five (5) directors to serve until the next Annual
Meeting of Stockholders and until their respective successors
are duly elected and qualified.

(2) Approval of the amendment to the Company's 1995 Non-Employee
Directors Stock Option Plan as described in the Proxy Statement
dated March 20, 2002.

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(3) Ratification and approval of selection by the Board of Directors
of Ernst & Young LLP as independent auditors of the Registrant
for the fiscal year ending December 31, 2002.

Item 6. EXHIBITS AND REPORTS ON FORM 8-K.

(A.) EXHIBITS. The following exhibit is included herein:

10.1(1) 1995 Non-Employee Directors Stock Opton Plan of
Intrusion Inc. (Amended and Restated as of
January 10, 2002).

99.1(2) Chief Executive Officer Certification Pursuant to
18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.

99.2(2) Chief Financial Officer Certification Pursuant to
18 U.S.C Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.

(1) Filed as an Exhibit in the Registrants'
Definitive Proxy Statement on Schedule 14A in
connection with the solicitation of proxies
for its 2002 Annual Meeting of Stockholders,
which Exhibit is incorporated herein by
reference.

(2) Filed herewith.

(B.) FORM 8-K. We filed no reports on Form 8-K during the six
months ended June 30, 2002.

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S I G N A T U R E S

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.

INTRUSION INC.

Date: August 2, 2002 /s/ JAY R. WIDDIG
-----------------------------------------------
Jay R. Widdig
Vice President, Chief Financial Officer,
Treasurer & Secretary
(Principal Financial & Accounting Officer)

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