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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2003
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 000-23655
INTERNET SECURITY SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 58-2362189
===================================== ========================================
(State or jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
6303 BARFIELD ROAD, ATLANTA, GEORGIA 30328
(Address of principal executive offices)
Registrant's telephone number, including area code (404) 236-2600
--------------
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 126-2 of the Exchange Act). Yes [X] No [ ]
Indicate the number of shares outstanding of each of the registrant's
classes of common stock, as of the latest practicable date.
Number of Shares Outstanding
Title of each class of common stock as of April 30, 2003
===================================== ========================================
Common stock, $0.001 par value 49,654,000
PAGE
PART I. FINANCIAL INFORMATION NUMBER
------
Item 1 Consolidated Financial Statements:
Consolidated Balance Sheets at March 31, 2003 and
December 31, 2002................................................. 3
Consolidated Statements of Operations for the three months
ended March 31, 2003 and March 31, 2002........................... 4
Consolidated Statements of Cash Flows for the three
months ended March 31, 2003 and March 31, 2002.................... 5
Notes to Consolidated Financial Statements........................ 6
Item 2 Management's Discussion and Analysis of
Financial Condition and Results of Operations..................... 12
Item 3 Quantitative and Qualitative Disclosures about Market Risk........ 24
Item 4 Controls and Procedures........................................... 24
PART II. OTHER INFORMATION
Item 6 Exhibits and Reports on Form 8-K.................................. 25
INTERNET SECURITY SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except share and per share amounts)
March 31, December 31,
2003 2002
------------ ------------
(UNAUDITED)
ASSETS
Current assets:
Cash and cash equivalents $ 170,110 $ 148,317
Marketable securities 46,309 53,999
Accounts receivable, less allowance for doubtful accounts
of $3,169 and $2,790, respectively 50,307 56,700
Inventory 596 1,055
Prepaid expenses and other current assets 8,701 7,000
------------ ------------
Total current assets 276,023 267,071
Property and equipment:
Computer equipment 39,759 38,403
Office furniture and equipment 21,492 21,446
Leasehold improvements 21,155 21,183
------------ ------------
82,406 81,032
Less accumulated depreciation 42,850 39,313
------------ ------------
39,556 41,719
Restricted marketable securities 14,125 14,690
Goodwill, less accumulated amortization of $27,381 200,857 200,464
Other intangibles, less accumulated amortization of
$10,471 and $9,223, respectively 14,136 15,384
Other assets 7,001 7,240
------------ ------------
Total assets $ 551,698 $ 546,568
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 3,836 $ 1,765
Accrued expenses 18,823 22,332
Deferred revenues 54,111 55,587
------------ ------------
Total current liabilities 76,770 79,684
Other non-current liabilities 2,647 2,328
Commitments and contingencies
Stockholders' equity:
Common stock, $.001 par value, 120,000,000 shares authorized,
49,639,000 and 49,544,000 issued and outstanding, respectively 50 50
Additional paid-in capital 467,983 463,779
Deferred compensation (418) (702)
Accumulated other comprehensive income 600 949
Retained earnings 7,876 2,514
Treasury stock, at cost (281,000 and 133,000 shares, respectively) (3,810) (2,034)
------------ ------------
Total stockholders' equity 472,281 464,556
------------ ------------
Total liabilities and stockholders' equity $ 551,698 $ 546,568
============ ============
INTERNET SECURITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except per share amounts)
(Unaudited)
Three months ended
March 31,
----------------------------
2003 2002
------------ ------------
Revenues:
Product licenses and sales $ 26,264 $ 30,213
Subscriptions 26,898 20,322
Professional services 6,291 7,842
------------ ------------
59,453 58,377
Costs and expenses:
Cost of revenues:
Product licenses and sales 1,441 2,327
Subscriptions and professional services 12,348 12,509
------------ ------------
Total cost of revenues 13,789 14,836
Research and development 9,671 8,607
Sales and marketing 21,176 22,687
General and administrative 5,540 5,444
Amortization of other intangibles and stock based
compensation 1,404 1,496
------------ ------------
51,580 53,070
Operating income 7,873 5,307
Interest income 643 730
Minority interest (88) (139)
Other income (expense) 24 (37)
Foreign currency exchange gain 244 23
------------ ------------
Income before income taxes 8,696 5,884
Provision for income taxes 3,334 2,515
------------ ------------
Net income $ 5,362 $ 3,369
============ ============
Basic net income per share of Common Stock $ 0.11 $ 0.07
============ ============
Diluted net income per share of Common Stock $ 0.11 $ 0.07
============ ============
Weighted average shares:
Basic 49,539 48,037
============ ============
Diluted 49,963 49,148
============ ============
INTERNET SECURITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
(Unaudited)
Three months ended
March 31,
----------------------------
2003 2002
------------ ------------
OPERATING ACTIVITIES
Net income $ 5,362 $ 3,369
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation 3,537 3,213
Amortization of intangibles and stock based compensation 1,404 1,496
Accretion of discount on marketable securities 90 469
Minority interest 88 139
Income tax benefit from exercise of stock options 2,783 1,843
Gain on issuance of subsidiary stock (47) --
Changes in assets and liabilities:
Accounts receivable 6,393 (2,115)
Inventory 459 65
Prepaid expenses and other assets (1,271) (2,728)
Accounts payable and accrued expenses (1,230) (973)
Deferred revenues (1,476) 3,013
------------ ------------
NET CASH PROVIDED BY OPERATING ACTIVITIES 16,092 7,791
INVESTING ACTIVITIES
Net proceeds from maturity of marketable securities 21,966 33,284
Purchases of marketable securities (14,366) (17,737)
Purchase of restricted marketable securities 565 --
Purchases of property and equipment (1,373) (4,899)
Issuance of subsidiary stock 69 --
------------ ------------
NET CASH PROVIDED BY INVESTING ACTIVITIES 6,861 10,648
FINANCING ACTIVITIES
Proceeds from exercise of stock options 101 2,420
Proceeds from employee stock purchase plan 823 1,148
Purchase of treasury stock (1,776) --
------------ ------------
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES (852) 3,568
Foreign currency impact on cash (308) (685)
------------ ------------
Net increase in cash and cash equivalents 21,793 21,322
Cash and cash equivalents at beginning of period 148,317 108,038
------------ ------------
Cash and cash equivalents at end of period $ 170,110 $ 129,360
============ ============
SUPPLEMENTAL CASH FLOW DISCLOSURE
============ ============
Income taxes paid $ 465 $ 2,332
============ ============
INTERNET SECURITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements of Internet Security Systems,
Inc. ("ISS") as of March 31, 2003 and for the three months ended March 31,
2003 and 2002 are unaudited and, in the opinion of management, contain
all adjustments, consisting of normal recurring items necessary for the fair
presentation of the financial position and results of operations for the
interim periods. The consolidated financial statements include the accounts of
Internet Security Systems, Inc. and its majority-owned subsidiaries. The
consolidated balance sheet at December 31, 2002 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.
These consolidated financial statements should be read in conjunction
with the Consolidated Financial Statements and Notes thereto included in our
Annual Report on Form 10-K for the year ended December 31, 2002. The results of
operations for the three months ended March 31, 2003 are not necessarily
indicative of the results to be expected for the entire year. All significant
intercompany accounts and transactions have been eliminated.
The preparation of financial statements and related disclosures in
conformity with accounting principles generally accepted in the United States
requires management to make estimates and assumptions that affect the amounts
reported in the financial statements and accompanying notes. Actual results may
differ from those estimates, and such differences may be material to the
consolidated financial statements.
GOODWILL AND INTANGIBLES
Goodwill and intangible assets are comprised of the following, as of
the dates indicated (in thousands):
MARCH 31, 2003 DECEMBER 31, 2002
GROSS CARRYING ACCUMULATED GROSS CARRYING ACCUMULATED
AMOUNT AMORTIZATION AMOUNT AMORTIZATION
=============== =============== =============== ===============
Unamortized intangible assets:
Goodwill $ 228,238 $ (27,381) $ 227,845 $ (27,381)
=============== =============== =============== ===============
Amortized intangible assets:
Core technology 3,853 (2,159) 3,853 (2,039)
Developed technology 16,857 (6,544) 16,857 (5,654)
Work force 1,407 (325) 1,407 (216)
Customer relationships 2,490 (1,443) 2,490 (1,314)
=============== =============== =============== ===============
Total $ 24,607 $ (10,471) $ 24,607 $ (9,223)
=============== =============== =============== ===============
The Company amortizes intangible assets over their estimated useful lives of
eight years for core technology, five years for developed technology, three to
six years for work force and three years for customer relationships.
Amortization expense of intangible assets is as follows (in thousands):
THREE MONTHS ENDED
MARCH 31,
2003 2002
============ ============
Core technology $ 120 $ 120
Developed technology 890 792
Work force 109 9
Customer relationships 129 208
============ ============
Total $ 1,248 $ 1,129
============ ============
INTERNET SECURITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The estimated future amortization expense of intangible assets as of
March 31, 2003 is as follows (in thousands):
AMOUNT
==========
Fiscal year:
2003 (remaining nine months) $ 3,523
2004 4,576
2005 4,121
2006 1,684
2007 232
==========
Total $ 14,136
==========
STOCK BASED COMPENSATION
SFAS 123, Accounting for Stock Based Compensation ("SFAS 123"),
establishes accounting and reporting standards for stock-based employee
compensation plans. As permitted by SFAS 123, ISS continues to account for
stock-based compensation in accordance with APB Opinion No. 25, Accounting for
Stock Issued to Employees, and has elected the pro forma disclosure alternative
of SFAS 123.
Although SFAS 123 allows the Company to continue to follow APB 25
guidelines, the following is pro forma net loss and pro forma net loss per
share as if the Company had adopted SFAS 123. The following table illustrates
the effect on net income per share if the provisions of SFAS 123 had been
applied. The pro forma impact of applying SFAS 123 as illustrated below will
not necessarily be representative of the pro forma impact in future years. Pro
forma information is as follows (amounts in thousands, except per share
amounts):
THREE MONTHS ENDED MARCH 31,
----------------------------------
2003 2002
--------------- ---------------
Net income, as reported .......................... $ 5,362 $ 3,369
Pro forma stock compensation expense
computed under the fair value method, net
of income taxes ................................ (6,684) (6,764)
--------------- ---------------
Pro forma net loss ............................... (1,322) (3,395)
=============== ===============
Basic net income per share of Common
Stock, as reported ............................. $ 0.11 $ 0.07
=============== ===============
Diluted net income per share of
Common Stock, as reported ...................... $ 0.11 $ 0.07
=============== ===============
Pro forma basic and diluted net loss per
share of Common Stock .......................... $ (0.03) $ (0.07)
=============== ===============
Inputs used for the fair value method for our employee stock options
are as follows:
THREE MONTHS ENDED MARCH 31,
----------------------------
2003 2002
------------ ------------
Volatility ...................................................... 118% 125%
Weighted-average expected lives (in years) ...................... 5 5
Expected dividend yields ........................................ -- --
Weighted-average risk-free interest rates ....................... 2.81% 4.39%
Weighted-average fair value per share of options granted ........ $ 12.82 $ 32.86
INTERNET SECURITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
RECENTLY ISSUED ACCOUNTING STANDARDS
In November 2002, the FASB issued FIN No. 45, Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others, which is an interpretation of SFAS No. 5, 57, and 107
and rescission of FASB Interpretation No. 34. The Interpretation requires that
a guarantor recognize, at the inception of a guarantee, a liability for the
fair value of the obligation undertaken by issuing the guarantee. The
Interpretation also requires additional disclosures to be made by a guarantor
in its interim and annual financial statements about its obligations under
certain guarantees it has issued. The accounting requirements for the initial
recognition of guarantees are applicable on a prospective basis for guarantees
issued or modified after December 31, 2002. The disclosure requirements are
effective during the first quarter of 2003 for all guarantees outstanding,
regardless of when they were issued or modified. The adoption of FIN No. 45 did
not have a material effect on our condensed consolidated financial statements
for the first quarter of 2003. The following is a summary of our agreements
that we have determined are within the scope of FIN No. 45.
Our sales agreements with customers generally contain infringement
indemnity provisions. Under these agreements, we agree to indemnify, defend and
hold harmless the customer in connection with patent, copyright or trade secret
infringement claims made by third parties with respect to the customer's
authorized use of our products and services. The indemnity provisions generally
provide for our control of defense and settlement and cover costs and damages
finally awarded against the customer, as well as our modification of the product
so it is no longer infringing or, if it cannot be corrected, return of the
product for a partial refund that reflects the reasonable value of prior use.
Our sales agreements with customers sometimes also contain indemnity provisions
for death, personal injury or property damage caused by our personnel or
contractors in the course of performing services to customers. Under these
agreements, we agree to indemnify, defend and hold harmless the customer in
connection with death, personal injury and property damage claims made by third
parties with respect to actions of our personnel or contractors. The indemnity
provisions generally provide for our control of defense and settlement and cover
costs and damages finally awarded against the customer. The indemnity
obligations contained in sales agreements generally have no specified expiration
date and no specified monetary limitation on the amount of award covered. We
have not previously incurred costs to settle claims or pay awards under these
indemnification obligations. As a result, we believe the estimated fair value of
these obligations is nominal. Accordingly, we have no liabilities recorded for
these agreements as of March 31, 2003.
We warrant that our software products will perform in all material
respects in accordance with our standard published specifications in effect at
the time of delivery of the licensed products to the customer for ninety days.
Additionally, we warrant that our services will be performed consistent with
generally accepted industry standards or specific service levels through
completion of the agreed upon services. If necessary, we would provide for the
estimated cost of product and service warranties based on specific warranty
claims and claim history, however, we have not incurred significant recurring
expense under our product or service warranties. As a result, we believe the
estimated fair value of these agreements is nominal. Accordingly, we have no
liabilities recorded for these agreements as of March 31, 2003.
Payments for certain operating leases for office space are secured by
collateralized standby letters of credit totaling $11.3 million at March 31,
2003. These standby letters of credit guarantee payments on certain lease
obligations and are renewed annually unless cancelled by either party. The lease
obligations have terms that expire at various dates through 2013. The
beneficiary of the standby letters of credit can draw on the letters of credit
if we default on the related lease obligation. Each standby letter of credit is
collateralized by securities. At March 31, 2003 $14.1 million of commercial
paper investments are pledged as collateral and are shown on the balance sheet
as restricted cash.
INTERNET SECURITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. INCOME TAXES
The Company recorded tax provisions of $3.3 million and $2.5 million
for the quarters ended March 31, 2003 and 2002, respectively. While income tax
expense was recorded on domestic income, domestic taxes payable was reduced by
deductions related to the employee exercise of stock options. The tax benefit
of these deductions was recorded as additional paid-in-capital. Taxes paid
generally relate to foreign operations and certain state taxes for which net
operating loss deductions have been suspended.
The effective tax rate was approximately 38% and 43% for the quarters
ended March 31, 2003 and 2002, respectively. The effective rates differ from
the statutory rates due to the impact of acquisition related intangibles that
are not deductible for income tax purposes.
As of March 31, 2003, ISS had a net operating loss carryforward of
approximately $46 million. The tax benefit of this carryforward will be
recorded as additional paid-in-capital as realized. There are also
approximately $6.3 million of research and development tax credit carryforwards
that expire between 2011 and 2022 and foreign tax credit carryforwards of $2.1
million that expire in 2006 and 2007.
3. BUSINESS ACQUISITION
In August 2002, Internet Security Systems KK ("ISS KK"), the
Company's Asia/Pacific subsidiary, acquired a primary ISS KK distributor in
Singapore, TriSecurity Holdings Pte Ltd. During the first quarter of 2003 ISS
KK amended its agreement with TriSecurity Holdings Pte Ltd. and agreed to make
payment of 245 shares of ISS KK stock in each of the first quarters of 2004 and
2005, relating to the annual contingent consideration payments defined in the
2002 purchase agreement. The additional consideration of $626,000, based on
current fair market value of the shares, was recorded as additional goodwill
and additional paid-in-capital. When such shares are actually issued, a gain or
loss will be recognized to the extent of any difference between the $626,000
fair value of the shares to be issued and the book value of those shares, in
accordance with Staff Accounting Bulletin No. 51, Accounting for Sales of Stock
by a Subsidiary.
4. COMPREHENSIVE INCOME
The components of comprehensive income are as follows (in thousands):
Three months ended
March 31,
------------------
2003 2002
------- -------
Net income, as reported $ 5,362 $ 3,369
Change in cumulative translation adjustment
(349) (685)
------- -------
Comprehensive income $ 5,013 $ 2,684
======= =======
5. INCOME PER SHARE
The computation of net income per share is as follows (amounts in
thousands, except per share amounts):
Three months ended
March 31,
-----------------
2003 2002
------- -------
Basic net income per share:
Net income $ 5,362 $ 3,369
Weighted average number of common shares
outstanding during the period 49,539 48,037
------- -------
Basic net income per share $ 0.11 $ 0.07
======= =======
INTERNET SECURITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Diluted net income per share:
Net income $ 5,362 $ 3,369
Weighted average number of common shares
outstanding during the period 49,539 48,037
Dilutive stock options 424 1,111
------- -------
Total shares for purpose of calculating
diluted net income per share 49,963 49,148
------- -------
Diluted net income per share $ 0.11 $ 0.07
======= =======
6. SEGMENT AND GEOGRAPHIC INFORMATION
ISS conducts business in one operating segment, providing information
security management solutions. The Company does, however, prepare information
for internal use on a geographic basis. This information consists of the
operating results of each geographic segment. The segment operating costs
reported internally generally consist of direct sales expenses, an executive
team and infrastructure to support its employee and customer and partner base,
and supporting billing and financial systems. Unallocated corporate expenses
include research and development, general and administrative costs that support
the global organization and amortization of intangibles and stock based
compensation.
The accounting policies of the segments are the same as those described
in the summary of significant accounting policies. There are no intersegment
sales. Our chief executive officer and chief financial officer evaluate
performance based on operating profit or loss from operations, and trade
accounts receivable for each segment. Other than trade accounts receivable,
assets and liabilities are not discretely allocated or reviewed by segment.
Goodwill is allocated to the segments in accordance with the requirements of
SFAS 142, Accounting for Goodwill and Other Intangibles. We do not allocate or
review goodwill by segment for internal reporting purposes.
The following table presents ISS's revenues, operating expenses and
operating income (loss) by reportable operating segment (in thousands):
AS OF OR FOR THE THREE MONTHS ENDED MARCH 31, 2003
AMERICAS EMEA ASIA/PAC UNALLOCATED TOTAL
------------ ------------ ------------ ------------ ------------
REVENUES FROM EXTERNAL CUSTOMERS:
Product licenses and sales $ 18,053 $ 4,964 $ 3,247 $ -- $ 26,264
Subscriptions 20,134 4,177 2,587 -- 26,898
Professional services 3,989 1,037 1,265 -- 6,291
------------ ------------ ------------ ------------ ------------
Total revenue $ 42,176 $ 10,178 $ 7,099 $ -- $ 59,453
COST OF REVENUES:
Product licenses and sales 1,416 -- 25 -- 1,441
Subscriptions and professional services 8,235 1,952 2,161 -- 12,348
------------ ------------ ------------ ------------ ------------
Total cost of revenues 9,651 1,952 2,186 -- 13,789
OPERATING EXPENSES 14,288 5,090 1,798 16,615 37,791
------------ ------------ ------------ ------------ ------------
TOTAL EXPENSES 23,939 7,042 3,984 16,615 51,580
------------ ------------ ------------ ------------ ------------
SEGMENT OPERATING INCOME (LOSS) $ 18,237 $ 3,136 $ 3,115 $ (16,615) $ 7,873
------------ ------------ ------------ ------------ ------------
ACCOUNTS RECEIVABLE, NET $ 27,966 $ 12,267 $ 10,074 $ 50,307
------------ ------------ ------------ ------------
GOODWILL $ 166,271 $ 6,456 $ 28,130 $ 200,857
------------ ------------ ------------ ------------
INTERNET SECURITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF OR FOR THE THREE MONTHS ENDED MARCH 31, 2002
AMERICAS EMEA ASIA/PAC UNALLOCATED TOTAL
------------ ------------ ------------ ------------ ------------
REVENUES FROM EXTERNAL CUSTOMERS:
Product licenses and sales $ 20,850 $ 4,330 $ 5,033 $ -- $ 30,213
Subscriptions 15,782 2,587 1,953 -- 20,322
Professional services 5,110 1,337 1,395 -- 7,842
------------ ------------ ------------ ------------ ------------
Total revenue 41,742 8,254 8,381 -- 58,377
COST OF REVENUES:
Product licenses and sales 2,285 -- 42 -- 2,327
Subscriptions and professional services 8,562 2,176 1,771 -- 12,509
------------ ------------ ------------ ------------ ------------
Total cost of revenues 10,847 2,176 1,813 -- 14,836
OPERATING EXPENSES 16,425 4,428 1,834 15,547 38,234
------------ ------------ ------------ ------------ ------------
TOTAL EXPENSES 27,272 6,604 3,647 15,547 53,070
------------ ------------ ------------ ------------ ------------
SEGMENT OPERATING INCOME (LOSS) $ 14,470 $ 2,554 $ 4,734 $ (15,547) $ 5,307
------------ ------------ ------------ ------------ ------------
ACCOUNTS RECEIVABLE $ 34,234 $ 8,656 $ 9,484 $ 52,374
------------ ------------ ------------ ------------
GOODWILL $ 163,003 $ 10,662 $ 23,219 $ 196,884
------------ ------------ ------------ ------------
7. 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 10b-5 thereunder.
Six such actions were filed in the United States District Court for the
Northern District of Georgia. All six actions have been consolidated into a
single case and the court has appointed lead plaintiffs and lead plaintiffs
counsel. The consolidated amended complaint was filed October 9, 2002 and
purports to be brought on behalf of a class of investors who purchased the
Company's stock during the period from April 5, 2001 through August 14, 2001
(the "Class Period"). The complaint generally alleges 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 complaint seeks damages in
an unspecified amount. On December 11, 2002, the Company and the individual
defendants moved to dismiss the consolidated amended complaint under the
Private Securities Litigation Reform Act of 1995. The Court has not yet ruled
on that motion. The Company believes that it has meritorious defenses and
intends to defend the actions vigorously.
INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
REULTS 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 current intent, belief or 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, 2002 as filed with the Securities and
Exchange Commission and available at the SEC's Web site at www.sec.gov.
OVERVIEW
We are a global leader in information protection solutions dedicated
to protecting online assets. Our proactive line of defense solutions protects
networks, servers and desktops against an ever-changing spectrum of threats,
with a comprehensive line of products and services designed specifically for
the particular needs of enterprise, service provider and risk management
markets. These threat protection solutions go beyond basic access control to
deliver multiple layers of defense that detect, prevent and respond to threats
prior to those threats causing damage to our customers' business operations.
We provide a wide range of proactive protection solutions that span
networks, servers and desktops, built around the need for comprehensive,
cost-effective detection, prevention and response arising from attacks, misuse
and security policy violations, all while promoting the confidentiality,
privacy, integrity and availability of proprietary information.
Our family of products is a critical element of an active Internet and
networking security program within today's world of global connectivity,
enabling organizations to proactively monitor, detect and respond to risks to
enterprise information. Our line of products is designed specifically for the
particular needs of enterprise, service provider, risk management, small
business and consumer markets.
Our managed protection services offerings provide remote management of
our best-of-breed security technology, focusing on security assessment and
intrusion detection systems, and include firewalls, VPNs, anti-virus and URL
filtering software. We focus on serving as the trusted security provider to our
customers by maintaining within our existing products the latest
counter-measures to security risks, creating new innovative products based on
our customers' needs and providing professional and managed services.
Many factors 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 and alliances with partners whose
products, technologies or services capabilities are complementary to our
solutions; and improve our internal operating and financial infrastructure in
support of our strategic goals and objectives. At the same time, we expect to
adjust our organization size in light of changing economic conditions and
maintain emphasis on controlling discretionary spending and capital
expenditures. While we believe in the long-term success of our business
solutions, our prospects must be considered in light of the experience, risks
and difficulties that are frequently encountered by companies in new and
rapidly evolving markets. See "Risk Factors".
CRITICAL ACCOUNTING POLICIES
The consolidated financial statements were prepared in conformity with
accounting principles generally accepted in the United States. As such,
management is required to make certain estimates, judgments and assumptions it
believes are reasonable based upon the information available. These estimates
and assumptions affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported amounts of revenues and
expenses during the periods presented. The significant accounting policies
which management believes are the most critical to aid in fully understanding
and evaluating our reported financial results include the following:
Revenue recognition
Revenue is recognized under Statement of Position ("SOP") 97-2 as
modified by SOP 98-9, when the following criteria have been met:
INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
REULTS OF OPERATIONS
o persuasive evidence of an arrangement exists;
o delivery has occurred or services have been rendered;
o price is fixed or determinable; and
o collection is probable.
We recognize perpetual license revenues upon (1) delivery of software
or, if the customer has evaluation software, delivery of the software key and
(2) issuance of the related license, assuming that no significant vendor
obligations or customer acceptance rights exist. Where payment terms are
extended over periods greater than 12 months, revenue is recognized as such
amounts become due and payable. Product sales consist of (1) appliances sold in
conjunction with ISS licensed software and (2) software developed by
third-party partners, combined in some instances with associated hardware
appliances and partner product support services. These sales are recognized
upon shipment to the customer provided all other revenue recognition criteria
are met.
License sales of enterprise products are generated both through a
direct sales force and through various partners, including system integrators,
value-added resellers and distributors. License revenue is recognized when the
end user sale has occurred, provided all other revenue recognition criteria are
met, which is identified through electronic delivery of a software key that is
necessary to operate the product. At the point of key delivery, the end-user
has no right of return.
License sales of consumer and small office products are made through a
distributor to retail establishments and are sold directly to customers via the
Internet. License revenue for sales made through resellers and distributors are
recognized only when the product is delivered to the end user provided all
other revenue recognition criteria are met.
Subscription revenues include product support, term licenses, and
managed service arrangements. Annual renewable product support is a separate
component of each perpetual license agreement for ISS products with revenue
recognized ratably over the product support term. Term licenses allow customers
to use our products and receive product support 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 fee-based service engagements
and training. Service engagements, typically billed on a time-and-materials
basis, primarily focus on security assessments of customer networks and the
development of customers' security policies. We recognize such professional
services revenues as the related services are rendered.
Multiple element arrangements can include any combination of hardware,
software or services. When some elements are delivered prior to others in an
arrangement, revenue is deferred until the delivery of the last element unless
there is all of the following:
o vendor specific objective evidence (VSOE) of fair value of
the undelivered elements;
o the functionality of the delivered elements is not dependent
on the undelivered elements; and
o delivery of the delivered elements represents the culmination
of the earnings process.
Our historical rate of return for our software products is negligible.
We offer demonstration software available via download from our website that
allows potential customers to see the functionality of the products on their
own networks. We did not have any transactions in the first three months of
either 2003 or 2002 involving reciprocal arrangements where goods or services
were purchased from an organization at the same time that we licensed software
or provided services to that organization.
Allowance for doubtful accounts
Our sales are global, with customers located in the United States,
Europe, Latin America and the Asia/Pacific regions. We perform periodic credit
evaluations of our customer's financial condition and do not require
collateral. Credit risk with respect to trade accounts receivable are limited
due to the large number of entities that comprise the Company's customer base.
We provide for estimated credit losses as such losses become probable. We
evaluate specific accounts when we become aware of a situation where a customer
may not be able to meet its financial obligations due to deterioration of its
liquidity or financial viability, credit ratings or
INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
REULTS OF OPERATIONS
bankruptcy. The allowance for doubtful accounts is established based on the
best facts available to us and is reevaluated and adjusted as additional
information is received. At March 31, 2003 the allowance for doubtful accounts
totals 5.9% of the $53.5 million of total trade receivables.
While actual credit losses have historically been within management's
expectations and the provisions established, we cannot guarantee that we will
continue to experience the same credit loss rates we have in the past. If the
financial condition of our customers were to deteriorate, resulting in an
impairment of their ability to make payments, additional allowances may be
required.
Impairment of goodwill
We review goodwill for impairment on an annual basis or on an interim
basis whenever events or changes in circumstances indicate that the carrying
amount of an asset may not be recoverable. All other long-lived and intangible
assets are reviewed for impairment whenever events or circumstances indicate
that the carrying amount of an asset may not be recoverable. Such impairment
loss would be measured as the difference between the carrying amount of the
asset and its fair value based on the present value of estimated future cash
flows. Significant judgment is required in the forecasting of future operating
results, which are used in the preparation of projected cash flows. Due to
uncertain market conditions and potential changes in our strategy and products,
it is possible that forecasts used to support our intangible assets may change
in the future which could result in significant non-cash charges that would
adversely affect our results of operations and financial condition.
We currently have intangible assets related to goodwill of
approximately $201 million, with $195 million related to our June 2001
acquisition of Network ICE. The determination of whether or not this asset is
impaired involves significant judgments based upon short and long-term
projections of future performance. We have concluded that this amount is
realizable based on forecasted discounted cash flows through 2006 and on our
stock market valuation. Neither method indicated that our goodwill had been
impaired and as a result, we did not record any impairment losses related to
goodwill during the quarters ended March 31, 2003 and 2002.
INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
REULTS OF OPERATIONS
RESULTS OF OPERATIONS
The following table sets forth our consolidated historical operating
information, as a percentage of total revenues, for the periods indicated:
Three months ended
March 31,
---------------------------
2003 2002
------------ ------------
Consolidated Statements of Operations Data:
Product licenses and sales 44% 52%
Subscriptions 45% 35%
Professional services 11% 13%
------------ ------------
Total revenues 100% 100%
------------ ------------
Cost of revenues:
Product licenses and sales 2% 4%
Subscriptions and
professional services 21% 21%
------------ ------------
Total cost of revenues 23% 25%
Research and development 16% 15%
Sales and marketing 36% 39%
General and administrative 9% 9%
Amortization of intangibles and stock based compensation
3% 3%
------------ ------------
Total costs and expenses 87% 91%
------------ ------------
Operating income 13% 9%
============ ============
REVENUES
Product licenses and sales
Product licenses and sales, including perpetual licenses and sales of
partner software and hardware appliances, represented 44% of total revenues for
the three month period ended March 31, 2003 and 52% for the corresponding
period in 2002. Third-party product revenues decreased from 4% of total
revenues in the quarter ended March 31, 2002 to 2% in the quarter ended March
31, 2003. The movement away from direct sales of third-party products was a
conscious effort to simplify our business by focusing on our own ISS solutions.
However, product sales in future quarters will include a hardware component of
our Proventia appliance offering, which begins shipping to customers in the
second quarter of 2003.
The general economic slowdown in information technology spending
further contributed to the decrease in product licenses and sales. Our
products, by their nature, involve a high ongoing labor component to provide
the security for which they are designed. We believe that this had a negative
effect during tight spending conditions. Our present product roadmap focuses
our development on product offerings and enhancements providing more central
control and manageability, easier deployment and more refined information. We
expect that this focus will make our products more cost effective to implement
and increase the future level of product licenses and sales, especially in the
current challenging market conditions.
Subscriptions
Subscriptions revenue represented 45% of total revenues in the three
months ended March 31, 2003 increasing from 35% of total revenues in the three
months ended March 31, 2002. Subscription revenues consist of product support,
term licenses of product usage and security-monitoring fees for managed
services offerings. The increase in subscriptions revenue as a percentage of
total revenues was primarily due to an increase in product support revenues,
the largest component, which grew from 25% of total revenues in the three
months ended March 31, 2002 to 31% in 2003. Product support includes software
updates, technical support and security content, including advisory updates
from our X-Force. We continue to increase our software client base that
generates product support revenues, through a combination of contracts
associated with new product licenses and a high renewal rate of existing
contracts.
Managed services revenues accounted for 10% of total revenues for the
quarter ended March 31, 2003, as compared with 6% in the corresponding period
of 2002. This increase was due to a strong demand in the market for proven,
financially sound, managed security service providers. We expect sales of
managed services to continue to increase as a percentage of total revenues as
we focus our efforts on developing new, innovative offerings, such as our
Managed Protection Services, to new and existing customers. Managed
INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
REULTS OF OPERATIONS
Protection Services is a premium service combining vulnerability assessment,
managed protection, and specific professional services with a performance-based
guarantee for one monthly fee.
Professional services
Professional services revenue represented 11% of total revenues in the
three months ended March 31, 2003 decreasing from 13% in the corresponding
period of 2002. This decrease is a result of reduced customer spending as
entities continued to curtail costs and limit spending of discretionary dollars
on professional services.
We have also continued to decrease the number of training classes
related to third-party products and increased our emphasis on courses related
to ISS solutions. Beginning in the first quarter of 2003, we delivered course
materials to our customers through authorized training centers. By working with
training facilities throughout the country, we provide education consistent
with our standards, but now available at several additional locations. We will
continue to offer training classes at our Atlanta headquarters and customers'
premises.
Geographic regions
Geographically, we derived the majority of our revenues from sales to
customers within the Americas region. Revenues by region represented the
following percentages of total revenues for the periods indicated:
Three months ended
March 31,
------------------------
2003 2002
---------- ----------
Americas 71% 72%
EMEA 17% 14%
Asia/Pacific Rim 12% 14%
Revenues in EMEA benefited from a strengthening currency, as products
are sold in Euros, as well as our emphasis on expansion in this region.
Asia/Pacific Rim decreased to 12% of total revenues in the three months ended
March 31, 2003; while this is a decrease from 14% in the corresponding period
of 2002, it is an increase from 10% in the fourth quarter of 2002. Asia/Pacific
Rim experienced difficult economic conditions in portions of the region
beginning in the latter part of 2002, which have continued into 2003. The
financial data for each segment can be found in Note 6 to the Consolidated
Financial Statements.
COSTS AND EXPENSES
Cost of product licenses and sales
Cost of product licenses and sales consists of several components.
Costs associated with licensing our software products are minor. 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 provide to
our customers as part of a single solution source. Costs of product licenses
and sales as a percentage of total revenues decreased from 4% for the three
months ended March 31, 2002 to 2% for the comparable period in 2003, as sales
of partner software and hardware appliances represented a lower percentage of
total revenues. This decrease as a percentage of revenue is consistent with our
movement away from the direct sales of third-party products, except where
related to ISS managed services or associated with the delivery of ISS
products, such as future appliance offerings. With the introduction of the ISS
Proventia appliance beginning in the second quarter of 2003, we expect the
costs of product sales to increase in future quarters and years.
Cost of subscriptions and professional services
Cost of subscription and services includes the cost of our technical
support personnel who provide assistance to customers under product support
agreements, the security operations center ("SOC") costs of providing managed
security monitoring services and the costs related to our professional services
and training. These costs as a percentage of total revenues remained constant
at 21% in the three months ended March 31, 2003 and 2002.
Costs associated with our technical support personnel and our security
operations centers increased to handle our increasing customer base. As our
subscription revenue base increased, we added personnel to handle additional
customers under product support agreements and under managed security
monitoring services, but at a much lower rate than revenue growth. We gained
efficiencies in
INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
REULTS OF OPERATIONS
our security operations centers and restructured our support groups to be more
productive. While we continue to seek increased productivity, we do expect to
increase costs with a continued increase in revenues in the future.
Offsetting this increase of costs associated with our technical
support personnel and our security operations centers is a decrease in costs
associated with our professional services and education services. As a result
of our effort to focus on core professional services combined with the
difficult economic conditions, costs associated with our professional services
and education services decreased in absolute dollars from the quarter ended
March 31, 2002 to the comparable quarter of 2003. Costs were controlled through
a continued narrowing of our consulting offerings to focus on services that
directly contribute to our protection platform strategy and a decrease in the
number of training classes related to third party products.
Research and development
Research and development expenses consist of salary and related costs
of research and development personnel, including costs for employee benefits,
and depreciation on computer equipment. These costs include those associated
with maintaining and expanding the X-Force, our internal team of security
experts. We believe our primary research and product development and managed
service offerings are important to retaining our leadership position in the
market.
Research and development expenses increased in absolute dollars from
$8.7 million in the three months ended March 31, 2002 to $9.7 million in the
three months ended March 31, 2003. These costs represented 16% of total
revenues in 2003, and 15% in 2002, respectively. This increase in absolute
dollars and as a percentage of total revenues is primarily due to the increase
in the number of our development personnel focused on our best-of-breed
products, enterprise applications, managed services offerings and research for
future product offerings.
We continue to add functionality to our product family, providing
network, server and desktop-based solutions, as well as to our security
management applications. In the first quarter of 2003, we provided enhancements
to our RealSecure Protection platform by releasing RealSecure Internet Scanner
7.0 which added improved accuracy and new ease-of-use features and
RealSecure(R) SiteProtector(TM) and Fusion versions 2.0. RealSecure
SiteProtector unifies the management of protection across networks, servers and
desktops to increase customers' ability to effectively detect, prevent and
respond to today's ever-changing spectrum of threats. RealSecure Fusion
provides additional features that allow customers to fully automate the
processes of security monitoring and instant correlation of security events
against known vulnerabilities.
In April 2003, we announced our entry into the security appliance
market with the introduction of our Proventia(TM) family of network protection
appliances. Our Proventia appliances are an integral component of our Dynamic
Threat Protection(TM) enterprise security platform. Proventia appliances will
feature unified, multi-function protection capabilities designed to identify
and prevent many forms of attack with minimal user intervention. They are
designed to operate in the most demanding network environments while easy to
deploy, easy to use and centrally managed, all in an effort to make our
solution more cost-effective.
While we are committed to continue our investment in X-Force research
capabilities that we believe to be a differentiator for ISS, we intend to seek
more leverage in the research and development area while enhancing current
technologies and developing new technologies.
Sales and marketing
Sales and marketing expenses consist of salaries, travel expenses,
commissions, advertising, maintenance of our Website, trade show expenses,
costs of recruiting sales and marketing personnel and costs of marketing
materials.
Sales and marketing expenses were $21.2 million in the three months
ended March 31, 2003 and $22.7 million in the corresponding period of 2002.
Gaining leverage in sales and marketing has been a key objective for us as
evidenced by the decrease in these expenses as a percentage of total revenues
from 39% in the three months ended March 31, 2002 to 36% in the three months
ended March 31, 2003.
In areas where revenue demand did not support our cost base, such as
Latin America and Europe, we reduced headcount during 2002. At the same time,
we have increased headcount where we believe there are long and near-term
opportunities, such as our United States public sector, which handles
opportunities on the federal, state and local levels. We also continue to
achieve leverage in our sales and marketing efforts by focusing our direct
sales force and continued expansion of the channel as a source of product
sales. The
INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
REULTS OF OPERATIONS
channel continues to be an important source of global revenue for us as we use
its capabilities to reach not just departmental and small companies, but larger
customers as well.
The decrease in absolute dollars in sales and marketing was the result
of the changes in headcount along with lower commissions due to the decrease in
product license and sales and lower marketing costs. Marketing costs for print
and media advertising were lower in 2003 compared to the first half of 2002
when we launched our first television and print advertising campaign designed
to demonstrate the multitude of threats that can compromise the security of a
company's networks, servers or desktops. This campaign was aimed at increasing
awareness of the ISS brand, especially at the mainstream business market.
General and administrative
General and administrative expenses of $5.5 million in the first
quarter of 2003 and $5.4 million in the first quarter of 2002 were 9% of total
revenues in both 2003 and 2002. General and administrative expenses consist of
personnel-related costs for executive, administrative, finance and human
resources, internal information systems and other support services costs, and
legal, accounting and other professional service fees.
Amortization
We incurred amortization expense related to intangible assets and
stock based compensation of $1.4 million and $1.5 million in the three months
ended March 31, 2003 and 2002, respectively. These intangible assets and stock
based compensation resulted from acquisitions accounted for under the purchase
method of accounting and are amortized over their useful lives.
Interest income
The market rate of interest paid on investment-quality commercial
paper and similar investments dropped from approximately 2.0% during the first
quarter of 2002 to approximately 1.4% in the first quarter of 2003. As a
result, interest income decreased despite an increase in total cash and cash
equivalents and interest bearing marketable securities. Specifically, net
interest income decreased from $730,000 in the quarter ended March 31, 2002 to
$643,000 in the comparable quarter of 2003.
Foreign currency exchange gain
The exchange gain of $244,000 in the three months ended March 31, 2003
and the exchange gain of $23,000 in the three months ended March 31, 2002, are
a result of fluctuations in currency exchange rates between the U.S. dollar and
other currencies, primarily the Japanese Yen and the Euro and changes in value
of assets and liabilities that are denominated in foreign currencies.
Provision for income taxes
The effective tax rate was 38% and 43% for the quarters ended March
31, 2003 and 2002, respectively. The effective rate differs from the statutory
rate due to the impact of acquisition related intangibles that are not
deductible for income tax purposes.
LIQUIDITY AND CAPITAL RESOURCES
We satisfy our working capital needs and capital equipment needs with
cash provided by operations. Net cash provided by operations in the first three
months of 2003 was $16.1 million. The major components of cash flows provided
by operating activities were net income of $5.4 million, non-cash depreciation
and amortization expense charges of $4.9 million, income tax benefit from
employee exercises of stock options of $2.8 million and decrease in accounts
receivable of $6.4 million.
Investing activities in the first three months of 2003 included
equipment totaling $1.4 million as we provided existing and new personnel with
improved computer hardware. The other activities were the purchase of $14.4
million of intermediate term marketable securities, primarily interest-bearing
government obligations and commercial paper, offset by net proceeds from the
maturity of marketable securities of $22.0 million. These assets have quality
characteristics similar to cash equivalents, except their maturities when we
acquire them are longer than three months.
Our financing activities included the purchase of 148,000 shares of
our common stock on the open market at an aggregate cost of $1.8 million under
our previously announced stock repurchase plan. This use was partially offset
INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
REULTS OF OPERATIONS
by financing activities that generated funds, namely the exercise of stock
options by our employees and the issuance of common stock through our employee
stock purchase plan.
Other than our non-cancelable operating leases for office space, we
have no off-balance sheet financing arrangements, any relationships with
"structured finance" or "special purpose" entities, or any contractual
obligations that would impact our liquidity. Payments for certain operating
leases are secured by three collateralized stand-by letters of credit totaling
approximately $11.3 million. The stand-by letters of credit are annually
renewable over the duration of the applicable leases. We do not anticipate
utilizing these stand-by letters of credit to provide any liquidity needs.
As of March 31, 2003, we had $216.4 million of cash and cash
equivalents and marketable securities, consisting primarily of money market
accounts and investment grade commercial paper. An additional $14.1 million of
commercial paper investments are pledged as collateral for stand-by letters of
credit related to the operating leases of our facilities and are shown on the
balance sheet as restricted cash. 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. Furthermore,
we are not aware of any trends, events or uncertainties that are reasonably
likely to result in any significant changes to our liquidity. From time to time
we evaluate possible acquisition and 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 and marketable securities. Pending such uses, we will continue to
invest our available cash in investment grade, interest-bearing investments.
RISK FACTORS
Forward-looking statements are inherently uncertain as they are based
on various expectations and assumptions concerning future events and are
subject to known and unknown risks and uncertainties. Our forward-looking
statements contained in this Annual Report and elsewhere should be considered
in light of the following important risk factors. Variations from our stated
intentions or failure to achieve objectives could cause actual results to
differ from those projected in our forward-looking statements. With respect to
our business outlook published in our earnings press release each quarter, you
may continue to rely on the revenue and earnings expectations prior to the
start of our "quiet period" unless we have published a notice stating
otherwise. Toward the end of each quarter, we have a "quiet period" when we
will not comment concerning the previously published financial expectations,
and we disclaim any obligation to update during the quiet period. The public
should not rely on previously published expectations during the "quiet period".
The "quiet period" runs from the 15th of the last month of the quarter until
our earnings release during the first month of the following quarter. We
otherwise undertake no obligation to update publicly any forward-looking
statements for any reason, even if new information becomes available or other
events occur in the future.
We Operate in a Rapidly Evolving Market
We operate in a new and rapidly evolving market and must, among other
things:
o respond to competitive developments;
o continue to upgrade and expand our product and services
offerings; and
o continue to attract, retain and motivate our employees.
We cannot be certain that we will successfully address these issues.
As a result, we cannot assure our investors that we will be able to continue to
operate profitably in the future.
Our Future Operating Results Will Likely Fluctuate Significantly
We cannot predict our future revenues and operating results with
certainty. However, we do expect our future revenues and operating results to
fluctuate due to a combination of factors, including:
o the growth in the acceptance of, and activity on, the
Internet and the world wide web, particularly by corporate,
institutional and government users;
INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
REULTS OF OPERATIONS
o the extent to which the public perceives that unauthorized
access to and use of online information are threats to
network security;
o the volume and timing of orders, including seasonal trends in
customer purchasing;
o our ability to develop new and enhanced product and managed
service offerings and expand our professional services
capabilities;
o the introduction of ISS branded appliances, including
increased cost of goods sold;
o our ability to provide scalable managed services offerings
through our partners in a cost effective manner;
o foreign currency exchange rates that affect our international
operations;
o product and price competition in our markets; and
o general economic conditions, both domestically and in our
foreign markets.
We increasingly focus our efforts on sales of enterprise-wide security
solutions, which consist of our entire product suite and related professional
services, and managed security services, rather than on the sale of component
products. As a result, each sale requires substantial time and effort from our
sales and support staff. In addition, the revenues associated with particular
sales vary significantly depending on the number of products licensed by a
customer, the number of devices used by the customer and the customer's
relative need for our professional services. Large individual sales, or even
small delays in customer orders, can cause significant variation in our license
revenues and results of operations for a particular period. The timing of large
orders is usually difficult to predict and, like many software and services
companies, many of our customers typically complete transactions in the last
month of a quarter.
We cannot predict our operating expenses based on our past results.
Instead, we establish our spending levels based in large part on our expected
future revenues. As a result, if our actual revenues in any future period fall
below our expectations, our operating results likely will be adversely affected
because very few of our expenses vary with our revenues. Because of the factors
listed above, we believe that our quarterly and annual revenues, expenses and
operating results likely will vary significantly in the future.
Our ability to provide timely guidance and meet the expectations of
investors with respect to our operating and financial results is impacted by
the tendency of a majority of our sales to be completed in the last month of a
quarter. We may not be able to determine whether we will experience material
deviations from guidance or expectations until the end of a quarter.
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:
o internal information technology departments of our customers
and the consulting firms that assist them in formulating
security systems;
o relatively smaller software companies offering relatively
limited applications for network and Internet security;
o large companies, including Symantec Corp., Cisco Systems,
Inc. and Network Associates, Inc., that sell or have
announced competitive products and offerings, as well as
other large software companies that have the technical
capability and resources to develop competitive products;
o software or hardware companies like Cisco Systems, Inc. that
could integrate features that are similar to our products
into their own products; and
o small and large companies with competitive offerings to
components of our managed services offerings.
INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
REULTS OF OPERATIONS
Mergers or consolidations among these competitors, or acquisitions of
small competitors by larger companies, represent risks. For example, Symantec
acquired Recourse Technologies and Riptech Inc. in the third quarter of 2002
and, Cisco recently announced agreements to acquire Psionic Software, Inc. and
Okena, Inc. Most recently, in April 2003 Network Associates, Inc. announced
agreements to acquire Intruvert Networks and Entercept Security Technologies.
These acquisitions will make these entities potentially more formidable
competitors to us if such products and offerings are effectively integrated.
Large companies may have advantages over us because of their longer operating
histories, greater name recognition, larger customer bases or greater
financial, technical and marketing resources. As a result, they may be able to
adapt more quickly to new or emerging technologies and changes in customer
requirements. They can also devote greater resources to the promotion and sale
of their products than we can. In addition, these companies have reduced and
could continue to reduce, the price of their security monitoring, detection and
response products and managed security services, which increases pricing
pressures within our market.
Several companies currently sell software products (such as
encryption, firewall, operating system security and virus detection software)
that our customers and potential customers have broadly adopted. Some of these
companies sell products that perform the same functions as some of our
products. In addition, the vendors of operating system software or networking
hardware may enhance their products to include the same kinds of functions that
our products currently provide. The widespread inclusion of comparable features
to our software in operating system software or networking hardware could
render our products 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:
o the extent to which businesses and others seek to establish
more secure networks;
o the extents to which hackers and others seek to compromise
secure systems;
o evolving computer hardware and software standards;
o changing customer requirements; and
o frequent introductions of new products and product
enhancements.
To remain successful, we must continue to change, adapt and improve
our products in response to these and other changes in technology. Our future
success hinges on our ability to both continue to enhance our current line of
products and professional services and to introduce new products and services
that address and respond to innovations in computer hacking, computer
technology and customer requirements. We cannot be sure that we will
successfully develop and market new products that do this. Any failure by us to
timely develop and introduce new products, to enhance our current products or
to expand our professional services capabilities in response to these changes
could adversely affect our business, operating results and financial condition.
Our products involve very complex technology, and as a consequence,
major new products and product enhancements require a long time to develop and
test before going to market. Because this amount of time is difficult to
estimate, we have had to delay the scheduled introduction of new and enhanced
products in the past and may have to delay the introduction of new and enhanced
products in the future.
The techniques computer hackers use to gain unauthorized access to, or
to sabotage, networks and intranets are constantly evolving and increasingly
sophisticated. Furthermore, because new hacking techniques are usually not
recognized until used against one or more targets, we are unable to anticipate
most new hacking techniques. To the extent that new hacking techniques harm our
customers' computer systems or businesses, affected or prospective customers
may believe that our products are ineffective, which may cause them or
prospective customers to reduce or avoid purchases of our products.
INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
REULTS OF OPERATIONS
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:
o the difficulty in managing an organization spread over
various countries located across the world;
o compliance with, and unexpected changes in, a wide range of
complex regulatory requirements in countries where we do
business;
o increased financial accounting and reporting burdens and
complexities and potentially adverse tax consequences;
o excess taxation due to overlapping tax structures;
o fluctuations in foreign currency exchange rates resulting in
losses or gains from transactions and expenses denominated in
foreign currencies;
o reduced protection for intellectual property rights in some
countries;
o reduced protection for enforcement of creditor and
contractual rights in some countries; and
o import and export license requirements and restrictions on
the import and export of certain technology, especially
encryption technology and trade restrictions.
We rely on distributors extensively in the Asia/Pacific region for the
sale and distribution of our products. Further, countries in the Asia/Pacific
region, particularly China, Japan and Korea, have experienced weakness in their
currency, banking and equity markets. These weaknesses could continue to
adversely affect our distributors' ability to pay us and adversely affect
demand for our products in the Asia/Pacific region. Despite these risks, we
believe that we must continue to expand our operations in international markets
to support our growth. To this end, we intend to establish additional foreign
sales operations, expand our existing offices, hire additional personnel,
expand our international sales channels and customize our products for local
markets. If we fail to execute this strategy, our international sales growth
will be limited.
Our Networks, Products and Services May be Targeted by Hackers
Like other companies, our websites, networks, information systems,
products and services may be targets for sabotage, disruption or
misappropriation by hackers. As a leading network security solutions company,
we are a high profile target. Although we believe we have sufficient controls
in place to prevent disruption and misappropriation, and to respond to such
situations, we expect these efforts by hackers to continue. If these efforts
are successful, our operations, reputation and sales could be adversely
affected.
We Must Successfully Integrate Acquisitions
As part of our growth strategy, we have and may continue to acquire or
make investments in companies with products, technologies or professional
services capabilities complementary to our solutions. When engaging in
acquisitions, we could encounter difficulties in assimilating or completing the
development of the technologies, new personnel and operations into our company.
These difficulties may disrupt our ongoing business, distract our management
and employees, increase our expenses and adversely affect our results of
operations. These difficulties could also include accounting requirements, such
as impairment charges related to goodwill or expensing in-process research and
development costs as occurred in the fourth quarter of 2002 related to the
acquisition of vCIS. We cannot be certain that we will successfully overcome
these risks with respect to any future acquisitions or that we will not
encounter other problems in connection with our recent or any future
acquisitions. In addition, any future acquisitions may require us to incur debt
or issue equity securities. The issuance of equity securities could dilute the
investment of our existing stockholders.
INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
REULTS OF OPERATIONS
We Depend on Our Intellectual Property Rights and Use Licensed Technology
We rely primarily on copyright, trademark, patent and trade secrets
laws, confidentiality procedures and contractual provisions to protect our
proprietary rights. We have obtained one United States patent and have a number
of patent applications pending, as well as numerous trademarks and trademark
applications pending. We 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 support are essential to establishing and maintaining our
technology leadership position. We cannot assure you that our competitors will
not develop technologies that are similar to ours.
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.
Some Provisions in the ISS Certificate of Incorporation and Bylaws Make a
Takeover of ISS Difficult
Our certificate of incorporation and bylaws contain provisions that
could have the effect of making it more difficult for a third party to acquire,
or of discouraging a third party from attempting to acquire, control of ISS.
These provisions:
o establish a classified board of directors;
o create preferred stock purchase rights that grant to holders
of common stock the right to purchase shares of Series A
Junior Preferred Stock in the event that a third party
acquires 20% or more of the voting power of our outstanding
common stock;
o prohibit the right of our stockholders to act by written
consent;
o limit calling special meetings of stockholders; and
o impose a requirement that holders of 66-2/3% of the
outstanding shares of common stock are required to amend the
provisions relating to the classification of our board of
directors and action by written consent of stockholders.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We have no material changes to the disclosure on this matter made in
our Annual Report on Form 10-K for the year ended December 31, 2002.
ITEM 4. CONTROLS AND PROCEDURES
As required by SEC rules, we have evaluated the effectiveness of the
design and operation of our disclosure controls and procedures within 90 days of
the filing of this quarterly report. This evaluation was carried out under the
supervision and with the participation of our management, including our
principal executive officer and principal financial officer. Based on this
evaluation, these officers have concluded that the design and operation of our
disclosure controls and procedures are effective. There were no significant
changes to our internal controls or in other factors that could significantly
affect disclosure controls subsequent to the date of their evaluation.
Disclosure controls and procedures are our controls and other
procedures that are designed to ensure that information required to be disclosed
by us in the reports that we file or submit under the Securities and Exchange
Act of 1934 is recorded, processed, summarized, and reported within the time
periods specified in the SEC's rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by us in the reports that we
file under the Exchange Act is accumulated and communicated to our management,
including principal executive officer and principal financial officer, as
appropriate, to allow timely decisions regarding disclosure.
OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
3.1 Restated Certificate of Incorporation (filed as Exhibit 3.1
to the Company's Quarterly Report on Form 10-Q, dated
November 14, 2000 and incorporated by reference herein).
3.2 Bylaws (filed as Exhibit 3.2 to the Company's Registration
Statement on Form S-1, Registration No. 373-44529 and
incorporated by reference herein).
11 Computation of Per Share Earnings *
99.1 Certification pursuant to 18 U.S.C. Section 1350, as adapted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.2 Certification pursuant to 18 U.S.C. Section 1350, as adapted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
* Data required by SFAS No. 128, "Earnings Per Share", is
provided in Note 5 to the consolidated financial statements
in this report
(b) Reports on Form 8-K.
ISS filed no reports on Form 8-K during this reporting period.
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: May 14, 2003 By /s/ Richard Macchia
------------------ ------------------------------------------
Senior Vice President, Finance and
Administration and Chief Financial Officer
By /s/ Maureen Richards
------------------------------------------
Corporate Controller
CERTIFICATION
I, Thomas E. Noonan, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Internet
Security Systems, Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect
to the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented
in this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors
and the audit committee of registrant's board of directors (or
persons performing the equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data and
have identified for the registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes
in internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: May 14, 2003
/s/ Thomas E. Noonan
------------------------------------
Thomas E. Noonan
Chairman, President and
Chief Executive Officer
CERTIFICATION
I, Richard Macchia, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Internet
Security Systems, Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect
to the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented
in this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors
and the audit committee of registrant's board of directors (or
persons performing the equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data and
have identified for the registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes
in internal controls or in other factors that could significantly
affect internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: May 14, 2003
/s/ Richard Macchia
-----------------------------------------
Richard Macchia
Senior Vice President, Finance and
Administration and Chief Financial Officer