INTERNET SECURITY SYSTEMS INC/GA - 10-Q Quarterly Report

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 September 30, 2002

		OR

o		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 o

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		as of November 8, 2002
Common Stock, $0.001 par value		49,496,000

TABLE OF CONTENTS


		PAGE
		NUMBER

PART I. FINANCIAL INFORMATION
Item 1 Consolidated Financial Statements:
	Consolidated Balance Sheets at September 30, 2002 and December 31, 2001		3
	Consolidated Statements of Operations for the three months and nine months ended September 30, 2002 and September 30, 2001		4
	Consolidated Statements of Cash Flows for the nine months ended September 30, 2002 and September 30, 2001		5
	Notes to Consolidated Financial Statements		6
Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations			11
Item 3 Quantitative and Qualitative Disclosures about Market Risk			24
Item 4 Controls and Procedures			24
PART II. OTHER INFORMATION			24
Item 1 Legal Proceedings			24
Item 6 Exhibits and Reports on Form 8-K			26

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


					September 30,			December 31,
					2002			2001

					(UNAUDITED)
				ASSETS
Current assets:
	Cash and cash equivalents				$	123,699		$	108,038
	Marketable securities					54,792			55,129
	Accounts receivable, less allowance for doubtful accounts of $2,612 and $2,563, respectively					63,102			50,259
	Inventory					2,273			1,768
	Prepaid expenses and other current assets					6,280			6,018

			Total current assets			250,146			221,212
Property and equipment:
	Computer equipment					36,591			31,043
	Office furniture and equipment					22,287			20,872
	Leasehold improvements					20,258			17,835

						79,136			69,750
	Less accumulated depreciation					36,035			25,254

						43,101			44,496
Restricted marketable securities						12,500			12,500
Goodwill, less accumulated amortization of $27,381						200,464			197,060
Other intangibles, less accumulated amortization of $8,030 and $4,644, respectively						15,384			19,722
Other assets						9,296			5,994

	Total assets				$	530,891		$	500,984


				LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable				$	2,803		$	3,553
	Accrued expenses					20,591			20,440
	Deferred revenues					52,092			48,139

			Total current liabilities			75,486			72,132
Other non-current liabilities						2,290			1,917
Commitments and contingencies Stockholders’ equity:
	Preferred stock, $.001 par value, 20,000,000 shares authorized, none issued or outstanding					—			—
	Common stock, $.001 par value, 120,000,000 shares authorized, 48,481,000 and 47,871,000 issued and outstanding, respectively					48			48
		Additional paid-in capital				442,037			430,449
		Deferred compensation				(745	)		(1,985	)
		Accumulated other comprehensive loss				(806	)		(2,312	)
		Retained earnings				14,570			735
		Less treasury stock, at cost (130,000 shares)				(1,989	)		—

				Total stockholders’ equity		453,115			426,935

				Total liabilities and stockholders’equity	$	530,891		$	500,984

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


			Three months ended						Nine months ended
			September 30,						September 30,

			2002			2001			2002			2001

Revenues:
	Product licenses and sales		$	30,150		$	27,435		$	90,550		$	91,699
	Subscriptions			24,153			17,663			67,263			48,259
	Professional services			7,465			7,636			22,363			25,641

				61,768			52,734			180,176			165,599
Costs and expenses:
	Cost of revenues:
		Product licenses and sales		1,928			1,401			5,599			11,552
		Subscriptions and professional services		12,766			12,788			38,637			38,083

		Total cost of revenues		14,694			14,189			44,236			49,635
	Research and development			8,692			9,276			26,120			26,531
	Sales and marketing			23,780			23,449			70,369			68,996
	General and administrative			5,918			5,509			18,194			15,105
	Charge for in-process research and development			—			—			—			2,910
	Write-off of lease obligation			—			—			—			1,072
	Amortization of other intangibles and stock-based compensation			1,326			2,213			4,286			3,451
	Amortization of goodwill			—			11,393			—			15,597

				54,410			66,029			163,205			183,297
Operating income (loss)				7,358			(13,295	)		16,971			(17,698	)
Interest income, net				877			1,524			2,479			5,274
Minority interest				(66	)		(156	)		(273	)		(156	)
Other income				2,068			13,620			3,904			15,258
Foreign currency exchange gain (loss)				145			(163	)		68			(445	)

Income before income taxes				10,382			1,530			23,149			2,233
Provision for income taxes				4,041			7,618			9,314			7,390

Net income (loss)			$	6,341		$	(6,088	)	$	13,835		$	(5,157	)

Basic net income (loss) per share of Common Stock			$	0.13		$	(0.13	)	$	0.29		$	(0.12	)

Diluted net income (loss) per share of Common Stock			$	0.13		$	(0.13	)	$	0.28		$	(0.12	)

Weighted average shares:
	Basic			48,393			47,693			48,080			44,764

	Diluted			48,855			47,693			48,865			44,764

INTERNET SECURITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
(Unaudited)


				Nine months ended
				September 30,

				2002			2001

OPERATING ACTIVITIES Net income (loss)				$	13,835		$	(5,157	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
			Depreciation		10,781			8,135
			Amortization of goodwill		—			15,597
			Amortization of other intangibles and stock-based compensation		4,286			3,451
			Accretion of discount on marketable securities		230			175
			Minority interest		273			156
			Charge for in-process research and development		—			2,910
			Income tax benefit from exercise of stock options		6,952			9,398
			Gain on issuance of subsidiary stock		(2,560	)		—
			Gain on sale of subsidiary stock		—			(15,252	)
			Other non-cash items		—			67
	Changes in assets and liabilities, excluding the effect of acquisitions:
			Accounts receivable		(11,566	)		1,271
			Inventory		(505	)		147
			Prepaid expenses and other assets		(3,377	)		(6,723	)
			Accounts payable and accrued expenses		(2,215	)		(6,214	)
			Deferred revenues		5,480			8,059

		NET CASH PROVIDED BY OPERATING ACTIVITIES			21,614			15,864
INVESTING ACTIVITIES Acquisitions, net of cash received					(1,348	)		(7,495	)
Net proceeds from maturity of marketable securities					63,315			105,492
Purchases of marketable securities					(63,208	)		(98,127	)
Purchases of property and equipment					(9,207	)		(26,683	)
Net proceeds from sale of subsidiary stock					—			16,529

		NET CASH USED IN INVESTING ACTIVITIES			(10,448	)		(10,284	)
FINANCING ACTIVITIES Proceeds from exercise of stock options					2,892			13,105
Proceeds from issuance of common stock					2,086			2,250
Purchase of treasury shares					(1,989	)		—

		NET CASH PROVIDED BY FINANCING ACTIVITIES			2,989			15,355
Foreign currency impact on cash					1,506			678

Net increase in cash and cash equivalents					15,661			21,613
Cash and cash equivalents at beginning of period					108,038			66,210

Cash and cash equivalents at end of period				$	123,699		$	87,823

SUPPLEMENTAL CASH FLOW DISCLOSURE Income taxes paid				$	2,770		$	—

INTERNET SECURITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of presentation and significant accounting policies

The consolidated financial statements of Internet Security Systems, Inc. (“ISS”) as of September 30, 2002 and for the three and nine months ended September 30, 2002 and 2001 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, 2001 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, 2001. The results of operations for the three and nine months ended September 30, 2002 are not necessarily indicative of the results to be expected for the entire year. All significant intercompany accounts and transactions have been eliminated. Certain previously reported amounts have been reclassified to conform to the current presentation format.

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 could differ from those estimates.

2. Business Combinations

On August 1, 2002 Internet Security Systems KK, our Asia-Pacific subsidiary, acquired a primary ISS KK distributor in Singapore, TriSecurity Holdings Pte Ltd. This acquisition provides our Asia-Pacific subsidiary direct support capabilities for their customers in Southeast Asia and allows ISS KK to expand its capabilities in this growing market. The consideration consisted of 1,000 shares of ISS KK stock and approximately $1.2 million of cash. Goodwill of approximately $4.0 million related to the purchase was recorded. There is additional annual contingent consideration dependent on the achievement of specified increasing levels of revenues and operating profits for the years 2002 through 2004. The total maximum additional consideration is 735 shares of ISS KK stock and will be recorded as additional purchase price.

The operating results of ISS include the operating results of TriSecurity Holdings Pte Ltd. since the date of acquisition.

3. Other income and expense

Other income for the third quarter of 2002 includes a $2.6 million gain related to the issuance of subsidiary shares in connection with the acquisition of TriSecurity Holdings Pte Ltd. The Company reported a gain on the difference between the fair market value of the shares issued and the book value of those shares, in accordance with Staff Accounting Bulletin No. 51 and company policy.

In the nine months ended September 30, 2002, other income also consists of a second quarter gain of $1.9 million on the sale of an investment in an ISS distributor in Japan. The shares of the publicly traded company were acquired when the distributor was privately held and were subsequently sold on the open market. The gain is substantially offset by second quarter expenses included in the general and administrative category resulting from the consolidation of Tokyo-based operations from several different locations to a new centralized headquarters in Tokyo. Costs associated with this move included lease termination costs, including remaining rent payments, write-off of leasehold improvements and moving costs.

Other income for the three and nine months ended September 30, 2001 includes a subsidiary IPO gain of $13.6 million from an initial public offering on the Japan over-the-counter market by the Company’s subsidiary responsible for Asia-Pacific operations. Proceeds of the IPO were retained by the subsidiary.

In the nine months ended September 30, 2001, other income included a second quarter non-recurring other income item of $1.6 million from the sale of approximately 2% of the outstanding shares of our Asia-Pacific subsidiary in March 2001. As part of the planning for an IPO in Japan of a minority interest in our Asia-Pacific subsidiary that was completed in September 2001, options were granted in the subsidiary as a means of key employee retention and approximately 2% of the outstanding shares were

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

sold to employees and key partners. The price was established based on a valuation of the company by an independent appraisal firm. The gain represents the difference between proceeds received and the underlying basis in the stock.

In the quarter ended March 31, 2001, the Company recorded a $1.1 million write-off of the remaining lease obligation on our previous Atlanta office space. This non-recurring expense originated in the first quarter as available subleased space in the area grew substantially as the result of layoffs, closures and consolidations, diminishing the prospects of subleasing our old space.

4. Goodwill and intangible assets

The Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” on January 1, 2002. As a result, goodwill is no longer amortized, but is instead tested for impairment annually or sooner if circumstances indicate that it may no longer be recoverable. Upon adoption, the Company completed the transitional goodwill impairment assessment required by SFAS No. 142 and concluded that goodwill was not impaired at January 1, 2002.

Goodwill and intangible assets are comprised of the following (in thousands):


		September 30, 2002					December 31, 2001
		Gross Carrying		Accumulated			Gross Carrying		Accumulated
		Amount		Amortization			Amount		Amortization

Unamortized intangible assets:
	Goodwill	$	227,845	$	(27,381	)	$	224,441	$	(27,381	)

Amortized intangible assets: