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, 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 (State or jurisdiction of incorporation or organization)		58-2362189 (I.R.S. Employer Identification No.)

6303 BARFIELD ROAD, ATLANTA, GEORGIA 30328
(Address of principal executive offices)

Registrant’s telephone number, including area code (404) 236-2600

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]

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


Title of each class of common stock Common stock, $0.001 par value		Number of Shares Outstanding as of October 31, 2003 49,787,000

TABLE OF CONTENTS


PART I. FINANCIAL INFORMATION
	Item 1. Consolidated Financial Statements
		CONSOLIDATED BALANCE SHEETS
		CONSOLIDATED STATEMENTS OF OPERATIONS
		CONSOLIDATED STATEMENTS OF CASH FLOWS
		NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
	Item 4. Controls and Procedures
PART II. OTHER INFORMATION
	Item 6. Exhibits and Reports on Form 8-K
SIGNATURES
EX-10.1 FORM OF RETENTION AGREEMENT
EX-31.1 SECTION 302 CERTIFICATION OF THE PEO
EX-31.2 SECTION 302 CERTIFICATION OF THE PFO
EX-32.1 SECTION 906 CERTIFICATION OF THE PEO
EX-32.2 SECTION 906 CERTIFICATION OF THE PFO


		PAGE
		NUMBER

	PART I – FINANCIAL INFORMATION
Item 1	Consolidated (Unaudited) Financial Statements:	3
	Consolidated Balance Sheets at September 30, 2003 and December 31, 2002	3
	Consolidated Statements of Operations for the three months and nine months ended September 30, 2003 and September 30, 2002	4
	Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and September 30, 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	24

PART I. FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

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


					September 30,			December 31,
					2003			2002

					(unaudited)
				ASSETS
Current assets:
	Cash and cash equivalents				$	170,997		$	148,317
	Marketable securities					56,136			53,999
	Accounts receivable, less allowance for doubtful accounts of $3,472 and $2,790, respectively					57,505			56,700
	Inventory					528			1,055
	Prepaid expenses and other current assets					9,010			7,000

		Total current assets				294,176			267,071
Property and equipment:
	Computer equipment					44,364			38,403
	Office furniture and equipment					21,218			21,446
	Leasehold improvements					22,103			21,183

						87,685			81,032
	Less accumulated depreciation					50,055			39,313

						37,630			41,719
Restricted marketable securities						14,125			14,690
Goodwill, net						201,162			200,464
Other intangibles, less accumulated amortization of $12,959 and $9,223, respectively						11,648			15,384
Other assets						7,417			7,240

		Total assets			$	566,158		$	546,568

			LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable				$	3,458		$	1,765
	Accrued expenses					20,869			22,332
	Deferred revenues					54,392			55,587

		Total current liabilities				78,719			79,684
Non-current liabilities						2,567			2,328
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, 49,767,000 and 49,544,000 issued and outstanding, respectively					50			50
	Additional paid-in capital					474,415			463,779
	Deferred compensation					(208	)		(702	)
	Accumulated other comprehensive income					4,301			949
	Retained earnings					17,802			2,514
	Treasury stock, at cost (911,000 and 133,000 shares, respectively)					(11,488	)		(2,034	)

		Total stockholders’ equity				484,872			464,556

		Total liabilities and stockholders’ equity			$	566,158		$	546,568

See accompanying notes

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,

			2003			2002			2003			2002

Revenues:
	Product licenses and sales		$	25,545		$	30,150		$	76,158		$	90,550
	Subscriptions			28,211			24,153			83,035			67,263
	Professional services			6,331			7,465			19,472			22,363

				60,087			61,768			178,665			180,176
Costs and expenses:
	Cost of revenues:
		Product licenses and sales		2,407			1,928			5,652			5,599
		Subscriptions and professional services		11,784			12,766			36,671			38,637

	Total cost of revenues			14,191			14,694			42,323			44,236
	Research and development			10,496			8,692			30,288			26,120
	Sales and marketing			21,113			23,780			63,284			70,369
	General and administrative			5,428			5,918			16,407			18,194
	Amortization of other intangibles and stock-based compensation			1,317			1,326			4,046			4,286

				52,545			54,410			156,348			163,205
Operating income				7,542			7,358			22,317			16,971
Interest income				610			877			1,990			2,479
Minority interest				(168	)		(66	)		(270	)		(273	)
Other income				68			2,068			101			3,904
Foreign currency exchange gain				28			145			497			68

Income before income taxes				8,080			10,382			24,635			23,149
Provision for income taxes				3,045			4,041			9,347			9,314

Net income			$	5,035		$	6,341		$	15,288		$	13,835

Basic net income per share of Common Stock			$	0.10		$	0.13		$	0.31		$	0.29

Diluted net income per share of Common Stock			$	0.10		$	0.13		$	0.31		$	0.28

Weighted average shares:
	Basic			49,142			48,393			49,123			48,080

	Diluted			49,884			48,855			49,773			48,865

See accompanying notes

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


				Nine months ended
				September 30,

				2003			2002

Operating activities
Net income				$	15,288		$	13,835
Adjustments to reconcile net income to net cash provided by operating activities:
		Depreciation			10,742			10,781
		Amortization of intangibles and stock-based compensation			4,046			4,286
		Accretion of discount on marketable securities			172			230
		Minority interest			270			273
		Income tax benefit from exercise of stock options			8,146			6,952
		Gain on issuance of subsidiary stock			(127	)		(2,560	)
	Changes in assets and liabilities:
		Accounts receivable			(805	)		(11,566	)
		Inventory			527			(505	)
		Prepaid expenses and other assets			(1,996	)		(3,377	)
		Accounts payable and accrued expenses			136			(2,215	)
		Deferred revenues			(1,195	)		5,480

			Net cash provided by operating activities		35,204			21,614
Investing activities
Acquisitions, net of cash received					—			(1,348	)
Net proceeds from maturity of marketable securities					49,977			63,315
Purchases of marketable securities					(52,284	)		(63,208	)
Proceeds from restricted marketable securities					565			—
Purchases of property and equipment					(6,653	)		(9,207	)
Issuance of subsidiary stock					189			—

			Net cash used in investing activities		(8,206	)		(10,448	)
Financing activities
Proceeds from exercise of stock options					439			2,892
Proceeds from employee stock purchase plan					1,609			2,086
Purchases of treasury stock					(9,454	)		(1,989	)

			Net cash provided by (used in) in financing activities		(7,406	)		2,989
Foreign currency impact on cash					3,088			1,506

Net increase in cash and cash equivalents					22,680			15,661
Cash and cash equivalents at beginning of period					148,317			108,038

Cash and cash equivalents at end of period				$	170,997		$	123,699

Supplemental cash flow disclosure
Income taxes paid				$	1,302		$	2,770

See accompanying notes

INTERNET SECURITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Significant Accounting Policies

Basis of Presentation

The consolidated financial statements of Internet Security Systems, Inc. (“ISS” or the “Company”) as of September 30, 2003 and for the three months and nine months ended September 30, 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 of 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 and nine months ended September 30, 2003 are not necessarily indicative of the results to be expected for the entire year. All significant intercompany accounts and transactions have been eliminated.

Certain prior year amounts have been reclassified to conform to current year presentation.

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):


			September 30, 2003					December 31, 2002

			Gross Carrying		Accumulated			Gross Carrying		Accumulated
			Amount		Amortization			Amount		Amortization

Unamortized intangible assets:
	Goodwill		$	228,543	$	(27,381	)	$	227,845	$	(27,381	)

Amortized intangible assets:
	Core technology			3,853		(2,400	)		3,853		(2,039	)
	Developed technology			17,808		(8,319	)		17,808		(5,654	)
	Work force			1,407		(542	)		1,407		(216	)
	Customer relationships			1,539		(1,698	)		1,539		(1,314	)

		Total	$	24,607	$	(12,959	)	$	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				Nine months ended
	September 30,				September 30,

	2003		2002		2003		2002

Core technology	$	122	$	120	$	361	$	361
Developed technology		902		890		2,722		2,671
Work force		108		9

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