UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission File Number 000-23655

INTERNET SECURITY SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

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.

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PART I. FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

INTERNET SECURITY SYSTEMS, INC.

See accompanying notes

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INTERNET SECURITY SYSTEMS, INC.

See accompanying notes

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INTERNET SECURITY SYSTEMS, INC.

See accompanying notes

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INTERNET SECURITY SYSTEMS, INC.

Note 1. Significant Accounting Policies

Basis of Presentation

     The consolidated financial statements of Internet Security Systems, Inc. (“ISS” or the “Company”) as of March 31, 2004 and for the three months ended March 31, 2004 and 2003 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 of the Company for the interim periods. The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. The consolidated balance sheet at December 31, 2003 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, 2003. The results of operations for the three months ended March 31, 2004 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):

     The changes in the carrying amounts of goodwill and other intangibles from December 31, 2003 to March 31, 2004 were primarily a result of the purchase of Cobion AG (“Cobion”) (see Note 3) and additional consideration related to a 2002 acquisition of TriSecurity Holdings Pte Ltd., resulting in approximately $22.3 million of goodwill and $16.5 million of other intangibles being recorded during the first quarter of 2004. The remaining fluctuation is the result of currency translation adjustments.

     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):

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     The estimated future amortization expense of intangible assets as of March 31, 2004 is as follows (in thousands):

Stock-Based Compensation

     Statement of Financial Accounting Standard 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), as amended by SFAS 148, “Accounting for Stock-Based Compensation — Transition and Disclosure”, 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 Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), 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 table shows pro forma net loss and pro forma net loss per share for the periods indicated 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):

     In the first quarter of 2004, 280,000 restricted shares were issued to officers and certain key employees of ISS. These shares shall vest in two installments: 50% will vest two years from the grant date, and the remaining 50% will vest three years from the grant date. Upon issuance of restricted shares, unearned compensation is recorded in stockholders’ equity as deferred compensation equal to the market value of the restricted shares and is recognized as compensation expense ratably over the vesting periods, as applicable. Total compensation expense for restricted stock awards, including the expense for 13,000 restricted shares issued to directors in 2003, amounted to $385,000 in the first quarter of 2004.

Recently Issued Accounting Standards

     In December 2003, the SEC issued Staff Accounting Bulletin No. 104 (“SAB 104”), “Revenue Recognition”, which supercedes Staff Accounting Bulletin No. 101 (“SAB 101”), “Revenue Recognition in Financial Statements.” The primary purpose of SAB 104 is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, which was superceded as a result of the issuance of Emerging Issues Task Force 00-21 (“EITF 00-21”), “Accounting for Revenue Arrangements with Multiple Deliverables.” SAB 104 also incorporated certain sections of the SEC’s “Revenue Recognition in Financial Statements—Frequently Asked Questions and Answers” document. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the

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revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104. The adoption of SAB 104 did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

     In January 2003, the FASB issued Financial Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which addresses consolidation by business enterprises of variable interest entities that either: (1) do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or (2) the equity investors lack an essential characteristic of a controlling financial interest. In December 2003, the FASB issued Financial Interpretation No. 46-R, “Consolidation of Variable Interest Entities” (“FIN 46-R”), which represents a revision to FIN No. 46. The provisions of FIN 46-R are effective for interests in variable interest entities as of the first interim or annual period ending after December 15, 2003. The adoption of FIN 46 and FIN 46-R did not have a material impact on the Company’s financial position, results of operations or liquidity as the Company did not have any variable interest entities that required consolidation or disclosure under FIN 46 or FIN 46-R.

Note 2. Income Taxes

     The Company recorded tax provisions of $3.0 million and $3.3 million for the three-month periods ended March 31, 2004 and 2003, respectively. While income tax expense was recorded on domestic income, the amount of domestic taxes payable was reduced by deductions related to the employee exercise of stock options in current and prior periods. 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 36% and 38% for the quarters ended March 31, 2004 and 2003, respectively. The effective rates differ from the statutory rates due primarily to the impact of acquisition related intangibles that are not deductible for income tax purposes.

     As of March 31, 2004, ISS had a net operating loss carryforward of approximately $14.6 million related to US operations. The tax benefit of this carryforward will be recorded as additional paid-in-capital as realized. There are also approximately $8.0 million of research and development tax credit carryforwards that expire between 2011 and 2023 and foreign tax credit carryforwards of $2.9 million that expire between 2006 and 2008.

     In addition, Cobion, which was acquired by ISS in January 2004, has a net operating loss carryforward of approximately $9.1 million. The tax value of this loss has been recorded as a deferred tax asset and the Company will not recognize a provisional benefit as this loss is utilized.

Note 3. Business Acquisition

     On January 14, 2004, ISS acquired Cobion, a privately held company based in Kassel, Germany. Cobion provides content filtering and anti-spam technology that protects individuals and enterprises against unwanted Web content, spam, misuse of information and lost productivity. The Company intends to continue to sell the Cobion product on a stand-alone basis as well as include the technology in the Company’s multi-function Proventia appliance in 2004.

     Total cash consideration for all of the outstanding shares of Cobion and the acquisition related fees was approximately $33.5 million. The Company adopted a plan to restructure Cobion whereby certain Cobion employees will be terminated over a six-month period following the acquisition. As a result, acquisition costs included the accrual of $172,000 of severance costs associated with these terminations. As of March 31, 2004, the Company had not yet paid out any severance. The Company will begin paying out severance against this accrual in the second quarter of 2004.

     The operating results of Cobion are included in the consolidated financial statements of ISS from the date of acquisition. The adjusted aggregate purchase price was allocated based on a valuation report of the Cobion intangibles as follows (in thousands):

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     The Company will amortize these intangible assets over their estimated useful lives of five years for developed technology and three years for customer relationships.

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

     The following summarizes the unaudited pro forma results of operations of the Company for the first quarter of 2003, assuming the acquisition of Cobion was concluded as of the beginning of 2003: (i) revenues of $59.7 million, (ii) net income of $4.0 million and (iii) basic and diluted net income per share of Common Stock of $.08. Net income and basic and diluted net income per share of Common Stock have been adjusted to reflect the amortization of intangibles. Unaudited pro forma results are not included for the corresponding period of 2004, as the impact of the acquisition would have been immaterial to the consolidated results of operations. This pro forma information is not necessarily indicative of what combined operations would have been if ISS had control of Cobion from the beginning of 2003.

     In August 2002, Internet Security Systems KK (“ISS KK”), acquired privately held TriSecurity Holdings Pte Ltd. (“TriSecurity”), a primary ISS KK distributor in Singapore. During the first quarter of 2003, ISS KK amended the agreement and agreed to make payment of 245 shares of ISS KK in each of the first quarters of 2004 and 2005, relating to annual contingent consideration payments defined in the 2002 purchase agreement. Due to regulatory issues, the agreement was amended prior to the 2004 payment to make the 2004 and 2005 payments in cash in lieu of shares. Additional consideration of $498,000 was paid in February 2004 based on the fair market value of the 245 shares, and is reflected as additional goodwill at March 31, 2004.

Note 4. Comprehensive Income

     The components of comprehensive income are as follows (in thousands):

Note 5. Income per Share

The following table sets forth the computation of basic and diluted net income per share (amounts in thousands, except per share amounts):

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Note 6. Segment and Geographic Information

     ISS conducts business in one operating segment; providing information security management solutions. The Company does, however, prepare operating results for internal use on a geographic basis. These geographical based operating costs consist of direct sales expenses, infrastructure to support its employee and customer and partner base, supporting billing and financial systems and a management team. Corporate expenses that are not charged directly to the other segments include research and development, general and administrative costs that support the global organization, amortization of intangibles, stock-based compensation and goodwill and costs that are one-time in nature, such as acquired in-process research and development.

     The accounting policies of the segments are the same as those described in the summary of significant accounting policies. There are no inter-segment 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.

     In accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”, the Company has included a summary of the segment financial information reported internally. The geographic segments are the Americas, Europe, Middle East and Africa (“EMEA”), and the Asia/Pacific region.

     The following table presents ISS’s revenues, operating expenses and operating income (loss) by reportable geographic segment (in thousands):