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.

PART I. FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

INTERNET SECURITY SYSTEMS, INC.

See accompanying notes

INTERNET SECURITY SYSTEMS, INC.

See accompanying notes

INTERNET SECURITY SYSTEMS, INC.

See accompanying notes

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 September 30, 2004 and for the three months and nine months ended September 30, 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 U.S. generally accepted accounting principles for complete financial statements.

     These consolidated financial statements should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. The results of operations for the three months and nine months ended September 30, 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 period amounts have been reclassified to conform to current period presentation.

     The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles 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 September 30, 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 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):

     Additional amortization expense totaling $375,000 in the third quarter of 2004 and $1.1 million in the nine months ending September 30, 2004 related to the purchase of a software license used in certain of the Company’s products is included in research and development expense.

     The estimated future amortization expense of intangible assets as of September 30, 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 income (loss) and pro forma net income (loss) per share for the periods indicated as if the Company had adopted SFAS 123. 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):

On March 31, 2004, the FASB issued its Exposure Draft, “Share-Based Payment”, which is a proposed amendment to SFAS No. 123, “Accounting for Stock-Based Compensation.” The amendment would require all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. The FASB expects to issue a final amendment late in 2004. On October 13, 2004, the FASB decided that the final amendment would be effective for public companies for any interim or annual period beginning after June 15, 2005, though early adoption would be encouraged, provided that financial statements for periods prior to the effective date have not been issued.

In 2004, 306,000 restricted shares have been issued to directors, officers and certain key employees of ISS. The shares issued to directors vest when the Company holds its annual stockholders meeting in 2005 and the shares issued to officers and certain key employees vest in two installments: 50% vests two years from the grant date, and the remaining 50% vests 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 over the vesting period. Total compensation expense for restricted stock awards amounted to $613,000 in the third quarter of 2004 and $1.6 million in the nine months ended September 30, 2004.

Note 2. Income Taxes

     The Company recorded tax provisions of $3.8 million and $3.0 million for the three-month periods ended September 30, 2004 and 2003, respectively, and tax provisions of $9.9 million and $9.3 million for the nine-month periods ended September 30, 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 exercise of employee 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 or fully utilized.

     The effective tax rate was approximately 37% for the three and nine months ended September 30, 2004 and 38% for the three and nine months ended September 30, 2003. The effective rates differ from the statutory rates due to the impact of acquisition-related intangibles and certain operating expenses that are not deductible for income tax purposes as well as federal and state tax credits.

     As of September 30, 2004, ISS had fully utilized its net operating loss carryforward related to US operations. The company has approximately $7.9 million of research and development tax credit carryforwards that expire between 2011 and 2023 and foreign tax credit carryforwards of $2.4 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 reduce its total income tax expense as this loss is utilized.

Note 3. Business Acquisition

     In January 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 is continuing to sell the Cobion product on a stand-alone basis and to OEM partners to incorporate in their products as well as including the technology in the Company’s multi-function Proventia appliance.

     Total cash consideration for all of the outstanding shares of Cobion and the acquisition related fees were approximately $33.5 million. The Company adopted a plan to restructure Cobion whereby certain Cobion employees were terminated over a six-month period following the acquisition. As a result, acquisition costs included the accrual of $203,000 of severance costs associated with these terminations. The Company has paid out the majority of the severance and will finish paying out the remaining severance in the fourth quarter of 2004 against the accrual of approximately $95,000 remaining at September 30, 2004.

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

     The Company is amortizing 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 three months and nine months ended September 30, 2003, assuming the acquisition of Cobion was concluded as of the beginning of 2003: (i) revenues of $60.4 million and $179.4 million, respectively, (ii) net income of $4.2 million and $12.3 million, respectively (iii) basic and diluted net income per share of Common Stock of $.08 and $0.17, respectively. Net income and basic and diluted net income per share have been adjusted to reflect the amortization of intangibles identified above. 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.

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):

Note 6. Segment and Geographic Information

     ISS conducts business in one operating segment: providing information security management solutions. However, the Company does 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):