<PAGE> 1
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, 1998
-------------------
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__________________
ISS GROUP, INC.
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(Exact name of registrant as specified in its charter)
<TABLE>
<S> <C>
DELAWARE 58-2362189
- ----------------------------- ------------------
(State or jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
</TABLE>
6600 PEACHTREE-DUNWOODY ROAD, 300 EMBASSY
ROW, SUITE 500, ATLANTA, GEORGIA 30328
-----------------------------------------
(Address of principal executive
offices)
Registrant's telephone number, including area code (678) 443-6000
--------------
NOT APPLICABLE
-------------------------------------------------------
(Former name, former address and former fiscal year, if
changed since last report.)
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 the number of shares outstanding of each of the registrant's
classes of common stock, as of the latest practicable date.
<TABLE>
<CAPTION>
Number of Shares Outstanding
Title of each class as of November 3, 1998
------------------------------- -----------------------------
<S> <C>
Common Stock, $0.001 par value 17,044,313
</TABLE>
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<PAGE> 2
<TABLE>
<CAPTION>
PAGE
PART I. FINANCIAL INFORMATION NUMBER
------
<S> <C>
Item 1 Consolidated Financial Statements:
Consolidated Statements of Operations for the Three Months
and Nine Months ended September 30, 1998 and September 30, 1997.....................3
Consolidated Balance Sheets at September 30, 1998 and
December 31, 1997...................................................................4
Consolidated Statements of Cash Flows for the Nine
Months ended September 30, 1998 and 1997............................................5
Notes to Consolidated Financial Statements..........................................6
Item 2 Management's Discussion and Analysis of
Financial Condition and Results of Operations......................................10
PART II. OTHER INFORMATION
Item 2 Changes in Securities and Use of Proceeds..........................................14
Item 6 Exhibits and Reports on From 10-Q..................................................16
</TABLE>
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<PAGE> 3
ISS GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
Three months ended Nine months ended
September 30, September 30,
----------------------- -----------------------
1998 1997 1998 1997
<S> <C> <C> <C> <C>
Revenues:
Licenses $ 6,596 $ 2,767 $17,030 $ 6,789
Subscriptions 2,152 691 4,808 1,553
Professional services 682 15 996 27
------- -------- ------- --------
9,430 3,473 22,834 8,369
Costs and expenses:
Cost of revenues 1,559 176 2,964 400
Research and development 2,541 895 6,009 1,957
Sales and marketing 5,632 3,051 15,711 7,147
General and administrative 1,046 443 3,127 1,064
------- -------- ------- --------
10,778 4,565 27,811 10,568
------- -------- ------- --------
Operating loss (1,348) (1,092) (4,977) (2,199)
Interest income, net 765 66 1,672 169
======= ======== ======= ========
Net loss $ (583) $ (1,026) (3,305) $ (2,030)
======= ======== ======= ========
Basic and diluted net loss per share of Common Stock $ (0.03) $ (0.13) $ (0.23) $ (0.26)
======= ======== ======= ========
Weighted average number of shares used in calculating
basic and diluted net loss per share of Common Stock 16,879 7,911 14,162 7,905
======= ======== ======= ========
Unaudited pro forma net loss per share of Common Stock $ (0.08) $ (0.21) $ (0.15)
======== ======= ========
Unaudited weighted average number of shares used in
calculating pro forma net loss per share of Common
Stock 13,648 15,904 13,294
======== ======= ========
</TABLE>
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<PAGE> 4
ISS GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data)
<TABLE>
<CAPTION>
SEPTEMBER 30, 1998 December 31, 1997
------------------ -----------------
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 59,846 $ 3,929
Accounts receivable, less allowance for doubtful
accounts of $258 and $292, respectively 7,334 4,038
Other current assets 677 281
-------- -------
Total current assets 67,857 8,248
Property and equipment:
Computer equipment 3,442 1,688
Office furniture and equipment 854 268
Leasehold improvements 249 15
-------- -------
4,545 1,971
less accumulated depreciation 1,205 402
-------- -------
3,340 1,569
Other assets 117 49
-------- -------
Total assets $ 71,314 $ 9,866
======== =======
Current liabilities:
Accounts payable $ 857 $ 2,002
Accrued expenses 2,668 1,798
Deferred revenues 4,904 2,106
Current portion of long term debt -- 70
-------- -------
Total current liabilities 8,429 5,976
Non-current liabilities 133 --
Long term debt -- 70
Redeemable, Convertible Preferred Stock (5,737,000
shares authorized):
Series A; $.001 par value; none issued or outstanding and
3,650,000 issued and outstanding; (liquidation preference
$1 per share) -- 3,621
Series B; $.001 par value; none issued or outstanding and
2,087,000 issued and outstanding (liquidation preference
$2.53 per share) -- 5,257
Stockholders' equity (deficit):
Common stock, $.001 par value, 50,000,000 shares
authorized, 16,877,000 and 7,921,000 issued and
outstanding, respectively 17 8
Additional paid-in capital 72,107 695
Deferred compensation (842) (571)
Cumulative adjustment for currency revaluation (36) --
Accumulated deficit (8,494) (5,190)
-------- -------
Total stockholders' equity (deficit) 62,752 (5,058)
-------- -------
Total liabilities and stockholders' equity: $ 71,314 $ 9,866
======== =======
</TABLE>
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<PAGE> 5
ISS GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands)
<TABLE>
<CAPTION>
For the Nine Months ended
September 30,
---------------------------------
1998 1997
<S> <C> <C>
OPERATING ACTIVITIES
Net loss $ (3,305) $ (2,030)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation 803 181
Deferred compensation expense 540 -
Deferred rent 133 -
Changes in assets and liabilities:
Accounts receivable (3,296) (1,932)
Prepaid expenses and other assets (464) (165)
Accounts payable and accrued expenses (273) 1,499
Deferred revenues 2,798 1,061
-------------------------------
Net cash used in operating activities (3,064) (1,386)
INVESTING ACTIVITIES
Purchases of property and equipment (2,574) (775)
-------------------------------
Net cash used in investing activities (2,574) (775)
FINANCING ACTIVITIES
Payments on long term debt (140) (53)
Net proceeds from Redeemable, Convertible
Preferred Stock issuance - 5,253
Proceeds from exercise of stock options 184 -
Net proceeds from initial public offering 61,547 -
-------------------------------
Net cash provided by financing activities 61,591 5,200
Foreign currency impact on cash (36) -
-------------------------------
Net increase in cash and cash equivalents 55,917 3,039
Cash and cash equivalents at beginning of period 3,929 2,007
-------------------------------
Cash and cash equivalents at end of period $ 59,846 $ 5,046
===============================
SUPPLEMENTAL CASH FLOW DISCLOSURE
Interest paid $ 14 $ 4
===============================
</TABLE>
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<PAGE> 6
ISS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Significant Accounting Policies
The accompanying consolidated financial statements of ISS Group, Inc.
("ISS" or "Company") should be read in conjunction with the Company's
consolidated financial statements for the year ended December 31, 1997.
Significant accounting policies disclosed therein have not changed.
The accompanying consolidated financial statements are unaudited; however,
in the opinion of management, they include all normal recurring adjustments
necessary for a fair presentation of the consolidated financial position of
the Company at September 30, 1998 and the consolidated results of its
operations and cash flows for the nine months ended September 30, 1998 and
1997. Results of operations reported for interim periods are not
necessarily indicative of results for the entire year.
The consolidated balance sheet at December 31, 1997 has been derived from
the audited financial statements at that date but does not include all the
footnotes required by generally accepted accounting principles for complete
financial statements.
The Company's business is focused on maintaining the latest security threat
and vulnerability checks within existing products and creating new products
and services that are consistent with the Company's goal of providing an
adaptive security management approach to network security. This approach
entails continuous security risk monitoring and response to develop an
active and informed network security policy.
2. Initial Public Offering
On March 23, 1998, ISS completed an initial public offering of its Common
Stock ("the IPO"). The Company's shares are traded on the National Market
of the NASDAQ Stock Market under the ticker symbol "ISSX". A total of
3,450,000 shares were sold in the IPO, including 3,070,000 newly issued
shares by the Company and 380,000 outstanding shares sold by existing
stockholders. The Company did not receive any of the proceeds from the sale
of stock by the selling stockholders. The shares were sold to the
underwriting group in the IPO at a price of $22.00 per share which, after
underwriters' discount of $4,728,000 and offering expenses of $1,265,000,
resulted in net proceeds to ISS of $61,547,000. The proceeds of the IPO
have been used for general corporate purposes and at September 30, 1998 are
invested in short-term interest-bearing investments.
Under the conversion feature of the Company's previously outstanding
Redeemable, Convertible Preferred Stock, all of the outstanding shares of
preferred stock were automatically converted into an aggregate of 5,737,000
shares of Common Stock upon the closing of the IPO.
Additionally, the Company's repurchase rights with respect to 4,586,000
shares that were originally issued to the Company's founder in 1994 in
exchange for the assignment of technology previously developed and
distributed by the founder as shareware expired as a result of the IPO.
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<PAGE> 7
ISS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
3. Stock Option Plans
During the fourth quarter of 1997 and the first quarter of 1998, the
Company recorded deferred compensation related to stock options that were
granted in December 1997 and in January and February 1998. The amount was
determined by comparing the exercise price of the stock options to the fair
value of the Common Stock on the respective dates of grant. The fair value
for December grants was established based on the estimated price range for
the IPO as set forth in the initial filing of the Company's Registration
Statement on Form S-1 that was filed with the Securities and Exchange
Commission (the "Commission") on January 20, 1998. The fair values for
January and February 1998 grants were determined to be $20 based on the
final estimated price range contained in the Company's March 1998
pre-effective amendment to its Registration Statement for the IPO.
Deferred compensation of $811,000 in the first quarter of 1998 and $571,000
in the fourth quarter of 1997 has been reflected as a reduction of
stockholders' equity in the accompanying consolidated balance sheets. The
amounts are being charged to operations proportionately over the four-year
vesting period of the related stock options. The statements of operations
for the three months and nine months ended September 30, 1998 included
$180,000 and $540,000, respectively, of compensation expense related to
such amortization.
4. Loss per share
Basic and diluted historical net loss per share was computed by dividing
net loss plus accretion of the Series A and Series B Redeemable,
Convertible Preferred Stock by the weighted average number of shares of
Common Stock outstanding. Common Stock equivalents were antidilutive and
therefore were not included in the computation of weighted average shares
used in computing diluted loss per share.
Pro forma loss per share was computed by dividing net loss by the weighted
average number of shares of Common Stock outstanding plus the conversion of
the Redeemable, Convertible Preferred Stock into 5,737,000 shares of Common
Stock as of the later of (i) the beginning of each period reported or (ii)
the date of issuance of such preferred stock, instead of the date when such
shares of preferred stock automatically converted into Common Stock (which
occurred on March 27, 1998).
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<PAGE> 8
ISS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The following tables set forth the computation of basic, diluted and
unaudited pro forma net loss per share for the three months and nine months
ended September 30:
<TABLE>
<CAPTION>
THREE MONTHS ENDED SEPTEMBER 30
1998 1997
------------ -------------
<S> <C> <C>
Numerator:
Net loss $ (583,000) $ (1,026,000)
Accretion of Series A and Series B Redeemable,
Convertible Preferred Stock -- (3,000)
------------ -------------
$ (583,000) $ (1,029,000)
Denominator:
Denominator for basic and diluted net loss per
share - weighted average shares 16,879,000 7,911,000
Redeemable, Convertible Preferred Stock 5,737,000
-------------
Weighted average shares for pro forma net loss per
share 13,648,000
Basic net loss per share $ (0.03) $ (0.13)
Diluted net loss per share $ (0.03) $ (0.13)
Pro forma net loss per share $ (0.03) $ (0.08)
</TABLE>
<TABLE>
<CAPTION>
NINE MONTHS ENDED SEPTEMBER 30
1998 1997
------------ ------------
<S> <C> <C>
Numerator:
Net loss $ (3,305,000) $ (2,030,000)
Accretion of Series A and Series B Redeemable
Convertible Preferred Stock -- (8,000)
------------ ------------
$ (3,305,000) $ (2,038,000)
Denominator:
Denominator for basic and diluted net loss per
share - weighted average shares 14,162,000 7,905,000
Redeemable, Convertible Preferred Stock 1,742,000 5,215,000
------------ ------------
Weighted average shares for pro forma net loss per
share 15,904,000 13,294,000
Basic net loss per share $ (0.23) $ (0.26)
Diluted net loss per share $ (0.23) $ (0.26)
Pro forma net loss per share $ (0.21) $ (0.15)
</TABLE>
Options aggregating 2,525,000 and 1,157,000 at September 30, 1998 and September
30, 1997, respectively are not included in the above calculations as they are
anti-dilutive.
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<PAGE> 9
ISS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
5. Commitments & Contingencies
In the first quarter of 1998, ISS entered into a noncancellable operating
lease for new headquarters and research and development facilities in
Atlanta, Georgia. The lease expires in June 2002 and provides for minimum
annual lease payments of approximately $842,000.
On July 7, 1998, Network Associates, Inc. ("Network Associates"), a
competitor of the Company, filed a patent infringement suit against ISS in
the Federal District Court for the Northern District of California. This
suit alleges that ISS' product, RealSecure, violates certain patent claims
issued for Network Associates' intrusion detection technology. ISS believes
the lawsuit is without merit, and intends to defend against it vigorously.
However, there can be no assurance that the Network Associates lawsuit will
not have or result in a material adverse effect on the Company's business,
operating results or financial condition. See also Exhibit 99 to this
Quarterly Report on Form 10-Q.
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<PAGE> 10
ISS GROUP, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS 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
contained herein, the matters discussed in this Quarterly Report on Form 10-Q
may be considered "forward-looking" statements within the meaning of Section 27A
of the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. Such statements include declarations regarding
the intent, belief or current expectations of the Company and its management.
Prospective investors are cautioned that any such forward-looking statements are
not guarantees of future performance and involve a number of risks and
uncertainties. Actual results could 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 included under Exhibit 99 at the end of this
Quarterly Report on Form 10-Q, as well as the risk factors identified in the
Company's Registration Statement on Form S-1 as filed with the Securities and
Exchange Commission ("the Commission") and available at the Commission's Web
site at www.sec.gov.
OVERVIEW
Internet Security Systems ("ISS" or "the Company") is the leading provider of
network security monitoring, detection and response software that protects the
security and integrity of enterprise information systems, according to various
market share reports, including a July 1998 report by The Yankee Group. The
Company's products rely on an innovative Adaptive Security Management ("ASM")
approach to network security which entails continuous security risk monitoring
and responses to develop an active and informed network security policy.
The Company continues to generate a substantial portion of its revenues from the
license and related maintenance of its SAFEsuite products. The Company has also
derived a portion of its revenues from responses to customer requests for
training and implementation services, typically billed on a time-and-materials
basis, to assist in the successful deployment of its products within customer
networks, development of customers' security policies and assessment of security
policy decisions. The Company believes that each of its current products and
products in development, together with professional services, will represent
important revenue sources in the future.
The market for the Company's products has recently emerged and studies indicate
that substantial growth may occur in this market. The ability of the Company to
sustain a leading position in its market is critical to its long-term success.
The Company's prospects must be considered in light of the risks, expenses and
difficulties frequently encountered by companies in the early stage of
development, particularly companies in new and rapidly evolving markets. There
can be no assurance that the Company will be successful in addressing such risks
or difficulties or that ISS will achieve profitability in the future. See the
risk factors included as Exhibit 99 to this Quarterly Report on Form 10-Q
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<PAGE> 11
ISS GROUP, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (Continued)
RESULTS OF OPERATIONS
The following table sets forth certain consolidated historical operating
information for the Company, as a percentage of total revenues, for the three
months and nine months ended September 30, 1998 and 1997.
<TABLE>
<CAPTION>
Three months ended Nine months ended
September 30 September 30
1998 1997 1998 1997
---- ---- ---- ----
<S> <C> <C> <C> <C>
Licenses 69.9% 79.7% 74.6% 81.1%
Subscriptions 22.8% 19.9% 21.1% 18.6%
Professional services 7.2% .4% 4.4% .3%
--------------------------------------------------------------
Total revenues 100.0% 100.0% 100.0% 100.0%
--------------------------------------------------------------
Costs of revenues 16.5% 5.1% 13.0% 4.8%
Research and development 26.9% 25.8% 26.3% 23.4%
Sales and marketing 59.7% 87.8% 68.8% 85.4%
General and administrative 11.1% 12.8% 13.7% 12.7%
--------------------------------------------------------------
Total costs and expenses 114.3% 131.4% 121.8% 126.3%
--------------------------------------------------------------
Operating loss (14.3)% (31.4)% (21.8)% (26.3)%
Interest income, net 8.1% 1.9% 7.3% 2.0%
--------------------------------------------------------------
Net loss (6.2)% (29.5)% (14.5)% (24.3)%
--------------------------------------------------------------
</TABLE>
REVENUES
The Company's revenues increased 172% to $9,430,000 for the three months ended
September 30, 1998 and 173% to $22,834,000 on a year-to date basis compared with
the same periods in the prior year. Perpetual license revenues continued to be
the primary source of revenue generation, but decreased as a percentage of total
revenues from approximately 80% and 81% of revenues in the three months and nine
months ended September 1997, respectively, to 70% and 75% in the three months
and nine months ended September 30, 1998, respectively. The Company's suite of
product offerings continues to provide increased product diversification,
especially due to significant increases in the sale of licenses for RealSecure,
the Company's network-based intrusion detection product offering. While sales of
licenses for Internet Scanner continued to grow and accounted for the majority
of license revenues, it decreased from 78% of new license revenues in the three
months ended September 30, 1997 to 57% of revenues in the three months ended
September 30, 1998.
Subscriptions revenues, consisting of maintenance and annual licenses of product
usage, accounted for 23% and 21% of total revenues in the three month and nine
month periods ended September 30, 1998, respectively. Professional services is
the smallest category of revenue but has grown from less than 1% of revenues
throughout 1997 to 7% of revenues in the three months ended September 30, 1998,
due primarily to continuation of the Company's 1998 initiative to
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<PAGE> 12
ISS GROUP, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (Continued)
build its capabilities to address the demand from its customers for
implementation, training and consultative services.
Geographically, the majority of the Company's revenues were from sales to
customers within North America; however, international operations continued to
be a significant contributor to revenues as revenues from customers outside of
North America represented 19% of revenues in the first nine months of 1998,
compared to 21% of total revenues for the full year in 1997.
COSTS AND EXPENSES
Costs of revenues include packaging and distribution costs for the Company's
software products which, since the Company uses the Internet to provide product
updates and keys necessary to activate a customer's software, is a minor cost.
The category also includes the costs related to the Company's professional
services offerings, which were provided by a dedicated employee group. During
1998, expenses included the recruitment and compensation of a professional
services management team and a larger billable consulting staff. As a result,
the growth in professional services revenues as a percentage of total revenues
during 1998 caused gross margin, represented by total revenues less costs of
revenues, to trend downward to 83% of total revenues for the three months ended
September 30, 1998 from 95% for the three months ended September 30, 1997.
Research and development expenses consist of salary and related costs of
research and development personnel, including costs for employee benefits,
depreciation on computer equipment and support services used in product and
technology development. This includes the "X-Force," a team composed of security
experts dedicated to understanding, documenting and coding new vulnerability
checks, real-time threats and attack signatures and developing solutions to
address global security issues. ISS continued to increase these expenditures as
it perceives primary research and product development as essential ingredients
for retaining its leadership position in its market. Additionally, the Company
began development efforts in connection with OEM arrangements that were entered
into during the third quarter of 1998 for which no revenues have yet been
generated. Accordingly, research and development expenses increased from
$895,000, or 26% of revenues, in the quarter ended September 30, 1997 to
$2,541,000, or 27% of revenues, in the comparable quarter in 1998. On a
year-to-date basis, research and development expenses increased 207% to
$6,009,000 in 1998 from $1,957,000 in 1997. These increases were due, in
principal part, to increases in research and personnel in Atlanta and the
establishment of a development team in Mountain View, California during the
first quarter of 1998.
Sales and marketing expenses consist primarily of salaries, travel expenses,
commissions, advertising, maintenance of the ISS Web site, trade show expenses,
personnel recruiting costs and costs of marketing materials. Sales and marketing
expenses continued to increase in absolute dollars, but showed leverage in the
quarter ended September 30, 1998 as a higher percentage of the ISS enterprise
sales force had been employed by ISS for a sufficient period of time to achieve
productivity. In the quarter ended September 30, 1998 sales and marketing
expenses were $5,632,000, or 60% of revenues, compared with $3,051,000, or 88%
of revenues, in the quarter ended September 30, 1997. For the nine months ended
September 30, these expenses totaled $15,711,000, or 69% of revenues, in 1998
compared with $7,147,000, or 85% of revenues, in 1997. The dollar increases
have occurred principally from higher personnel head counts, which have
increased each quarter since early 1997 both domestically and internationally.
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<PAGE> 13
ISS GROUP, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (Continued)
General and administrative expenses in the quarter ended September 30, 1998
increased to $1,046,000 from $443,000 in the comparable quarter in 1997. For the
nine months ended September 30 these expenses totaled $3,127,000 in 1998 and
$1,064,000 in 1997. Such expenses included salaries and other personnel-related
costs for the Company's executive, administrative, finance and human resources
personnel, support services and professional services fees. In the first half of
1998, the Company successfully implemented upgrades to its internal financial
reporting systems and expects to continue these efforts to enhance management's
ability to obtain and analyze information about its domestic and international
operations. In addition, ISS incurred approximately $250,000 of expense in the
first half of 1998 in connection with the Company's relocation of its
headquarters and research and development facilities to a new location in
Atlanta. Also, in the first nine months of 1998 the Company incurred
approximately $540,000 of amortization of deferred compensation related to the
valuation of stock options to employees and directors granted around the time of
the Company's initial public offering of shares of Common Stock in March 1998
(the "IPO"), the majority of which is recorded in the general and administrative
expense category.
No provision for federal, state or foreign income taxes has been recorded
because the Company had a net loss for the 1997 and 1998 periods. The Company
has not recognized any benefit from the future use of loss carryforwards for
these periods or any other periods since inception because management's
evaluation of all the available evidence in assessing the realizability of the
tax benefits of such loss carryforwards indicates that the underlying
assumptions of future profitable operations contain risks that do not provide
sufficient assurance to recognize such benefits currently.
CAPITAL RESOURCES AND LIQUIDITY
Net cash used in operations in the first nine months of 1998 of $3,064,000
resulted from the net loss of $3,305,000 in the period offset by non-cash
expense charges plus an increase in working capital. Accounts receivable
increased by $3,296,000 at September 30, 1998 commensurate with the growth in
the Company's business, which was largely offset by an increase of $2,798,000 in
the deferred revenue account balance. The increase in deferred revenue was due
to growth in annual maintenance contracts, the upfront billing of multi-year
maintenance arrangements with certain customers and growth in term licenses.
Investment in equipment totaled $2,574,000 in the first nine months of 1998 as
ISS provided existing and new personnel with the necessary hardware and software
tools to perform their job. This included a new telephone switch and engineering
lab equipment installed at the time of the relocation of the Company to its new
headquarters facilities.
Cash provided by financing activities of $61,592,000 was primarily the result of
the IPO that was consummated in March 1998. Additionally, upon consummation of
the IPO, all shares of the Company's Convertible, Redeemable Preferred Stock
automatically converted into shares of ISS Common Stock, removing the
possibility of any redemption requirements in the future with respect to such
shares.
As of September 30, 1998, the Company had $59,846,000 of cash and cash
equivalents, consisting primarily of money market accounts and short-term,
commercial paper carrying the highest investment grade rating. The Company
believes that these investments will be sufficient to fund its anticipated
operating losses and to meet its working capital needs and capital expenditures
for the foreseeable future. On October 6, 1998, the Company used $4,750,000 in
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<PAGE> 14
ISS GROUP, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (Continued)
cash to acquire March Information Systems, Limited. The Company expects to
evaluate other acquisition and joint venture opportunities from time to time
although there any no other current agreements or negotiations with respect to
any such transactions that would utilize any significant amount of the Company's
cash. In the event ISS determines to pursue such opportunities, it may use its
available cash and cash equivalents. Pending such uses, cash will continue to be
invested in short-term, investment grade, interest-bearing investments.
Year 2000
The Company believes that the purchasing patterns of customers and potential
customers may be affected by Year 2000 issues. Many companies are expending
significant resources to correct, patch or replace their current software
systems to achieve Year 2000 compliance. These expenditures may result in
reduced funds available to purchase products and services offered by the
Company. Other potential customers may also defer purchasing Year 2000 compliant
products until they believe it is absolutely necessary, thus resulting in
potentially deferred sales. Conversely, Year 2000 issues may cause other
companies to accelerate purchases of the Company's products. In addition to
identifying potential security weaknesses that may be caused by Year 2000
programming efforts, the Company's products can reduce the exposure of customer
networks to security weaknesses, thereby reducing the uncertainty of whether
problems that might occur upon the arrival of Year 2000 are due to security
breaches or non compliant software programs. These Year 2000 issues could
materially affect the Company's business, financial condition and results of
operations.
The Company has reviewed its products offered to customers and believes that
these products are designed to properly function through and beyond the year
2000. Furthermore, because the nature of the Company's products require
customers to use the current version of the product to obtain the value that the
software is intended to provide, the Company only supports the current and the
next most recently released version of its products. While the Company has
conducted tests of its software and asserted compliance to its customers, there
can be no absolute assurance that the Company's products contain all date code
changes necessary to ensure Year 2000 compliance, particularly when such
products incorporate third party software.
In addition, the Company relies to a significant extent upon several internal
management and other information systems that are used to monitor and operate
the business. Since the Company has experienced most of its growth in systems
and personnel since January 1, 1997, purchases and upgrades of systems have
occurred principally during that period. Internal systems for financial, human
resources and sales reporting, as well as telephone, voice mail and other office
support systems, have all been purchased during 1998 and are reflected in either
the balance sheet as property and equipment or expensed under Company policy.
The selection process of these systems included ascertaining Year 2000
compliance.
The Company is in the process of contacting providers of various tools used in
its product development process and the providers of desktop systems, primarily
Microsoft, to determine that these systems (such as NT and Windows 98) will be
Year 2000 compliant with appropriate fixes. The Company does not depend on any
suppliers or manufacturers whose failure to be Year 2000 compliant would have
any significant impact on the Company's financial condition or results of
operations. The Company expects to complete its Year 2000 project for these
remaining items by the middle of 1999. The Company does not expect to expend any
significant funds to correct Year 2000 issues. Any minor expenses will be funded
through operating cash flows.
-14-
<PAGE> 15
ISS GROUP, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (Continued)
Based on available information, the Company does not believe any material
exposure to significant business interruptions exists as a result of Year 2000
compliance issues, or that the cost of remedial actions will have a material
adverse effect on its business, financial condition or results of operations.
Accordingly, the Company has not adopted any formal contingency plan in the
event its Year 2000 compliance project is not completed in a timely manner.
Subsequent event - Acquisition of March Information Systems Limited
On October 6, 1998, the Company acquired privately held March Information
Systems, a United Kingdom-based developer of Windows NT and Unix-based security
assessment technologies. Under the terms of the agreement, ISS acquired all of
the outstanding stock of March Information Systems in exchange for $4.75 million
in cash and 120,000 shares of the Company's common stock. The transaction has
been accounted for using the purchase method of accounting and the results of
March Information Systems will be included in future results of the Company from
October 6, 1998, the closing date of the transaction. In its most recent fiscal
year ended March 31, 1998 March Information Systems reported revenues of
approximately $2 million.
-15-
<PAGE> 16
ITEM 1. LEGAL PROCEEDINGS
On July 7, 1998, Network Associates, Inc. ("Network Associates"), a
competitor of the Company, filed a patent infringement suit against ISS in
the Federal District Court for the Northern District of California. This
suit alleges that ISS' product, RealSecure, violates certain patent claims
issued for Network Associates' intrusion detection technology. ISS believes
the lawsuit is without merit, and intends to defend against it vigorously.
However, there can be no assurance that the Network Associates lawsuit will
not have or result in a material adverse effect on the Company's business,
operating results or financial condition.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
(d) Use of Proceeds.
(1) On March 23, 1998 the Company's Registration Statement on Form
S-1, SEC Registration No. 333-44529 was declared effective by
oral order of the SEC. Net proceeds to the Company from the
Offering were $61,547,200. Through September 30, 1998, the
Company used $1,701,000 of the proceeds from the offering for
general corporate purposes, including working capital. The
remaining $59,846,000 of proceeds remains in temporary
investments consisting of money market accounts available on a
daily basis and short-term commercial paper.
ITEM 6. EXHIBITS AND REPORTS ON FORM 10-Q
(a) Exhibits.
27 Financial Data Schedule (for SEC use only).
99 Private Securities Litigation Reform Act of 1995 Safe Harbor
Compliance Statements for Forward-Looking Statements
-16-
<PAGE> 17
ISS GROUP, 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.
ISS GROUP, INC.
(Registrant)
Date: November 13, 1998 By /s/ Richard Macchia
------------------- --------------------------------------------
Chief Financial Officer
(Principal Financial and Accounting Officer)
-17-
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS OF ISS GROUP, INC. AS OF AND FOR THE
NINE MONTHS ENDED SEPTEMBER 30, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<CURRENCY> U.S. DOLLARS
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<EXCHANGE-RATE> 1
<CASH> 59,846
<SECURITIES> 0
<RECEIVABLES> 7,592
<ALLOWANCES> 258
<INVENTORY> 0
<CURRENT-ASSETS> 67,857
<PP&E> 4,545
<DEPRECIATION> 1,205
<TOTAL-ASSETS> 71,314
<CURRENT-LIABILITIES> 8,429
<BONDS> 0
0
0
<COMMON> 17
<OTHER-SE> 0
<TOTAL-LIABILITY-AND-EQUITY> 62,735
<SALES> 0
<TOTAL-REVENUES> 22,834
<CGS> 0
<TOTAL-COSTS> 27,811
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 14
<INCOME-PRETAX> (3,305)
<INCOME-TAX> 0
<INCOME-CONTINUING> (3,305)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (3,305)
<EPS-PRIMARY> (.23)
<EPS-DILUTED> (.23)
</TABLE>
<PAGE> 1
EXHIBIT 99
Private Securities Litigation Reform Act of 1995
Safe Harbor Compliance Statement for Forward-Looking Statements
In passing the Private Securities Litigation Reform Act of 1995 (the "Reform
Act"), Congress encouraged public companies to make "forward-looking statements"
by creating a safe-harbor to protect companies from securities law liability in
connection with forward-looking statements. ISS Group, Inc. ("ISS") intends to
qualify both its written and oral forward-looking statements for protection
under the Reform Act.
In addition to the other information in this Quarterly Report on Form 10-Q,
stockholders should carefully consider the following factors in evaluating the
Company and its business, as well as the Risk Factors set forth in the Company's
Registration Statement on Form S-1 as filed with the Securities and Exchange
Commission on March 23, 1998.
To qualify oral forward-looking statements for protection under the Reform Act,
a readily available written document must identify important factors that could
cause actual results to differ materially from those in the forward-looking
statements. ISS provides the following information in connection with its
continuing effort to qualify forward-looking statements for the safe harbor
protection of the Reform Act.
SIGNIFICANT POTENTIAL FLUCTUATIONS IN FUTURE OPERATING RESULTS
The Company's future revenues and operating results are uncertain and
are expected to fluctuate from quarter to quarter and from year to year due to a
combination of factors, including the level of demand for the Company's
products, the volume and timing of orders, product and price competition, the
Company's ability to expand its domestic and international sales and marketing
organizations, the Company's ability to successfully integrate businesses and
products that it acquires with the Company's operations and product line; the
Company's ability to develop new and enhanced products, the Company's ability to
attract and retain personnel, including personnel at acquired businesses; the
mix of distribution channels through which the Company's products are sold, the
growth in the acceptance of, and use of the Internet and private Internet
protocol ("IP") networks or "intranets"; the extent to which unauthorized access
and use of online information is perceived as a threat to network security,
customer budgets, the assertion of infringement claims with respect to the
Company's intellectual property, seasonal trends in customer purchasing, foreign
currency exchange rates, general economic factors in domestic and international
markets; and risks concerning the rapid change in technology. As the Company
increasingly focuses on sales of the Company's product suite rather than
individual products, the Company expects that the sales cycle associated with
the purchase of the Company's products will lengthen. In addition, the amount of
revenues associated with particular licenses can vary significantly based upon
the number of products that are licensed and the number of devices involved in
the installation. The Company has experienced, and may continue to experience
from time to time, large individual license sales which can cause significant
variations in quarterly license revenues. Moreover, small delays in customer
orders can cause significant variability in the Company's license revenues and
results of operations for any particular period. As a result, the timing of
significant orders is unpredictable and, like many software companies, the
Company typically realizes a significant portion of its software license
revenues in the last month of a quarter. The Company establishes its expenditure
levels for product development, sales and marketing and other operating expenses
based, in large part, on its expected future revenues. As a result, if revenues
fall below expectations, operating results and net income are likely to be
adversely and disproportionately affected because only a small portion of the
Company's expenses vary with its revenues.
<PAGE> 2
LIMITED OPERATING HISTORY
The Company has only a limited operating history upon which an
evaluation of the Company and its prospects can be based and is subject to all
of the risks inherent in the establishment of an emerging business enterprise.
The Company has never achieved profitability, nor does the Company expect to
achieve profitability in the foreseeable future.
COMPETITION
The market for security monitoring, detection and response products and
services is intensely competitive and the Company expects competition to
increase further in the future. There can be no assurance that the Company can
maintain its competitive position against current and potential competitors,
especially those with significantly greater financial, marketing, service,
support, technical and other competitive resources.
RAPID TECHNOLOGICAL CHANGE AND NEW PRODUCTS
The market for the Company's products is characterized by rapid
technological advances, including by those seeking to establish more secure
systems and those seeking to compromise such systems, evolving industry
standards in computer hardware and software technology, changes in customer
requirements and frequent new product introductions and enhancements. As a
result, the Company must continually change and improve its products in response
to changes in operating systems, application and networking software, computer
and communications hardware, programming tools and computer language technology.
INTEGRATION OF RECENT ACQUISITION; POTENTIAL FUTURE ACQUISITIONS
In October 1998, the Company acquired privately-held March Information
Systems, a United Kingdom-based developer of Windows NT and Unix-based security
assessment technologies ("March"). The success of this acquisition depends
primarily on the Company's ability to (i) retain, motivate and integrate the
acquired personnel with the Company's operations; (ii) integrate multiple
information systems; and (iii) integrate acquired software with the Company's
SAFEsuite family of products. No assurance can be given that the Company will
not encounter difficulties in integrating the operations and products of March
with those of the Company, or that the benefits expected from such integration
will be realized. Failure to successfully integrate March's operations and
products into the Company's operations and products could have a material
adverse effect on the Company's business, operating results and financial
condition.
The Company may in the future pursue additional acquisitions of
businesses, products and technologies, or enter into joint venture arrangements,
that could complement or expand the Company's business. The negotiation of
potential acquisitions or joint ventures as well as the integration of an
acquired business, product or technology could cause diversion of management's
time and resources. Future acquisitions by the Company could result in
potentially dilutive issuances of equity securities, the incurrence of debt and
contingent liabilities, amortization of goodwill and other intangibles, research
and development write-offs and other acquisition-related expenses. Further, no
assurances can be given that any acquired business will be successfully
integrated with the Company's operations. If any such acquisition were to occur,
there can be no assurance that the Company will receive the intended benefits of
the acquisition. Further acquisitions, whether or not consummated, could have a
material adverse effect on the Company's business, operating results and
financial condition.
<PAGE> 3
INTELLECTUAL PROPERTY RIGHTS; USE OF LICENSED TECHNOLOGY
The Company relies primarily on a combination of copyright and
trademark laws, trade secrets, confidentiality procedures and contractual
provisions to protect its proprietary rights. The Company also believes that
factors such as the technological and creative skills of its personnel, new
product developments, frequent product enhancements, name recognition and
reliable product maintenance are essential to establishing and maintaining a
technology leadership position.
Although the Company is not aware that any of its products infringes
the proprietary rights of third parties, there can be no assurance that third
parties will not claim infringement by the Company with respect to current or
future products and, in fact, a competitor of the Company has filed a complaint
alleging infringement of its patents by the Company's intrusion detection
technology. The Company is vigorously defending this suit, and although the
Company believes that the claims asserted are without merit, there can be no
assurance that the Company will prevail in this suit or, if the Company does not
prevail, that no material adverse effect to the Company's results of operations
will result. The Company expects that software product developers will
increasingly be subject to infringement claims as the number of products and
competitors in the Company's industry segment grows and the functionality of
products in different industry segments overlaps. Any such claims, with or
without merit, could be time consuming, distract management attention, result in
costly litigation, cause product shipment delays or require the Company to enter
into royalty or licensing agreements. Such royalty or licensing agreements, if
required, may not be available on terms acceptable to the Company or at all,
which could have a material adverse effect upon the Company's business,
operating results and financial condition.
RISKS ASSOCIATED WITH THE EMERGING MARKET FOR SECURITY PRODUCTS
The market for the Company's products is rapidly evolving. There can be
no assurance that Internet protocols will continue to be used to facilitate
communications or that the market for security monitoring, detection and
response systems in general will continue to expand. If the market for products
to monitor Internet and intranet security fails to grow or grows more slowly
than the Company currently anticipates, the Company's business, operating
results and financial condition would be materially and adversely affected.
OTHER RISK FACTORS
In addition to the above-referenced items, the Company's business,
financial condition and results of operations may be affected by (i) risks
associated with its international operations, (ii) the Company's reliance on
indirect distribution channels, (iii) current product concentration, (iv) the
Company's dependence on key personnel, (v) management of growth, (vi) the
Company's inability to provide complete protection with respect to its
proprietary intellectual property, (vii) potential product liability or product
defects, (viii) the risk of targeted attacks against the Company and (ix)
government regulation of the Company's products. For a more complete description
of these risks, stockholders and others are encouraged to review the section
captioned "Risk Factors" in the Company's Registration Statement on Form S-1 as
filed with the Securities and Exchange Commission on March 23, 1998.
