<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, 1999
--------------------------------------
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
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Commission File Number
---------------
ISS GROUP, 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.)
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.
Number of Shares Outstanding
Title of each class as of October 22, 1999
------------------------------ ----------------------------
Common Stock, $0.001 par value 40,626,751
<PAGE> 2
<TABLE>
<CAPTION>
PAGE
PART I. FINANCIAL INFORMATION NUMBER
------
<S> <C> <C>
Item 1 Consolidated Financial Statements:
Consolidated Statements of Operations for the Three Months
and Nine Months ended September 30, 1999 and September 30, 1998.....................3
Consolidated Balance Sheets at September 30, 1999 and
December 31, 1998...................................................................4
Consolidated Statements of Cash Flows for the Nine
Months ended September 30, 1999 and September 30, 1998..............................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 1 Legal Proceedings..................................................................16
Item 2 Changes in Securities and Use of Proceeds..........................................16
Item 6 Exhibits and Reports on Form 10-Q..................................................16
</TABLE>
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<PAGE> 3
ISS GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------ ---------------------
1999 1998 1999 1998
----------- -------- -------- -------
<S> <C> <C> <C> <C>
Revenues:
Product licenses and sales $ 19,200 $ 8,335 $ 51,264 $ 23,146
Subscriptions 6,202 3,312 16,582 8,070
Professional services 4,599 2,165 12,409 4,897
----------- -------- -------- --------
30,001 13,812 80,255 36,113
Costs and expenses:
Cost of revenues:
Product 5,055 1,419 12,529 4,984
Subscription and service 4,801 3,068 13,051 7,355
----------- -------- -------- --------
Total cost of revenues 9,856 4,487 25,580 12,339
Research and development 5,315 2,616 14,162 6,247
Sales and marketing 10,991 6,511 30,589 18,040
General and administrative 2,105 1,456 6,556 4,491
Merger costs 2,329 -- 2,329 --
Amortization 247 -- 746 --
----------- -------- -------- --------
30,843 15,070 79,962 41,117
Operating income (loss) (842) (1,258) 293 (5,004)
Interest income, net 1,640 730 4,014 1,618
----------- -------- -------- --------
Income (loss) before income taxes 798 (528) 4,307 (3,386)
Provision for income taxes (105) -- (311) --
----------- -------- -------- --------
Net income (loss) $ 693 $ (528) $ 3,996 $ (3,386)
=========== ======== ======== ========
Basic net income (loss) per share of Common Stock $ 0.02 $ (0.01) $ 0.10 $ (0.11)
=========== ======== ======== ========
Diluted net income (loss) per share of Common Stock $ 0.02 $ (0.01) $ 0.09 $ (0.11)
=========== ======== ======== ========
Weighted average number of shares:
Basic 40,582 36,343 39,710 30,909
=========== ======== ======== ========
Diluted 43,946 36,343 43,437 30,909
=========== ======== ======== ========
Unaudited pro forma net loss per share of
Common Stock $ (0.10)
========
Unaudited weighted average number of shares used in
calculating unaudited pro forma net loss per share of Common Stock 34,393
========
</TABLE>
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<PAGE> 4
ISS GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(amounts in thousands, except share amounts)
<TABLE>
<CAPTION>
September 30, 1999 December 31, 1998
------------------ -----------------
(Unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $134,451 $52,921
Restricted cash -- 135
Accounts receivable, less allowance for doubtful accounts
of $644 and $412, respectively 22,864 16,590
Inventory 487 48
Prepaid expenses and other current assets 2,107 806
-------- -------
Total current assets 159,909 70,500
Property and equipment:
Computer equipment 9,283 5,706
Office furniture and equipment 4,469 3,139
Leasehold improvements 862 565
-------- -------
14,614 9,410
Less accumulated depreciation 6,095 3,265
-------- -------
8,519 6,145
Goodwill, less accumulated amortization of $317
and $77, respectively 2,854 3,094
Other intangibles, less accumulated amortization of $658
and $154, respectively 4,187 4,692
Other assets 510 293
-------- -------
Total assets $175,979 $84,724
======== =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 4,077 $ 3,149
Accrued expenses 5,735 4,941
Deferred revenues 14,917 8,333
Current portion of long-term debt and capital leases obligations 607 470
Other current liabilities 210 450
-------- -------
Total current liabilities 25,546 17,343
Long-term debt, including capital lease obligations 516 742
Non-current liabilities 94 134
-------- -------
Total liabilities 26,156 18,219
Stockholders' equity:
Common stock, $.001 par value, 120,000,000 shares authorized,
40,625,000 and 37,169,000 issued and outstanding,
respectively 41 37
Additional paid-in captial 155,813 76,152
Deferred compensation (382) (662)
Cumulative adjustment for currency revaluation 13 142
Accumulated deficit (5,662) (9,164)
-------- -------
Total stockholders' equity 149,823 66,505
======== =======
Total liabilities and stockholders' equity $175,979 $84,724
======== =======
</TABLE>
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<PAGE> 5
ISS GROUP, INC.
Consolidated Statements of Cash Flows
(amounts in thousands)
(unaudited)
<TABLE>
<CAPTION>
Nine Months ended
-----------------------------
9/30/99 9/30/98
---------- ----------
(restated)
<S> <C> <C>
OPERATING ACTIVITIES
Net income (loss) $ 3,996 $ (3,386)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation 2,807 1,427
Amortization 746 --
Deferred compensation expense 280 540
Other non-cash expense (36) 133
Changes in assets and liabilities:
Accounts receivable (6,171) (3,362)
Inventory (439) 132
Prepaid expenses and other assets (1,501) (530)
Accounts payable and accrued expenses 1,676 (135)
Deferred revenues and customer deposits 6,584 2,907
-------- --------
Net cash provided by (used in) operating activities 7,942 (2,274)
INVESTING ACTIVITIES
Purchases of property and equipment (4,787) (3,094)
-------- --------
Net cash used in investing activities (4,787) (3,094)
FINANCING ACTIVITIES
Net proceeds from (payments on) long term debt (193) 222
Net borrowings (payments) under line of credit 210 (125)
Payments on long term debt and capital leases (200) (266)
Capital transactions of merged entity (972) (202)
Proceeds from exercise of stock options 2,262 185
Net proceeds from secondary and initial public offering 77,397 61,547
-------- --------
Net cash provided by financing activities 78,504 61,361
Foreign currency impact on cash (129) (36)
-------- --------
Net increase in cash and cash equivalents 81,530 55,957
Cash and cash equivalents at beginning of period 52,921 4,174
-------- --------
Cash and cash equivalents at end of period $134,451 $ 60,131
======== ========
SUPPLEMENTAL CASH FLOW DISCLOSURE
Interest paid $ 82 $ 79
======== ========
Capital lease obligations incurred during the period $ 304 $ 274
======== ========
</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 the "Company") should be read in conjunction with the Company's
consolidated financial statements for the year ended December 31, 1998.
ISS' goal is to provide an adaptive security management solution to
network security. This approach entails continuous security risk
monitoring and response to develop an active and informed network security
policy. Our business includes maintaining the latest security threat and
vulnerability checks within existing products and creating new products
and services that are consistent with this approach.
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, 1999 and the
consolidated results of its operations and cash flows for the nine months
ended September 30, 1999 and 1998. Results of operations reported for
interim periods are not necessarily indicative of results for the entire
year.
The consolidated balance sheet at December 31, 1998 has been derived from
the audited financial statements of ISS and Netrex, Inc. at that date but
does not include all the footnotes required by generally accepted
accounting principles for complete financial statements.
The Company's significant accounting policies have not changed since
December 31, 1998; however, the operating results of ISS include the
operations of Netrex, Inc. (see Business Combination footnote below).
Therefore, the policies for revenue recognition and cost of sales are
presented below to include the operations of Netrex:
Revenue Recognition
Product licenses and sales include ISS perpetual licenses and Netrex
product sales. Perpetual license revenues are recognized upon (i) delivery
of software or, if the customer has evaluation software, delivery of the
software key, and (ii) issuance of the related license, assuming no
significant vendor obligations or customer acceptance rights exist. For
perpetual license agreements when payment terms are extended over periods
greater than 12 months, revenue is recognized as such amounts are
billable. Netrex product sales consist of software developed by
third-party partners, combined in some instances with associated hardware
appliances and partner maintenance services. These sales are recognized
upon shipment to the customer.
Subscription revenues include maintenance, term licenses and managed
services. Annual renewable maintenance is a separate component of ISS
perpetual license agreements with revenues recognized ratably over the
maintenance contract term. Term licenses allow customer use of the product
and maintenance for a specified period, generally 12 months, for which
revenues are also recognized ratably over the contract term. Managed
services consist of Netrex ePatrol security monitoring services of
information assets and systems and are recognized as such services as
provided. Professional service revenues, including consulting and
training, are recognized as such services are performed.
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<PAGE> 7
ISS GROUP, INC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Cost of Revenues
Cost of revenues includes the cost of products and services. Cost of
products represents the cost of product sales due to Netrex partners. ISS
incurs this expense upon recognition of the associated product revenues.
Cost of services includes the cost of technical support groups who provide
assistance to customers with maintenance agreements, the operations center
costs of providing managed services, and the costs related to professional
services and training.
2. Business Combinations
In August 1999, ISS executed a definitive agreement to acquire privately
held Netrex, Inc. which is based in Southfield, Michigan. Founded in 1992
with a current services customer base of more than 500 customers, Netrex
is a leading provider of remote, security monitoring services of digital
assets under the ePatrol name. Upon closing the acquisition in August
1999, approximately 2,450,000 unregistered shares of ISS stock were issued
in exchange for all of the outstanding stock of Netrex. Additionally,
options outstanding under the Netrex Stock Plan were assumed by ISS
resulting in approximately 510,000 additional ISS shares being reserved
for outstanding grants under the Netrex Stock Plan. These Netrex Plan
options had exercise prices ranging from $3.15 to $5.46 per share of ISS
common stock. These options generally vest in annual or quarterly
installments over four years measured from the date of grant. The
acquisition is being accounted for using the pooling-of-interests method
of accounting. The consolidated financial statements of ISS, including
share and per share data, have been restated for all periods presented to
include the results of Netrex with all intercompany transactions with ISS
eliminated in such restatement.
Netrex was a subchapter S Corporation for reporting income taxes. In
general, the income or loss of a Subchapter S Corporation is passed
through to its stockholders rather than being subjected to taxes at the
corporate level.
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<PAGE> 8
ISS GROUP, INC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
Revenues and net income (loss) of the separate companies that includes
periods preceding the Netrex merger were as follows:
<TABLE>
<CAPTION>
Nine months ended Three months ended
September 30 September 30
---------------------- ----------------------
1999 1998 1999 1998
------- ------- ------- -------
<S> <C> <C> <C> <C>
Total revenues
ISS $51,946 $22,834 $19,011 $ 9,430
Netrex 28,309 13,279 10,990 4,382
------- ------- ------- -------
Total revenues, as reported $80,255 $36,113 $30,001 $13,812
======= ======= ======= =======
Net income (loss)
ISS $ 4,836 $(3,305) $ 1,886 $ (583)
Netrex (840) (81) (1,193) 55
------- ------- ------- -------
Combined $ 3,996 $(3,386) $ 693 $ (528)
Business combination expenses 2,329 -- 2,329 --
Pro forma income tax expense (368) -- (227) (22)
------- ------- ------- -------
Pro forma net income (loss) $ 5,957 $(3,386) $ 2,795 $ (550)
======= ======= ======= =======
</TABLE>
Pro forma net income (loss) reflects adjustments to net income (loss) to
record an estimated provision for income taxes for each period presented
assuming Netrex was a taxpaying entity and excludes merger costs.
In September 1999, ISS acquired privately-held NJH Security Consulting
("NJH"), which was based in Atlanta, Georgia. NJH is a consulting firm
focused on providing information security services to organizations
worldwide. NJH provides a technology foundation to provide an outsource
solution for the automatic detection and management of customers' security
risks using ISS software solutions. This technology is being incorporated
into the ISS ePatrol monitoring services. Upon closing the acquisition in
September 1999, approximately 142,000 unregistered shares of ISS common
stock with a value of approximately $3.9 million were issued in exchange
for all of the outstanding stock of NJH. The transaction is being
accounted for using the pooling-of-interests method of accounting;
however, this transaction was not material to ISS' consolidated operations
and financial position and, therefore, the operating results of ISS have
not been restated for this transaction. The operating results of ISS
include the results of operations of NJH since the date of acquisition.
The consolidated statements of operations include merger costs of
$2,329,000 in 1999 that represent the direct out-of-pocket costs of these
business combinations. These costs are principally investment advisor,
legal and accounting fees.
As part of the terms of these acquisitions, ISS has filed a shelf
registration statement on Form S-3 covering 724,000 shares issued in
connection with the acquisitions of Netrex and NJH, which it anticipates
will be effective in the fourth quarter of 1999.
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<PAGE> 9
ISS GROUP, INC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
3. Comprehensive Income
Comprehensive income for the quarter and nine months ended September 30,
1999 aggregated $745,000 and $4,125,000, respectively. The effects of
foreign exchange gains and losses arising from translations of assets and
liabilities of foreign operations into U.S. dollars at September 30, 1999
are included as a component of comprehensive income. Such amounts were
$52,000 and $129,000 in the quarter and nine months ended September 30,
1999, respectively.
4. Secondary Stock Offering
On March 2, 1999, ISS completed a public offering of its Common Stock (the
"Offering"). A total of 5,177,600 shares were sold in the Offering
including 2,777,600 newly issued shares by the Company and 4,400,000
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
Offering at a price of $29.50 per share which, after underwriters'
discount and offering expenses, resulted in net proceeds to ISS of
$77,397,000. The proceeds of the Offering are invested in short-term,
interest-bearing investments at September 30, 1999.
5. Income (loss) per share
On April 1, 1999, the Company's Board of Directors declared a two-for-one
stock split effected in the form of a stock dividend paid on May 19, 1999
to stockholders of record on May 5, 1999. Accordingly, all share and
income (loss) per share amounts have been retroactively restated for this
100% stock dividend.
Basic historical net income (loss) per share was computed by dividing net
income (loss) by the weighted average number of shares of Common Stock
outstanding. Diluted historical net income (loss) per share was computed
by dividing net income (loss) by the weighted average shares outstanding,
including Common Stock equivalents if dilutive. For the quarter and nine
months ended September 30, 1998, options aggregating 4,955,000 were
antidilutive and therefore were not included in the computation. For the
quarter and nine months ended September 30, 1999 weighted average shares
included 3,363,000 and 3,726,000 shares, respectively, to reflect the
dilutive impact of stock options.
Pro forma net loss per share for the nine months ended September 30, 1998
was computed by dividing the 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
January 1, 1998 instead of March 27, 1998 when such shares of preferred
stock automatically converted into Common Stock.
6. Commitments & Contingencies
On July 13, 1999 ISS and Network Associates, Inc. announced that the
patent infringement suit filed in July 1998 by Network Associates, Inc.
against Internet Security Systems, Inc. (a wholly owned subsidiary of ISS)
was resolved to the parties' mutual satisfaction. The resolution of this
previously pending litigation had no material adverse effect on the
business, operating results, or financial condition of ISS.
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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,
the matters discussed in this Quarterly Report on Form 10-Q may be considered
"forward-looking" statements. Such statements include declarations regarding
our intent, belief or current expectations. Such forward-looking statements are
not guarantees of future performance and involve a number of risks and
uncertainties. Actual results may 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 Annual Report on Form 10-K for the year ended December 31,
1998 as filed with the Securities and Exchange Commission and available at
their Web site at www.sec.gov.
OVERVIEW
We are a leading source for e-business security management solutions. Our
Adaptive Security Management approach to information security protects
distributed computing environments, such as internal corporate networks,
inter-company networks and electronic commerce environments, from attacks,
misuse and security policy violations, while ensuring the confidentiality,
privacy, integrity and availability of proprietary information. We deliver an
end-to-end security management solution through our SAFEsuite security
management platform coupled with around-the-clock remote security monitoring
through our ePatrol managed services offerings. Our SAFEsuite family of
products is a critical element of an active Internet and networking security
program within today's world of global connectivity, enabling organizations to
proactively monitor, detect and respond to risks to enterprise information.
ePatrol currently provides remote management of the industry's best-of-breed
security technology including firewalls, virtual private networks or VPNs,
anti-virus and URL filtering software, security assessment and intrusion
detection systems. We focus on serving as the trusted security provider to our
customers by maintaining within our existing products the latest
counter-measures to security risks, creating new innovative products based on
our customers' needs and providing professional and managed services.
We generate a majority of our revenues from our SAFEsuite family of products in
the form of perpetual licenses and subscriptions, and sales of best of breed
technology products developed by our partners. We recognize perpetual license
revenues from ISS developed products upon delivery of software or, if the
customer has evaluation software, delivery of the software key and issuance of
the related license, assuming that no significant vendor obligations or
customer acceptance rights exist. Where payment terms are extended over periods
greater than 12 months, revenue is recognized as such amounts are billable.
Product sales, consisting of software developed by third-party partners
combined in some instances with associated hardware appliances and partner
maintenance services, are recognized upon shipment to the customer. If
maintenance is subcontracted, as with partner maintenance services, the revenue
less the related subcontract expense is recognized when the contract is placed
in service.
Annual renewable maintenance is a separate component of each perpetual license
agreement for ISS products with revenue recognized ratably over the maintenance
term. Subscription revenues include maintenance, term licenses, and managed
service arrangements. Term licenses allow customers to use our products and
receive maintenance coverage for a specified period, generally 12 months. We
recognize revenues from these term agreements ratably over the subscription
term. Managed services consist of Netrex ePatrol monitoring services of
information assets and systems and are recognized as such services as provided.
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<PAGE> 11
ISS GROUP, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (CONTINUED)
Professional service revenues include consulting services and training.
Consulting services, typically billed on a time-and-materials basis, assist in
the successful deployment of our products within customer networks, the
development of customers' security policies and the assessment of security
policy decisions. We recognize such professional service revenues as they are
rendered.
We believe that our total solutions approach requires us to grow all of our
revenue categories. This includes our products and managed services offerings,
as well as maintenance and professional services and training. While we expect
the expansion of these product and service offerings to originate primarily
from internal development, our strategy includes acquiring products and
technologies that fit within our product strategy and that potentially
accelerate the timing of the commercial introduction of such products and
technologies. Over the last 12 months, we have made four different
acquisitions, each of which included such products or technologies.
Two of these acquisitions, Netrex, Inc. and NJH Security Consulting, were
completed in the third quarter of 1999. Founded in 1992 with a current services
customer base of more than 500 customers, Netrex is a leading provider of
remote, security monitoring services of digital assets under the ePatrol name.
NJH Security Consulting includes a technology foundation to provide an
outsourced solution for the automatic detection and management of customer'
security risks using ISS software solutions. This technology is being
incorporated into our ePatrol monitoring services. These transactions are being
accounted for using the pooling-of-interests method of accounting. Our
consolidated financial statements have been restated for all periods presented
to include the results of Netrex.
Our business has grown rapidly since 1995. We expect to continue to expand our
domestic and international sales and marketing operations, increase our
investment in product development and our proprietary threat and vulnerability
database, seek acquisition candidates that will enhance our products and market
share, and improve our internal operating and financial infrastructure in
support of our strategic goals and objectives. All of these initiatives will
increase operating expenses. As a result, while we narrowed our operating
losses over the course of 1998 and achieved profitability during the first
three quarters of 1999, we cannot be certain that we can sustain such
profitability.
Due to our fast growth in an emerging market, period-to-period comparisons of
our operating results are not meaningful. Although we continue to experience
significant revenue growth, we cannot assure our stockholders that such growth
can be sustained and, therefore, investors should not rely on our past growth
as a predictor of future performance. Rather, our prospects must be considered
in light of the risks and difficulties frequently encountered by companies in
new and rapidly evolving markets. There can be no assurance that we will be
successful in addressing such risks and difficulties. Stockholders should
carefully review the risk factors included as Exhibit 99 to this Quarterly
Report on Form 10-Q.
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<PAGE> 12
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, as a percentage of total revenues, for the three months and nine
months ended September 30, 1999 and 1998:
<TABLE>
<CAPTION>
Three months ended Nine months ended
September 30 September 30
-------------------- --------------------
1999 1998 1999 1998
---- ---- ---- ----
<S> <C> <C> <C> <C>
Product and license sales 64.0% 60.3% 63.9% 64.1%
Subscriptions 20.7% 24.0% 20.7% 22.3%
Professional services 15.3% 15.7% 15.4% 13.6%
----- ----- ----- -----
Total revenues 100.0% 100.0% 100.0% 100.0%
----- ----- ----- -----
Cost of revenues 32.8% 32.5% 31.9% 34.2%
Research and development 17.7% 18.9% 17.6% 17.3%
Sales and marketing 36.6% 47.1% 38.1% 50.0%
General and administrative 7.0% 10.5% 8.2% 12.4%
Merger costs 7.8% 0.0% 2.9% 0.0%
Amortization 0.8% 0.0% 0.9% 0.0%
----- ----- ----- -----
Total costs and expenses 102.8% 109.1% 99.6% 113.9%
----- ----- ----- -----
Operating income (loss) (2.8)% (9.1)% 0.4% (13.9)%
</TABLE>
REVENUES
Our total revenues increased 117% to $30,001,000 for the three months ended
September 30, 1999 and 122% to $80,255,000 on a year-to-date basis compared
with the same periods in the prior year. Product and license sales, including
perpetual licenses and sales of partner software and hardware appliances,
continued to be the primary source of revenue generation, and increased as a
percentage of total revenues from approximately 60% in the three months ended
September 30, 1998 to 64% in 1999. This increase was due to lower levels of
Netrex product sales in the third quarter of 1998. For the nine months ended
September 30, 1998 and 1999, product and license sales as a percentage of total
revenues remained consistent at 64%. We continued to add significant
functionality to our SAFEsuite product family, providing customers with more
powerful and easier-to-use solutions for security management across the
enterprise. The sales of partner software and hardware appliances are a part of
our total solution approach whereby we provision partner products to provide a
single solution source for our customers.
Both subscription revenues and professional service revenues increased in
dollar amounts compared to the comparable periods in the prior year.
Subscription revenues consisting of maintenance, term licenses of product usage
and managed services accounted for 21% of our total revenues in both the three
month and nine month periods ended September 30, 1999. This percentage was less
than the respective 1998 periods as relatively lower Netrex product sales in
the third quarter of 1998 made the other revenue categories disproportionately
high. Professional services, represented 15% of total revenues in both the
three and nine month periods ended September 30, 1999 as we continued to build
our service capabilities to address the demand from our customers for
implementation, training and consulting services.
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<PAGE> 13
ISS GROUP, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (CONTINUED)
Geographically, we derived the majority of our revenues 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 18% and 17% of revenues in the three and nine month
periods ended September 30, 1999, respectively, compared to 15% and 12% of
total revenues for the comparable periods in 1998.
COSTS AND EXPENSES
Costs of revenues consist of several components. The largest component is the
cost of product sales representing payment to Netrex partners for product
sales. The other important component is cost of services. This includes the
cost of technical support groups who provide assistance to customers with
maintenance agreements, the operations center costs of providing managed
services and the costs related to professional services and training. As Netrex
carries a significant portion of its costs in cost of product revenues, our
gross margin, represented by total revenues less cost of revenues expressed as
a percentage of total revenues fluctuates depending on the level of Netrex
product sales. This explains most of the fluctuation in gross profit between
66% and 68% in the various periods of 1998 and 1999.
Research and development expenses consist of salary and related costs of
research and development personnel, including costs for employee benefits, and
depreciation on computer equipment. These costs include those associated with
maintaining and expanding the "X-Force," our internal 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.
Research and development expenses increased from $2,616,000, or 19% of total
revenues, in the quarter ended September 30, 1998 to $5,315,000, or 18% of
total revenues, in the comparable quarter in 1999. On a year-to-date basis,
research and development expenses increased 127% to $14,162,000 in 1999 from
$6,247,000 in 1998 while remaining at a consistent percentage of total
revenues. We continue to increase these expenditures as we perceive primary
research and product development and managed service offerings as essential
ingredients for retaining our leadership position in the market. These
increases were due primarily to increases in personnel focused on our
best-of-breed products, enterprise applications and research for future product
offerings.
Sales and marketing expenses consist primarily of salaries, travel expenses,
commissions, advertising, maintenance of the our Website, trade show expenses,
costs of recruiting sales and marketing personnel and costs of marketing
materials. In the quarter ended September 30, 1999, sales and marketing
expenses were $10,991,000 or 37% of total revenues, compared to $6,511,000 or
47% of total revenues, in the quarter ended September 30, 1998. Year-to-date
figures exhibit similar trends. The increases in dollar amounts have occurred
principally from our larger workforce, which has increased each quarter since
1997, both domestically and internationally. The decrease in sales and
marketing expenses as a percentage of total revenues continues a trend that
began during 1998 as a higher percentage of our sales force is achieving
greater levels of productivity due to more experience in selling our broadening
enterprise offering of products and services.
-13-
<PAGE> 14
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, 1999
increased to $2,105,000, or 7% of our total revenues from $1,456,000, or 11% of
our total revenues in the comparable quarter in 1998. Year-to-date amounts
reflect similar dollar and percentage trends. General and administrative
expenses consist of personnel-related costs for executive, administrative,
finance and human resources, information systems and other support services and
legal, accounting and other professional service fees. The increase in these
expenses in absolute dollars is attributable to our effort, through additional
employees and systems, to enhance our management's ability to obtain and
analyze information about our domestic and international operations, as well as
the expansion of our facilities.
Merger costs of $2,329,000 represent the direct out-of-pocket costs of two
acquisitions completed in the third quarter of 1999. These costs are
principally investment advisor, legal and accounting fees.
We recorded $746,000 of amortization expense in the nine months ended September
30, 1999 related to goodwill and intangible assets resulting from the October
1998 acquisitions of March Information Systems, Inc., a United Kingdom-based
developer of Windows NT and Unix-based security assessment technologies, and
the technology assets of DbSecure, Inc., a developer of database security risk
assessment software.
INCOME TAXES
We recorded a provision for income taxes of $105,000 and $311,000 for the
quarter and nine month periods ended September 30, 1999, respectively, related
to our European operations. No provision for federal, state or foreign income
taxes has been recorded for the United States and Asia/Pacific operations due
to the existence of net operating loss carryforwards, or, in the case of Netrex
for periods prior to our merger, its Subchapter S status. We have not
recognized any benefit from the future use of loss carryforwards for these
periods or any other periods since our inception because management's
evaluation of all the available evidence related to the realizability of the
tax benefits of such loss carryforwards indicates that the underlying
assumptions of continued profitable operations in the future contain risks that
do not provide sufficient assurance to recognize such benefits currently.
LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operations in the first nine months of 1999 was $7,942,000
and included net income of $3,996,000 and $3,797,000 of non-cash expense
charges. Billings and collections generated additional cash as the increase in
net accounts receivable in the nine months of 1999 of $6,171,000 associated
with our growth was more than offset by the $6,584,000 increase in deferred
revenues. The increase in deferred revenues was due principally to growth in
both annual maintenance contracts and term licenses.
Investment in equipment totaled $4,787,000 in the nine months of 1999 as we
continued to provide existing and new personnel with the necessary hardware and
software tools to perform their job functions.
Cash provided by financing activities of $78,504,000 was primarily the result
of our secondary stock offering that was consummated in March 1999. The net
proceeds resulting from the stock offering were $77,397,000.
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<PAGE> 15
ISS GROUP, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (CONTINUED)
As of September 30, 1999, we had $134,451,000 of cash and cash equivalents,
consisting primarily of United States government agency securities, money
market accounts and short-term, commercial paper carrying the highest
investment grade rating. We believe that such cash and cash equivalents will be
sufficient to meet our working capital needs and capital expenditures for the
foreseeable future. We expect to evaluate possible acquisition and investment
opportunities in businesses, products or technologies that are complementary to
ours. Although we have not identified any specific businesses, products or
technologies that we intend to acquire or invest in, nor are there any current
agreements with respect to any such transactions, from time to time we expect
to evaluate such opportunities. In the event we determine to pursue such
opportunities, we may use our available cash and cash equivalents. Pending such
uses, we will continue to invest our available cash in short-term, investment
grade, interest-bearing investments.
YEAR 2000
We have reviewed our products and believe that they are designed to properly
function through and beyond the year 2000. Furthermore, we only support the
current and the most recent prior version of our products. While we have
conducted tests of our software and have informed our customers that our
products are Year 2000 compliant, we cannot guarantee that our products,
particularly when they incorporate third-party software, will contain all date
code changes necessary to ensure Year 2000 compliance.
In addition, we use several internal management and other information systems
in the operation of our business. Since we have experienced most of our growth
in systems and personnel since January 1, 1997, purchases and upgrades of
systems have occurred principally since 1997. Internal systems for financial,
human resources and sales reporting, as well as telephone, voice mail and other
office support systems, have all been purchased since 1998 and are reflected in
either the balance sheet as property and equipment or expensed under our
standard policy. We used our best efforts to ensure that these new systems are
Year 2000 compliant.
We have either tested or contacted providers of various tools used in our
product development process and the providers of desktop systems (primarily
Microsoft) to determine that these recognized systems, such as Windows NT and
Windows 95/98, will be Year 2000 compliant with appropriate fixes. We do not
depend on any suppliers or manufacturers whose failure to be Year 2000
compliant would have any significant impact on our financial condition or
results of operations. The majority of our Year 2000 project was complete as of
September 30, 1999. We anticipate completing the remaining few items by October
31, 1999. We do not expect to expend any significant funds to correct Year 2000
issues. Any minor expenses will be funded through cash provided by operations.
Based on available information, we do 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 our business, financial condition or results of operations.
Accordingly, we have not adopted any formal contingency plan in the event we do
not achieve Year 2000 compliance.
-15-
<PAGE> 16
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On July 13, 1999, ISS and Network Associates, Inc. announced that the
patent infringement suit filed by Network Associates, Inc. in July 1998
against Internet Security Systems, Inc. (a wholly-owned subsidiary of
ISS) was resolved to the parties' mutual satisfaction. The resolution
of this previously pending litigation had no material adverse effect on
the business, operating results, or financial condition of ISS.
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 (the "IPO Registration
Statement") was declared effective by oral order of the SEC.
Net proceeds to the Company from this offering were
$61,547,200. During the three months ended September 30, 1999,
the Company used none of the proceeds from the offering for
general or other corporate purposes. The remaining $52,585,400
of the proceeds remain in temporary investments consisting of
money market accounts available on a daily basis, U.S.
Government agency investments and short-term, commercial paper.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(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
(b) Reports on Form 8-K.
A report on Form 8-K was filed on September 15, 1999, with respect to
the acquisition of Netrex Inc.
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<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: October 29, 1999 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
CONSOLIDATED FINANCIAL STATEMENTS OF ISS GROUP, INC. AS OF AND FOR THE NINE
MONTHS ENDED SEPTEMBER 30, 1999 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE
TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> SEP-30-1999
<CASH> 134,451
<SECURITIES> 0
<RECEIVABLES> 23,508
<ALLOWANCES> 644
<INVENTORY> 0
<CURRENT-ASSETS> 159,909
<PP&E> 14,614
<DEPRECIATION> 6,095
<TOTAL-ASSETS> 175,979
<CURRENT-LIABILITIES> 25,546
<BONDS> 0
0
0
<COMMON> 41
<OTHER-SE> 149,782
<TOTAL-LIABILITY-AND-EQUITY> 175,979
<SALES> 0
<TOTAL-REVENUES> 80,255
<CGS> 0
<TOTAL-COSTS> 79,962
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 4,307
<INCOME-TAX> 311
<INCOME-CONTINUING> 3,996
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 3,996
<EPS-BASIC> 0.10
<EPS-DILUTED> 0.09
</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 1, 1999.
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.
RISK FACTORS
Forward-looking statements are inherently uncertain as they are based on
various expectations and assumptions concerning future events and are subject
to known and unknown risks and uncertainties. Our forward-looking statements
should be considered in light of the following important risk factors.
Variations from our stated intentions or failure to achieve objectives could
cause actual results to differ from those projected in our forward-looking
statements. We undertake no obligation to update publicly any forward-looking
statements for any reason, even if new information becomes available or other
events occur in the future.
WE ARE A YOUNG COMPANY THAT HAS INCURRED LOSSES
We began operations in April 1994 and have only achieved profitability over the
past three quarters ended September 30, 1999. We cannot be certain that we can
sustain such profitability in any future period. You should be aware that we
have only a limited operating history upon which to evaluate our business and
prospects. We operate in a new and rapidly evolving market and must, among
other things:
o respond to competitive developments;
o continue to upgrade and expand our product and services
offerings; and
o continue to attract, retain and motivate our employees.
We cannot be certain that we will successfully address these risks.
OUR FUTURE OPERATING RESULTS WILL FLUCTUATE SIGNIFICANTLY
As a result of our limited operating history, we cannot predict our future
revenues and operating results. However, we do expect our future revenues and
operating results to fluctuate due to a combination of factors, including:
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<PAGE> 2
o the growth of private Internet-based networks (often referred
to as intranets);
o the extent to which the public perceives that unauthorized
access to and use of online information is a threat to network
security;
o the volume and timing of orders, including seasonal trends in
customer purchasing;
o our ability to develop new and enhanced products and expand our
professional services;
o the growth in the acceptance of, and activity on, the Internet
and the World Wide Web, particularly by corporate,
institutional and government users;
o customer budgets which may limit their ability to purchase our
products;
o foreign currency exchange rates that affect our international
operations;
o the mix of distribution channels through which we sell our
products;
o product and price competition in our markets; and
o general economic conditions, both domestically and in our
foreign markets.
We increasingly focus our efforts on sales of enterprise-wide security
solutions, which consist of our entire product suite and related professional
services, rather than on the sale of component products. As a result, we expect
that each sale may require additional time and effort from our sales staff. In
addition, the revenues associated with particular sales vary significantly
depending on the number of products licensed by a customer, the number of
devices used by the customer and the customer's relative need for our
professional services. Large individual sales, or even small delays in customer
orders, can cause significant variation in our license revenues and results of
operations for a particular period. The timing of large orders is usually
difficult to predict and, like many software companies, our customers typically
license most of our products in the last month of a quarter.
Our future operating expenses are expected to increase in future periods as we
intend to:
o expand our domestic and international sales and marketing
operations;
o increase our investments in product development and our
proprietary threat and vulnerability database;
o expand our professional services capabilities;
o seek acquisition candidates that will enhance our products and
market share; and
o improve our internal operating and financial systems.
We cannot predict our operating expenses based on our past results. Instead, we
establish our spending levels based in large part on our expected future
revenues. As a result, if our actual revenues in any future period fall below
our expectations, our operating results likely will be adversely affected
because very few of our expenses vary with our revenues. Because of the factors
listed above, we believe that our quarterly and annual revenues, expenses and
operating results likely will vary significantly in the future.
WE FACE INTENSE COMPETITION IN OUR MARKET
The market for network security monitoring, detection and response solutions is
intensely competitive, and we expect competition to increase in the future. We
cannot guarantee that we will compete successfully against our current or
potential competitors, especially those with significantly greater financial
resources or brand name recognition. Our chief competitors generally fall
within one of four categories:
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<PAGE> 3
o internal information technology departments of our customers
and the consulting firms that assist them in formulating
security systems;
o relatively smaller software companies offering relatively
limited applications for network and Internet security;
o large companies, including Axent Technologies and Network
Associates, that sell competitive products and offerings, as
well as other large software companies that have the technical
capability and resources to develop competitive products; and
o software or hardware companies that could integrate features
that are similar to our products into their own products.
Mergers or consolidations among these competitors, or acquisitions of small
competitors by larger companies, would make such combined entities more
formidable competitors to us. Large companies may have advantages over us
because of their longer operating histories, greater name recognition, larger
customer bases or greater financial, technical and marketing rescues. As a
result, they may be able to adapt more quickly to new or emerging technologies
and changes in customer requirements. They can also devote greater resources to
the promotion and sale of their products than we can. In addition, these
companies have reduced, and could continue to reduce, the price of their
security monitoring, detection and response products, which increases pricing
pressures within our market. In addition, large companies with broad product
offerings, such as Network Associates, have bundled their security products
with their other products and we expect them to continue to do so in the
future. These companies may develop security monitoring, detection and response
products that are better than our current or future products and this may
render our products obsolete.
Several companies currently sell software products (such as encryption,
firewall, operating system security and virus detection software) that our
customers and potential customers have broadly adopted. Some of these companies
sell products which perform the same functions as some of our products. In
addition, the vendors of operating system software or networking hardware may
enhance their products to include the same kinds of functions that our products
currently provide. The widespread inclusion of comparable features to our
software in operating system software or networking hardware could render our
products obsolete, particularly if such features are of a high quality. Even if
security functions integrated into operating system software or networking
hardware are more limited than those of our software, a significant number of
customers may accept more limited functionality to avoid purchasing additional
software.
For the above reasons, we may not be able to compete successfully against our
current and future competitors. Increased competition may result in price
reductions, reduced gross margins and loss of market share.
WE FACE RAPID TECHNOLOGICAL CHANGE IN OUR INDUSTRY AND FREQUENT INTRODUCTIONS
OF NEW PRODUCTS
Rapid changes in technology pose significant risks to us. We do not control nor
can we influence the forces behind these changes, which include:
o the extent to which businesses and others seek to establish
more secure networks;
o the extent to which hackers and others seek to compromise
secure systems;
o evolving computer hardware and software standards;
-3-
<PAGE> 4
o changing customer requirements; and
o frequent introductions of new products and product
enhancements.
To remain successful, we must continue to change, adapt and improve our
products in response to these and other changes in technology. Our future
success hinges on our ability to both continue to enhance our current line of
products and professional services and to introduce new products that address
and respond to innovations in computer hacking, computer technology and
customer requirements. We cannot be sure that we will successfully develop and
market new products that do this. Any failure by us to timely develop and
introduce new products, to enhance our current products or to expand our
professional services capabilities in response to these changes could adversely
affect our business, operating results and financial condition.
Our products involve very complex technology, and as a consequence, major new
products and product enhancements require a long time to develop and test
before going to market. Because this amount of time is difficult to estimate,
we have had to delay the scheduled introduction of new and enhanced products in
the past and may have to delay the introduction of new products and product
enhancements in the future.
The techniques computer hackers use to gain unauthorized access to or to
sabotage networks and intranets are constantly evolving and increasingly
sophisticated. Furthermore, because new hacking techniques are usually not
recognized until used against one or more targets, we are unable to anticipate
most new hacking techniques. To the extent that new hacking techniques harm our
customers' computer systems or businesses, affected customers may believe that
our products are ineffective, which may cause them or prospective customers to
reduce or avoid purchases of our products.
RISKS ASSOCIATED WITH OUR GLOBAL OPERATIONS
The expansion of our international operations includes the maintenance of sales
offices in dispersed locations throughout the world, including throughout
Europe and the Asia/Pacific and Latin America regions. Our international
presence and expansion exposes us to risks not present in our U.S. operations,
such as:
o the difficulty in managing an organization spread over various
countries located across the world;
o unexpected changes in regulatory requirements in countries
where we do business;
o excess taxation due to overlapping tax structures;
o fluctuations in foreign currency exchange rates, which may be
aggravated in European markets by the recent introduction of
the Euro currency;
o export license requirements and restrictions on the export of
certain technology, especially encryption technology;
o trade restrictions;
o changes in tariff and freight rates; and
o depressed regional and economic conditions, such as those
currently affecting many regions in Asian markets.
Despite these risks, we believe that we must continue to expand our operations
in international markets to support our growth. To this end, we intend to
establish additional foreign sales operations, expand our existing offices,
hire additional personnel, expand our international sales channels and
customize our products for local markets. If we fail to execute this strategy,
our international sales growth will be limited.
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<PAGE> 5
To date, we have primarily denominated our revenues from international
operations in United States dollars; however, we will increasingly denominate
sales in local foreign currencies in the future. An increase in the value of
the United States dollar relative to foreign currencies would make our products
more expensive and, therefore, potentially less competitive in foreign markets.
In addition, even if we successfully expand our international operations, we
may not be able to maintain or increase international market demand for our
products.
WE RELY ON INDIRECT DISTRIBUTION CHANNELS
Although our direct sales have accounted for a majority of our revenues in this
quarter, we expect to continue to license a significant percentage of our
products to end users through indirect distribution channels in the future. Our
indirect distribution channel partners include:
o original equipment manufacturers that bundle our products with
products that they sell to their customers;
o managed service providers, such as telecommunications companies
and Internet service providers, that host networking and
Internet operations for business customers; and
o consultants and systems integrators that incorporate our
products into customized solutions that they have implemented
for their customers.
Our future performance will also depend, in part, on our ability to both retain
the channel partner relationships we have built and attract new channel
partners to market and support our products effectively, especially in new
markets. We cannot assure you that revenue from channel partners that accounted
for significant revenues in past periods will continue or, if continued, will
reach or exceed past performance levels. In addition, we often depend upon our
channel partners to install and support our products for end users. If our
channel partners fail to provide adequate installation and support, end users
of our products could cease using, or improperly implement and operate, our
products. Such a failure could substantially increase our customer support
costs and adversely affect our business.
POTENTIAL FUTURE ACQUISITIONS OR INVESTMENTS
We have recently acquired Netrex, Inc. and NJH Security Consulting. As part of
our growth strategy, we may continue to acquire or may make investments in,
companies with products, technologies or professional services capabilities
complementary to our solutions. In our recent acquisitions as well as in future
acquisitions we could encounter difficulties in assimilating new personnel and
operations into our company. These difficulties may disrupt our ongoing
business, distract our management and employees, increase our expenses and
adversely affect our results of operations. These difficulties could also
include accounting requirements, such as amortization of goodwill or in-process
research and development expense. We cannot be certain that we will
successfully overcome these risks with respect to any or our recent or future
acquisitions or that we will not encounter other problems in connection with
our recent or any future acquisitions. In addition, any future acquisitions may
require us to incur debt or issue equity securities. The issuance of equity
securities could dilute the investment of our existing stockholders.
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<PAGE> 6
WE DEPEND ON OUR KEY PERSONNEL
Our future success also depends on our continuing ability to attract and retain
highly qualified engineers, managers and sales and professional services
personnel. The competition for employees at all levels of the software
industry, especially those with experience in the relatively new discipline of
security software, is increasingly intense.
WE DEPEND ON OUR INTELLECTUAL PROPERTY RIGHTS AND USE LICENSED TECHNOLOGY
We rely primarily on copyright and trademark laws, trade secrets,
confidentiality procedures and contractual provisions to protect our
proprietary rights. We also believe that the technological and creative skills
of our personnel, new product developments, frequent product enhancements, our
name recognition, our professional services capabilities and delivery of
reliable product maintenance are essential to establishing and maintaining our
technology leadership position. We cannot assure you that our competitors will
not independently develop technologies that are similar to ours.
We seek to protect our software, documentation and other written materials
under the trade secret and copyright laws, which afford only limited
protection. We have also submitted two United States patent applications.
Patents may not issue from these applications or, if issued, may not provide
any meaningful competitive advantages to us.
Despite our efforts to protect our proprietary rights, unauthorized parties may
attempt to copy aspects of our products or to obtain and use information that
we regard as proprietary. Policing unauthorized use of our products is
difficult. While we cannot determine the extent to which piracy of our software
products occurs, we expect software piracy to be a persistent problem. In
addition, the laws of some foreign countries do not protect our proprietary
rights to as great an extent as do the laws of the United States and many
foreign countries do not enforce these laws as diligently as U.S. government
agencies and private parties.
We are not aware that any of our products infringes the proprietary rights of
others, but it is conceivable that our current or future products may infringe
the proprietary rights of others. In fact, in July 1998 Network Associates, one
of our competitors, filed a lawsuit against us alleging that our Real Secure
product violated a patent claim for intrusion detection technology held by
Network Associates. The parties resolved this lawsuit in July 1999 without any
material affect on our business, operating results or financial condition.
We expect the number of intellectual property infringement lawsuits against
software companies to increase. Any such claims, with or without merit, could
be time consuming, result in costly litigation, cause product shipment delays
or require us to enter into royalty or licensing agreements.
WE LACK CERTAIN TRADEMARK PROTECTION
We currently cannot obtain trademark protection on the name "Internet Security
Systems" due to its general use in a variety of security-related applications.
While we have in the past taken and will continue to take action against any
use of that name in a manner that may create confusion for our products in our
current or future markets, we may not be successful in these efforts.
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<PAGE> 7
WE FACE POTENTIAL PRODUCT LIABILITY EXPOSURE AND PRODUCT DEFECTS
Many organizations use our products for critical functions of monitoring and
enhancing network security. As a result, we risk product liability and related
claims for our products if they do not adequately perform this function. In our
licensing agreements, we typically seek to limit our liability for special,
consequential or incidental damages, but these provisions may not in all cases
be enforceable under applicable laws. In addition, we currently have $2.0
million of product liability insurance coverage that, subject to customary
exclusions, covers claims resulting from failure of our products or services to
perform their intended function or to serve their intended purpose. A product
liability claim, to the extent not covered by our insurance, could materially
and adversely affect our business, operating results and financial condition.
Complex software products such as ours may contain undetected "bugs" that,
despite our testing, are discovered only after installation and use by our
customers. The occurrence of these bugs could result in adverse publicity, loss
of or delay in market acceptance or claims by customers against us, any of
which could have a material adverse effect upon our business, operating results
and financial condition. Customers who deploy or use our products improperly or
incompletely may experience temporary disruptions to their computer networking
systems, which could damage our relationship with them and our reputation. Our
current products may not be error-free and it is extremely doubtful that our
future products will be error-free. Furthermore, computers are manufactured in
a variety of different configurations with different operating systems (such as
Windows, Unix, Macintosh and OS/2) and embedded software. As a result, it is
very difficult to comprehensively test our software products for programming or
compatibility errors. Errors in the performance of our products, whether due to
our design or their compatibility with products of other companies, could
hinder the acceptance of our products.
-7-
