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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, 2000
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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 0-23655
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INTERNET SECURITY SYSTEMS, INC.
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(Exact name of registrant as specified in its charter)
DELAWARE 58-2362189
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(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
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(Address of principal executive offices)
Registrant's telephone number, including area code (678) 443-6000
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ISS GROUP, INC.
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(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 November 3, 2000
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Common Stock, $0.001 par value 42,303,231
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<TABLE>
<CAPTION>
PAGE
PART I. FINANCIAL INFORMATION NUMBER
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<S> <C> <C>
Item 1 Consolidated Financial Statements:
Consolidated Statements of Operations for the Three Months
and Nine months ended September 30, 2000 and September 30, 1999.....................3
Consolidated Balance Sheets at September 30, 2000 and
December 31, 1999...................................................................4
Consolidated Statements of Cash Flows for the Nine
Months ended September 30, 2000 and September 30, 1999..............................5
Notes to Consolidated Financial Statements..........................................6
Item 2 Management's Discussion and Analysis of
Financial Condition and Results of Operations...................................... 9
Item 3 Quantitative and Qualitative Disclosures About Market Risk.........................15
PART II. OTHER INFORMATION
Item 2 Changes in Securities and Use of Proceeds..........................................16
Item 6 Exhibits and Reports on Form 8-K...................................................16
</TABLE>
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PART I
FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
INTERNET SECURITY SYSTEMS, 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
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2000 1999 2000 1999
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<S> <C> <C> <C> <C>
Revenues:
Product licenses and sales $ 31,770 $ 19,200 $ 82,879 $51,264
Subscriptions 10,938 6,202 28,564 16,582
Professional services 9,079 4,599 23,852 12,409
-------- --------- --------- -------
51,787 30,001 135,295 80,255
Costs and expenses:
Cost of revenues:
Product licenses and sales 6,525 5,055 16,222 12,529
Subscriptions and services 9,884 4,801 25,214 13,051
-------- --------- --------- -------
Total cost of revenues 16,409 9,856 41,436 25,580
Research and development 8,449 5,315 22,817 14,162
Sales and marketing 17,406 10,991 47,348 30,589
General and administrative 3,429 2,105 9,804 6,556
Merger costs -- 2,329 -- 2,329
Amortization 289 247 785 746
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45,982 30,843 122,190 79,962
Operating income (loss) 5,805 (842) 13,105 293
Interest income, net 2,253 1,640 6,191 4,014
Exchange loss (463) -- (494) --
-------- --------- --------- -------
Income before income taxes 7,595 798 18,802 4,307
Provision for income taxes 2,740 105 6,796 311
-------- --------- --------- -------
Net income $ 4,855 $ 693 $ 12,006 $ 3,996
======== ========= ========= =======
=======
Basic net income per share of common stock $ 0.12 $ 0.02 $ 0.29 $ 0.10
======== ========= ========= =======
Diluted net income per share of common stock $ 0.11 $ 0.02 $ 0.27 $ 0.09
======== ========= ========= =======
Weighted average number of shares:
Basic 41,984 40,582 41,752 39,710
======== ========= ========= =======
Diluted 45,099 43,946 45,039 43,437
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</TABLE>
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INTERNET SECURITY SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
--------------------------------
2000 1999
(UNAUDITED) (AUDITED)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 28,593 $ 70,090
Marketable securities 110,670 56,693
Accounts receivable, less allowance for doubtful accounts
of $999 and $848, respectively 42,524 26,934
Inventory 1,392 473
Prepaid expenses and other current assets 3,824 2,122
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Total current assets 187,003 156,312
Property and equipment:
Computer equipment 17,637 10,108
Office furniture and equipment 6,206 5,232
Leasehold improvements 1,843 870
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25,686 16,210
Less accumulated depreciation 11,702 7,277
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13,984 8,933
Restricted marketable securities 12,500 12,500
Goodwill, less accumulated amortization of $675 and $396, respectively 3,473 2,775
Other intangible assets, less accumulated amortization of $1,331
and $827, respectively 3,514 4,019
Other assets 1,060 306
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Total assets $ 221,534 $ 184,845
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LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 6,489 $ 5,144
Accrued expenses 11,405 6,298
Deferred revenues 25,596 17,155
Current portion of long-term debt and capital lease obligations 192 580
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Total current liabilities 43,682 29,177
Long-term debt, including capital lease obligations 187 435
Other non-current liabilities 57 80
Commitments and contingencies
Stockholders' equity:
Preferred stock, $.001 par value; 20,000,000 shares authorized, none
issued or outstanding -- --
Common stock, $.001 par value, 120,000,000 shares authorized,
42,062,000 and 40,980,000 shares issued and outstanding, respectively 42 41
Additional paid-in capital 167,765 157,467
Deferred compensation (137) (288)
Accumulated other comprehensive income
Retained earnings (accumulated deficit) 9,884 (2,167)
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Total stockholders' equity 177,608 155,153
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Total liabilities and stockholders' equity $ 221,534 $ 184,845
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</TABLE>
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INTERNET SECURITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
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2000 1999
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<S> <C> <C>
OPERATING ACTIVITIES
Net income $ 12,006 $ 3,996
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation 4,358 2,807
Amortization of goodwill and intangibles 783 746
Accretion of discount on marketable securities (1,309) --
Other non-cash items 117 244
Income tax benefit from exercise of stock options 4,985 --
Changes in assets and liabilities:
Accounts receivable (14,845) (6,171)
Inventory (919) (439)
Prepaid expenses and other assets (2,195) (1,501)
Accounts payable and accrued expenses 5,782 1,676
Deferred revenues 8,441 6,584
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NET CASH PROVIDED BY OPERATING ACTIVITIES 17,204 7,942
INVESTING ACTIVITIES
Acquisitions, net of cash received (1,262) --
Net proceeds from maturity of marketable securities 45,861 --
Purchases of marketable securities (98,529) --
Purchases of property and equipment (9,212) (4,787)
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NET CASH USED IN INVESTING ACTIVITIES (63,142) (4,787)
FINANCING ACTIVITIES
Payments on long term debt and capital leases (827) (393)
Net borrowings (payments) under line of credit -- 210
Capital transactions of merged entity -- (972)
Proceeds from exercise of stock options 3,681 2,262
Proceeds from issuance of common stock 1,633 --
Net proceeds from public offering -- 77,397
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NET CASH PROVIDED BY FINANCING ACTIVITIES 4,487 78,504
Foreign currency impact on cash (46) (129)
-------- ---------
Net (decrease) increase in cash and cash equivalents (41,497) 81,530
Cash and cash equivalents at beginning of period 70,090 52,921
-------- ---------
Cash and cash equivalents at end of period $ 28,593 $ 134,451
======== =========
Supplemental cash flow disclosure:
Interest paid 50 82
======== =========
Capital lease obligations incurred during the period -- 304
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</TABLE>
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INTERNET SECURITY SYSTEMS, INC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Significant Accounting Policies
The accompanying consolidated financial statements of Internet Security
Systems, Inc. ("ISS" or "Company") should be read in conjunction with
the Company's consolidated financial statements for the year ended
December 31, 1999.
Prior to the opening of business on July 20, 2000, Internet Security
Systems, Inc. operated under the name of ISS Group, Inc. This name
change, which was approved by the stockholders of the Company at its
annual stockholder meeting earlier this year, allows the Company to be
identified by the name used in the marketplace for its products and
services. The NASDAQ National Market symbol for the Company remained
unchanged as ISSX.
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, 2000
and the consolidated results of its operations and cash flows for the
nine months ended September 30, 2000 and 1999. Results of operations
reported for interim periods are not necessarily indicative of results
for the entire year.
The consolidated balance sheet at December 31, 1999 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.
Revenue Recognition
ISS recognizes its perpetual license revenue 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 extend over periods
greater than twelve months, revenue is recognized as such amounts are
billable. 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.
Subscriptions revenues include maintenance, term licenses and security
monitoring services. Annual renewable maintenance is a separate
component of perpetual license agreements for which the revenue is
recognized ratably over the maintenance contract term. Term licenses
allow customer use of the product and maintenance for a specified
period, generally twelve months, for which revenues are also recognized
ratably over the contract term. Security monitoring services of
information assets and systems are part of managed services and are
recognized as such services are provided. Professional services
revenue, including training and consulting, are recognized as such
services are performed.
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INTERNET SECURITY SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Cost of Revenues
Cost of revenues includes the costs of products and services. Cost of
products represents the cost of product sales which are incurred upon
recognition of the associated product revenues. Cost of services includes
the cost of ISS's technical support group who provide assistance to
customers with maintenance agreements, the operations center costs of
providing managed services and the costs related to ISS's professional
services and training.
2. Business combinations
In August 2000, ISS acquired privately-held ISYI of Padova, Italy. ISYI is
a leader in advanced network security services in the Italian market place
and an early provider of remote security monitoring services. Upon closing
the acquisition in August 2000, approximately 29,100 shares of ISS common
stock were issued in a transaction exempt from registration under the
Securities Act of 1933 with a value, at the time of transfer, of
approximately $2.3 million in exchange for all of the outstanding stock of
ISYI. The transaction is being accounted for using the pooling-of-interests
method of accounting; however, this transaction was not material to ISS's
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 ISYI since
the date of acquisition.
In August 2000, we formed a Brazilian subsidiary, Internet Security Systems
Ltda, to effect the acquisition of Seguranca Ativa de Redes Internet e
Sistemas Ltda ("SARIS") for cash of $5,000. SARIS was formed in 1999 in
order to create and implement a security methodology for the Brazilian
market. The transaction is being accounted for using the purchase method of
accounting. Goodwill related to the purchase of $976,000 was recorded and
is being amortized using the straight-line method over 24 months. The
operating results of ISS include the results of operations of SARIS since
the date of acquisition.
3. Income taxes
The tax provision for the quarter ended September 30, 1999 relates
primarily to the Company's European operations. In 1999, ISS utilized net
operating loss carryforwards to offset tax expense that would otherwise be
recorded on profits from domestic operations for 1999. As of December 31,
1999, substantially all net operating loss carryforwards that would reduce
future income tax expense related to United States operations had been
utilized. While income tax expense was recorded on domestic income for the
quarter ended September 30, 2000, taxes payable was reduced by deductions
related to the exercise of stock options. The tax benefit for the use of
stock option deductions was recorded as additional paid-in capital.
4. Comprehensive Income
Comprehensive income aggregated $5,033,000 for the quarter ended September
30, 2000 and $11,960,000 for the nine months ended September 30, 2000. In
1999 comprehensive income aggregated $745,000 for the quarter ended
September 30, 1999 and $3,867,000 for the nine months ended September 30,
1999. The effects of foreign exchange gains and losses arising from
translations of assets and liabilities of foreign operations into U.S.
dollars are included as a component of comprehensive income. Such amounts
were $178,000 in the quarter ended September 30, 2000 and $(46,000) for the
nine months ended September 30, 2000. In 1999 such amounts were $52,000 for
the quarter ended September 30, 1999 and $(129,000) for the nine months
ended September 30, 1999.
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5. Income per share
Basic net income per share was computed by dividing net income by the
weighted average number of shares of common stock outstanding. Diluted net
income per share was computed by dividing net income by the weighted
average shares outstanding, including common stock equivalents if dilutive.
For the quarters ended September 30, 2000 and 1999, weighted average shares
included 3,115,000 and 3,364,000 shares, respectively, to reflect the
dilutive impact of stock options. Year-to-date weighted average shares
included 3,287,000 shares in 2000 and 3,727,000 shares in 1999 to reflect
the dilutive impact of stock options.
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ITEM 2.
INTERNET SECURITY SYSTEMS, 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, 1999 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 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. Our managed
security services offerings currently provide remote management of the
industry's best-of-breed security technology including firewalls, virtual
private networks, or VPNs, anti-virus, URL filtering software and 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 education, consulting 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 software 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. When payment terms are extended over periods
greater than 12 months, revenue is recognized as such amounts are billable.
Product sales include ISS software integrated with hardware appliances and
software developed by third-party partners combined in some instances with
associated hardware appliances and partner maintenance services. Revenues on
such product sales are recognized upon shipment to the customer. For partner
maintenance services that are subcontracted, 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 our products with revenue recognized ratably over the maintenance
term. Subscriptions 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
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INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (CONTINUED)
12 months. We recognize revenues from these term agreements ratably over the
subscription term. Managed services consist of security monitoring services of
information assets and systems and are recognized as such services as provided.
Professional services revenues include consulting services and training.
Consulting services, typically billed on a time-and-materials basis, assist in
the development of customers' security policies, the assessment of security
policy decisions and the successful deployment of our products within customer
networks. We recognize such professional services revenues as the related
services are rendered.
We believe that our total solutions approach will 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, technologies and
service and sales distribution capabilities that fit within our strategy and
that potentially accelerate the timing of the commercial introduction of such
products and technologies. During the last two years, we have made six different
acquisitions, each of which included one or more of these capabilities.
In the quarter ended September 30, 2000, we completed two acquisitions that
expanded our international presence. We acquired ISYI of Padova, Italy, a leader
in advanced network security services in the Italian market place, and provider
of remote security monitoring services. Founded in 1996 as a privately-held
network security consulting company, ISYI has grown to encompass security
services, including remote security management, in large network and e-business
environments. We also formed a Brazilian subsidiary in connection with our
acquisition of Saris - Seguranca Ativa de Redes Internet e Sistemas Ltda. The
subsidiary, named Internet Security Systems Ltda., will be responsible for
delivering Internet security solutions in Brazil, Argentina, Chile, Uruguay and
Paraguay and will be a key part of our global strategy to offer complete
security solutions through consulting, products and managed security.
Our business has been growing rapidly. 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. We expect to continue to expand our domestic
and international sales and marketing operations, increase our investment in
product development including our proprietary threat and vulnerability database
and managed services capabilities, 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. Thus, our prospects must be
considered in light of the risks and difficulties frequently encountered by
companies in new and rapidly evolving markets. As a result, while we achieved
profitability throughout 1999 and in 2000, we cannot be certain that we can
sustain such profitability. See the risk factors included as Exhibit 99 to this
Quarterly Report on Form 10-Q.
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INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (CONTINUED)
RESULTS OF OPERATIONS
The following tables set forth certain consolidated historical operating
information, as a percentage of total revenues, for the periods indicated:
<TABLE>
<CAPTION>
Three months ended Nine months ended
September 30, September 30,
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2000 1999 2000 1999
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<S> <C> <C> <C> <C>
Product licenses and sales 61% 64% 61% 64%
Subscriptions 21% 21% 21% 21%
Professional services 18% 15% 18% 15%
---------------------------------------------------
Total revenues 100% 100% 100% 100%
---------------------------------------------------
Cost of revenues 32% 33% 31% 32%
Research and development 16% 18% 17% 18%
Sales and marketing 34% 37% 35% 38%
General and administrative 7% 7% 7% 8%
Merger costs -- 8% -- 3%
Amortization 1% 1% 1% 1%
---------------------------------------------------
Total costs and expenses 90% 103% 91% 100%
---------------------------------------------------
Operating income (loss) 10% (3)% 9% --%
===================================================
</TABLE>
REVENUES
Our total revenues increased 73% to $51.8 million for the three months ended
September 30, 2000 and 69% to $135.3 million for the nine months ended September
30, 2000 as compared to the corresponding 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,
representing 61% of total revenues for the three-month period ended September
30, 2000 and 64% of total revenues for the three months ended September 30,
1999.
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INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (CONTINUED)
Licenses of our product offerings grew in absolute dollars in the three months
and nine months ended September 30, 2000 when compared to the corresponding
periods in the prior year. This growth reflected continued customer confidence
in each component of our solution.
We continued to add significant functionality to our SAFEsuite product family
during 2000, including the introduction of Nokia RealSecure, an integrated
offering of ISS intrusion detection software on a Nokia appliance. These
improvements and new offerings provide our customers with more powerful and
easier-to-use solutions for security management across the enterprise. Sales of
partner software and hardware appliances are a part of our total solution
approach whereby we provision third-party partner products to provide a single
solution source for our customers or provide security monitoring services to
these customers.
Subscriptions revenues consist of maintenance, term licenses, and security
monitoring fees for managed services offerings. These revenues increased 76%
from $6.2 million in the three months ended September 30, 1999 to $10.9 million
in the three months ended September 30, 2000, representing 21% of total revenues
in both of these periods. For the nine months ended September 30, subscriptions
revenues grew 72% in 2000 and represented 21% of total revenues in both 2000 and
1999.
Professional services revenues increased 98% from $4.6 million for the three
months ended September 30, 1999 to $9.1 million for the three months ended
September 30, 2000, increasing from 15% of total revenues in the third quarter
of 1999 to 18% of total revenues in the third quarter of 2000. For the nine
months ended September 30, 2000, professional services revenues increased 92%
from $12.4 million for the nine months ended September 30, 1999 to $23.9 million
for the nine months ended September 30, 2000. We continue to build our service
capabilities to address the demand from our customers for security consulting
and implementation services and for expanded training offerings.
Geographically, we derived the majority of our revenues from sales to customers
within North America; however, international operations continued to be an
increasing component of revenues. For the three months ended September 30, 2000,
revenues from customers outside of North America represented 22% of total
revenues compared to 18% of total revenues for the comparable period in 1999.
For the nine months ended September 30, 2000, international revenues represented
23% of total revenues as compared to 17% of total revenues for the comparable
period in 1999. International growth occurred in all theatres, including Europe,
the Asia/Pacific region and Latin America.
COSTS AND EXPENSES
Cost of revenues
Cost of revenues consists of several components. Substantially all of the cost
of product licenses and sales represents payments to partners for their products
that we integrate with our products or provision to our customers in providing a
single solution source. Costs associated with licensing our products are minor.
Cost of product revenues as a percentage of total revenues decreased from 17%
for the three months ended September 30, 1999 to 13% for the comparable period
in 2000 as sales of partner software and hardware appliances represented a lower
percentage of total revenues. For the same reason, cost of product revenues
decreased to 12% of total revenues for the nine months ended September 30, 2000
as compared to 16% in the corresponding period of 1999.
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INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (CONTINUED)
Cost of subscription and service includes the cost of our technical support
personnel who provide assistance to customers under maintenance agreements, the
operations center costs of providing security monitoring services and the costs
related to professional services and training. Each of these categories are
experiencing cost increases as we consciously invest in improving our
capabilities, both in terms of systems and personnel resources. These costs
represented 16% of total revenues for the three-month period ended September 30,
1999 and 19% of total revenues for the three months ended September 30, 2000.
For the nine months ended September 30 these costs represented 16% of total
revenues in 1999 and 19% in 2000.
Research and development
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 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. We continue to increase these expenditures, as we
perceive primary research and product development as essential ingredients for
retaining our leadership position in the market. We also increased the number of
our development personnel focused on our best-of-breed products, enterprise
applications, and managed services offerings. Accordingly, research and
development expenses increased 59% from $5.3 million in the three months ended
September 30, 1999 to $8.4 million in the three months ended September 30, 2000.
For the nine months ended September 30 research and development expenses
increased 61% to $22.8 million in 2000 from $14.2 million in 1999.
While continuing to invest in research and development, we are showing leverage
as these costs decreased to 16% of total revenues for the three months ended
September 30, 2000 as compared to 18% in the corresponding period of 1999. For
the nine months ended September 30 these costs represented 17% of total
revenues in 2000 and 18% in 1999.
Sales and marketing
Sales and marketing expenses consist primarily of salaries, travel expenses,
commissions, advertising, maintenance of our Website, trade show expenses, costs
of recruiting sales and marketing personnel and costs of marketing materials. In
the quarter ended September 30, 2000, sales and marketing expenses were $17.4
million, or 34% of total revenues, as compared to $10.9 million, or 37% of total
revenues, in the quarter ended September 30, 1999. Results for the nine months
ended September 30 exhibited a similar trend, with increases in the dollar
amount of sales and marketing expenditures and a decrease in sales and marketing
expense as a percentage of total revenues from 38% in 1999 to 35% in 2000.
Increases in sales and marketing expenses have occurred principally from the
growth in our workforce, which has continued to increase each quarter, both
domestically and internationally. The decrease in sales and marketing expenses
as a percentage of total revenues was due to greater levels of productivity
achieved by our sales force. We believe that sales force productivity has
benefited from the experience gained by sales personnel in selling our
broadening enterprise offering of products and services as well as the
heightened interest of the marketplace in such offerings.
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<PAGE> 14
INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (CONTINUED)
General and administrative
General and administrative expenses in the quarter ended September 30, 2000
increased to $3.4 million from $2.1 million in the corresponding quarter of
1999. On a quarterly basis these costs remained at 7% of total revenues and on a
year to date basis these costs decreased to 7% of total revenues as compared to
8% in the corresponding period of 1999. General and administrative expenses
consist of personnel-related costs for executive, administrative, finance and
human resources, information systems and other support services costs, and
legal, accounting and other professional services 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.
We recorded $289,000 of amortization expense in the three months ended September
30, 2000 related to goodwill and intangible assets resulting from acquisitions.
Interest income and exchange loss
Net interest income increased from $1.6 million in the quarter ended September
30, 1999 to $2.3 million in the comparable quarter of 2000, due to increased
amounts of cash invested in interest-bearing securities and higher rates of
interests. For the nine months ended September 30, net interest income was $6.2
million in 2000 compared to $4.0 million in 1999. The exchange loss of $463,000
in the three months ended September 30, 2000 was the result of fluctuations in
currency exchange rates between the U.S. dollar and other currencies, primarily
the Euro and, to a lesser degree, the Japanese Yen.
Provision for income taxes
We recorded provisions for income taxes of $105,000 for the quarter ended
September 30, 1999 and $2.7 million for the quarter ended September 30, 2000.
The tax provision for the quarter ended September 30, 1999 relates primarily to
our European operations. In 1999, we utilized net operating loss carryforwards
to offset tax expense that would otherwise be recorded on profits from domestic
operations for 1999. As of December 31, 1999, substantially all of our net
operating loss carryforwards that would reduce future income tax expense related
to United States operations had been utilized. While income tax expense was
recorded on domestic income for the quarter ended September 30, 2000, taxes
payable were reduced by deductions related to the exercise of stock options. The
tax benefit for the use of these stock option deductions was recorded as
additional paid-in capital. As of September 30, 2000, we had a carryforward of
approximately $73 million for stock option deductions. The tax benefit for this
carryforward will be recorded as additional paid-in capital as realized. We also
have approximately $1.9 million of research and development tax credit
carryforwards that expire between 2011 and 2019.
LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operations in the first nine months of 2000 was $17.2
million and included net income of $12 million and non-cash expense charges of
$5.1 million. Billing and collection activities used cash as the increase in net
accounts receivable of $14.8 million in the nine months ended September 30, 2000
associated with our growth was only partially offset by the $8.4 million
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<PAGE> 15
INTERNET SECURITY SYSTEMS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS (CONTINUED)
increase in deferred revenues. The increase in deferred revenues was due to
growth in both annual maintenance contracts and term licenses.
Investing activities include the purchase and maturity of marketable securities.
These assets have quality characteristics similar to cash equivalents except
their maturities are longer than three months. Investing activities in the first
nine months of 2000 also included the purchase of $9.2 million of equipment in
order to provide existing and new personnel with the necessary hardware and
software tools to perform their job functions.
Cash provided by financing activities of $4.5 million was primarily due to
proceeds from the exercise of stock options and proceeds from issuance of common
stock through our Employee Stock Purchase Plan.
As of September 30, 2000, we had $139 million of cash, unrestricted cash
equivalents and marketable securities, consisting primarily of United States
government agency securities, money market accounts and commercial paper
carrying the highest investment grade rating. We believe that such cash and cash
equivalents and marketable securities will be sufficient to meet our working
capital needs and capital expenditures for the foreseeable future. From time to
time we evaluate possible acquisition and investment opportunities in
businesses, products or technologies that are complementary to ours. 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 available
cash in investment grade, interest-bearing investments.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued SFAS 133,
Accounting for Derivative Investments and Hedging Activities. SFAS 133
establishes a new model for accounting for derivatives and hedging activities
and supersedes several existing standards. SFAS 133, as amended by SFAS 137 and
SFAS 138, is effective for all fiscal quarters of fiscal years beginning after
June 15, 2000. We do not expect that the adoption of SFAS 133 will have a
material impact on our financial statements.
In December 1999, the SEC staff issued Staff Accounting Bulletin No. 101,
Revenue Recognition in Financial Statements. SAB 101 explains how the SEC staff
applies by analogy the existing rules on revenue recognition to other
transactions not covered by such rules. In March 2000, the SEC issued SAB 101A
that delayed the original effective date of SAB 101 until the second quarter of
2000 for calendar year companies. In June 2000, the SEC issued SAB 101B that
further delayed the effective date of SAB 101 until no later than the fourth
fiscal quarter of fiscal years beginning after December 15, 1999. We do not
expect that the adoption of SAB 101 will have a material impact on our financial
statements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We have not entered into any transactions using derivative financial instruments
or derivative commodity instruments and believe that our exposure to market risk
associated with other financial instruments (such as marketable securities) is
not material.
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<PAGE> 16
PART II
OTHER INFORMATION
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 order of
the SEC. Net proceeds to the Company from this offering were
$61,547,200. During the three months ended September 30, 2000,
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.
3.1 Restated Certificate of Incorporation
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.
The Company filed a report on Form 8-K on October 20, 2000 containing
the Company's press release announcement of its results for the period
ended September 30, 2000.
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<PAGE> 17
INTERNET SECURITY SYSTEMS, 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.
INTERNET SECURITY SYSTEMS, INC.
-------------------------------
(Registrant)
Date: November 14, 2000 By /s/ Richard Macchia
-------------------- ----------------------------------
Chief Financial Officer
(Principal Financial and Accounting
Officer)
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