Intrusion, Inc. (NASDAQ:INTZ) Q3 2019 Earnings Conference Call November 11, 2019 5:00 PM ET Company Participants Mike Paxton - Interim CEO and Chief Financial Officer Joe Head - Senior Vice President and Co-Founder Conference Call Participants Howard Brous - Wunderlich Securities Walter Schenker - MAZ Capital Advisors Operator Ladies and gentlemen, thank you for standing-by and welcome to the Intrusion Inc. Third Quarter Financial Conference Call. At this time, all participants are in a listen-only mode. Af ...

☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2019 OR ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number 0-20191 INTRUSION INC. UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Exact name of registrant as specified in its charter) (State or other jurisdiction of incorporation or organization) Del ...

Financial Data and Key Metrics Changes - Revenue for Q2 2019 was $4 million, an increase from $3.2 million in Q1 2019 and $2.4 million in Q2 2018 [7][9] - Net income reached $1.8 million, up from $947,000 in Q1 2019 and $474,000 in Q2 2018 [7][11] - Gross profit margin was 60%, consistent with Q1 2019 and slightly down from 61% in Q2 2018 [9] Business Line Data and Key Metrics Changes - The company booked $2.9 million in renewals during Q2 2019, indicating a stable base business with some growth [14] - Sales and marketing expenses were reduced to $0.7 million in Q2 2019 from $0.9 million in the same quarter of 2018, benefiting from a reimbursement of prior expenses [10][11] Market Data and Key Metrics Changes - The company anticipates a pattern of slow bookings in Q3, with an expected uptick in renewals in Q4 2019 [14] - The company is pursuing several large orders that are expected to contribute to growth in the future [19] Company Strategy and Development Direction - The company is focusing on expanding its customer base and pursuing larger projects, with 14 new prospects currently in the pipeline [16][18] - Management is prioritizing hiring senior-level staff to enhance capabilities and support growth [49][58] Management's Comments on Operating Environment and Future Outlook - Management expressed confidence in the stability of the current business and the potential for growth from new and renewing contracts [19] - The company is optimistic about the upcoming renewals of large orders from 2018, which are expected to contribute to revenue in Q4 2019 [19] Other Important Information - The company noted that operating expenses are expected to return to traditional levels in Q3 2019 after a reduction in Q2 [10][11] - Management highlighted the importance of maintaining customer satisfaction while pursuing larger opportunities [18] Q&A Session Summary Question: What should be expected for new orders in Q3 and Q4? - Management indicated that Q3 will primarily consist of renewals, with larger orders expected in 2020 [21][22] Question: Status of new customer orders mentioned in previous calls? - There is one order still awaiting confirmation, which is expected to grow into a larger contract next year [25] Question: Current status of potential large orders for Savant? - Management confirmed that discussions are ongoing, with some orders potentially moving to 2020 [26][28] Question: Need for hiring higher caliber staff? - Management acknowledged the need to hire senior-level staff and is actively pursuing candidates [49][50] Question: Status of partnerships for expanding Savant's market reach? - Management is in discussions with potential partners but noted that interest typically arises after demonstrating successful deployments [53][55] Question: Clarification on the financial performance of the quarter? - Management confirmed that the quarter's performance was strong, with no atypical factors affecting profitability [57][58] Question: Will there be more frequent communications regarding significant contracts? - Management expressed a commitment to communicate more frequently about material developments as they arise [82][85]

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q ☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2019 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1101 East Arapaho Road, Suite 200, Richardson, Texas 75081 (Address of principal executive offices) (Zip Code) OR ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE A ...

Financial Data and Key Metrics Changes - Revenue for Q1 2019 reached $3.2 million, an increase from $2.3 million in Q1 2018 and $3 million in Q4 2018 [11][9] - Net income for Q1 2019 was $947,000, up from $346,000 in Q1 2018 and $851,000 in Q4 2018 [12][9] - Gross profit margin was 60% in Q1 2019, down from 62% in Q1 2018 [11] Business Line Data and Key Metrics Changes - The company reported zero new bookings in Q1 2019 as all major projects were booked in 2018, but $2.3 million in renewals were booked in Q2 2019 [16][17] - A significant $2.4 million order from a new customer was renewed for a second year, indicating strong customer retention [18] Market Data and Key Metrics Changes - The company is focusing on expanding its customer base and has identified 13 new customer prospects, up from 9 in the previous quarter [41][42] - The majority of potential contracts are related to TraceCop, with some incremental growth expected in Savant business [43] Company Strategy and Development Direction - The company aims to leverage its large data sets and expertise in big data solutions to address larger customer challenges [34][35] - There is a focus on building partnerships with commercial entities to enhance sales and expand market reach [66][69] Management's Comments on Operating Environment and Future Outlook - Management expressed optimism about continued growth in sales and profits, supported by significant orders received in the previous quarters [36] - The company is actively hiring sales and engineering personnel to sustain growth [36] Other Important Information - The company is developing new data sets for TraceCop, which are expected to generate additional subscription fees in the future [26][28] - Management is preparing to kick off discussions regarding a potential IR firm partnership [56][58] Q&A Session Summary Question: Comparison of cadence for new and renewed orders - Joe Head indicated that the cadence for new and renewed orders is expected to be similar to the previous year [39] Question: Status of the $1.2 million TraceCop subscription - Joe Head clarified that the renewal mentioned previously was different and is still being pursued [40] Question: Size of potential contracts and their nature - Joe Head noted that most potential contracts are related to TraceCop, with some minor Savant opportunities [43] Question: Market size for TraceCop in the DoD sector - Joe Head estimated that the market could be significantly larger, potentially four to ten times the current size [54] Question: Progress on discussions with an IR firm - Ward Paxton confirmed that progress is being made and they are ready to initiate discussions soon [56][58]

[PART I](index=4&type=section&id=PART%20I) [Item 1. Business](index=4&type=section&id=Item%201.%20Business) Intrusion Inc. develops and markets entity identification and threat detection products for government and enterprise networks, with success dependent on innovation and marketing [General](index=4&type=section&id=General) The company develops and markets products for entity identification, high-speed data mining, cybercrime, and advanced persistent threat detection, primarily for government and enterprise networks - Company develops, markets, and supports entity identification, high-speed data mining, cybercrime, and advanced persistent threat detection products[15](index=15&type=chunk) - Product families include TraceCop (entity identification, cybercrime detection) and Savant (high-speed data mining, advanced persistent threat detection)[19](index=19&type=chunk) - Products protect critical information assets by detecting, protecting, analyzing, and reporting attacks/misuse for government and enterprise networks[16](index=16&type=chunk) - Markets products through direct sales force to end-users and value-added resellers, including U.S. federal, state, and local government entities, large conglomerates, and manufacturing entities[17](index=17&type=chunk)[19](index=19&type=chunk) [Government Sales](index=5&type=section&id=Government%20Sales) A substantial portion of the company's revenue is derived from government sales, which carry inherent risks such as budget disruptions and contract cancellations Government Sales Revenue Percentage | Year | % of Total Revenue | | :--- | :--- | | 2018 | 83.9% | | 2017 | 81.6% | - Expects to continue deriving a substantial portion of revenue from government sales[20](index=20&type=chunk) - Government sales present risks including budget disruptions, delays in federal budget approval, and the government's right to cancel contracts without penalty[20](index=20&type=chunk)[21](index=21&type=chunk) [Industry Background](index=5&type=section&id=Industry%20Background) The company's products are crucial for protecting critical infrastructure and data assets, addressing daily cybersecurity challenges for government and large enterprises - Products are integral for protecting critical infrastructure and data information assets[22](index=22&type=chunk) - Key component to daily cybersecurity challenges for government and large enterprises by detecting, protecting, analyzing, and reporting attacks and misuse of classified information[22](index=22&type=chunk) [Products](index=5&type=section&id=Products) The company offers core cybersecurity products, TraceCop for entity identification and cybercrime detection, and Savant for high-speed data mining and advanced persistent threat detection, alongside reselling third-party hardware [TraceCop](index=5&type=section&id=TraceCop) TraceCop provides a comprehensive database of IP addresses and threat feeds to identify vulnerabilities and potential cyber security threats, licensed annually with updates - TraceCop includes a database of worldwide IP addresses, registrant information, and related IP data, some dating back nearly two decades[23](index=23&type=chunk) - Used with Intrusion's cyber security 'global threat feeds' and proprietary tools to identify vulnerabilities and potential cyber security threats[23](index=23&type=chunk) - Licensed for a yearly fee with scheduled updates, installed either at Intrusion's facility or on customer servers[24](index=24&type=chunk) [Savant](index=5&type=section&id=Savant) Savant is a patented high-speed network data mining and analysis product designed to detect advanced persistent threats and identify network user habits at over 20 gigabits per second - Savant is a high-speed network data mining and analysis product that organizes data into networks of relationships and associations[25](index=25&type=chunk) - Patented design ensures 'deep dives' into data-in-motion to quickly and accurately detect advanced persistent threats, operating at over **20 gigabits per second** with **100% inspection**[25](index=25&type=chunk) - Uses include data mining, data loss prevention, advanced persistent threat detection, and identification of Internet habits of network users[26](index=26&type=chunk) [Third-Party Products](index=6&type=section&id=Third-Party%20Products) The company resells standard commercial computers and servers integrated with its proprietary software, though these third-party relationships are not considered material to its business - Resells standard commercially available computers and servers, integrated with proprietary software for customer networks[27](index=27&type=chunk) - Third-party relationships are not considered material to the Company's business or results of operations[27](index=27&type=chunk) [Customer Services](index=6&type=section&id=Customer%20Services) Product sales include essential installation and threat data interpretation services to ensure effective deployment and utilization - Product sales include installation and threat data interpretation[28](index=28&type=chunk) [Product Development](index=6&type=section&id=Product%20Development) Future success depends on timely product enhancements and new technology development to meet evolving cybersecurity needs, with R&D expenditures expensed as incurred - Future success depends on timely enhancement of existing products and development of new, technologically advanced products to meet cybersecurity needs[29](index=29&type=chunk) Research and Development Expenditures | Year | Expenditure (in millions) | | :--- | :--- | | 2018 | $1.2 | | 2017 | $2.2 | - All R&D expenditures are expensed as incurred[30](index=30&type=chunk) - As of December 31, 2018, **21 employees** were engaged in research, product development, and engineering[30](index=30&type=chunk) [Manufacturing and Supplies](index=6&type=section&id=Manufacturing%20and%20Supplies) The company's internal manufacturing processes encompass software, packaging, testing, and quality control, while hardware components are sourced as standard off-the-shelf products - Internal manufacturing includes software, packaging, testing, and quality control[31](index=31&type=chunk) - Hardware sold consists of standard off-the-shelf products[31](index=31&type=chunk) [Intellectual Property and Licenses](index=6&type=section&id=Intellectual%20Property%20and%20Licenses) The company protects its proprietary technology through contractual rights, trade secrets, copyrights, and two patents, while licensing non-material software and product components from third parties - Relies on contractual rights, trade secrets, copyright laws, and **two patents** to protect proprietary technology[32](index=32&type=chunk) - Uses non-disclosure agreements with suppliers, resellers, and customers to limit access to proprietary information[32](index=32&type=chunk) - Licenses software and product components from various suppliers, which are complementary but not considered material or exclusive[33](index=33&type=chunk) [Sales, Marketing and Customers](index=6&type=section&id=Sales%2C%20Marketing%20and%20Customers) The company employs a direct sales force and partners with resellers to market its cybersecurity solutions to government and enterprise customers, focusing primarily on domestic sales [Field Sales Force](index=6&type=section&id=Field%20Sales%20Force) The direct sales organization targets major accounts and channel partners, providing training and technical support for cyber-secure data networking solutions - Direct sales organization focuses on major account sales and channel partners (distributors, VARs, integrators)[34](index=34&type=chunk) - Provides training and technical support to resellers and end-users, assisting with cyber-secure data networking solutions[34](index=34&type=chunk) [Resellers](index=6&type=section&id=Resellers) Resellers, including system integrators and VARs, sell the company's products as standalone solutions or integrated with other vendors' offerings under non-exclusive agreements - Resellers (system integrators, VARs) sell products as stand-alone solutions or integrate them with other vendors' products[35](index=35&type=chunk) - Agreements with resellers are non-exclusive, and they may sell competing products[35](index=35&type=chunk) [Foreign Sales](index=7&type=section&id=Foreign%20Sales) The company reported no export sales in 2018 and 2017, primarily due to a strategic focus on domestic revenue generation - No export sales in 2018 and 2017, primarily due to a focus on domestic revenue sales[36](index=36&type=chunk) [Marketing](index=7&type=section&id=Marketing) Marketing efforts include participation in trade shows, seminars, distribution of sales literature, and direct communication with resellers and end-user customers - Marketing methods include trade shows, seminars, sales literature distribution, and communication with resellers and end-user customers[37](index=37&type=chunk) [Customers](index=7&type=section&id=Customers) The company's end-user customer base includes U.S. federal, state, and local government entities, large conglomerates, and manufacturing entities, with a significant portion of revenue from government sources - End-user customers include U.S. federal, state, and local government entities, large conglomerates, and manufacturing entities[38](index=38&type=chunk) Revenue from U.S. Government Entities | Year | % of Total Revenue | Number of Gov. Customers > 10% Revenue | | :--- | :--- | :--- | | 2018 | 83.9% | 4 | | 2017 | 81.6% | 3 | [Backlog](index=7&type=section&id=Backlog) The company's non-cancelable order backlog is immaterial, with commercial orders typically fulfilled within two days to two weeks, or over several months, not exceeding one year - Non-cancelable order backlog is immaterial[40](index=40&type=chunk) - Commercial orders are generally fulfilled within two days to two weeks, or over several months, not exceeding one year[40](index=40&type=chunk) [Customer Support, Service and Warranty](index=7&type=section&id=Customer%20Support%2C%20Service%20and%20Warranty) The company provides comprehensive customer support, including on-site and telephone technical assistance, network security design, system installation, and consulting, with products warranted for 90 days to 36 months - Provides service, repair, and technical support on-site and by telephone, including network security design, system installation, and technical consulting[41](index=41&type=chunk) - Products are warranted against defects for **90 days to 36 months**; extended warranty services are separately invoiced[42](index=42&type=chunk) [Competition](index=7&type=section&id=Competition) The network and data protection security market is highly competitive, characterized by frequent product introductions and new technologies, with many competitors possessing greater resources and market recognition - Market for network and data protection security solutions is intensely competitive, characterized by frequent product introductions and new technologies[43](index=43&type=chunk) - Limited competitors for TraceCop, but expects new ones; believes its historical data collection is a unique advantage[44](index=44&type=chunk) - Competes in data mining and advanced persistent threat detection with companies like Niksun, NetScout, Fireeye, and Palo Alto Networks[44](index=44&type=chunk) - Many competitors have substantially greater financial, technical, sales, and marketing resources, better name recognition, and larger customer bases[45](index=45&type=chunk) - Anticipates increased competition from large networking equipment vendors and private 'start-up' companies[46](index=46&type=chunk) [Employees](index=8&type=section&id=Employees) As of December 31, 2018, the company had 31 employees across sales, R&D, and administration, with future success dependent on retaining qualified personnel in a competitive recruiting environment Employee Count by Department (as of Dec 31, 2018) | Department | Number of Employees | | :--- | :--- | | Sales, Marketing & Technical Support | 6 | | Research, Product Development & Engineering | 21 | | Administration & Finance | 4 | | **Total** | **31** | - None of the employees are represented by a labor organization, and no work stoppages have occurred[47](index=47&type=chunk) - Future success depends on the ability to hire, motivate, and retain qualified personnel in an intensely competitive recruiting environment[48](index=48&type=chunk) [Item 1A. Risk Factors](index=8&type=section&id=Item%201A.%20Risk%20Factors) The company faces significant risks including liquidity, government dependence, market acceptance, competition, dilution, technological obsolescence, and intellectual property protection [Liquidity and Capital Resources Risks](index=8&type=section&id=Liquidity%20and%20Capital%20Resources%20Risks) The company's liquidity is supported by cash and a promissory note from its CEO, but future funding may dilute stockholders, and sustained profitability is crucial for continued operations Cash and Net Income/Loss (in thousands) | Metric | Dec 31, 2018 | Dec 31, 2017 | | :--- | :--- | :--- | | Cash & Cash Equivalents | $1,652 | $224 | | Net Income (Loss) | $2,287 | $(30) | | Accumulated Deficit | $(59,200) | $(61,500) | - **$885,000** funding available from a promissory note with the CEO as of Feb 28, 2019[50](index=50&type=chunk) - Expects to have sufficient cash through March 31, 2020, based on projected revenue growth, net income, and CEO borrowings[50](index=50&type=chunk) - Future funding may involve additional private equity and debt, potentially diluting existing common stockholders[50](index=50&type=chunk) - Continued profitability requires consistent or increased revenue generation[51](index=51&type=chunk) [Market Acceptance and Revenue Growth Risks](index=9&type=section&id=Market%20Acceptance%20and%20Revenue%20Growth%20Risks) The company's security products have limited market acceptance and long sales cycles, requiring timely introduction of new technologies and complementary products to achieve sustained revenue growth - Security products, advanced persistent threat detection, and entity identification products have limited market acceptance and potentially longer sales cycles[52](index=52&type=chunk) - No assurance that present or future products will achieve sustained market acceptance or generate sufficient revenues[53](index=53&type=chunk) - Must introduce complementary security products, incorporate new technologies, and commercialize higher-performance products in a timely manner to achieve market acceptance and revenue growth[53](index=53&type=chunk) [Government Customer Dependence Risks](index=9&type=section&id=Government%20Customer%20Dependence%20Risks) The company heavily relies on government sales, with over 80% of its revenue from this sector, exposing it to risks such as budget disruptions and contract cancellations Revenue from U.S. Government Entities | Year | % of Total Net Revenues | | :--- | :--- | | 2018 | 83.9% | | 2017 | 81.6% | | 2016 | 69.3% | - Loss of one or more key government relationships could materially harm business and prospects[54](index=54&type=chunk) - Government sales involve risks like appropriation/spending pattern disruptions, federal budget delays, and the government's right to cancel contracts for convenience[55](index=55&type=chunk) [Indirect Sales Channel Dependence Risks](index=9&type=section&id=Indirect%20Sales%20Channel%20Dependence%20Risks) The company's significant reliance on indirect sales channels for revenue growth exposes it to increased competition and potential pressure on profit margins Revenue from Indirect Sales Channels | Year | % of Revenues | | :--- | :--- | | 2018 | 83.9% | | 2017 | 81.6% | | 2016 | 70.7% | - Must expand sales through indirect channels to increase revenues[56](index=56&type=chunk) - Competition in indirect channels could lead to lower prices and reduced profit margins[56](index=56&type=chunk) [Preferred Stock Dividend and Dilution Risks](index=9&type=section&id=Preferred%20Stock%20Dividend%20and%20Dilution%20Risks) Accrued dividends on preferred stock reduce cash resources and can trigger penalties or redemption rights, while conversion of preferred stock and exercise of options pose significant dilution risks to common stockholders - Accrued dividends on preferred stock (Series 1, 2, and 3) will reduce available cash resources[50](index=50&type=chunk)[95](index=95&type=chunk) - Inability to pay scheduled preferred stock dividends can result in an **18% per annum late fee penalty** for Series 2 and 3, and trigger redemption rights for holders[60](index=60&type=chunk)[61](index=61&type=chunk) Preferred Stock Outstanding (as of Feb 28, 2019) | Series | Shares Outstanding | Common Stock upon Conversion | | :--- | :--- | :--- | | Series 1 | 200,000 | 318,065 | | Series 2 | 460,000 | 460,000 | | Series 3 | 289,377 | 289,377 | - Conversion of all outstanding preferred stock would increase common stock outstanding by approximately **7.9%** (from **13,515,236 to 14,582,679 shares** as of Feb 28, 2019)[62](index=62&type=chunk) - Exercise of current stock options (at or below **$2.73**) would increase common stock outstanding by approximately **6.7%** (to **14,421,000 shares**)[70](index=70&type=chunk) - Preferred stock terms require approval from holders for issuing senior capital stock or incurring certain indebtedness, potentially hindering future financing[69](index=69&type=chunk) [Developmental Stage Company Risks](index=11&type=section&id=Developmental%20Stage%20Company%20Risks) As a developmental stage company, the company relies on products with limited market acceptance and faces risks related to market adoption, cost management, key personnel, financing, and competitive value - Depends exclusively on revenues from network security/advanced persistent threat detection products (Savant) and entity identification/data mining products (TraceCop), which have limited market acceptance[71](index=71&type=chunk) - Faces risks including the need for market acceptance, ability to manage costs, dependence on key personnel, ability to obtain financing, and ability to offer greater value than competitors[72](index=72&type=chunk) [Technological Obsolescence and Competition Risks](index=12&type=section&id=Technological%20Obsolescence%20and%20Competition%20Risks) The company operates in a rapidly changing and intensely competitive market, requiring continuous product innovation to counter numerous competitors with superior resources and market presence - Must develop and introduce new products and enhancements in a timely manner to meet changing customer requirements and evolving industry standards due to rapid technological changes[73](index=73&type=chunk) - Faces intense competition from numerous companies in data security markets, whose products may have advantages in various aspects[74](index=74&type=chunk) - Competitors often have greater financial, technical, marketing resources, better name recognition, more comprehensive solutions, and larger customer bases[75](index=75&type=chunk) [Management Control and Product Liability Risks](index=12&type=section&id=Management%20Control%20and%20Product%20Liability%20Risks) Significant voting power held by executive officers, directors, and preferred stockholders allows substantial control over company matters, while complex products carry inherent risks of defects and potential product liability claims - Executive officers, directors, and preferred stockholders beneficially own approximately **31%** of voting power, with other related parties controlling **27%**, allowing significant control over stockholder-approved matters[76](index=76&type=chunk) - Highly technical and complex products may contain undetected errors, defects, or security vulnerabilities, leading to revenue loss, increased service/warranty costs, and potential product liability claims[77](index=77&type=chunk) [Sales and Implementation Cycle Risks](index=13&type=section&id=Sales%20and%20Implementation%20Cycle%20Risks) Lengthy sales and implementation cycles for large enterprise and government customers require significant resource expenditure before revenue generation, potentially impacting quarterly and annual operating results - Sales and implementation cycles for products sold to large companies and government entities are lengthy, involving extensive education, technical evaluation, and capital commitment[80](index=80&type=chunk) - Significant time and resources may be expended before revenue is received, potentially harming quarterly and annual operating results if forecasted orders are not realized[80](index=80&type=chunk) [Industry Consolidation Risks](index=13&type=section&id=Industry%20Consolidation%20Risks) Industry consolidation, through competitors' acquisitions, may lead to broader product lines and increased market shares for rivals, making it more challenging for the company to compete effectively - Competitors' acquisitions of security companies may accelerate their development of broader product lines and more comprehensive solutions[81](index=81&type=chunk) - Business combinations are creating companies with larger market shares, making it more difficult for the company to compete[81](index=81&type=chunk) [Intellectual Property Protection and Infringement Risks](index=13&type=section&id=Intellectual%20Property%20Protection%20and%20Infringement%20Risks) The company's intellectual property protection measures may not prevent misappropriation, especially in foreign countries, and defending against infringement claims could lead to costly litigation and sales delays - No assurance that intellectual property protection measures (patents, copyrights, trade secrets, NDAs) will prevent misappropriation or independent development by competitors[82](index=82&type=chunk) - Policing unauthorized use of products is difficult, especially in foreign countries with weaker intellectual property laws[82](index=82&type=chunk) - May incur substantial expenses defending against third-party claims of intellectual property infringement, potentially leading to costly litigation, sales delays, or unfavorable licensing agreements[84](index=84&type=chunk) [Stock Price Volatility and Acquisition Risks](index=15&type=section&id=Stock%20Price%20Volatility%20and%20Acquisition%20Risks) Fluctuations in operating results and external factors contribute to high stock price volatility, while future acquisitions could dilute ownership, incur debt, and present integration challenges - Operating results have varied significantly, and fluctuations in quarterly revenues can cause the common stock price to decline[85](index=85&type=chunk) - Common stock price has been highly volatile (e.g., **$0.81 to $3.91 in 2018**) and may continue to be due to factors like operating results, analyst estimates, competitor valuations, and key announcements[86](index=86&type=chunk) - Future acquisitions could dilute ownership, incur debt/liabilities, and lead to integration challenges, harming financial condition and operating results[87](index=87&type=chunk) [Export Regulation Risks](index=16&type=section&id=Export%20Regulation%20Risks) Certain data security products with encryption technology require U.S. Department of Commerce clearances and export licenses, and delays in obtaining these approvals could materially affect sales and operating results - Certain data security products with encryption technology require clearances and export licenses from the U.S. Department of Commerce[88](index=88&type=chunk) - Inability to obtain necessary clearances or foreign regulatory approvals in a timely manner could delay sales and materially affect operating results[88](index=88&type=chunk) [Item 2. Properties](index=16&type=section&id=Item%202.%20Properties) The company's headquarters are located in Richardson, Texas, occupying 23,000 square feet with a lease extending through November 2024. Additionally, approximately 30% of its R&D and engineering staff are housed in two smaller facilities in San Diego, California, with leases set to expire in March 2020. Management believes these existing facilities are adequate for operational requirements through 2019 - Headquarters in Richardson, Texas, occupying **23,000 sq ft**, with a lease extending through November 2024[89](index=89&type=chunk) - Approximately **30%** of security software R&D and engineering staff are in two small facilities in San Diego, California, with leases expiring March 2020[90](index=90&type=chunk) - Existing facilities are deemed adequate for operational requirements through 2019[91](index=91&type=chunk) [Item 3. Legal Proceedings](index=16&type=section&id=Item%203.%20Legal%20Proceedings) The company is involved in ordinary course legal proceedings but does not believe any current claims will have a material adverse effect on its consolidated financial position, operating results, or cash flows. However, it cannot assure that such legal proceedings will not have a material impact on future results - Subject to legal proceedings and claims arising in the ordinary course of business[92](index=92&type=chunk) - Does not believe current claims will have a material adverse effect on consolidated financial position, operating results, or cash flows[92](index=92&type=chunk) [PART II](index=17&type=section&id=PART%20II) [Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities](index=17&type=section&id=Item%205.%20Market%20for%20Registrant%27s%20Common%20Equity%2C%20Related%20Stockholder%20Matters%20and%20Issuer%20Purchases%20of%20Equity%20Securities) Intrusion Inc.'s common stock trades on the OTCQB, with approximately 120 registered holders. The company has various series of preferred stock that accrue cash dividends, and equity compensation plans with outstanding options, which could lead to future dilution [Common Stock Market and Holders](index=17&type=section&id=Common%20Stock%20Market%20and%20Holders) The company's common stock trades on the OTCQB under the symbol 'INTZ,' with approximately 120 registered holders of record - Common stock trades on the OTCQB under the symbol 'INTZ'[94](index=94&type=chunk) - Approximately **120 registered holders** of record of common stock as of February 28, 2019[94](index=94&type=chunk) [Preferred Stock Dividends](index=17&type=section&id=Preferred%20Stock%20Dividends) The company's preferred stock accrues annual cash dividends, with payments subject to Delaware law regarding capital surplus or net profits Preferred Stock Dividend Accruals (2018) | Preferred Stock Series | Annual Dividend per Share | 2018 Accrued Dividends (in thousands) | | :--- | :--- | :--- | | 5% Convertible | $0.25 | $50 | | Series 2 5% Convertible | $0.125 | $57 | | Series 3 5% Convertible | $0.109 | $32 | | **Total Accrued** | | **$139** | - Delaware law permits dividend payments only from capital surplus or net profits of the current/preceding fiscal year[95](index=95&type=chunk) [Equity Compensation Plans](index=17&type=section&id=Equity%20Compensation%20Plans) The company's equity compensation plans include outstanding options for over 1.2 million shares, with a weighted average exercise price of $0.83, and additional shares available for future issuance Equity Compensation Plan Summary (as of Dec 31, 2018) | Metric | Value | | :--- | :--- | | Number of shares to be issued upon exercise of outstanding options (in thousands) | 1,234.6 | | Weighted average exercise price of outstanding options | $0.83 | | Number of shares of common stock remaining available for future issuance (in thousands) | 483.0 | - Outstanding options include **1,117,600** from the 2005 Stock Incentive Plan and **117,000** from the 2015 Stock Option Plan[97](index=97&type=chunk) [Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations](index=17&type=section&id=Item%207.%20Management%27s%20Discussion%20and%20Analysis%20of%20Financial%20Condition%20and%20Results%20of%20Operations) The company achieved significant revenue growth and net income in 2018, with this section detailing financial performance, accounting policies, liquidity, and contractual obligations ["Safe Harbor" Statement](index=17&type=section&id=%22Safe%20Harbor%22%20Statement) This section contains forward-looking statements that are subject to various risks and uncertainties, which could cause actual results to differ materially from projections - Contains forward-looking statements subject to risks and uncertainties that may cause actual results to differ materially[98](index=98&type=chunk) - Factors causing differences include failure to respond to technological changes, lack of market acceptance, intense competition, government customer risks, and liquidity issues[98](index=98&type=chunk)[103](index=103&type=chunk) [Overview](index=19&type=section&id=Overview) The company develops and markets TraceCop and Savant cybersecurity products, maintaining consistent revenues and gross margins, with future growth dependent on sustained operating profits and cash flow - Develops, markets, and supports TraceCop (entity identification, cybercrime detection) and Savant (high-speed data mining, advanced persistent threat detection) products[101](index=101&type=chunk)[104](index=104&type=chunk) - Revenues have been fairly consistent, with no significant competition causing price decreases in TraceCop and Savant markets[102](index=102&type=chunk) - Employee headcount remained stable at **31 full-time persons** in 2018 and 2017[102](index=102&type=chunk) - Gross margins for direct labor were comparable at **64.0% in 2017** and **63.0% in 2018**[102](index=102&type=chunk) - Future growth requires generating and sustaining sufficient operating profits and cash flow through increased sales and effective spending control[103](index=103&type=chunk) [Critical Accounting Policies and Estimates](index=20&type=section&id=Critical%20Accounting%20Policies%20and%20Estimates) The company's financial reporting relies on critical accounting policies for revenue recognition, allowances for doubtful accounts, and fair value measurements of financial instruments, which involve significant management estimates [Revenue Recognition](index=20&type=section&id=Revenue%20Recognition) Product revenue is generally recognized upon shipment, including hardware, perpetual software licenses, and data sets, while service revenue is recognized upon delivery of the service - Generally recognizes product revenue upon shipment, including hardware, perpetual software licenses, and data sets (majority of sales)[107](index=107&type=chunk) - Recognizes sales of data sets in accordance with FASB ASC Topic 606, requiring five criteria to be met before revenue recognition[107](index=107&type=chunk) - Service revenue (maintenance, training, installation) is recognized upon delivery of the service[108](index=108&type=chunk) [Allowances for Doubtful Accounts](index=20&type=section&id=Allowances%20for%20Doubtful%20Accounts) The company maintains allowances for doubtful accounts based on estimates of customer payment ability, considering credit-worthiness, transaction history, economic trends, and payment terms - Maintains allowances for doubtful accounts for estimated losses from customer payment inability[111](index=111&type=chunk) - Receivables are uncollateralized; estimates are based on customer credit-worthiness, transaction history, economic trends, and payment terms[111](index=111&type=chunk) [Fair Value of Financial Instruments](index=21&type=section&id=Fair%20Value%20of%20Financial%20Instruments) The estimated fair value of most current financial instruments approximates their carrying amounts due to short maturities, but the fair value of the related-party loan payable to an officer cannot be estimated due to non-market interest rates - Estimated fair value of accounts receivable, accounts payable, accrued expenses, and dividends payable approximates carrying amounts due to short maturity[112](index=112&type=chunk) - Loan payable to officer is with a related party and does not bear market rates of interest; management cannot estimate its fair value[112](index=112&type=chunk) [Results of Operations](index=21&type=section&id=Results%20of%20Operations) The company experienced significant revenue and gross profit growth in 2018, primarily driven by its TraceCop product line, leading to improved operating income despite increased sales and marketing expenses Consolidated Statements of Operations (Percentage of Net Revenue) | Metric | 2018 | 2017 | | :--- | :--- | :--- | | Net product revenue | 100.0% | 100.0% | | Total cost of revenue | 37.4% | 41.2% | | Gross profit | 62.6% | 58.8% | | Sales and marketing | 15.6% | 22.3% | | Research and development | 12.1% | 31.5% | | General and administrative | 10.8% | 15.9% | | Operating income (loss) | 24.1% | (10.9)% | | Interest expense, net | (1.8)% | (3.0)% | | Other income, net | 0.0% | 13.5% | | Income (loss) from operations before income taxes | 22.3% | (0.4)% | | Net income (loss) | 22.3% | (0.4)% | | Preferred stock dividends accrued | (1.4)% | (2.1)% | | Net income (loss) attributable to common stockholders | 20.9% | (2.5)% | [Net Revenue (2018 compared with 2017)](index=21&type=section&id=Net%20Revenue%20%282018%20compared%20with%202017%29) Net revenue increased significantly in 2018, primarily due to growth in the TraceCop product line, with expectations for continued increases from existing and new customers Net Revenue | Year | Net Revenue (in millions) | YoY Change | | :--- | :--- | :--- | | 2018 | $10.3 | +49.8% | | 2017 | $6.9 | | - Increase in revenue was related to growth in the TraceCop product line[115](index=115&type=chunk) - Expects product revenues to increase with continued sales to existing customers and new customer additions[115](index=115&type=chunk) - No export sales in 2018 and 2017 due to focus on domestic revenue[116](index=116&type=chunk) [Gross Profit (2018 compared with 2017)](index=21&type=section&id=Gross%20Profit%20%282018%20compared%20with%202017%29) Gross profit increased by 59.2% in 2018, with the gross profit percentage rising to 62.6%, driven by higher-margin new projects and economies of scale from increased sales Gross Profit | Year | Gross Profit (in millions) | Gross Profit % of Net Revenue | YoY Change (Gross Profit) | | :--- | :--- | :--- | :--- | | 2018 | $6.4 | 62.6% | +59.2% | | 2017 | $4.0 | 58.8% | | - Gross profit percentage increased due to higher margin new projects and economies related to increased sales[118](index=118&type=chunk) [Sales and Marketing (2018 compared with 2017)](index=22&type=section&id=Sales%20and%20Marketing%20%282018%20compared%20with%202017%29) Sales and marketing expenses increased slightly in 2018 due to higher sales labor, and are expected to rise further with increasing net revenue in 2019 Sales and Marketing Expenses | Year | Expense (in millions) | % of Net Revenue | | :--- | :--- | :--- | | 2018 | $1.6 | 15.6% | | 2017 | $1.5 | 22.3% | - Increase in expense due to increased sales labor expense[120](index=120&type=chunk) - Expects sales and marketing expenses to increase as net revenue levels increase in 2019[120](index=120&type=chunk) [Research and Development (2018 compared with 2017)](index=22&type=section&id=Research%20and%20Development%20%282018%20compared%20with%202017%29) Research and development expenses decreased in 2018 as labor costs shifted to direct project work, with all R&D costs expensed as incurred and expected to increase in 2019 Research and Development Expenses | Year | Expense (in millions) | % of Net Revenue | | :--- | :--- | :--- | | 2018 | $1.2 | 12.1% | | 2017 | $2.2 | 31.5% | - Decrease due to labor expense shifted to direct labor costs on new projects[121](index=121&type=chunk) - R&D costs are expensed as incurred and are expected to increase with rising net revenue in 2019[121](index=121&type=chunk) [General and Administrative (2018 compared with 2017)](index=22&type=section&id=General%20and%20Administrative%20%282018%20compared%20with%202017%29) General and administrative expenses remained constant in 2018 due to cost control efforts, but are anticipated to increase proportionally with rising net revenue in 2019 General and Administrative Expenses | Year | Expense (in millions) | % of Net Revenue | | :--- | :--- | :--- | | 2018 | $1.1 | 10.8% | | 2017 | $1.1 | 15.9% | - Expenses remained constant due to continuing efforts to keep spending under control[122](index=122&type=chunk) - Expected to remain fairly constant but increase as net revenue levels increase in 2019[122](index=122&type=chunk) [Interest Expense (2018 compared with 2017)](index=22&type=section&id=Interest%20Expense%20%282018%20compared%20with%202017%29) Interest expense decreased in 2018, primarily due to a reduced outstanding balance on the Loan Payable to Officer Interest Expense | Year | Expense (in thousands) | | :--- | :--- | | 2018 | $189 | | 2017 | $209 | - Decrease due to decreased amount of Loan Payable to Officer[123](index=123&type=chunk) [Other Income (2018 compared with 2017)](index=22&type=section&id=Other%20Income%20%282018%20compared%20with%202017%29) The company reported no other income in 2018, contrasting with 2017 when it recognized significant income from the sale of unused IP addresses and an investment Other Income (2017) | Source | Amount (in thousands) | | :--- | :--- | | Sale of unused IP addresses | $872 | | Sale of an investment | $56 | | **Total Other Income** | **$928** | - No other income in 2018[124](index=124&type=chunk) [Income Taxes (2018 compared with 2017)](index=22&type=section&id=Income%20Taxes%20%282018%20compared%20with%202017%29) The effective income tax rate was 0% in both 2018 and 2017 due to valuation allowances on deferred tax assets, despite the federal income tax rate reduction to 21% in 2018 - Effective income tax rate was **0%** in 2018 and 2017 due to valuation allowances on net deferred tax assets[125](index=125&type=chunk) - The Tax Cuts and Jobs Act lowered the statutory federal income tax rate from a maximum of **39% to 21%** effective January 1, 2018[125](index=125&type=chunk) [Liquidity and Capital Resources](index=22&type=section&id=Liquidity%20and%20Capital%20Resources) The company significantly improved its cash position and operating cash flow in 2018, supported by a revolving promissory note from its CEO, and anticipates sufficient liquidity through March 2020, though future funding may involve dilution Cash and Working Capital | Metric | Dec 31, 2018 (in millions) | Dec 31, 2017 (in millions) | | :--- | :--- | :--- | | Cash and cash equivalents | $1.7 | $0.2 | | Working capital | $0.5 | $0.8 | Net Cash Provided by Operating Activities | Year | Amount (in millions) | | :--- | :--- | | 2018 | $2.6 | | 2017 | $0.3 | - Net cash used in investing activities was **$202 thousand in 2018** (purchases of property and equipment) compared to **$36 thousand provided in 2017** (sale of investments offset by purchases)[129](index=129&type=chunk)[181](index=181&type=chunk) - Amended unsecured revolving promissory note with CEO G. Ward Paxton for up to **$2.7 million** through March 2021 (amended Feb 7, 2019)[134](index=134&type=chunk)[226](index=226&type=chunk) - Borrowings outstanding under CEO Note totaled **$1.815 million** with **$479 thousand** accrued interest as of Dec 31, 2018[135](index=135&type=chunk)[227](index=227&type=chunk) - Believes sufficient cash resources will finance operations and capital expenditures through March 31, 2020, relying on anticipated profits and CEO borrowings[136](index=136&type=chunk) - Future funding may involve additional private equity and debt, potentially diluting existing common stockholders[136](index=136&type=chunk)[138](index=138&type=chunk) [Contractual Obligations](index=25&type=section&id=Contractual%20Obligations) As of December 31, 2018, the company has total future contractual obligations of $2.224 million, primarily consisting of operating lease payments and capital lease obligations extending through 2022 and beyond Future Contractual Obligations (as of Dec 31, 2018, in thousands) | Year ending December 31, | Operating Leases | Capital Lease Obligations | Total | | :--- | :--- | :--- | :--- | | 2019 | $284 | $62 | $346 | | 2020 | $354 | $45 | $399 | | 2021 | $358 | $21 | $379 | | 2022 and thereafter | $1,100 | $0 | $1,100 | | **Total** | **$2,096** | **$128** | **$2,224** | [Off-Balance Sheet Arrangements](index=25&type=section&id=Off-Balance%20Sheet%20Arrangements) The company reported no significant off-balance sheet arrangements as of December 31, 2018 - No significant off-balance sheet arrangements as of December 31, 2018[141](index=141&type=chunk) [Recent Accounting Pronouncements](index=25&type=section&id=Recent%20Accounting%20Pronouncements) For detailed information on recent accounting pronouncements and their potential impact, refer to Note 2 of the consolidated financial statements - Refer to Note 2 for information on recent accounting pronouncements[142](index=142&type=chunk) [Item 8. Financial Statements for years ended December 31, 2018 and 2017](index=31&type=section&id=Item%208.%20Financial%20Statements%20for%20years%20ended%20December%2031%2C%202018%20and%202017) This section presents the audited consolidated financial statements for 2018 and 2017, including balance sheets, statements of operations, cash flows, and notes on business and accounting policies [Report of Independent Registered Public Accounting Firm](index=31&type=section&id=Report%20of%20Independent%20Registered%20Public%20Accounting%20Firm) Whitley Penn LLP issued an **unqualified opinion** on the consolidated financial statements for 2018 and 2017, affirming fair presentation in accordance with U.S. GAAP, without auditing internal control over financial reporting - Whitley Penn LLP provided an **unqualified opinion** on the consolidated financial statements for 2018 and 2017[168](index=168&type=chunk) - Financial statements present fairly the financial position, results of operations, and cash flows in conformity with U.S. GAAP[168](index=168&type=chunk) - The audit was conducted in accordance with PCAOB standards, but did not include an audit of internal control over financial reporting[170](index=170&type=chunk) [Consolidated Balance Sheets](index=32&type=section&id=Consolidated%20Balance%20Sheets) The company's balance sheet shows significant improvements in cash and total assets in 2018, alongside a reduction in the total stockholders' deficit, reflecting improved financial health Consolidated Balance Sheet Highlights (in thousands) | Metric | Dec 31, 2018 | Dec 31, 2017 | Change (2018 vs 2017) | | :--- | :--- | :--- | :--- | | Cash and cash equivalents | $1,652 | $224 | +$1,428 | | Accounts receivable | $1,967 | $962 | +$1,005 | | Total current assets | $3,710 | $1,290 | +$2,420 | | Total assets | $4,069 | $1,452 | +$2,617 | | Total current liabilities | $3,252 | $2,079 | +$1,173 | | Loan payable to officer | $1,815 | $2,865 | -$1,050 | | Total stockholders' deficit | $(1,062) | $(3,509) | +$2,447 | [Consolidated Statements of Operations](index=33&type=section&id=Consolidated%20Statements%20of%20Operations) The company achieved a net income of $2.287 million in 2018, a significant improvement from a net loss in 2017, driven by a substantial increase in net product revenue and gross profit Consolidated Statements of Operations Highlights (in thousands, except per share) | Metric | 2018 | 2017 | Change (2018 vs 2017) | | :--- | :--- | :--- | :--- | | Net product revenue | $10,276 | $6,862 | +$3,414 | | Gross profit | $6,429 | $4,038 | +$2,391 | | Operating income (loss) | $2,476 | $(749) | +$3,225 | | Net income (loss) | $2,287 | $(30) | +$2,317 | | Net income (loss) attributable to common stockholders | $2,148 | $(169) | +$2,317 | | Basic EPS | $0.16 | $(0.01) | | | Diluted EPS | $0.14 | $(0.01) | | [Consolidated Statements of Changes in Stockholders' Deficit](index=34&type=section&id=Consolidated%20Statements%20of%20Changes%20in%20Stockholders%27%20Deficit) The company's accumulated deficit significantly decreased in 2018 due to a net income of $2.287 million, contributing to a substantial improvement in total stockholders' deficit Stockholders' Deficit Changes (in thousands) | Metric | Dec 31, 2018 | Dec 31, 2017 | | :--- | :--- | :--- | | Preferred Stock | $1,843 | $1,843 | | Common Stock | $133 | $128 | | Treasury Shares | $(362) | $(362) | | Additional Paid-in-Capital | $56,609 | $56,518 | | Accumulated Deficit | $(59,242) | $(61,529) | | Accumulated Other Comprehensive Loss | $(43) | $(107) | | **Total Stockholders' Deficit** | **$(1,062)** | **$(3,509)** | - Net income of **$2,287 thousand** in 2018 reduced the accumulated deficit from **$(61,529) thousand to $(59,242) thousand**[178](index=178&type=chunk) [Consolidated Statements of Cash Flows](index=35&type=section&id=Consolidated%20Statements%20of%20Cash%20Flows) The company experienced a significant increase in net cash provided by operating activities in 2018, driven by net income and changes in working capital, leading to a substantial rise in cash and cash equivalents Consolidated Statements of Cash Flows Highlights (in thousands) | Activity | 2018 | 2017 | | :--- | :--- | :--- | | Net cash provided by operating activities | $2,578 | $272 | | Net cash provided by (used in) investing activities | $(202) | $36 | | Net cash used in financing activities | $(948) | $(148) | | Net increase in cash and cash equivalents | $1,428 | $160 | | Cash and cash equivalents at end of year | $1,652 | $224 | - Operating cash flow driven by net income, increase in deferred revenue (**$598k**), and accounts payable (**$421k**) in 2018[128](index=128&type=chunk)[181](index=181&type=chunk) - Investing activities in 2018 primarily for property and equipment purchases[129](index=129&type=chunk)[181](index=181&type=chunk) - Financing activities in 2018 included payments on CEO loan (**$1.2 million**), capital leases (**$66 thousand**), offset by CEO loan borrowings (**$150 thousand**) and stock option exercises (**$168 thousand**)[130](index=130&type=chunk)[181](index=181&type=chunk) [Notes to Consolidated Financial Statements](index=36&type=section&id=Notes%20to%20Consolidated%20Financial%20Statements) These notes provide detailed disclosures on the company's business, significant accounting policies, and specific financial items, including liquidity, risk concentrations, revenue recognition, and income taxes [1. Description of Business](index=36&type=section&id=1.%20Description%20of%20Business) The company develops and markets cybersecurity products like TraceCop, Savant, and Compliance Commander to diverse customers, and despite improved liquidity in 2018, future financings may dilute stockholders - Develops, markets, and supports TraceCop, Savant, and Compliance Commander products for entity identification, data mining, and data privacy protection[183](index=183&type=chunk) - Markets products to end-users, distributors, system integrators, MSPs, and VARs, including financial institutions, government entities, and healthcare providers[184](index=184&type=chunk) - Cash and cash equivalents increased to **$1,652,000** in 2018 from **$224,000** in 2017, with a net income of **$2,287,000** in 2018 compared to a net loss of **$30,000** in 2017[186](index=186&type=chunk) - **$885,000** in funding available from CEO promissory note as of Feb 28, 2019; expects sufficient cash through March 31, 2020, but future financings may dilute stockholders[186](index=186&type=chunk) [2. Summary of Significant Accounting Policies](index=36&type=section&id=2.%20Summary%20of%20Significant%20Accounting%20Policies) This section outlines the company's key accounting principles, including consolidation, cash equivalents, risk concentration, accounts receivable, property and equipment, long-lived assets, foreign currency, stock options, revenue recognition, R&D costs, use of estimates, fair value, and income taxes [Principles of Consolidation](index=36&type=section&id=Principles%20of%20Consolidation) The consolidated financial statements include all accounts of Intrusion Inc. and its wholly-owned subsidiaries, with intercompany balances and transactions eliminated - Consolidated financial statements include accounts of Intrusion Inc. and its wholly-owned subsidiaries, with intercompany balances and transactions eliminated[187](index=187&type=chunk) [Cash and Cash Equivalents](index=36&type=section&id=Cash%20and%20Cash%20Equivalents) Cash and cash equivalents are defined as cash and highly liquid investments with original maturities of less than three months - Defined as cash and highly liquid investments with original maturities of less than three months[188](index=188&type=chunk) [Risk Concentration](index=36&type=section&id=Risk%20Concentration) The company's financial instruments are exposed to credit risk, with cash deposits exceeding FDIC insured amounts and investments held in U.S. government obligations, corporate securities, and money market funds - Financial instruments subject to credit risk are cash, cash equivalents, investments, and accounts receivable[189](index=189&type=chunk) - Cash deposits exceed FDIC insured amounts; investments are in U.S. government obligations, corporate securities, and money market funds with two major U.S. financial institutions[189](index=189&type=chunk) - Primarily sells products domestically; future international sales may face currency exchange risk[190](index=190&type=chunk) [Accounts Receivable and Allowance for Doubtful Accounts](index=37&type=section&id=Accounts%20Receivable%20and%20Allowance%20for%20Doubtful%20Accounts) Trade accounts receivable are recorded at their expected collectible amount, with allowances for doubtful accounts based on customer credit-worthiness and economic factors, though no allowance was recorded in 2018 and 2017 - Trade accounts receivable are stated at expected collectible amount; allowances for doubtful accounts are maintained based on customer credit-worthiness, transaction history, economic trends, and payment terms[191](index=191&type=chunk) - No allowance for doubtful accounts at December 31, 2018 and 2017[191](index=191&type=chunk) [Property and Equipment](index=37&type=section&id=Property%20and%20Equipment) Property and equipment are recorded at cost and depreciated on a straight-line basis over 1-5 years, with leasehold improvements amortized over the shorter of their useful life or lease term - Stated at cost less accumulated depreciation, depreciated on a straight-line basis over **1-5 years**. Leasehold improvements amortized over shorter of useful life or lease term (**2-5 years**)[192](index=192&type=chunk) Depreciation and Amortization Expense (in thousands) | Year | Amount | | :--- | :--- | | 2018 | $133 | | 2017 | $206 | [Long-Lived Assets](index=37&type=section&id=Long-Lived%20Assets) Long-lived assets are reviewed for impairment when circumstances suggest their carrying amount may not be recoverable, with no impairment recognized in 2018 and 2017 - Reviewed for impairment when circumstances indicate carrying amount may not be recoverable; no impairment recognized in 2018 and 2017[193](index=193&type=chunk) [Foreign Currency](index=37&type=section&id=Foreign%20Currency) Assets and liabilities of foreign subsidiaries translated at year-end exchange rates, while revenues and expenses use average rates, with translation gains/losses recorded in accumulated other comprehensive loss - Assets and liabilities of foreign subsidiaries translated at year-end exchange rates; revenues and expenses at average rates. Translation gains/losses in accumulated other comprehensive loss, not net income[194](index=194&type=chunk) [Accounting for Stock Options](index=37&type=section&id=Accounting%20for%20Stock%20Options) The company accounts for stock options by recognizing share-based payments based on fair values, with compensation expense determined by awards expected to vest, reduced by estimated forfeitures - Accounts for stock options using FASB ASC Topic 718, recognizing share-based payments based on fair values[195](index=195&type=chunk) - Stock-based compensation expense is based on awards expected to vest, reduced by estimated forfeitures[196](index=196&type=chunk) [Valuation Assumptions](index=38&type=section&id=Valuation%20Assumptions) The Black-Scholes model is used for valuation, with key assumptions including zero dividend yield, varying risk-free interest rates, and significant expected volatility Black-Scholes Valuation Assumptions | Assumption | 2018 | 2017 | | :--- | :--- | :--- | | Weighted average grant date fair value | $0.49 | $0.26 | | Expected dividend yield | 0.00% | 0.00% | | Risk-free interest rate | 0.83% | 1.77% | | Expected volatility | 225.21% | 75.46% | | Expected life (in years) | 4.91 | 5.00 | [Net Loss Per Share](index=38&type=section&id=Net%20Loss%20Per%20Share) The company reports basic and diluted net loss per share, with common stock equivalents included in diluted EPS unless they are anti-dilutive - Reports basic and diluted net loss per share. Common stock equivalents (convertible preferred stock, options) are included in diluted EPS unless anti-dilutive[199](index=199&type=chunk) - Zero common stock equivalents excluded from diluted EPS in 2018; **2,941,861** excluded in 2017[199](index=199&type=chunk) [Revenue Recognition](index=38&type=section&id=Revenue%20Recognition) The company adopted ASU No. 2014-09 in 2018, recognizing product revenue upon shipment or performance obligation satisfaction, and service revenue upon delivery, with standard payment terms of net 30 days domestically - Adopted ASU No. 2014-09 on Jan 1, 2018, with no material impact[200](index=200&type=chunk) - Recognizes product revenue upon shipment or performance obligation satisfaction, primarily from data set updates and perpetual software licenses[201](index=201&type=chunk)[202](index=202&type=chunk) - Service revenue (maintenance, training, installation) recognized upon delivery[203](index=203&type=chunk) - Normal payment terms are net **30 days** domestically, net **45 days** internationally; payment in advance required for customers not meeting credit standards[204](index=204&type=chunk) - Shipping and handling costs billed to customer and included in product revenue, expensed as cost of product revenue[205](index=205&type=chunk) [Research and Development Costs](index=39&type=section&id=Research%20and%20Development%20Costs) Research and development costs, primarily for new security software and enhancements, are expensed as incurred, with software development capitalization being insignificant due to short development periods - R&D costs primarily for new security software, appliances, integrated solutions, and major enhancements; expensed as incurred[206](index=206&type=chunk) - Software development costs are expensed as incurred; capitalization after technological feasibility has been insignificant due to short development periods[207](index=207&type=chunk) [Use of Estimates](index=39&type=section&id=Use%20of%20Estimates) The preparation of financial statements requires management to make estimates and assumptions for various accounts, including doubtful accounts, revenue recognition, warranty costs, and income taxes - Financial statements require management estimates and assumptions for various accounts, including doubtful accounts, revenue recognition, warranty costs, and income taxes[208](index=208&type=chunk) [Fair Value of Financial Instruments](index=39&type=section&id=Fair%20Value%20of%20Financial%20Instruments) The fair value of most current financial instruments approximates their carrying amounts, but the fair value of the related-party loan payable to an officer cannot be estimated due to non-market interest rates - Fair value of accounts receivable, accounts payable, accrued expenses, and dividends payable approximate carrying amounts[209](index=209&type=chunk) - Loan payable to officer is related party, does not bear market rates, and fair value cannot be estimated[209](index=209&type=chunk) [Income Taxes](index=39&type=section&id=Income%20Taxes) Deferred income taxes are determined using the liability method, with a full valuation allowance against deferred tax assets due to uncertainty of realization, and the federal income tax rate was reduced to 21% in 2018 - Deferred income taxes determined using liability method (FASB ASC 740); valuation allowance established for deferred tax assets unlikely to be realized[210](index=210&type=chunk) - No unrecognized tax benefits to disclose[211](index=211&type=chunk) - Federal income tax returns for **2015-2017** remain open for examination[212](index=212&type=chunk) - Tax Cuts and Jobs Act lowered federal income tax rate to **21%** effective Jan 1, 2018[212](index=212&type=chunk) [Recent Accounting Pronouncements](index=40&type=section&id=Recent%20Accounting%20Pronouncements) The adoption of ASU No. 2016-02, Leases (Topic 842), effective in Q1 2019, is not expected to materially impact the consolidated financial statements - Adoption of ASU No. 2016-02, Leases (Topic 842), effective Q1 2019, is not expected to have a material impact on consolidated financial statements[213](index=213&type=chunk) [3. Accrued Expenses](index=40&type=section&id=3.%20Accrued%20Expenses) Total accrued expenses increased to $1.403 million in 2018, primarily driven by higher accrued interest for related parties and other accrued liabilities Accrued Expenses (in thousands) | Category | Dec 31, 2018 | Dec 31, 2017 | | :--- | :--- | :--- | | Accrued payroll | $154 | $131 | | Accrued vacation | $310 | $284 | | Rent payable | $191 | $139 | | Accrued interest, related party | $479 | $348 | | Other | $269 | $86 | | **Total** | **$1,403** | **$988** | [4. Commitments and Contingencies](index=40&type=section&id=4.%20Commitments%20and%20Contingencies) The company has commitments related to operating and capital leases for its facilities and is subject to ordinary course legal proceedings, which are not expected to materially impact its financial position [Leases](index=40&type=section&id=Leases) The company leases office space for its headquarters and R&D staff, with future minimum operating lease payments totaling $2.096 million and capital lease obligations of $128 thousand as of December 31, 2018 - Leases office space for headquarters in Richardson, Texas (expires Nov 2024) and R&D staff in San Diego/San Marcos, California (expire March 2020)[215](index=215&type=chunk) Future Minimum Operating Lease Payments (as of Dec 31, 2018, in thousands) | Year ending December 31, | Minimum Lease Payments | | :--- | :--- | | 2019 | $284 | | 2020 | $354 | | 2021 | $358 | | 2022 and thereafter | $1,100 | | **Total** | **$2,096** | Future Minimum Capital Lease Obligations (as of Dec 31, 2018, in thousands) | Year ending December 31, | Capital Lease Obligations | | :--- | :--- | | 2019 | $62 | | 2020 | $45 | | 2021 | $21 | | **Total** | **$128** | [Legal Proceedings](index=41&type=section&id=Legal%20Proceedings) The company is involved in routine legal proceedings but does not anticipate any material adverse effects on its financial position, operating results, or cash flows - Subject to legal proceedings in the ordinary course of business[219](index=219&type=chunk) - Does not believe the outcome of current matters will have a material adverse effect on financial position, operating results, or cash flows[219](index=219&type=chunk) [5. Employee Benefit Plan](index=41&type=section&id=5.%20Employee%20Benefit%20Plan) The company offers a 401(k) Savings Plan with a matching contribution of $0.25 per dollar on the first 4% of employee compensation, totaling $30 thousand in both 2018 and 2017 - Offers a 401(k) Savings Plan for employees, allowing tax-deferred salary deductions[221](index=221&type=chunk) - Company matches employee contributions at **$0.25 per $1.00** on the first **4%** of compensation[222](index=222&type=chunk) 401(k) Matching Contributions (in thousands) | Year | Amount | | :--- | :--- | | 2018 | $30 | | 2017 | $30 | [6. Borrowings from Officer](index=41&type=section&id=6.%20Borrowings%20from%20Officer) The company has an unsecured revolving promissory note with its CEO, allowing borrowings up to $2.7 million through March 2021, with $1.815 million outstanding and $479 thousand in accrued interest as of December 31, 2018 - Unsecured revolving promissory note with CEO G. Ward Paxton allows borrowing up to **$2.7 million** through March 2021 (amended Feb 7, 2019)[226](index=226&type=chunk) - Interest accrues at SVB prime rate plus **1%** (**6.5%** at Dec 31, 2018)[227](index=227&type=chunk) CEO Loan Details (as of Dec 31, 2018, in thousands) | Metric | Amount | | :--- | :--- | | Borrowings outstanding | $1,815 | | Accrued interest | $479 | [7. Income Taxes](index=42&type=section&id=7.%20Income%20Taxes) The company has a full valuation allowance against its deferred tax assets due to uncertainty of realization, despite significant federal net operating loss carryforwards and the reduced federal income tax rate of 21% Deferred Tax Assets (in thousands) | Category | Dec 31, 2018 | Dec 31, 2017 | | :--- | :--- | :--- | | Net operating loss carryforwards (federal) | $20,720 | $21,175 | | Net operating loss carryforwards (foreign) | $374 | $374 | | Other deferred tax assets | $110 | $105 | | **Total Deferred Tax Assets** | **$21,204** | **$21,654** | | Valuation allowance | $(21,204) | $(21,654) | | **Deferred tax assets, net** | **$0** | **$0** | - Full valuation allowance recorded against deferred tax assets due to uncertainty of realization[228](index=228&type=chunk) - Federal net operating loss carryforwards of approximately **$86.0 million** at Dec 31, 2018, begin to expire in 2022[229](index=229&type=chunk) - Federal statutory income tax rate reduced to **21%** effective Jan 1, 2018, by the Tax Act[212](index=212&type=chunk)[229](index=229&type=chunk) [8. Stock Options](index=42&type=section&id=8.%20Stock%20Options) The company has two stock incentive plans, the expired 2005 plan and the active 2015 plan, with a total of 1.235 million options outstanding at year-end 2018, and unrecognized compensation cost of $16 thousand [2005 Stock Incentive Plan](index=42&type=section&id=2005%20Stock%20Incentive%20Plan) The 2005 Stock Incentive Plan, which expired in 2015, authorized 3,700,000 shares and had 1,117,600 options outstanding at December 31, 2018, with no shares remaining for grant - Approved in 2005, amended multiple times to increase shares, totaling **3,700,000 shares** authorized[231](index=231&type=chunk) - Expired on June 14, 2015; no shares remain for grant[231](index=231&type=chunk) - At Dec 31, 2018, **1,117,600 options** were outstanding under this plan[231](index=231&type=chunk) [2015 Stock Incentive Plan](index=44&type=section&id=2015%20Stock%20Incentive%20Plan) The 2015 Stock Incentive Plan, approved as a replacement for the 2005 Plan, authorizes 600,000 shares for issuance through various programs, with 117,000 options outstanding and 483,000 shares available for future grants as of December 31, 2018 - Approved in 2015 as a replacement for the 2005 Plan, authorizing **600,000 shares** of common stock for issuance[233](index=233&type=chunk) - Includes Discretionary Option Grant, Stock Issuance, and Automatic Option Grant Programs (for non-employee Board members)[234](index=234&type=chunk) - At Dec 31, 2018, **117,000 options** were outstanding, and **483,000 shares** remained available for future grant[234](index=234&type=chunk) [Stock Incentive Plan Summary](index=44&type=section&id=Stock%20Incentive%20Plan%20Summary) The Compensation Committee determines the terms for employee stock options, and the company saw a decrease in outstanding options from 1.746 million in 2017 to 1.235 million in 2018 - Compensation Committee determines terms for employee options (term, exercise price, vesting rate)[235](index=235&type=chunk) Stock Option Activity (in thousands, except price) | Metric | 2018 | 2017 | | :--- | :--- | :--- | | Outstanding at beginning of year | 1,746 ($0.68) | 2,254 ($0.64) | | Granted | 24 ($1.15) | 24 ($0.42) | | Exercised | (451) ($0.37) | (50) ($0.22) | | E

Financial Data and Key Metrics Changes - Net income for Q4 2018 reached nearly $900,000, up 38% from Q3 2018 [7] - Revenue in Q4 2018 was just under $3 million, up 10% from Q3 2018 [7] - For the year 2018, net income was $2.3 million compared to a net loss of $30,000 in 2017 [7] - Revenue for 2018 reached $10.3 million, up 50% from 2017 [7][10] - Gross profit margin was 63% in Q4 2018 compared to 58% in Q4 2017 [10] Business Line Data and Key Metrics Changes - Q4 2018 bookings included $5.2 million, mostly from renewals, and $6.3 million in Q3 2018, with $5.5 million from a single order [13][15] - The company expects a decrease in new orders for the first half of 2019 compared to the end of 2018 [17] Market Data and Key Metrics Changes - The company has been focusing on expanding its customer base beyond traditional government contracts, with new commercial opportunities emerging [86] Company Strategy and Development Direction - The company aims to leverage its large datasets to address customer security challenges and expand its market presence [29] - Plans to hire additional sales and engineering personnel to support growth and new projects [34][75] - The company is exploring larger contracts, with potential annual revenues of $10 million to $12 million from new proposals [51][110] Management's Comments on Operating Environment and Future Outlook - Management expressed optimism about continued growth in revenue and profits, driven by new projects and customer satisfaction [7][34] - The company anticipates fluctuations in quarterly orders but expects overall growth to continue [32] Other Important Information - The company is working on improving its investor relations and plans to communicate updates soon [42][44] - Management is focused on meeting NASDAQ listing requirements as profitability improves [46][100] Q&A Session Summary Question: Are the bulk of your orders sole-source contracts? - Yes, all of them are sole-source contracts [40][41] Question: What is the status of the IR firm? - Progress is being made, and updates will be communicated soon [42][44] Question: What is the potential for Savant? - The potential includes both TraceCop and Savant, with opportunities for larger contracts [49][51] Question: What are the expectations for margins going forward? - Margins are expected to remain around 63% for the year, with some variability [54][57] Question: What is the outlook for commercial markets? - The company is ready to pursue commercial markets and expects meaningful orders in 2019 [96][99]