A couple of slaps administered by the sell-side took a bit more steam out of Internet Security Systems ( ISSX) this week, and the stock's bullish run has slowed to a walk.

Since the network security provider reported third-quarter earnings in late October, its shares have traded in near tandem with the Nasdaq, gaining just 7%. Compare that with the spring and summer, when its stock jumped 45% between mid-April and mid-September, outperforming the index by a factor of three.

The flattening curve is no mystery. Investors are wondering if most of the good news this company will deliver for a while is already priced in. Jefferies analyst Katherine Egbert, for example, downgraded the stock to hold this week, saying, "We think that current consensus for another year of 14% top-line growth in 2006 reflects an unrealistic level of optimism."

Moreover, Egbert and others say that Check Point Software Technologies ( CHKP), ISS's larger rival, could become significantly more competitive as it enters ISS' core intrusion prevention business via the $225 million acquisition of Sourcefire.

"CheckPoint is a formidable competitor and one ISS has not had to deal with head on,' says Gartner analyst Amrit Williams. But CheckPoint, he adds, will have to prove it can integrate Sourcefire's open-source technology into its more conventional business model.

Also expanding efforts in enterprise security are Computer Associates ( CA), Juniper Networks ( JNPR)and Cisco Systems ( CSCO)

ISS made a name for itself in the first part of the decade, becoming a leader in the market for intrusion detection technology to alert techies that their corporate networks were under attack. But by 2003, the market flattened and the company changed course, moving from software-based detection products to appliance-based intrusion detection systems, or IPS.

The company's technology gets high marks from analysts, and leads the pack with an approximate 28% share of the nearly $500 million market for intrusion prevention and detection, according to market research firm IDC. And driven by the need to comply with increasingly stringent government and industry regulation, the market will reach $879.3 million in 2006, IDC predicts.

Although CheckPoint is considerably larger than ISS, (sales are double and market cap is four times greater) that kind of muscle doesn't necessarily translate into a win in the security space, says Bruce Schneier, a security consultant and founder of Counterpane Internet Security. Being nimble in response to the latest threat is much more significant, he added.

ISS CEO Tom Noonan says he has "no concerns, none" about heightened competition from CheckPoint. "If they'd had purchased Sourcefire 10 years ago, they would have been competitive, but not now," he said during an interview. Noonan argues that most of Sourcefire's bases were among "hobbyists" who downloaded the open-source code for free and that IT managers won't be impressed with what he called its limited capabilities. "We have years of experience in the IPS market that they can't match."

There have been rumors that ISS has been an acquisition target. "It's the last remaining best-of-breed," says Hambrecht analyst Hung Hoang. "It could provide significant value."

Although Noonan shows no signs wanting to sell his company, and M&A activity in the security sector appears to have peaked, a potential takeover puts a floor under the value of the stock, Hoang says.

Even so, the analyst initiated his coverage of the company this week with a hold, saying, "With the stock trading at a premium to the group and at the upper end of its historical valuation range, we believe this future growth potential is mostly embedded in the shares."

He has a point, at least for now. The stock closed Friday at $24.35, just 59 cents below the consensus target price of $24.94, according to Thomson First Call. (Neither Jefferies nor Hambrecht has an investment banking business with ISS.)

Expense Accounting

The debate over expensing stock options is long over -- but the real party has just begun. Cisco placed the quintessential Silicon Valley goody on the income statement for the first time this week, and plenty of other technology companies will feel the same pain as they're forced to treat stock options the same way they would any other compensation expense.

Options cost the networking giant $228 million, or 4 cents a share, in its just-reported first quarter and that lowered its EPS to 20 cents. A year ago, when Cisco didn't have to expense them, it also posted a 20-cent profit.

Although the use of options has slowed dramatically , companies are now paying for the sins of the past, i.e., accounting for options handed out some time ago. Red Hat ( RHAT) investors will watch their company's bottom line take a hit of about 51% in 2006 simply as a result of the new accounting rules. Mercury Interactive ( MERQE), smarting from an ugly options-related scandal that caused the resignation of its CEO and CFO, will take a 49-cent hit.

On top of the options hit, companies with significant overseas exposure will face an even stiffer currency-related headwind in the next few months.

"The dollar has strengthened further since 3Q reporting season in mid-October, making year-over-year top-line growth comparisons tougher than they already were for coming quarters," says Goldman Sachs analyst Laura Conigliaro.

If currency rates stay where they are now, the "average" multinational technology company with an exposures of about 24% in Europe, 8% in the U.K. and 10% in Japan and Europe, will be faced with a 4- to 5-point hit on the top line in December. That's about a point more than they faced in the October quarter.

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Index Closing Change
Nasdaq Composite 2202 1.5%
Philadelphia Semiconductor 461 2.0%
Goldman Sachs Software 170 1.8%
TSC Internet 211 2.4%