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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2010

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 000-30093

 

 

Websense, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware   51-0380839
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)

10240 Sorrento Valley Road

San Diego, California 92121

858-320-8000

(Address of principal executive offices, zip code and telephone number, including area code)

 

 

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 by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large Accelerated Filer   x    Accelerated Filer   ¨
Non-Accelerated Filer   ¨ (Do not check if a smaller reporting company)    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):    Yes  ¨    No  x

The number of shares outstanding of the registrant’s Common Stock, $.01 par value, as of October 29, 2010 was 41,762,816.

 

 

 


Table of Contents

 

Websense, Inc.

Form 10-Q

For the Period Ended September 30, 2010

TABLE OF CONTENTS

 

               Page  
Part I. Financial Information   
   Item 1.    Consolidated Financial Statements (Unaudited)   
      Consolidated Balance Sheets as of September 30, 2010 and December 31, 2009      3   
      Consolidated Statements of Operations for the three and nine months ended September 30, 2010 and 2009      4   
      Consolidated Statement of Stockholders’ Equity for the nine months ended September 30, 2010      5   
      Consolidated Statements of Cash Flows for the nine months ended September 30, 2010 and 2009      6   
      Notes to Consolidated Financial Statements (Unaudited)      7   
   Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations      15   
   Item 3.    Quantitative and Qualitative Disclosures About Market Risk      27   
   Item 4.    Controls and Procedures      29   
Part II. Other Information   
   Item 1.    Legal Proceedings      29   
   Item 1A.    Risk Factors      29   
   Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds      41   
   Item 3.    Defaults upon Senior Securities      42   
   Item 4.    (Removed and Reserved)      42   
   Item 5.    Other Information      42   
   Item 6.    Exhibits      43   
Signatures      44   

 

2


Table of Contents

 

Part I – Financial Information

 

Item 1. Consolidated Financial Statements (Unaudited)

Websense, Inc.

Consolidated Balance Sheets

(Unaudited and in thousands)

 

     September 30,
2010
    December 31,
2009
 
           (See Note 1)  

Assets

    

Current assets:

    

Cash and cash equivalents

   $ 85,738      $ 82,862   

Cash and cash equivalents – restricted

     243        267   

Accounts receivable, net

     53,493        82,529   

Income tax receivable/prepaid income tax

     6,693        11,446   

Current portion of deferred income taxes

     38,578        36,538   

Other current assets

     13,673        11,461   
                

Total current assets

     198,418        225,103   

Cash and cash equivalents – restricted, less current portion

     420        167   

Property and equipment, net

     17,572        16,494   

Intangible assets, net

     47,691        67,563   

Goodwill

     372,445        372,445   

Deferred income taxes, less current portion

     12,007        11,795   

Deposits and other assets

     9,347        8,094   
                

Total assets

   $ 657,900      $ 701,661   
                

Liabilities and stockholders’ equity

    

Current liabilities:

    

Accounts payable

   $ 8,552      $ 5,135   

Accrued compensation and related benefits

     20,802        21,953   

Other accrued expenses

     18,364        19,965   

Current portion of income taxes payable

     8,530        1,938   

Current portion of senior secured term loan

     12,328        12,429   

Current portion of deferred tax liability

     2,323        4,572   

Current portion of deferred revenue

     234,893        239,010   
                

Total current liabilities

     305,792        305,002   

Other long term liabilities

     2,210        1,298   

Income taxes payable, less current portion

     17,706        15,988   

Senior secured term loan, less current portion

     54,672        74,571   

Deferred tax liability, less current portion

     1,374        970   

Deferred revenue, less current portion

     134,538        141,102   
                

Total liabilities

     516,292        538,931   

Stockholders’ equity:

    

Common stock

     543        529   

Additional paid-in capital

     361,924        330,451   

Treasury stock, at cost

     (257,410     (194,672

Retained earnings

     38,152        28,416   

Accumulated other comprehensive loss

     (1,601     (1,994
                

Total stockholders’ equity

     141,608        162,730   
                

Total liabilities and stockholders’ equity

   $ 657,900      $ 701,661   
                

See accompanying notes.

 

3


Table of Contents

 

Websense, Inc.

Consolidated Statements of Operations

(Unaudited and in thousands, except per share amounts)

 

     Three Months Ended     Nine Months Ended  
     September 30,
2010
    September 30,
2009
    September 30,
2010
    September 30,
2009
 

Revenues

   $ 84,748      $ 78,601      $ 246,388      $ 234,004   

Cost of revenues

     13,563        13,169        38,673        37,400   
                                

Gross profit

     71,185        65,432        207,715        196,604   

Operating expenses:

        

Selling and marketing

     36,428        40,739        116,134        122,073   

Research and development

     13,186        13,696        40,957        39,147   

General and administrative

     9,161        9,734        27,479        30,894   
                                

Total operating expenses

     58,775        64,169        184,570        192,114   
                                

Income from operations

     12,410        1,263        23,145        4,490   

Interest expense

     (791     (1,700     (2,834     (5,659

Other (expense) income, net

     (59     184        (949     612   
                                

Income (loss) before income taxes

     11,560        (253     19,362        (557

Provision (benefit) for income taxes

     5,779        1,672        9,626        (880
                                

Net income (loss)

   $ 5,781      $ (1,925   $ 9,736      $ 323   
                                

Net income (loss) per share:

        

Basic net income (loss) per share

   $ 0.14      $ (0.04   $ 0.23      $ 0.01   
                                

Diluted net income (loss) per share

   $ 0.13      $ (0.04   $ 0.22      $ 0.01   
                                

Weighted average shares – basic

     42,200        44,131        42,536        44,444   
                                

Weighted average shares – diluted

     42,907        44,131        43,527        44,812   
                                

See accompanying notes.

 

4


Table of Contents

 

Websense, Inc.

Consolidated Statement of Stockholders’ Equity

(Unaudited and in thousands)

 

     Common stock      Additional     Treasury     Retained      Accumulated
other
comprehensive
    Total
stockholders’
 
     Shares     Amount      paid-in capital     stock     earnings      loss     equity  

Balance at December 31, 2009

     43,410      $ 529       $ 330,451      $ (194,672   $ 28,416       $ (1,994   $ 162,730   

Issuance of common stock upon exercise of options

     742        7         12,210        0        0         0        12,217   

Issuance of common stock for ESPP purchase

     233        3         3,128        0        0         0        3,131   

Issuance of common stock from restricted stock units, net

     254        4         0        (2,740     0         0        (2,736

Share-based compensation expense

     0        0         17,496        0        0         0        17,496   

Tax shortfall from share-based compensation

     0        0         (1,361     0        0         0        (1,361

Purchase of treasury stock

     (2,906     0         0        (59,998     0         0        (59,998

Other comprehensive income:

                

Net income

     0        0         0        0        9,736         0        9,736   

Net change in unrealized gain on derivative contracts, net of tax

     0        0         0        0        0         393        393   
                      

Comprehensive income

                   10,129   
                                                          

Balance at September 30, 2010

     41,733      $ 543       $ 361,924      $ (257,410   $ 38,152       $ (1,601   $ 141,608   
                                                          

See accompanying notes.

 

5


Table of Contents

 

Websense, Inc.

Consolidated Statements of Cash Flows

(Unaudited and in thousands)

 

     Nine Months Ended  
     September 30,
2010
    September 30,
2009
 

Operating activities:

    

Net income

   $ 9,736      $ 323   

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation and amortization

     28,037        38,597   

Share-based compensation

     17,496        18,412   

Deferred income taxes

     (4,352     (9,378

Unrealized (gain) loss on foreign exchange

     (14     141   

Excess tax benefit from share-based compensation

     (1,220     (200

Changes in operating assets and liabilities:

    

Accounts receivable

     30,939        23,388   

Other assets

     (3,863     (2,330

Accounts payable

     2,914        139   

Accrued compensation and related benefits

     (1,577     66   

Other liabilities

     (3,152     (2,231

Deferred revenue

     (10,682     (307

Income taxes payable and receivable/prepaid

     11,814        (2,788
                

Net cash provided by operating activities

     76,076        63,832   
                

Investing activities:

    

Change in restricted cash and cash equivalents

     (197     747   

Purchase of property and equipment

     (6,162     (9,159
                

Net cash used in investing activities

     (6,359     (8,412
                

Financing activities:

    

Principal payments on senior secured term loan

     (20,000     (26,000

Principal payment on capital lease obligation

     (532     0   

Proceeds from exercise of stock options

     12,217        2,237   

Proceeds from issuance of common stock for employee stock purchase plan

     3,131        2,787   

Excess tax benefit from share-based compensation

     1,220        200   

Tax payments related to restricted stock unit issuances

     (2,736     (322

Purchase of treasury stock

     (59,714     (22,454
                

Net cash used in financing activities

     (66,414     (43,552
                

Effect of exchange rate changes on cash and cash equivalents

     (427     292   

Increase in cash and cash equivalents

     2,876        12,160   

Cash and cash equivalents at beginning of period

     82,862        64,096   
                

Cash and cash equivalents at end of period

   $ 85,738      $ 76,256   
                

Supplemental disclosures of cash flow information:

    

Income taxes paid, net of refunds

   $ 2,850      $ 12,885   

Interest paid

   $ 2,332      $ 4,748   

Increase in other accrued expenses for purchase of treasury stock

   $ 284      $ 47   

Capital lease obligation incurred for a software license arrangement

   $ 1,688      $ 0   

See accompanying notes.

 

6


Table of Contents

 

Websense, Inc.

Notes to Consolidated Financial Statements (Unaudited)

1. Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in conformity with United States generally accepted accounting principles (“GAAP”) for interim financial statements and with the instructions to Form 10-Q and Article 10 of Regulation S-X and on the same basis as the audited financial statements included on Websense, Inc.’s (“Websense,” the “Company,” “we,” “us,” or “our”) annual report on Form 10-K for the year ended December 31, 2009. Accordingly, certain information or footnote disclosures normally included in complete financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the statements include all adjustments necessary, which are of a normal and recurring nature, for the fair presentation of our financial position and results of operations for the interim periods presented.

These financial statements should be read in conjunction with the audited consolidated financial statements and notes for the fiscal year ended December 31, 2009, included in Websense’s Annual Report on Form 10-K filed with the Securities and Exchange Commission. Operating results for the three and nine months ended September 30, 2010 are not necessarily indicative of the results that may be expected for any other interim period or for the fiscal year ending December 31, 2010. The balance sheet at December 31, 2009 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by GAAP for complete financial statements. Certain prior period amounts have been reclassified to conform to the current period presentation.

2. Net Income Per Share

Basic net income per share (“EPS”) is computed by dividing the net income for the period by the weighted average number of common shares outstanding during the period. Diluted EPS is computed by dividing the net income for the period by the weighted average number of common and common equivalent shares outstanding during the period. Common equivalent shares consist of dilutive stock options, employee stock purchase plan shares and restricted stock units. Dilutive stock options, employee stock purchase plan shares and dilutive restricted stock units are calculated based on the average share price for each fiscal period using the treasury stock method. If, however, the Company reports a net loss, the diluted EPS is computed in the same manner as the basic EPS.

Potentially dilutive securities totaling approximately 6,188,000 and 9,090,000 shares for the three months ended September 30, 2010 and 2009, respectively, were excluded from the diluted EPS calculation because their exercise price was greater than the average market price of common shares and, therefore, the effect would be anti-dilutive. Potentially dilutive securities totaling 5,618,000 and 9,402,000 shares for the nine months ended September 30, 2010 and 2009, respectively, were excluded from the diluted EPS calculation because of their anti-dilutive effect.

The following is a reconciliation of the numerator and denominator used in calculating basic EPS to the numerator and denominator used in calculating diluted EPS for all periods presented:

 

     Net Income
(Numerator)
    Shares
(Denominator)
     Per Share
Amount
 
     (In thousands, except per share amounts)  

For the Three Months Ended:

       

September 30, 2010:

       

Basic EPS

   $ 5,781        42,200       $ 0.14   

Effect of dilutive securities

     —          707         (0.01
                         

Diluted EPS

   $ 5,781        42,907       $ 0.13   
                         

September 30, 2009:

       

Basic EPS

   $ (1,925     44,131       $ (0.04

Effect of dilutive securities

     —          —           —     
                         

Diluted EPS

   $ (1,925     44,131       $ (0.04
                         

 

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Table of Contents

Websense, Inc.

Notes to Consolidated Financial Statements (Unaudited)—(Continued)

 

 

For the Nine Months Ended:

        

September 30, 2010:

        

Basic EPS

   $ 9,736         42,536       $ 0.23   

Effect of dilutive securities

     —           991         (0.01
                          

Diluted EPS

   $ 9,736         43,527       $ 0.22   
                          

September 30, 2009:

        

Basic EPS

   $ 323         44,444       $ 0.01   

Effect of dilutive securities

     —           368         —     
                          

Diluted EPS

   $ 323         44,812       $ 0.01   
                          

3. Comprehensive Income

The components of comprehensive income were as follows (in thousands):

 

     Three Months Ended     Nine Months Ended  
     September 30,
2010
     September 30,
2009
    September 30,
2010
     September 30,
2009
 

Net income (loss)

   $ 5,781       $ (1,925   $ 9,736       $ 323   

Net change in unrealized gain on derivative contracts, net of tax of $80, $183, $255 and $658, respectively

     152         273        393         1,005   
                                  

Comprehensive income (loss)

   $ 5,933       $ (1,652   $ 10,129       $ 1,328   
                                  

The accumulated derivative unrealized (loss) gain, net of tax, on the Company’s derivative contracts included in “Accumulated other comprehensive loss” was as follows (in thousands):

 

     Three Months Ended     Nine Months Ended  
     September 30,
2010
    September 30,
2009
    September 30,
2010
    September 30,
2009
 

Beginning balance

   $ (128   $ (827   $ (369   $ (1,559

Net change during the period

     152        273        393        1,005   
                                

Ending balance

   $ 24      $ (554   $ 24      $ (554
                                

4. Intangible Assets

Intangible assets subject to amortization consisted of the following as of September 30, 2010 (in thousands):

 

     Remaining
Weighted Average  Life
(years)
     Cost      Accumulated
Amortization
    Net  

Technology

     2.4       $ 32,448       $ (24,286   $ 8,162   

Customer relationships

     5.1         129,200         (89,798     39,402   

Trade name

     1.3         510         (383     127   
                            

Total

     4.6       $ 162,158       $ (114,467   $ 47,691   
                            

 

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Table of Contents

Websense, Inc.

Notes to Consolidated Financial Statements (Unaudited)—(Continued)

 

 

As of September 30, 2010, remaining amortization expense is expected to be as follows (in thousands):

 

Years Ending December 31,

  

2010

   $ 6,612   

2011

     15,550   

2012

     8,329   

2013

     5,577   

2014

     4,545   

Thereafter

     7,078   
        

Total

   $ 47,691   
        

5. Senior Secured Credit Facility

In October 2007, the Company entered into an amended and restated senior secured credit agreement, which was subsequently amended in December 2007, June 2008 and February 2010 (the “2007 Senior Credit Agreement”). The $225 million senior secured credit facility consists of a five year $210 million senior secured term loan and a $15 million revolving credit facility. The senior secured term loan was fully funded on October 11, 2007, and the revolving line of credit remains unused. At September 30, 2010, the outstanding balance under the senior secured term loan was $67 million as a result of the Company making principal payments totaling $3 million in the three months ended September 30, 2010. The senior secured credit facility is secured by substantially all of the assets of the Company, including pledges of stock of certain of its subsidiaries (subject to limitations in the case of foreign subsidiaries) and by secured guarantees by the Company’s domestic subsidiaries. The senior secured term loan bears interest at a spread above LIBOR with the spread determined based upon the Company’s total leverage ratio, as defined in the 2007 Senior Credit Agreement. Based on the total leverage ratio as of June 30, 2010, the spread on the senior secured term loan was LIBOR plus 225 basis points per annum and the fee for the unused portion of the revolving credit facility was 25 basis points per annum during the quarter ended September 30, 2010. The weighted average interest rate on the senior secured term loan at September 30, 2010 was 2.5%. The 2007 Senior Credit Agreement contains financial covenants, including a consolidated leverage ratio and a consolidated interest coverage ratio, as well as affirmative and negative covenants. Among the negative covenants are restrictions on the Company’s ability to borrow money, including restrictions on (a) the incurrence of more than $15 million of new debt, including capital leases (subject to certain exceptions), (b) the incurrence of more than $7.5 million in letters of credit, (c) the incurrence of more than $50 to $75 million of new debt, depending on the Company’s leverage ratio, to finance future acquisitions or (d) the assumption of more than $15 million of new debt in connection with acquisitions. Also, the Company is not permitted to pay cash dividends under the terms of the 2007 Senior Credit Agreement.

As of September 30, 2010, future remaining minimum principal payments under the senior secured term loan are as follows (in thousands):

 

Years Ending December 31,

  

2010

   $ 2,680   

2011

     12,864   

2012

     51,456   
        

Total

   $ 67,000   
        

On October 22, 2010, the Company entered into a new credit agreement intended to replace the 2007 Senior Credit Agreement, with more extended principal repayment terms and overall terms and conditions that are more favorable to the Company. On October 29, 2010, the Company repaid the term loan and retired the 2007 Senior Credit Agreement (See Note 11. Subsequent Events).

6. Fair Value Measurements and Derivatives

Fair Value Measurements on a Recurring Basis

Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurements. The Company’s assessment of the significance of a particular input to the fair value measurements requires judgment, and may affect the valuation of the assets and liabilities being measured and their placement within the fair value hierarchy.

 

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Table of Contents

Websense, Inc.

Notes to Consolidated Financial Statements (Unaudited)—(Continued)

 

 

The following table presents the balances of assets and liabilities measured at fair value on a recurring basis as of September 30, 2010 (in thousands):

 

     Level 1  (1)      Level 2  (2)      Level 3  (3)      Total  

Assets:

           

Israeli Shekel contracts designated as cash flow hedges

   $ —         $ 33       $ —         $ 33   

Liabilities:

           

Currency forward contracts not designated as hedges

     —           303         —           303   

 

(1)  –  

quoted prices in active markets for identical assets or liabilities

(2)  –  

observable inputs other than quoted prices in active markets for identical assets and liabilities

(3)  –  

no observable pricing inputs in the market

Included in Other assets and in Other accrued expenses are derivative contracts, comprised of currency forward contracts, that are valued using models based on readily observable market parameters for all substantial terms of the Company’s derivative contracts and thus are classified within Level 2.

The Company uses derivative financial instruments to manage foreign currency risk relating to foreign exchange rates and to manage interest rate risk relating to the Company’s variable rate senior secured term loan. The Company does not use these instruments for speculative or trading purposes. The Company’s objective is to reduce the risk to earnings and cash flows associated with changes in foreign currency exchange rates and changes in interest rates. Derivative instruments are recognized as either assets or liabilities in the accompanying financial statements and are measured at fair value. Gains and losses resulting from changes in the fair values of those derivative instruments are recorded to earnings or other comprehensive income (loss) depending on the use of the derivative instrument and whether it qualifies for hedge accounting.

The 2007 Senior Credit Agreement provides that the Company must maintain hedge agreements so that at least 50% of the aggregate principal amount of the senior secured credit facility is subject to fixed interest rate protection for a period of not less than 2.5 years from the initial funding date of October 11, 2007, however, on October 29, 2010, the Company retired the 2007 Senior Credit Agreement using the proceeds from the Company’s new senior credit facility (See Note 11. Subsequent Events), and the new facility does not require the Company to maintain any hedge agreements. On the initial funding date of the 2007 Senior Credit Agreement, the Company entered into an interest rate swap agreement to pay a fixed rate of interest (4.85% per annum) and receive a floating rate interest payment (based on three month LIBOR) on an equivalent amount. The notional amount of the swap agreement was $11 million during the quarter ended September 30, 2010 and the swap agreement expired on September 30, 2010. In addition, on October 11, 2007 the Company entered into an interest rate cap agreement to limit the maximum interest rate on a portion of its senior secured term loan to 6.5% per annum. The amount of principal protected by this agreement was $74.3 million during the quarter ended September 30, 2010 and the cap agreement expired on September 30, 2010.

During the nine months ended September 30, 2010 and 2009, the Company utilized Euro, British Pound and Australian Dollar foreign currency forward contracts to hedge anticipated foreign currency denominated net monetary assets. All such contracts entered into were designated as fair value hedges and were not required to be tested for effectiveness as hedge accounting was not elected. The gains (losses) related to the contracts designated as fair value hedges are included in other (expense) income, net, in the accompanying consolidated statements of operations and amounted to approximately $(806,000) and $(255,000) for the three months ended September 30, 2010 and 2009, respectively, and $358,000 and $277,000 for the nine months ended September 30, 2010 and 2009, respectively. All of the fair value hedging contracts in place as of September 30, 2010 will be settled before February 2011.

During the nine months ended September 30, 2010 and 2009, the Company utilized Israeli Shekel forward contracts to hedge anticipated operating expenses. All such contracts entered into were designated as cash flow hedges and were considered effective. None of the contracts were terminated prior to settlement. Net realized gains (losses) of $(18,000) and $61,000 during the three months ended September 30, 2010 and 2009, respectively and $(33,000) and $54,000 during the nine months ended September 30, 2010 and 2009, respectively related to the contracts designated as cash flow hedges are included in the respective operating categories for which the Company hedges its Israeli Shekel expenditures. All of the Israeli Shekel hedging contracts in place as of September 30, 2010 will be settled before January 2011.

 

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Websense, Inc.

Notes to Consolidated Financial Statements (Unaudited)—(Continued)

 

 

Notional and fair values of the Company’s foreign currency hedging positions at September 30, 2010 and 2009 are presented in the table below (in thousands):

 

     September 30, 2010      September 30, 2009  
      Notional
Value
Local
Currency
     Notional
Value
USD
     Fair Value
USD
     Notional
Value
Local
Currency
     Notional
Value
USD
     Fair Value
USD
 

Fair Value Hedges

                 

Euro

     2,000       $ 2,523       $ 2,727         4,500       $ 6,513       $ 6,588   

British Pound

     2,250         3,518         3,535         2,000         3,216         3,196   

Australian Dollar

     1,000         885         967         2,000         1,703         1,754   
                                         

Total

      $ 6,926       $ 7,229          $ 11,432       $ 11,538   
                                         

Cash Flow Hedges

                 

Israel Shekel

     4,500       $ 1,195       $ 1,228         3,750       $ 897       $ 996   

The effects of derivative instruments on the Company’s financial statements were as follows as of September 30, 2010 and 2009 and for the three and nine months then ended (in thousands). There was no ineffective portion nor was any amount excluded from effectiveness testing during any of the periods presented below.

 

     Fair Value of Derivative Instruments     Fair Value of Derivative Instruments  
     September 30, 2010     September 30, 2009  
     Balance Sheet Location      Fair Value     Balance Sheet Location      Fair Value  

Currency contracts designated as cash flow hedges

     Other assets       $ 33        Other assets       $ 99   

Interest rate swap contracts designated as cash flow hedges

     Other accrued expenses         —          Other accrued expenses         (1,040
                      

Total derivatives designated as hedges

      $ 33         $ (941

Currency forward contracts not designated as hedges

     Other accrued expenses       $ (303     Other accrued expenses       $ (106
                      

Total derivatives

      $ (270      $ (1,047
                      

 

     Amount of Gain (Loss)
Recognized in
Accumulated OCI on
Derivatives
(Effective Portion)
     Location and Amount of Gain
(Loss) Reclassified from
Accumulated OCI into Income
(Effective Portion)
 

Derivatives in Cash

Flow Hedging Relationships

   Three Months  Ended
September 30,
    Nine Months Ended
September 30,
            Three Months Ended
September 30,
    Nine Months  Ended
September 30,
 
   2010      2009     2010      2009             2010     2009     2010     2009  

Interest rate swap contracts

   $ 119       $ 465      $ 614       $ 1,569         Interest expense      $ (121   $ (587   $ (625   $ (1,864

Currency contracts

     111         (5     33         95         R&D         (18     61        (33     54   
                                                                      

Total

   $ 230       $ 460      $ 647       $ 1,664          $ (139   $ (526   $ (658   $ (1,810
                                                                      

 

     Location and Amount of Gain (Loss)
Recognized in Income on Derivatives
 

Derivatives Not Designated as Hedges

         Three Months  Ended
September 30,
    Nine Months  Ended
September 30,
 
         2010     2009     2010      2009  

Currency forward contracts

    
 
Other 
 
(expense) income, 
net 
  $ (806   $ (255   $ 358       $ 277   

 

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Websense, Inc.

Notes to Consolidated Financial Statements (Unaudited)—(Continued)

 

 

Fair Value Measurements on a Nonrecurring Basis

During the three and nine months ended September 30, 2010, the Company did not re-measure any nonfinancial assets and liabilities measured at fair value on a nonrecurring basis (e.g., goodwill, intangible assets, property and equipment and nonfinancial assets and liabilities initially measured at fair value in a business combination). As of September 30, 2010, the Company’s senior secured term loan, with a carrying value of $67.0 million, had an estimated fair value of $67.5 million which the Company determined using a discounted cash flow model with a discount rate of 2.0% which represents the Company’s estimated incremental borrowing rate.

7. Stockholders’ Equity

Share-Based Compensation

Employee Stock Plans

The following table summarizes the Company’s restricted stock unit activity since December 31, 2009:

 

     Number of
Shares
 

Balance at December 31, 2009

     1,203,403   

Granted

     841,022   

Released

     (395,843

Cancelled

     (167,076
        

Balance at September 30, 2010

     1,481,506   
        

The following table summarizes the Company’s stock option activity since December 31, 2009:

 

     Number of
Shares
    Weighted
Average
Exercise Price
 

Balance at December 31, 2009

     9,775,678      $ 21.85   

Granted

     316,000        20.27   

Exercised

     (742,050     16.46   

Cancelled

     (992,904     22.21   
          

Balance at September 30, 2010

     8,356,724        22.22   
          

The results of operations for the three and nine months ended September 30, 2010 and 2009 include share-based compensation expense in the following expense categories of the consolidated statements of operations (in thousands):

 

     Three Months Ended      Nine Months Ended  
     September 30,
2010
     September 30,
2009
     September 30,
2010
     September 30,
2009
 

Share-based compensation in:

           

Cost of revenues

   $ 294       $ 345       $ 990       $ 1,012   
                                   

Total share-based compensation in cost of revenues

     294         345         990         1,012   

Selling and marketing

     1,569         1,951         5,449         5,933   

Research and development

     1,126         1,376         4,135         3,804   

General and administrative

     1,794         2,483         6,922         7,663   
                                   

Total share-based compensation in operating expenses

     4,489         5,810         16,506         17,400   
                                   

Total share-based compensation

   $ 4,783       $ 6,155       $ 17,496       $ 18,412   
                                   

 

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Websense, Inc.

Notes to Consolidated Financial Statements (Unaudited)—(Continued)

 

 

The Company used the following assumptions to estimate the fair value of the stock options granted:

 

     Three Months Ended     Nine Months Ended  
     September 30,
2010
    September 30,
2009
    September 30,
2010
    September 30,
2009
 

Average expected life (years)

     3.4        3.3        3.4        3.1   

Average expected volatility factor

     42.6     46.3     42.4     45.5

Average risk-free interest rate

     0.9     1.7     1.4     1.4

Average expected dividend yield

     —          —          —          —     

Treasury Stock

The Company repurchased shares of its common stock during the first nine months of 2010 as follows:

 

     Shares      Average Price
Per Share
 

Shares repurchased through December 31, 2009

     11,534,024       $ 19.50   

Shares repurchased during the nine months ended September 30, 2010

     2,906,206         20.63   
           

Total shares repurchased through September 30, 2010

     14,440,230         19.73   
           

The remaining number of shares authorized for repurchase under the Company’s stock repurchase program as of September 30, 2010 was 1,559,770 shares. As of October 26, 2010, the Company increased the number of shares authorized for repurchase under the program by 8,000,000 shares. As of October 29, 2010 the Company retired the 2007 Senior Credit Agreement using the proceeds from the Company’s new senior credit facility (See Note 11. Subsequent Events). The new facility does not prohibit repurchases by the Company of its common stock so long as it is not in default under the new facility, has complied with all of its financial covenants, and has liquidity, as defined in the new senior credit facility, of at least $20 million; provided, however, if, after giving effect to any repurchase, the Company’s consolidated leverage ratio is greater than 1.75:1; such repurchases cannot exceed $10 million in the aggregate in any fiscal year.

8. Tax Matters

For the three months ended September 30, 2010, the Company recognized an income tax expense of $5.8 million which represented an effective tax rate of 50.0%. For the nine months ended September 30, 2010, the Company recognized an income tax expense of $9.6 million which represented an effective tax rate of 49.7%. The effective tax rate variances from the statutory rates for these periods was primarily related to an increase in the valuation allowance for net operating losses of one of the Company’s subsidiaries in the United Kingdom, the unfavorable impact on deferred tax amounts resulting from a California law change, foreign withholding taxes and non-deductible share-based payments, which offset the benefit of income taxed at lower rates in foreign jurisdictions.

The Company and its subsidiaries file tax returns which are routinely examined by tax authorities in the U.S. and in various state and foreign jurisdictions. The Company is currently under examination by the respective tax authorities for tax years 2005 to 2008 in the United States, for 2006 to 2007 in the United Kingdom and for 2006 to 2008 in Israel. The Company has various other on-going audits in various stages of completion. In general, the tax years 2005 through 2009 could be subject to examination by U.S. federal and most state tax authorities.

During the first quarter of 2010, the Company was informed by the U.S. Internal Revenue Service (the “IRS”) that they had completed their audit for the tax years ended December 31, 2005 through December 31, 2007. Accordingly, the IRS issued the Company a 30-day letter which outlines all of their proposed audit adjustments and requires the Company to either accept the proposed adjustments, subject to future litigation, or file a formal administrative protest contesting those proposed adjustments within 30 days. The proposed adjustments relate primarily to the cost sharing arrangement between Websense, Inc. and its Irish subsidiary, including the amount of cost sharing buy-in, as well as to the Company’s claim of research and development tax credits and income tax deductions for equity compensation awarded to certain executive officers. The amount of additional tax proposed by the IRS totals approximately $19.0 million, of which $14.8 million relates to the amount of cost sharing buy-in, $2.5 million relates to research and development credits and $1.7 million relates to equity compensation awarded to certain executive officers. The total additional tax proposed excludes interest, penalties and state income taxes, each of which may be significant, and also excludes a potential reduction in tax on the Irish subsidiary. The proposed adjustments also do not include the future impact that changes in the Company’s cost sharing arrangement could have on the Company’s effective tax rate. The Company disagrees with all of the proposed adjustments and has submitted a formal protest to the IRS for each matter. The IRS has acknowledged the receipt of the Company’s protest and the Company is now awaiting an appointment with the IRS Appeals Office. The Company intends to continue to defend its position on all of these matters, including through litigation if required. The timing of the ultimate resolution of these matters cannot be reasonably estimated at this time.

 

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Websense, Inc.

Notes to Consolidated Financial Statements (Unaudited)—(Continued)

 

 

9. Litigation

On July 12, 2010, Finjan, Inc. filed a complaint entitled Finjan, Inc. v. McAfee, Inc., Symantec Corp., Webroot Software, Inc., Websense, Inc. and Sophos, Inc. in the United States District Court for the District of Delaware. The complaint alleges that the Company’s making, using, importing, selling and/or offering for sale Websense Web Filter, Websense Web Security and Websense Web Security Gateway infringes U.S. Patent No. 6,092,194 (“194 Patent”). Finjan, Inc. seeks an injunction from further infringement of the 194 Patent and damages. The Company denies infringing any valid claims of the 194 Patent and intends to vigorously defend the lawsuit.

The Company is involved in various other legal actions in the normal course of business. Based on current information, including consultation with the Company’s attorneys, the Company believes that it has adequately reserved for any ultimate liability that may result from these actions such that any liability would not materially affect the Company’s consolidated financial position, results of operations or cash flows. The Company’s evaluation of the likely impact of these actions could change in the future and unfavorable outcomes and/or defense costs, depending upon the amount and timing, could have a material adverse effect on the Company’s results of operations or cash flows in a future period.

10. Recently Issued Accounting Standards

In October 2009, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance on revenue recognition that will become effective for the Company beginning January 1, 2011, with earlier adoption permitted. Under the new guidance on arrangements that include software elements, tangible products that have software components that are essential to the functionality of the tangible product will no longer be within the scope of the software revenue recognition guidance, and software-enabled products will now be subject to other relevant revenue recognition guidance. Additionally, the FASB issued authoritative guidance on revenue arrangements with multiple deliverables that are outside the scope of the software revenue recognition guidance. Under the new guidance, when vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. The new guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. The Company is currently evaluating both the timing and the impact of the pending adoption of these standards on its consolidated financial statements.

11. Subsequent Events

As of October 26, 2010, the Company increased the number of shares authorized for repurchase under its stock repurchase program by 8,000,000 shares.

On October 22, 2010, the Company entered into a new credit agreement with a syndicate of lenders led by Bank of America, N.A., and arranged by Banc of America Securities LLC and KeyBank National Association (the “New Credit Agreement”). The New Credit Agreement was intended to replace the 2007 Senior Credit Agreement, with more extended principal repayment terms and overall terms and conditions that are more favorable to the Company. The New Credit Agreement provides for a secured revolving credit facility that matures on October 29, 2015 with an initial maximum aggregate commitment of $120 million, including a $15 million sublimit for issuances of letters of credit and a $5 million sublimit for swing line loans. The Company may increase the maximum aggregate commitment under the New Credit Agreement up to $200 million if certain conditions are satisfied, including that the Company is not in default under the New Credit Agreement at the time of the increase and that the Company obtains the commitment of the lenders participating in the increase. Loans under the New Credit Agreement are designated at the Company’s election as either base rate or Eurodollar rate loans. Base rate loans bear interest at a rate equal to the highest of (i) the federal funds rate plus 0.5%, (ii) the Eurodollar rate plus 1.00%, and (iii) Bank of America’s prime rate, in each case plus a margin set forth below. Eurodollar rate loans bear interest at a rate equal to (i) the Eurodollar rate, plus (ii) a margin set forth below.

 

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Websense, Inc.

Notes to Consolidated Financial Statements (Unaudited)—(Continued)

 

The applicable margins until the date that the Company files its Form 10-K for the fiscal year ended December 31, 2010, are 0.75% for base rate loans and 1.75% for Eurodollar rate loans. Thereafter the applicable margins are determined by reference to the Company’s leverage ratio, as set forth in the table below:

 

Consolidated Leverage Ratio

   Eurodollar Rate
Loans
    Base Rate
Loans
 

<1.25:1.0

     1.75     0.75

>1.25:1.0

     2.00     1.00

For each commercial Letter of Credit, the Company must pay a fee equal to 0.125% per annum times the daily amount available to be drawn under such Letter of Credit and, for each standby Letter of Credit, the Company must pay a fee equal to the applicable margin for Eurodollar rate loans times the daily amount available to be drawn under such Letter of Credit. A quarterly commitment fee is payable to the lenders in an amount equal to the unused portion of the credit facility multiplied by 0.25%.

Indebtedness under the New Credit Agreement is secured by substantially all of the assets of the Company, including pledges of stock of certain of its subsidiaries (subject to limitations in the case of foreign subsidiaries) and by secured guarantees by the Company’s first-tier domestic subsidiaries. The New Credit Agreement contains affirmative and negative covenants, including an obligation to maintain a certain consolidated leverage ratio and consolidated interest coverage ratio and restrictions on, the Company’s ability to borrow money, to incur liens, to enter into mergers and acquisitions, to make dispositions, to pay cash dividends or repurchase capital stock, and to make investments, subject to certain exceptions. For example, the Credit Agreement permits the Company to repurchase its securities so long as it is not in default under the New Credit Agreement, has complied with all of its financial covenants, and has liquidity of at least $20 million; provided, however, if, after giving effect to any repurchase, the Company’s leverage ratio is greater than 1.75:1, such repurchase cannot exceed $10 million in the aggregate in any fiscal year. The New Credit Agreement does not require the Company to use excess cash to pay down debt.

The New Credit Agreement provides for acceleration of the Company’s obligations thereunder upon certain events of default. The events of default include, without limitation, failure to pay loan amounts when due, any material inaccuracy in the Company’s representations and warranties, failure to observe covenants, defaults on any other indebtedness, entering bankruptcy, existence of a judgment or decree against the Company or its subsidiaries involving an aggregate liability of $10 million or more, the security interest or guarantee ceasing to be in full force and effect, any person becoming the beneficial owner of more than 35% of the Company’s outstanding common stock, or the Company’s board of directors ceasing to consist of a majority of Continuing Directors, where “Continuing Directors” means the members of the Company’s board of directors on the effective date of the New Credit Agreement and each other director nominated for election to the Company’s board of directors by at least a majority of the Continuing Directors.

On October 29, 2010, the Company received an advance of $67 million under the revolving credit facility and used the entire proceeds to pay off the Company’s existing term loan under the 2007 Senior Credit Agreement. $53 million of the revolving credit facility remains unused, and the Company has not requested any letters of credit under the New Credit Agreement. In connection with the pay off of the existing term loan under the 2007 Senior Credit Agreement, the Company has written off the remaining unamortized deferred financing fees of approximately $0.8 million in October 2010.

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with the financial statements and related notes contained elsewhere in this report. See “Risk Factors” under Part II, Item 1A regarding certain factors known to us that could cause reported financial information not to be necessarily indicative of future results.

Forward-Looking Statements

This report on Form 10-Q includes “forward-looking statements” within the meaning of the federal securities laws made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements, which represent our expectations or beliefs concerning various future events, may contain words such as “may,” “will,” “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates” or other words indicating future results. Such statements may include but are not limited to statements concerning the following:

 

   

anticipated trends in revenue;

 

   

plans, strategies and objectives of management for future operations;

 

   

growth opportunities in domestic and international markets;

 

   

new and enhanced reliance on channels of distribution;

 

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customer acceptance and satisfaction with our products, services and fee structures;

 

   

expectations regarding competitive products and pricing;

 

   

changes in domestic and international market conditions;

 

   

risks associated with fluctuations in foreign currency exchange rates;

 

   

the impact of macro-economic conditions on our customers;

 

   

expected trends in operating and other expenses;

 

   

anticipated cash and intentions regarding usage of cash, including risks related to the required use of cash for debt servicing;

 

   

risks related to compliance with the covenants in our senior secured credit facility;

 

   

risks associated with integrating acquired businesses and launching new product offerings;

 

   

changes in effective tax rates, laws and interpretations and statements related to tax audits and proposed adjustments;

 

   

risks related to changes in accounting interpretations or accounting guidance;

 

   

anticipated product enhancements or releases;

 

   

the volatile and competitive nature of the Internet and security industries; and

 

   

the success of our brand development efforts.

These forward-looking statements are subject to risks and uncertainties, including those risks and uncertainties described herein under Part II, Item 1A “Risk Factors,” that could cause actual results to differ materially from those anticipated as of the date of this report. We assume no obligation to update any forward-looking statements to reflect events or circumstances arising after the date of this report.

Overview

We are a leading provider of information technology (“IT”) security solutions, including Web security, data security, and email security solutions. Our solutions are available as software installed on standard server hardware, as software pre-installed on optimized appliances, and as software-as-a-service (“SaaS”) offerings. Our products and services are sold to enterprises, mid-market, small and medium sized businesses (“SMB”), and Internet service providers through a network of distributors, value added resellers and original equipment manufacturer (“OEM”) arrangements. Our portfolio of real-time Web security, URL filtering, data loss prevention (“DLP”) and email anti-spam and security software allows organizations to:

 

   

dynamically categorize user-generated and other dynamic Web 2.0 content;

 

   

prevent access to undesirable and dangerous elements on the Web, such as Web sites that contain inappropriate content or sites that download viruses, spyware, keyloggers, hacking tools and an ever-increasing variety of malicious code, including Web 2.0 sites with user-generated content;

 

   

identify and remove malicious applications from incoming Web traffic;

 

   

prevent the unauthorized use and loss of sensitive data, such as customer or employee information;

 

   

filter spam out of incoming email traffic;

 

   

filter viruses and other malicious attachments from email and instant messages;

 

   

manage the use of non-Web Internet traffic, such as peer-to-peer communications and instant messaging;

 

   

protect from spam and malware embedded in Web-based user-generated content; and

 

   

control misuse of an organization’s valuable computing resources, including unauthorized downloading of high-bandwidth content.

Since we commenced operations in 1994, Websense has evolved from a reseller of computer security products to a leading provider of IT security software solutions, including Web security, URL filtering, DLP, email, anti-spam and messaging security solutions. Our first Web filtering software product was released in 1996 and prevented access to inappropriate Web content. Since then, we have focused on adapting our Web filtering and content classification capabilities to address changing Internet use patterns and the growing incidence of Web-based criminal activity, as well as integrating Web security with data security and email security solutions.

During the three and nine months ended September 30, 2010, we derived 50% and 51%, respectively, of our revenue from international sales compared to 49% and 50% during the three and nine months ended September 30, 2009, respectively. The United Kingdom comprised 12% and 13% of our total revenue in the three and nine months ended September 30, 2010, respectively, compared to 14% and 15% of our total revenue in the three and nine months ended September 30, 2009, respectively.

 

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We utilize a two-tier distribution strategy in North America to sell our products, with an objective of increasing the number of value-added resellers selling our products and further extending our reach into the SMB market segment. Our distribution strategy outside North America also relies on a multi-tiered system of distributors and value-added resellers. Sales through indirect channels currently account for more than 90% of our revenue. We also have several arrangements with OEMs that grant the OEM customers the right to incorporate our products into the OEM’s products for resale to end-users.

We sell subscriptions to our products, generally in 12, 24 or 36 month contract durations, which are for a fixed number of seats or devices. As described elsewhere in this report, we generally recognize revenue from subscriptions to our products, including our appliances and our add-on modules, on a daily straight-line basis commencing on the day the term of the subscription begins, over the term of the subscription agreement. We recognize revenue associated with OEM contracts ratably over the contractual period for which we are obligated to provide our services. We generally recognize the operating expenses related to these sales as they are incurred. These operating expenses include sales commissions, which are based on the total amount of the subscription contract and are fully expensed in the first period the product and/or key is delivered. Our operating expenses in the first nine months of 2010 decreased compared to the first nine months of 2009, primarily due to a reduction in the amortization of acquired intangible assets offset by our increased headcount and increased amortization of deferred costs associated with the sale of our appliance products. Our increase in headcount compared to the first nine months of 2009 was primarily due to the expansion of our product research and development.

Critical Accounting Policies and Estimates

Critical accounting policies are those that may have a material impact on our financial statements and also require management to exercise significant judgment due to a high degree of uncertainty at the time the estimate is made. Our senior management has discussed the development and selection of our accounting policies, related accounting estimates and disclosures with the Audit Committee of our Board of Directors. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition. When a purchase decision is made for our products, including our appliance products, customers enter into a subscription agreement, which is generally 12, 24 or 36 months in duration and is for a fixed number of seats or devices. Other services such as upgrades/enhancements and standard post-contract technical support services are sold together with our product subscription and provided throughout the subscription term. We recognize revenue, including our appliance product revenue, on a daily straight-line basis, commencing on the date the term of the subscription begins, and continuing over the term of the subscription agreement, provided the fee is fixed or determinable, persuasive evidence of an arrangement exists, delivery has occurred and collectability is reasonably assured. Upon entering into a subscription arrangement for a fixed or determinable fee, we electronically deliver access codes to users, and in the case of our appliance product we ship the product with our software pre-installed on the product, and then promptly invoice customers for the full amount of their order. Payment is due for the full term of the subscription, generally within 30 to 60 days of the invoice. We record amounts billed to customers in excess of recognizable revenue as deferred revenue on our balance sheet. When we enter into a subscription agreement that is denominated and paid in a currency other than U.S. dollars, we record the subscription billing and deferred revenue in U.S. dollars based upon the currency exchange rate in effect on the last day of the previous month before the subscription agreement is effective. Changes in currency rates relative to the U.S. dollar may have a significant impact on the revenue that we will recognize under contracts that are denominated in currencies other than U.S. dollars. To the extent we sell appliances to customers who have already purchased appliance products with pre-installed software, we may recognize the entire revenue for the sale of the additional equipment not tied to a subscription upon shipment.

For our OEM contracts, we grant our OEM customers the right to incorporate our products into their products for resale to end users. The OEM customer generally pays us a royalty fee for each resale of our product to an end user over a specified period of time. We recognize revenue associated with the OEM contracts ratably over the contractual period for which we are obligated to provide our services. The timing of the OEM revenue recognition will vary for each OEM depending on the information available, such as underlying end user subscription periods, to determine the contractual obligation period. To the extent we provide any custom software and engineering services in connection with an OEM arrangement we defer recognition of all revenue until acceptance of the custom software.

We record distributor marketing payments and channel rebates as an offset to revenue. We recognize distributor marketing payments as an offset to revenue as the marketing service is provided. We recognize channel rebates as an offset to revenue on a straight-line basis over the term of the subscription agreement.

Acquisitions, Goodwill and Other Intangible Assets. We account for acquired businesses using the acquisition method of accounting in accordance with GAAP accounting rules for business combinations which requires that the assets acquired and liabilities assumed be recorded at the date of acquisition at their respective fair values. Any excess of the purchase price over the

 

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estimated fair values of net assets acquired is recorded as goodwill. The fair value of intangible assets, including acquired technology and customer relationships, is based on significant judgments made by management. The valuations and useful life assumptions are based on information available near the acquisition date and are based on expectations and assumptions that are considered reasonable by management. In our assessment of the fair value of identifiable intangible assets acquired in the PortAuthority and SurfControl acquisitions, management used valuation techniques and made various assumptions. Our analysis and financial projections were based on management’s prospective operating plans and the historical performance of the acquired businesses. We engaged third party valuation firms to assist management in the following:

 

   

developing an understanding of the economic and competitive environment for the industry in which we and the acquired companies participate;

 

   

identifying the intangible assets acquired;

 

   

reviewing the acquisition agreements and other relevant documents made available;

 

   

interviewing our employees, including the employees of the acquired companies, regarding the history and nature of the acquisition, historical and expected financial performance, product lifecycles and roadmap, and other factors deemed relevant to the valuation;

 

   

performing additional market research and analysis deemed relevant to the valuation analysis;

 

   

estimating the fair values and recommending useful lives of the acquired intangible assets; and

 

   

preparing a narrative report detailing methods and assumptions used in the valuation of the intangible assets.

All work performed by the outside valuation firms was discussed and reviewed in detail by management to determine the estimated fair values of the intangible assets. The judgments made in determining estimated fair values assigned to assets acquired and liabilities assumed, as well as asset lives, can materially impact our results of operations.

We review goodwill that has an indefinite useful life for impairment at least annually in our fourth fiscal quarter, or more frequently if an event occurs indicating the potential for impairment. To date, our reporting unit has not been at risk of failing the impairment test. We amortize the cost of identified intangible assets using amortization methods that reflect the pattern in which the economic benefits of the intangible assets are consumed or otherwise used up. We review intangible assets that have finite useful lives when an event occurs indicating the potential for impairment. We review for impairment by facts or circumstances, either external or internal, indicating that we may not recover the carrying value of the asset. We measure impairment losses related to long-lived assets based on the amount by which the carrying amounts of these assets exceed their fair values. We measure fair value generally based on the estimated future cash flows. Our analysis is based on available information and on assumptions and projections that we consider to be reasonable and supportable. If necessary, we perform subsequent calculations to measure the amount of the impairment loss based on the excess of the carrying value over the fair value of the impaired assets.

Share-Based Compensation. We account for share-based compensation under the fair value method. Share-based compensation expense related to stock options and employee stock purchase plan share grants is recorded based on the fair value of the award on its grant date. We estimate the fair value using the Black-Scholes valuation model. Share-based compensation expense related to restricted stock unit awards is calculated based on the market price of our common stock on the date of grant.

At September 30, 2010, there was $41.6 million of total unrecognized compensation cost related to share-based compensation arrangements granted under all equity compensation plans (excluding tax effects). That total unrecognized compensation cost will be adjusted for estimated forfeitures as well as for future changes in estimated forfeitures. We expect to recognize that cost over a weighted average period of approximately 2.0 years.

We estimate the fair value of options granted using the Black-Scholes option valuation model and the assumptions described below. We estimate the expected term of options granted based on the history of grants and exercises in our option database. We estimate the volatility of our common stock at the date of grant based on both the historical volatility as well as the implied volatility of publicly traded options for our common stock. We base the risk-free interest rate that is used in the Black-Scholes option valuation model on the implied yield in effect at the time of option grant on U.S. Treasury zero-coupon issues with equivalent remaining terms. We have never paid any cash dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero in the Black-Scholes option valuation model. We amortize the fair value ratably over the vesting period of the awards, which is typically four years. We use historical data to estimate pre-vesting option forfeitures and record share-based expense only for those awards that are expected to vest. We may elect to use different assumptions under the Black-Scholes option valuation model in the future or select a different option valuation model altogether, which could materially affect our net income or loss and net income or loss per share in the future.

We determine the fair value of share-based payment awards on the date of grant using an option-pricing model that is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include, but are not limited to our expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors. Option-pricing models were developed for use in estimating the value of traded options that have no vesting or hedging restrictions and are fully transferable. Because our employee stock options have certain characteristics that are significantly different

 

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from traded options, and because changes in the subjective assumptions can materially affect the estimated value, in management’s opinion the existing valuation models may not provide an accurate measure of the fair value of our employee stock options. Although the fair value of employee stock options is determined using an option-pricing model, that value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction.

Income Taxes. We are subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes. During the ordinary course of business, there are many transactions and calculations for which the ultimate tax determination is uncertain. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. These reserves for tax contingencies are established when we believe that certain positions might be challenged despite our belief that our tax return positions are consistent with prevailing law and practice. We adjust these reserves in light of changing facts and circumstances, such as the outcome of tax audits. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate.

Deferred tax assets are evaluated for future realization and reduced by a valuation allowance to the extent we believe a portion will not be realized. We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent cumulative earnings experience and expectations of future taxable income by taxing jurisdiction, the carry-forward periods available to us for tax reporting purposes, and other relevant factors.

We use a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our tax positions and tax benefits, which require periodic adjustments and which may not accurately anticipate actual outcomes.

During the first quarter of 2010, we were informed by the IRS that they had completed their audit for the tax years ended December 31, 2005 through December 31, 2007. Accordingly, the IRS issued us a 30-day letter which outlined all of their proposed audit adjustments and requires us to either accept the proposed adjustments, subject to future litigation, or file a formal administrative protest contesting those proposed adjustments within 30 days. The proposed adjustments relate primarily to the cost sharing arrangement between Websense, Inc. and our Irish subsidiary, including the amount of cost sharing buy-in, as well as to our claim of research and development tax credits and income tax deductions for equity compensation awarded to certain executive officers. The amount of additional tax proposed by the IRS totals approximately $19.0 million, of which $14.8 million relates to the amount of cost sharing buy-in, $2.5 million relates to research and development credits and $1.7 million relates to equity compensation awarded to certain executive officers. The total additional tax proposed excludes interest, penalties and state income taxes, each of which may be significant, and also excludes a potential reduction in tax on the Irish subsidiary. The proposed adjustments also do not include the future impact that changes in our cost sharing arrangement could have on our effective tax rate. We disagree with all of the proposed adjustments and have submitted a formal protest to the IRS for each matter. The IRS has acknowledged the receipt of our protest and we are now awaiting an appointment with the IRS Appeals Office. We intend to continue to defend our position on all of these matters, including through litigation if required. The timing of the ultimate resolution of these matters cannot be reasonably estimated at this time.

Allowance for Doubtful Accounts and Other Loss Contingencies. We maintain an allowance for doubtful accounts for estimated losses resulting from the inability or unwillingness of our customers to pay their invoices. We establish this allowance using estimates that we make based on factors such as the composition of the accounts receivable aging, historical bad debts, changes in payment patterns, changes to customer creditworthiness, current economic trends and other facts and circumstances of our existing customers. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Other loss contingencies are recorded as liabilities when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable. Contingent liabilities are often resolved over long time periods. Estimating probable losses requires significant judgment by management based on the facts and circumstances of each matter.

 

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Results of Operations

Three months ended September 30, 2010 compared with the three months ended September 30, 2009

The following table summarizes our operating results as a percentage of total revenue for each of the periods shown.

 

     Three Months Ended  
     September 30,
2010
    September 30,
2009
 
     (Unaudited)  

Revenues

     100     100

Cost of revenues

     16        17   
                

Gross profit

     84        83   

Operating expenses:

    

Selling and marketing

     43        52   

Research and development

     15        17   

General and administrative

     11        12   
                

Total operating expenses

     69        81   
                

Income from operations

     15        2   

Interest expense

     (1     (2

Other (expense) income, net

     —          —     
                

Income (loss) before income taxes

     14        —     

Provision for income taxes

     7        2   
                

Net income (loss)

     7     (2 )% 
                

Revenues

Revenues increased to $84.7 million in the third quarter of 2010 from $78.6 million in the third quarter of 2009. The increase was primarily a result of incremental sales, which include new customers and upgrades to existing customers, including increased sales of Web Security and Web Security Gateway products pre-installed on appliances from the third quarter of 2009 to the third quarter of 2010. Revenue from products sold in the United States accounted for $42.1 million or 50% of third quarter 2010 revenue compared to $39.7 million or 51% in the third quarter of 2009. Revenue from products sold internationally accounted for $42.6 million or 50% of third quarter 2010 revenue compared to $38.9 million or 49% in the third quarter of 2009. We had current deferred revenue (defined as revenue that will be recognized within the next 12 months) of $234.9 million as of September 30, 2010, compared to $218.6 million as of September 30, 2009. For the remainder of 2010, we expect our revenue to increase over 2009 revenue levels due to the amount of current deferred revenue that will be recognized as revenue in the fourth quarter of 2010, subscriptions that are scheduled for renewal that are expected to be renewed and upgraded and expected new business for which some revenue will be recognized during 2010. Our revenue is impacted by the duration of contracts for renewal and new subscriptions, the timing of sales of renewal and new subscriptions, the average annual contract value and per seat price, and the effect of currency exchange rates on new and renewal subscriptions in international markets.

Cost of Revenues

Cost of revenues. Cost of revenues consists of the costs of Web content review, amortization of acquired technology, amortization of deferred costs associated with the sale of our appliance products, technical support and infrastructure costs associated with maintaining our databases and costs associated with providing our hosted security services. Cost of revenues increased to $13.6 million in the third quarter of 2010 from $13.2 million in the third quarter of 2009. The $0.4 million increase was primarily due to increased cost of sales related to our Websense appliances of $1.5 million offset by decreased amortization of acquired technology of $1.0 million and decreased personnel costs of $0.1 million. Amortization of acquired technology was $2.2 million in the third quarter of 2010 compared to $3.2 million in the third quarter of 2009. The decrease of $1.0 million in amortization of acquired technology was primarily due to certain acquired technology being fully amortized in 2009. As of September 30, 2010, the acquired technology is being amortized over a remaining weighted average period of 2.4 years. Our full-time employee headcount in cost of revenue departments decreased from an average of 264 employees during the third quarter of 2009 to an average of 260 employees during the third quarter of 2010. We allocate the costs for human resources, employee benefits, payroll taxes, information technology, facilities

 

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and fixed asset depreciation to each of our functional areas based on headcount data. As a percentage of revenue, cost of revenues was 16% during the third quarter of 2010 compared to 17% during the third quarter of 2009. We expect cost of revenues will increase in absolute dollars and as a percentage of revenues primarily due to increased sales of our appliance products for the remainder of 2010 as compared to 2009.

Gross Profit

Gross profit increased to $71.2 million in the third quarter of 2010 from $65.4 million in the third quarter of 2009 primarily as a result of increased revenue. As a percentage of revenue, gross profit was 84% in the third quarter of 2010 compared to 83% in third quarter of 2009. We expect that gross profit as a percentage of revenue will remain in excess of 80% in the fourth quarter.

Operating Expenses

Selling and marketing. Selling and marketing expenses consist primarily of salaries, commissions and benefits related to personnel engaged in selling, marketing and customer support functions, including costs related to public relations, advertising, promotions and travel, amortization of acquired customer relationships as well as allocated costs. Selling and marketing expenses do not include payments to channel partners for marketing services and rebates as those are recorded as an offset to revenue. Selling and marketing expenses were $36.4 million, or 43% of revenue, in the third quarter of 2010, compared to $40.7 million, or 52% of revenue, in the third quarter of 2009. The $4.3 million decrease in total selling and marketing expenses was primarily due to a reduction in the amortization of acquired intangibles (customer relationships) of approximately $2.2 million, a reduction in personnel costs of $1.4 million and decreased allocated costs of $0.4 million. As of September 30, 2010, the acquired customer relationships intangible assets are being amortized over a remaining weighted average period of approximately 5.1 years. Our headcount in sales and marketing decreased from an average of 610 employees during the third quarter of 2009 to an average of 580 employees for the third quarter of 2010 and headcount is expected to remain relatively flat for the remainder of 2010. We expect overall selling and marketing expenses to decrease in absolute dollars and as a percentage of revenue for the remainder of 2010 as compared to 2009 primarily due to a reduction of amortization of acquired intangibles from the SurfControl acquisition. Based on the existing sales and marketing related intangible assets as of September 30, 2010, we expect amortization of acquired intangibles of $4.4 million for the fourth quarter which would be a reduction of approximately $2.2 million from the fourth quarter of 2009.

Research and development. Research and development expenses consist primarily of salaries and benefits for software developers and allocated costs. Research and development expenses decreased to $13.2 million, or 15% of revenue, in the third quarter of 2010 from $13.7 million, or 17% of revenue, in the third quarter of 2009. The decrease of $0.5 million in research and development expenses was primarily due to a decrease in allocated costs of $0.3 million and decreased personnel costs of $0.2 million. Although our headcount increased in research and development from an average of 422 employees for the third quarter of 2009 to an average of 456 employees for the third quarter of 2010, our personnel costs decreased slightly due to currency exchange rate fluctuations and a reduction in temporary contractors. While we expect research and development expenses to be relatively flat for the fourth quarter of 2010 as compared to 2009, we expect research and development expenses as a percentage of revenues will decrease in 2010 compared to 2009 due to the expected increase in revenues. We have managed the increase in our research and development expenses by operating research and development facilities in multiple international locations, including a facility in Beijing, China, that have lower costs than do our operations in the United States. We also have research and development facilities in Ra’anana, Israel, Los Gatos and San Diego, California and Reading, England.

General and administrative. General and administrative expenses consist primarily of salaries, benefits and related expenses for our executive, finance and administrative personnel, third party professional service fees and allocated costs. General and administrative expenses decreased to $9.2 million, or 11% of revenue, in the third quarter of 2010 from $9.7 million, or 12% of revenue, in the third quarter of 2009. The $0.5 million decrease in general and administrative expenses was primarily due to decreased personnel costs of $0.8 million and reduced allocated costs of $0.2 million offset by an increase in third party professional service fees of $0.6 million. Our headcount decreased in general and administrative departments from an average of 122 employees during the third quarter of 2009 to an average of 114 employees for the third quarter of 2010. We expect general and administrative expenses to increase slightly in absolute dollars due to costs related to supporting our expanding global business, but remain relatively flat as a percentage of revenue for the remainder of 2010 as compared to 2009 due to the expected increase in revenue.

Interest Expense

Interest expense decreased to $0.8 million in the third quarter of 2010 from $1.7 million in the third quarter of 2009. The decrease was primarily due to a lower average outstanding loan balance on our senior secured term loan of $69 million during the third quarter of 2010 compared to an average loan balance of $105 million during the third quarter of 2009. In addition, the effective interest rate was lower in the third quarter of 2010 compared to 2009 primarily due to the reduction in the notional amount of principal subject to the fixed rate swap agreement. Included in the interest expense for the third quarter of 2010 and 2009 is $0.1 million and

 

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$0.3 million, respectively, of amortization of deferred financing fees that were capitalized as part of the senior secured credit facility. We made principal payments on the senior secured term loan totaling $3.0 million and $11.0 million during the third quarter of 2010 and 2009, respectively. As a result of reductions in the LIBOR interest rate and reductions in the notional amount of principal subject to the fixed rate swap agreement, our weighted average interest rate decreased from 4.35% at September 30, 2009 to 2.51% at September 30, 2010. Interest expense should decline in the remaining quarter of 2010 as compared to 2009 due to the lower outstanding principal amount and the expected lower marginal interest rate from the expiration of the swap agreement on September 30, 2010. In connection with the pay off of the existing term loan under the 2007 Senior Credit Agreement (see Note 11 to the financial statements), we have written off the remaining unamortized deferred financing fees of approximately $0.8 million in October 2010.

Other (Expense) Income, Net

Other (expense) income, net went from a net other income of $0.2 million in the third quarter of 2009 to a net other expense of $59,000 in the third quarter of 2010. The change was due primarily to foreign exchange related losses of $0.1 million in the third quarter of 2010 compared to gains of $0.1 million in the third quarter of 2009 due to movements in the currency exchange rates during the third quarter of 2010 and 2009.

Provision for Income Taxes

For the three months ended September 30, 2010 we recognized an income tax expense of $5.8 million compared to $1.7 million for the three months ended September 30, 2009. The effective tax rates reflect a tax expense of approximately 50.0% for the three months ended September 30, 2010 and approximately 660% for the three months ended September 30, 2009. For the third quarter of 2010, the effective tax rate variance from the statutory rate was primarily related to an increase in the valuation allowance for net operating losses of one of our subsidiaries in the United Kingdom, the unfavorable impact on deferred tax amounts resulting from a California law change, foreign withholding taxes and non-deductible share-based payments, which offset the benefit of income taxed at lower rates in foreign jurisdictions. For the third quarter of 2009, the effective tax rate variance from the statutory rate was primarily related to non-deductible items, including certain share-based payments and an increase in the valuation allowance related to net operating losses of one of our subsidiaries in the United Kingdom which offset the favorable settlement of foreign taxes accrued from prior years.

Our effective tax rate may change in future periods due to differences in the composition of taxable income between domestic and international operations along with the potential changes or interpretations in tax rules and legislation, or corresponding accounting rules.

We assess, on a quarterly basis, the ultimate realization of our deferred income tax assets. Realization of deferred income tax assets is dependent upon taxable income in prior carryback years, estimates of future taxable income, tax planning strategies and reversals of existing taxable temporary differences. Based on our assessment of these items during the third quarter of 2010, we believe that it is more likely than not that we will fully realize the balance of the deferred tax assets currently reflected on our consolidated balance sheet.

 

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Nine months ended September 30, 2010 compared with the nine months ended September 30, 2009

The following table summarizes our operating results as a percentage of total revenue for each of the periods shown.

 

     Nine Months Ended  
     September 30,
2010
    September 30,
2009
 
     (Unaudited)  

Revenues

     100     100

Cost of revenues

     16        16   
                

Gross profit

     84        84   

Operating expenses:

    

Selling and marketing

     47        52   

Research and development

     17        17   

General and administrative

     11        13   
                

Total operating expenses

     75        82   
                

Income from operations

     9        2   

Interest expense

     (1     (2

Other (expense) income, net

     —          —     
                

Income (loss) before income taxes

     8        —     

Provision (benefit) for income taxes

     4        —     
                

Net income

     4     —  
                

Revenues

Revenues increased to $246.4 million in the first nine months of 2010 from $234.0 million in the first nine months of 2009. The increase was primarily a result of incremental sales, which include new customers and upgrades to existing customers, including increased sales of Web Security and Web Security Gateway products pre-installed on appliances from the first nine months of 2009 to the first nine months of 2010. Revenue from products sold in the United States accounted for $121.8 million or 49% of the first nine months of 2010 revenue compared to $116.0 million or 50% of the first nine months of 2009. Revenue from products sold internationally accounted for $124.6 million or 51% of the first nine months of 2010 revenue compared to $118.0 million or 50% in the first nine months of 2009.

Cost of Revenues

Cost of revenues. Cost of revenues increased to $38.7 million in the first nine months of 2010 from $37.4 million in the first nine months of 2009. The $1.3 million increase was primarily due to increased cost of sales related to our Websense appliances of $3.6 million, increased personnel costs of $0.4 million and increased allocated costs of $0.2 million offset by a $3.0 million reduction in amortization of acquired technology from the first nine months of 2009 to the first nine months of 2010 which was primarily due to certain acquired technology being fully amortized in 2009. Our headcount in cost of revenue departments increased from an average of 252 employees during the first nine months of 2009 to an average of 268 employees during the first nine months of 2010.

Gross Profit

Gross profit increased to $207.7 million in the first nine months of 2010 from $196.6 million in the first nine months of 2009. As a percentage of revenues, gross profit was 84% in the first nine months of both 2010 and 2009 primarily due to the increased revenue described in the above Revenues section.

Operating Expenses

Selling and marketing. Selling and marketing expenses decreased to $116.1 million, or 47% of revenues, in the first nine months of 2010, from $122.1 million, or 52% of revenues, in the first nine months of 2009. The $6.0 million decrease was primarily due to a reduction in the amortization of acquired intangibles (customer relationships) of approximately $6.6 million and decreased allocated

 

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costs of $0.5 million offset by increased personnel costs of $1.0 million. Our headcount in sales and marketing decreased slightly from an average of 595 employees during the first nine months of 2009 to an average of 589 employees during the first nine months of 2010. The increased personnel costs was primarily due to higher sales commissions in the first nine months of 2010 compared to the first nine months of 2009.

Research and development. Research and development expenses increased to $41.0 million, or 17% of revenue, in the first nine months of 2010 from $39.1 million, or 17% of revenue, in the first nine months of 2009. The increase of $1.9 million in research and development expenses was primarily due to increased personnel costs of $2.3 million offset by decreased allocated costs of $0.5 million. Our headcount increased in research and development from an average of 403 employees during the first nine months of 2009 to an average of 447 employees during the first nine months of 2010.

General and administrative. General and administrative expenses decreased to $27.5 million, or 11% of revenue, in the first nine months of 2010 from $30.9 million, or 13% of revenue, in the first nine months of 2009. The $3.4 million decrease in general and administrative expenses was primarily due to a reduction in third party professional service fees of $1.5 million, reduced allocated costs of $1.0 million and decreased personnel costs of $0.6 million. Our headcount in general and administrative departments decreased from an average of 122 employees during the first nine months of 2009 to an average of 115 employees during the first nine months of 2010.

Interest Expense

Interest expense decreased to $2.8 million in the first nine months of 2010 from $5.7 million in the first nine months of 2009. The decrease was primarily due to a lower average outstanding balance on our senior secured term loan of $75 million during the first nine months of 2010 compared to an average loan balance of $111 million during the first nine months of 2009. In addition, the effective interest rate was lower in the first nine months of 2010 compared to 2009 primarily due to the reduction in the notional amount of principal subject to the fixed rate swap agreement. Included in the interest expense for the first nine months of 2010 and 2009 is $0.6 million and $0.9 million, respectively, of amortization of deferred financing fees that were capitalized as part of the senior secured credit facility. We made principal payments on the senior secured term loan totaling $20 million and $26 million during the first nine months of 2010 and 2009, respectively.

Other (Expense) Income, Net

Other (expense) income, net decreased to a net other expense of $0.9 million in the first nine months of 2010 from a net other income of $0.6 million in the first nine months of 2009. The change was due primarily to foreign exchange related losses of $1.1 million in the first nine months of 2010 compared to gains of $0.4 million in the first nine months of 2009 due to movements in the currency exchange rates during those respective periods of 2010 and 2009.

Provision for Income Taxes

We recognized an income tax expense of $9.6 million and an income tax benefit of $0.9 million for the nine months ended September 30, 2010 and 2009, respectively. Our effective tax rates were a tax provision of 49.7% and a tax benefit of approximately 158% for the nine months ended September 30, 2010 and 2009, respectively. For the first nine months of 2010, the effective tax rate variance from the statutory rate was primarily related to an increase in the valuation allowance for net operating losses of one of our subsidiaries in the United Kingdom, the unfavorable impact on deferred tax amounts resulting from a California law change, foreign withholding taxes and non-deductible share-based payments, which offset the benefit of income taxed at lower rates in foreign jurisdictions. For the first nine months of 2009, the effective tax rate variance from the statutory rate was primarily related to the favorable settlement of foreign taxes accrued from prior years which was partially offset by non-deductible items, including certain share-based payments and an increase in the valuation allowance related to net operating losses of one of our subsidiaries in the United Kingdom.

Liquidity and Capital Resources

Cash Flow Activity. As of September 30, 2010, we had cash and cash equivalents of $85.7 million and retained earnings of $38.2 million. During the first nine months of 2010, we used our cash and cash equivalents primarily to pay down $20 million on our senior secured term loan as principal payments and for stock repurchases of approximately $60 million.

Net cash provided by operating activities was $76.1 million in the first nine months of 2010 compared with $63.8 million in the first nine months of 2009. The $12.3 million increase in cash provided by operating activities was primarily due to increased cash collections from our customers and lower net cash taxes paid in the first nine months of 2010 compared to 2009. Our operating cash flow is significantly influenced by new and renewal subscriptions, including average duration of the subscriptions, accounts receivable collections and cash expenses. A decrease in sales of new and/or renewal subscriptions, shortening in average duration of the subscriptions, decrease in accounts receivable collections, or an increase in our cash expenses, would negatively impact our operating cash flow.

 

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Net cash used in investing activities was $6.4 million in the first nine months of 2010 compared with $8.4 million in the first nine months of 2009. The $2.0 million decrease in net cash used in investing activities was due to a $3.0 million reduction in the purchases of property and equipment primarily due to the completion of the build out of our facilities in Ireland and China during 2009, offset by an approximate $1.0 million change in restricted cash and cash equivalents.

Net cash used in financing activities was $66.4 million in the first nine months of 2010 compared with $43.6 million in the first nine months of 2009. The $22.8 million increase in net cash used in financing activities was primarily due to an increase in stock repurchases of $37.3 million and tax payments related to restricted stock unit issuances of $2.4 million offset by a decrease in principal payments on the senior secured term loan of $6.0 million in the first nine months of 2010 compared to the first nine months of 2009 and increased proceeds from exercises of stock options and issuance of common stock under the employee stock purchase plan of $10.3 million.

In January 2008, we adopted a 10b5-1 plan that provides for quarterly purchases of our common stock in open market transactions. Depending on market conditions and other factors, purchases by our agent under a stock repurchase program established by our Board of Directors may be commenced or suspended at any time, or from time to time, without prior notice to us. During the nine months ended September 30, 2010, we repurchased 2,906,206 shares of our common stock for an aggregate of approximately $60.0 million at an average price of $20.63 per share. As of September 30, 2010, we have repurchased a total of 14,440,230 shares of our common stock under this program, for an aggregate of $284.9 million at an average price of $19.73 per share. As of September 30, 2010, the remaining number of shares that we can purchase under this program was 1,559,770 shares, and, on October 26, 2010, we increased the number of shares authorized for repurchase under the program by 8,000,000 shares. We intend to continue to repurchase shares during the remainder of 2010.

During the first quarter of 2010, the IRS issued us a 30-day letter which outlined proposed audit adjustments that would result in an additional amount of tax totaling approximately $19.0 million. The proposed adjustments relate primarily to the cost sharing arrangement between us and our Irish subsidiary, including the amount of cost sharing buy-in, as well as to our claim of research and development tax credits and income tax deductions for equity compensation awarded to certain executive officers. The total additional tax proposed excludes interest, penalties and state income taxes, each of which may be significant, and also excludes a potential reduction in tax on the Irish subsidiary. The proposed adjustments also do not include the future impact that changes in our cost sharing arrangement could have on our effective tax rate. We disagree with all of the proposed adjustments and have submitted a formal protest to the IRS for each matter; however, if these matters are not resolved in our favor, the additional tax payments would decrease the amount of cash available to us.

Capital Resources. In October 2007, we entered into the 2007 Senior Credit Agreement. The $225 million senior secured credit facility consists of a five year $210 million senior secured term loan and a $15 million revolving credit facility. The senior secured term loan was fully funded on October 11, 2007, and the revolving line of credit remains unused. At September 30, 2010, the outstanding balance under our senior secured term loan was $67 million as a result of making principal payments totaling $20 million during the first nine months of 2010. The senior secured credit facility is secured by substantially all of our assets, including pledges of stock of certain of our subsidiaries (subject to limitations in the case of foreign subsidiaries) and by secured guarantees by our domestic subsidiaries. The senior secured term loan bears interest at a spread above LIBOR with the spread determined based upon our total leverage ratio, as defined in the 2007 Senior Credit Agreement. Based on the total leverage ratio as of June 30, 2010, the spread on the senior secured term loan was LIBOR plus 225 basis points per annum and the fee for the unused portion of the revolving credit facility was 25 basis points per annum during the quarter ended September 30, 2010. The weighted average interest rate on the senior secured term loan at September 30, 2010 was 2.5%.

The 2007 Senior Credit Agreement contains financial covenants, including a consolidated leverage ratio and a consolidated interest coverage ratio, as well as affirmative and negative covenants. Among the negative covenants are restrictions on our ability to borrow money, including restrictions on (a) the incurrence of more than $15 million of new debt, including capital leases (subject to certain exceptions), (b) the incurrence of more than $7.5 million in letters of credit, (c) the incurrence of more than $50 to $75 million of new debt, depending on our leverage ratio, to finance future acquisitions or (d) the assumption of more than $15 million of new debt in connection with one or more acquisitions.

The 2007 Senior Credit Agreement provides that we must maintain hedge agreements so that at least 50% of the aggregate principal amount of the senior secured credit facility is subject to fixed interest rate protection for a period of not less than 2.5 years from the initial funding date of October 11, 2007. On the initial funding date, of the 2007 Senior Credit Agreement, we entered into an interest rate swap agreement to pay a fixed rate of interest (4.85% per annum) and receive a floating rate interest payment (based on three month LIBOR) on an equivalent amount. The notional amount of the swap agreement was $11 million during the quarter ended September 30, 2010 and the swap agreement expired on September 30, 2010. In addition, on October 11, 2007 we entered into an interest rate cap agreement to limit the maximum interest rate on a portion of our senior secured term loan to 6.5% per annum. The amount of principal protected by this agreement was $74.3 million during the quarter ended September 30, 2010 and the cap agreement expired on September 30, 2010.

 

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On October 22, 2010, we entered into the New Credit Agreement. The New Credit Agreement was intended to replace the 2007 Senior Credit Agreement, with more extended principal repayment terms and overall terms and conditions that are more favorable to us. The New Credit Agreement provides for a secured revolving credit facility that matures on October 29, 2015 with an initial maximum aggregate commitment of $120 million, including a $15 million sublimit for issuances of letters of credit and $5 million sublimit for swing line loans. We may increase the maximum aggregate commitment under the New Credit Agreement up to $200 million if certain conditions are satisfied, including that we are not in default under the New Credit Agreement at the time of the increase and that we obtain the commitment of the lenders participating in the increase. Loans under the New Credit Agreement are designated at our election as either base rate or Eurodollar rate loans. Base rate loans bear interest at a rate equal to the highest of (i) the federal funds rate plus 0.5%, (ii) the Eurodollar rate plus 1.00%, and (iii) Bank of America’s prime rate, in each case plus a margin set forth below. Eurodollar rate loans bear interest at a rate equal to (i) the Eurodollar rate, plus (ii) a margin set forth below.

The applicable margins until the date that we file our Form 10-K for the fiscal year ended December 31, 2010, are 0.75% for base rate loans and 1.75% for Eurodollar rate loans. Thereafter the applicable margins are determined by reference to our leverage ratio, as set forth in the table below:

 

Consolidated Leverage Ratio

   Eurodollar Rate
Loans
    Base Rate
Loans
 

<1.25:1.0

     1.75     0.75

>1.25:1.0

     2.00     1.00

For each commercial Letter of Credit, we must pay a fee equal to 0.125% per annum times the daily amount available to be drawn under such Letter of Credit and, for each standby Letter of Credit, we must pay a fee equal to the applicable margin for Eurodollar rate loans times the daily amount available to be drawn under such Letter of Credit. A quarterly commitment fee is payable to the lenders in an amount equal to the unused portion of the credit facility multiplied by 0.25%.

Indebtedness under the New Credit Agreement is secured by substantially all of our assets, including pledges of stock of certain of our subsidiaries (subject to limitations in the case of foreign subsidiaries) and by secured guarantees by our domestic subsidiaries. The 2007 Senior Credit Agreement contains affirmative and negative covenants, including an obligation to maintain a certain consolidated leverage ratio and consolidated interest coverage ratio and restrictions on our ability to borrow money, to incur liens, to enter into mergers and acquisitions, to make dispositions, to pay cash dividends or repurchase capital stock, and to make investments, subject to certain exceptions. For example, the New Credit Agreement permits us to repurchase our securities so long as we are not in default under the New Credit Agreement, have complied with all of our financial covenants, and have liquidity of at least $20 million; provided, however, if, after giving effect to any repurchase, our leverage ratio is greater than 1.75:1, such repurchase cannot exceed $10 million in the aggregate in any fiscal year. The New Credit Agreement does not require us to use excess cash to pay down debt.

The New Credit Agreement provides for acceleration of the Company’s obligations thereunder upon certain events of default. The events of default include, without limitation, failure to pay loan amounts when due, any material inaccuracy in the Company’s representations and warranties, failure to observe covenants, defaults on any other indebtedness, entering bankruptcy, existence of a judgment or decree against the Company or its subsidiaries involving an aggregate liability of $10 million or more, the security interest or guarantee ceasing to be in full force and effect, any person becoming the beneficial owner of more than 35% of the Company’s outstanding common stock, or the Company’s board of directors ceasing to consist of a majority of Continuing Directors, where “Continuing Directors” means the members of the Company’s board of directors on the effective date of the New Credit Agreement and each other director nominated for election to the Company’s board of directors by at least a majority of the Continuing Directors.

On October 29, 2010, we received an advance of $67 million under the revolving credit facility and used the entire proceeds to pay off our existing term loan under the 2007 Senior Credit Agreement. $53 million of the revolving credit facility remains unused, and we have not requested any letters of credit under the New Credit Agreement. If any event of default occurs, and we are unable to obtain a waiver from a majority of the lenders, any borrowings under the New Credit Agreement would become immediately due and payable.

Despite recent uncertainties in the financial markets, to date we have not experienced difficulty accessing the credit markets or incurred higher interest costs. Future volatility in the capital markets, however, may increase costs associated with debt instruments or affect our ability to access those markets. We believe that our cash and cash equivalents balances, accounts receivable and cash generated by operations, together with access to external sources of funds as described above, will be sufficient to meet our operating and capital needs for at least the next 12 months. Our cash requirements may increase for reasons we do not currently foresee or we may make acquisitions as part of our growth strategy that increase our cash requirements. We may elect to raise funds for these purposes or to reduce our cost of capital through capital markets transactions or debt or private equity transactions as appropriate. We intend to continue to invest our cash in excess of current operating and capital requirements in interest-bearing, investment-grade money market funds.

 

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Obligations and commitments. The following table summarizes our contractual payment obligations and commitments as of September 30, 2010 (in thousands):

 

     Payment Obligations by Year  
     2010      2011      2012      2013      2014      Thereafter      Total  

2007 Senior Credit Agreement:

                    

Scheduled principal payments

   $ 2,680       $ 12,864       $ 51,456       $ —         $ —         $ —         $ 67,000   

Estimated interest and fees

     454         1,609         915         —           —           —           2,978   

Operating leases

     1,962         5,904         4,944         5,197         1,128         463         19,598   

Other commitments

     70         994         875         29         4         —           1,972   
                                                              

Total

   $ 5,166       $ 21,371       $ 58,190       $ 5,226       $ 1,132       $ 463       $ 91,548   
                                                              

Obligations under our 2007 Senior Credit Agreement represent the future minimum principal debt payments due under the senior secured term loan. Estimated interest and fees represent interest and fees expected to be incurred under the 2007 Senior Credit Agreement based on known rates and scheduled principal payments as of September 30, 2010 (see Note 5 to the financial statements).

On October 29, 2010, we retired the 2007 Senior Credit Agreement using the proceeds from the loan under the New Credit Agreement. Had the New Credit Agreement been in place as of September 30, 2010, our contractual payment obligations and commitments with respect to the New Credit Agreement would have been as follows (in thousands):

 

     Payment Obligations by Year  
     2010      2011      2012      2013      2014      Thereafter      Total  

New Credit Agreement:

                    

Scheduled principal payments

   $ —         $ —         $ —         $ —         $ —         $ 67,000       $ 67,000   

Estimated interest and fees

     258         1,517         1,536         1,532         1,532         1,273         7,648   
                                                              

Total

   $ 258       $ 1,517       $ 1,536       $ 1,532       $ 1,532       $ 68,273       $ 74,648   
                                                              

Obligations under our New Credit Agreement represent the future minimum principal debt payments due under the revolving credit facility. Estimated interest and fees represent interest and fees expected to be incurred under the New Credit Agreement based on known rates and scheduled principal payments as of October 29, 2010 (see Note 11 to the financial statements).

We lease our facilities under operating lease agreements that expire at various dates through 2015. Over 40% of our operating lease commitments are related to our corporate headquarters lease in San Diego, which extends through December 2013 and has escalating rent payments from 2010 to 2013. The rent expense related to our worldwide office space leases are generally recorded monthly on a straight-line basis in accordance with GAAP.

Other commitments represent minimum contractual commitments for inbound software licenses, equipment maintenance and automobile leases.

In addition, due to the uncertainty with respect to the timing of future cash flows associated with our unrecognized tax benefits at September 30, 2010, we are unable to make reasonably reliable estimates of the period of cash settlement with the respective taxing authorities. Therefore, $15.2 million of gross unrecognized tax benefits have been excluded from the contractual payment obligations table above.

Off-Balance Sheet Arrangements

As of September 30, 2010, we did not have any off-balance sheet arrangements.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our market risk exposures are related to our cash and cash equivalents and senior secured term loan. We currently invest our excess cash in highly liquid short-term investments such as money market funds. These investments are not held for trading or other speculative purposes. Changes in interest rates affect the investment income we earn on our investments and the interest expense incurred on our senior secured term loan and therefore impact our cash flows and results of operations.

A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would materially affect our interest expense. Based on our outstanding senior secured term loan balance at September 30, 2010, our interest expense would increase on a pre-tax basis by approximately $577,000 during the next 12 months if there were a 100 basis point adverse move in the interest rate yield curve.

A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest sensitive investments at September 30, 2010. Changes in interest rates over time will, however, affect our interest income.

 

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We utilize foreign currency forward contracts to hedge foreign currency market exposures of underlying assets, liabilities and expenses. We bill certain international customers in Euros, British Pounds, Australian Dollars, Chinese Renminbi and Japanese Yen. We also keep working funds necessary to facilitate the short-term operations of our subsidiaries in the local currencies in which they do business. Our objective is to reduce the risk to earnings and cash flows associated with changes in currency exchange rates. We do not use foreign currency contracts for speculative or trading purposes.

Notional and fair values of our hedging positions at September 30, 2010 and 2009 are presented in the table below (in thousands):

 

     September 30, 2010      September 30, 2009  
     Notional
Value
Local
Currency
     Notional
Value
USD
     Fair Value
USD
     Notional
Value
Local
Currency
     Notional
Value
USD
     Fair Value
USD
 

Fair Value Hedges

                 

Euro

     2,000       $ 2,523       $ 2,727         4,500       $ 6,513       $ 6,588   

British Pound

     2,250         3,518         3,535         2,000         3,216         3,196   

Australian Dollar

     1,000         885         967         2,000         1,703         1,754   
                                         

Total

      $ 6,926       $ 7,229          $ 11,432       $ 11,538   
                                         

Cash Flow Hedges

                 

Israeli Shekel

     4,500       $ 1,195       $ 1,228         3,750       $ $897       $ 996   

The $4.0 million notional decrease in our Euro hedged position at September 30, 2010 compared to September 30, 2009 was primarily a result of the timing differences between when assets were acquired and/or liabilities incurred. All of the Euro hedging contracts in place as of September 30, 2010 will be settled before January 2011. For the first nine months of 2010, less than 15% of our total billings were denominated in the Euro. We expect Euro billings to represent less than 20% of our total billings during 2010.

The $0.3 million increase in our British Pound hedge position at September 30, 2010 compared to September 30, 2009 was primarily a result of the timing differences between when assets were acquired and/or liabilities incurred. All of the British Pound hedging contracts in place as of September 30, 2010 will be settled before February 2011. For the first nine months of 2010, less than 15% of our total billings were denominated in the British Pound. We expect British Pound billings to represent less than 15% of our total billings during 2010.

The $0.8 million notional decrease in our Australian Dollar hedge position at September 30, 2010 compared to September 30, 2009 was primarily due to the timing differences between when assets were acquired and/or liabilities incurred. All of the Australian Dollar hedging contracts in place as of September 30, 2010 will be settled before November 2010. For the first nine months of 2010, less than 5% of our total billings were denominated in the Australian Dollar. We expect Australian Dollar billings to represent less than 5% of our total billings during 2010.

The $0.3 million notional increase in our Israeli Shekel hedge position at September 30, 2010 compared to September 30, 2009 was primarily due to an increased effort to further reduce currency volatility associated with our Israeli Shekel denominated expenditures. All of the Israeli Shekel hedging contracts in place as of September 30, 2010 will be settled before January 2011.

A significant portion of our foreign subsidiaries’ operating expenses are incurred in foreign currencies so if the U.S. dollar weakens, our consolidated operating expenses would increase. Should the U.S. dollar strengthen, our products may become more expensive for our international customers with subscription contracts denominated in U.S. dollars, especially if the trend continues of international sales growing as a percentage of our total sales. Changes in currency rates also impact our future revenue under subscription contracts that are not denominated in U.S. dollars. Our revenue and deferred revenue for these foreign currencies are recorded in U.S. dollars when the subscription is entered into based upon currency exchange rates in effect on the last day of the previous month before the subscription agreement is entered into. We engage in currency hedging activities with the intent of limiting the risk of exchange rate fluctuations, but our foreign exchange hedging activities also involve inherent risks that could result in an unforeseen loss.

 

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Item 4. Controls and Procedures

Disclosure Controls and Procedures

We maintain disclosure controls and procedures (as defined in Rules 13a - 15(e) and 15d - 15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) designed to ensure that the information required to be disclosed in the reports we file or submit under the Exchange Act is (a) recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission and (b) accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures. Our Chief Executive Officer and Chief Financial Officer evaluated our disclosure controls and procedures as of the end of the period covered by this report. Based on their evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that these controls and procedures are effective as of the end of the period covered by this Quarterly Report.

Changes In Internal Control Over Financial Reporting

There have been no changes in our internal control over financial reporting or in other factors that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting, including corrective actions with regard to significant deficiencies and material weaknesses, during the period covered by this Quarterly Report.

Part II - Other Information

 

Item 1. Legal Proceedings

On July 12, 2010, Finjan, Inc. filed a complaint entitled Finjan, Inc. v. McAfee, Inc., Symantec Corp., Webroot Software, Inc., Websense, Inc. and Sophos, Inc. in the United States District Court for the District of Delaware. The complaint alleges that by making, using, importing, selling and/or offering for sale Websense Web Filter, Websense Web Security and Websense Web Security Gateway, we infringe the 194 Patent. Finjan, Inc. seeks an injunction from further infringement of the 194 Patent and damages. We deny infringing any valid claims of the 194 Patent and intend to vigorously defend the lawsuit.

We are involved in various other legal actions in the normal course of business. Based on current information, including consultation with our attorneys, we believe that we have adequately reserved for any ultimate liability that may result from these actions such that any liability would not materially affect our consolidated financial position, results of operations or cash flows. Our evaluation of the likely impact of these actions could change in the future and unfavorable outcomes and/or defense costs, depending upon the amount and timing, could have a material adverse effect on our results of operations or cash flows in a future period.

 

Item 1A. Risk Factors

In addition to the other information in this report, including the important information in “Forward-Looking Statements,” you should carefully consider the following information in evaluating our business and our prospects. The risks and uncertainties described below are those that we currently deem to be material and that we believe are specific to our company and our industry. In addition to these risks, our business may be subject to risks currently unknown to us. If any of these or other risks actually occur, our business may be adversely affected, the trading price of our common stock could decline, and you may lose all or part of your investment in Websense.

We have marked with an asterisk (*) those risk factors that reflect material changes from the risk factors included in our Quarterly Report for the quarter ending June 30, 2010 on Form 10-Q filed with the Securities and Exchange Commission on August 6, 2010.

Recent volatility in the global economy may adversely impact our business, results of operations, financial condition or liquidity.

The global economy has been experiencing a period of unprecedented volatility characterized by the bankruptcy, failure, collapse or sale of various financial institutions and an unprecedented level of intervention from governments and regulatory agencies worldwide. We believe that financial distress and associated headcount reductions implemented by certain of our end user customers have caused these customers to choose shorter contract durations and/or reduce the number of seats under subscription and in some cases, have caused customers not to renew contracts at all. While the number of distressed customers appears to have stabilized, we expect this trend to continue until there is a broad worldwide economic recovery and positive job growth. These trends may negatively impact the duration and scope of contract renewals and, in some cases, may result in customer losses. Our average contract duration may be volatile as we seek contract renewals without eroding our average contract price, which may result in a shortening of our average contract duration. Credit markets may also adversely affect our resellers through whom our distributors distribute products and limit the credit value-added resellers may extend to their customers. The volatility of currency exchange rates can also significantly affect sales of our products denominated in foreign currencies. In addition, events in the global financial markets may make it difficult for us to access the credit markets or to obtain financing or refinancing, if needed, on satisfactory terms or at all.

 

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Fluctuations in foreign currency exchange rates could materially affect our financial results.

A significant portion of our foreign subsidiaries’ operating expenses are incurred in foreign currencies so if the U.S. dollar weakens, our consolidated operating expenses would increase. Should the U.S. dollar strengthen, our products may become more expensive for our international customers with subscription contracts denominated in U.S. dollars, and as a result, our results of operations and net cash flows from international operations may be adversely affected, especially if the trend continues of international sales growing as a percentage of our total sales. Changes in currency rates also impact our future revenue under subscription contracts that are not denominated in U.S. dollars as we bill certain international customers in Euros, British Pounds, Australian Dollars, Chinese Renminbi and Japanese Yen. Our revenue and deferred revenue for these currencies are recorded in U.S. dollars when the subscription is entered into based upon currency exchange rates in effect on the last day of the previous month before the subscription agreement is entered into. This increases our risks associated with fluctuations in currency exchange rates since we cannot be assured of receiving the same U.S. dollar equivalent as when we bill exclusively in U.S. dollars. Upon the strengthening of the U.S. dollar, we would experience a reduction in subscription amounts as recorded in U.S. dollars relative to the foreign currency in which the subscription was priced to the customer. As a result, the strengthening of the U.S. dollar for current sales would reduce our future revenue from these contracts, even though these foreign currencies may strengthen during the term of these subscriptions. As currency exchange rates remain volatile, our future revenue could be adversely affected by currency fluctuations. We engage in currency hedging activities with the intent of limiting the risk of exchange rate fluctuations, but our foreign exchange hedging activities also involve inherent risks that could result in an unforeseen loss. If we fail to properly forecast our billings, expenses and currency exchange rates these hedging activities could have a negative impact.

Our future success depends on our ability to sell new, renewal and upgraded subscriptions to our security products.

Substantially all of our revenue for the quarter ended September 30, 2010 was derived from new and renewal subscriptions to our Web filtering and Web security products, and we expect that a significant majority of our sales for the remainder of 2010 will continue to be derived from our Web filtering and Web security products, including our Web Security Gateway sold with or without appliances. We expect sales of our DLP products; SaaS offerings; Triton unified Web, data and email security solution; and other products under development to comprise a relatively small portion of our revenue in 2010, but represent a meaningful portion of our sales growth in 2010. Our revenue growth is dependent on incremental sales of security products to new customers and to customers who upgrade products upon renewal, which must also offset declines in sales from the renewals of Web filtering subscriptions and declines in sales from OEM customers. If our products fail to meet the needs of our existing and target customers, or if they do not compare favorably in price, features and performance to competing products, our operating results and our business will be significantly impaired. If we cannot sufficiently increase our customer base with the addition of new customers and upgrade subscriptions for additional product offerings from existing customers or renew a sufficient number of customers, we will not be able to grow our business to meet expectations.

Subscriptions for our Web security, data security and email security products typically have durations of 12, 24 or 36 months. Our revenue depends upon maintaining a high rate of sales of renewal subscriptions and adding additional product offerings to existing customers as well as new customer sales. Our customers have no obligation to renew their subscriptions upon expiration, and if they renew, they may elect to renew for a shorter duration than the previous subscription period. As a result of macroeconomic conditions, our customers may elect to renew subscriptions for shorter durations and may reduce their subscribed products due to contractions of work forces of their respective organizations. This may require increasingly costly sales efforts targeting senior management and other management personnel associated with our customers’ Internet and security infrastructure. We may not be able to maintain or continue to generate increasing revenue from existing customers.

Failure of our security products, including our security gateway products, DLP products, SaaS security solutions and our V-series appliance platform, to achieve more widespread market acceptance will seriously harm our business.

Our ability to generate revenue growth depends on our ability to diversify our offerings by successfully developing, introducing and gaining customer acceptance of our new products and services, particularly our security gateway offerings. We now sell our next generation Web content gateway to address emerging Web 2.0 threats, Websense Web Security Gateway, as well as our V10000 appliance pre-loaded with our software. We also sell the Websense Data Security Suite, our DLP offering for the data security market, Websense Hosted Web Security and Websense Hosted Email Security, our SaaS offerings, and Websense Email Security, our email filtering solution. In February 2010, we introduced our Triton unified Web, data and email security solution, which combines our products into a single platform, and in June 2010 we released our V5000TM appliance. We continue to develop and release products in accordance with our announced product roadmap. We may not be successful in achieving market acceptance of these or any new products that we develop and may be unsuccessful in obtaining incremental sales as a result. If we fail to continue to upgrade and diversify our products, we could lose revenue from renewal subscriptions for our Web filtering products as these products become more of a commodity.

 

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Our V-series appliance platform exposes us to risks inherent with the sale of hardware, to which we were not previously exposed as a software company.

With the launch of our V10000 appliance in 2009 and the release of our V5000 appliance in June 2010, we are now selling products that are hardware-based and not solely software-based. Our V-series appliances are manufactured by a third-party contract manufacturer, and a third-party logistics company is providing logistical services, including product configuration and shipping. Our ability to deliver our V-series appliances to our customers could be delayed if we fail to effectively manage our third-party relationships or if our contract manufacturer or logistics provider experiences delays, disruptions or quality control problems in manufacturing, configuring or shipping the appliance. If our third-party providers fail for any reason to manufacture and deliver the V-series appliances with acceptable quality, in the required volumes, and in a cost-effective and timely manner, it could be costly to us, as well as disruptive to product shipments. In addition, supply disruptions or cost increases could increase our cost of goods sold and negatively impact our financial performance. Our V-series appliance platform may also face greater obsolescence risks than our pure software products.

Our revenue is derived almost entirely from sales through indirect channels and we depend upon these channels to create demand for our products.

Our revenue has been derived almost entirely from sales through indirect channels, including value-added resellers, distributors that sell our products to end-users, providers of managed Internet services and other resellers. Although we rely upon these indirect channels of distribution, we also depend upon our internal sales force to generate sales leads and sell products through the reseller network. Ingram Micro, one of our broad-line distributors in North America, accounted for approximately 31% and 32% of our revenues during the three and nine months ended September 30, 2010, respectively. Should Ingram Micro experience financial difficulties, difficulties in collecting their accounts receivable or otherwise delay or prevent our collection of accounts receivable from them, our revenue and cash flow would be adversely affected. Also, should our resellers be subject to credit limits or have financial difficulties that limit financing terms available to them, our revenue and cash flow could be adversely affected. Our indirect sales model involves a number of additional risks, including:

 

   

our resellers and distributors, including Ingram Micro, are not subject to minimum sales requirements or any obligation to market our products to their customers;

 

   

we cannot control the level of effort our resellers and distributors expend or the extent to which any of them will be successful in marketing and selling our products;

 

   

we cannot assure that our channel partners will market and sell our newer product offerings such as our security-oriented offerings, our Web Security Gateway, our V-series appliances, our DLP offerings or our SaaS security products;

 

   

our reseller and distributor agreements are generally nonexclusive and may be terminated at any time without cause; and

 

   

our resellers and distributors frequently market and distribute competing products and may, from time to time, place greater emphasis on the sale of these products due to pricing, promotions and other terms offered by our competitors.

Our ability to meaningfully increase the amount of our products sold through our sales channels also depends on our ability to adequately and efficiently support these channel partners with, among other things, appropriate financial incentives to encourage pre-sales investment and sales tools, such as sales training, technical training and product materials needed to support their customers and prospects. The diversity and sophistication of our product offerings have required us to focus on additional sales and technical training, and we are making increased investments in this area. Additionally, we are continually evaluating the changes to our internal ordering and partner management systems in order to effectively execute our two-tier distribution strategy. Any failure to properly and efficiently support our sales channels will result in lost sales opportunities.

If our internal controls are not effective, current and potential stockholders could lose confidence in our financial reporting.

Section 404 of the Sarbanes-Oxley Act of 2002 requires companies to conduct a comprehensive evaluation of their internal control over financial reporting. To comply with this statute, we are required to document and test our internal control over financial reporting; our management is required to assess and issue a report concerning our internal control over financial reporting; and our independent registered public accounting firm is required to attest to and report on the effectiveness of internal control over financial reporting.

 

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In our annual and quarterly reports (as amended) for the periods from December 31, 2008 through September 30, 2009, we reported material weaknesses in our internal control over financial reporting which related to our revenue recognition under OEM contracts and our computation of our income tax benefit for the year ended December 31, 2008. We have taken a number of actions to remediate these material weaknesses, which included reviewing and designing enhancements to certain of our controls and processes relating to revenue recognition and the computation of the income tax provision as well as conducting additional training in these areas. Based upon these remediation actions, management concluded that the material weaknesses described above were remediated as of December 31, 2009.

Although we believe we have taken appropriate actions to remediate the material weaknesses we cannot assure you that we will not discover other material weaknesses in the future. The existence of one or more material weaknesses could result in errors in our financial statements, and substantial costs and resources may be required to rectify these or other internal control deficiencies. If we cannot produce reliable financial reports, investors could lose confidence in our reported financial information, the market price of our common stock could decline significantly, and our business and financial condition could be harmed.

We face increasing competition from much larger software and hardware companies, which places pressure on our pricing and which could prevent us from increasing our revenue. In addition, as we increase our emphasis on our security-oriented products, we face competition from better-established security companies that have significantly greater resources.

The market for our products is intensely competitive and is likely to become even more so in the future. Our current principal Web filtering competitors frequently offer their products at a significantly lower price than our products, which has resulted in pricing pressures on sales of our products and potentially could result in the commoditization of products in our space. We also face current and potential competition from vendors of Internet servers, operating systems and networking hardware, many of which now, or may in the future, develop and/or bundle Web filtering or other competitive products with their current products with no price increase to these current products. Increased competition may cause price reductions or a loss of market share, either of which could have a material adverse effect on our business, results of operations and financial condition. If we are unable to maintain the current pricing on sales of our products or increase our pricing in the future, our results of operations could be negatively impacted. Even if our products provide greater functionality and are more effective than certain other competitive products, potential customers might accept this limited functionality. In addition, our own indirect sales channels may decide to develop or sell competing products instead of our products. Pricing pressures and increased competition generally could result in reduced sales, reduced margins or the failure of our products to achieve or maintain widespread market acceptance, any of which could have a material adverse effect on our business, results of operations and financial condition.

Our current principal competitors include:

 

   

companies offering Web filtering and Web security solutions, such as Microsoft, Symantec/Message Labs, McAfee (recently announced to be acquired by Intel Corporation), Cisco Systems, Juniper Networks, Trend Micro, Google, Webroot/BrightCloud, Cisco Systems/ScanSafe, Blue Coat Systems, SafeNet/Aladdin, FaceTime, St. Bernard Software, M86 Security, Clearswift, Sophos, Barracuda Networks, Digital Arts, RuleSpace, Commtouch and Computer Associates;

 

   

companies integrating Web filtering into specialized security appliances, such as Blue Coat Systems, Cisco Systems, McAfee (recently announced to be acquired by Intel Corporation), WatchGuard, Check Point Software, St. Bernard Software, Barracuda Networks, Juniper Networks, Trend Micro, SonicWALL, Sophos, Network Box, Fortinet and M86 Security;

 

   

companies offering DLP solutions, such as Symantec, Verdasys, Trustwave, EMC, McAfee (recently announced to be acquired by Intel Corporation), IBM, Trend Micro, Proofpoint, Palisade Systems, Computer Associates, Raytheon, Intrusion, Fidelis, GTB Technologies, Workshare, Check Point Software and Code Green Networks;

 

   

companies offering messaging security, such as McAfee (recently announced to be acquired by Intel Corporation), Symantec/Message Labs, Google, Cisco Systems, Barracuda Networks, SonicWALL, Trend Micro, Axway, Sophos, Microsoft, Proofpoint, Clearswift, Commtouch, Zix Corporation, WatchGuard, M86 Security, Webroot, and Fortinet;

 

   

companies offering on-demand email and Web security services, such as Google, Microsoft, Symantec/Message Labs, McAfee (recently announced to be acquired by Intel Corporation), Webroot/Bright Cloud, St. Bernard Software, Barracuda Networks, Webroot/BrightCloud, Zscaler, Trend Micro and Cisco Systems/ScanSafe;

 

   

companies offering desktop security solutions such as Check Point Software, Cisco Systems, McAfee (recently announced to be acquired by Intel Corporation), Microsoft, Symantec, Computer Associates, Sophos, Webroot, IBM and Trend Micro; and

 

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companies offering Web gateway solutions such as Microsoft, Blue Coat Systems, Cisco Systems, Trend Micro, Check Point Software, McAfee (recently announced to be acquired by Intel Corporation), Juniper Networks, Optinet, Safe Net/Aladdin, M86 Security, Clearswift, Computer Associates, FaceTime and Barracuda Networks.

As we develop and market our products with an increasing security-oriented emphasis, we also face growing competition from security solutions providers. Many of our competitors within the Web security market, such as Symantec, McAfee (recently announced to be acquired by Intel Corporation), Trend Micro, Cisco Systems, Google and Microsoft enjoy substantial competitive advantages, including:

 

   

greater name recognition and larger marketing budgets and resources;

 

   

established marketing relationships and access to larger customer bases; and

 

   

substantially greater financial, technical and other resources.

As a result, we may be unable to gain sufficient traction as a provider of Web security solutions, and our competitors may be able to respond more quickly and effectively than we can to new or emerging technologies and changes in customer requirements, or devote greater resources to the development, marketing, promotion and sale of their products than we can. Current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the functionality and market acceptance of their products. In addition, our competitors may be able to replicate our products, make more attractive offers to existing and potential employees and strategic partners, develop new products or enhance existing products and services more quickly. Accordingly, new competitors or alliances among competitors may emerge and rapidly acquire significant market share. In addition, many of our competitors made recent acquisitions in some of our product areas, and, we expect competition to increase as a result of this industry consolidation. Through an acquisition, a competitor could bundle separate products to include functions that are currently provided primarily by our Web and data security solutions and sell the combined product at a lower cost which could essentially include, at no additional cost, the functionality of our stand-alone solutions. For all of the foregoing reasons, we may not be able to compete successfully against our current and future competitors.

The covenants in our credit facility restrict our financial and operational flexibility, including our ability to complete additional acquisitions and invest in new business opportunities.*

In connection with our acquisition of SurfControl in October 2007, we entered into the 2007 Senior Credit Agreement to provide financing for a substantial portion of the acquisition purchase price. On October 26, 2010, we announced that we had entered into the New Credit Agreement and will use the initial proceeds to repay our term loan and retire the 2007 Senior Credit Agreement. Both the 2007 Senior Credit Agreement and the New Credit Agreement contain covenants that restrict, among other things, our ability to borrow money, make particular types of investments, including investments in our subsidiaries, make other restricted payments, pay down subordinated debt, swap or sell assets, merge or consolidate or make acquisitions. An event of default under either agreement could allow the lenders to declare all amounts outstanding with respect to the agreement to be immediately due and payable. As collateral for the loan, we pledged substantially all of our consolidated assets and the stock of certain of our subsidiaries (subject to limitations with respect to foreign subsidiaries) to secure the debt under our credit agreements. If the amounts outstanding under the credit agreements were accelerated, the lenders could proceed against those consolidated assets and the stock of certain of our subsidiaries. Any event of default, therefore, could have a material adverse effect on our business. Our credit agreements also require us to maintain specified financial ratios. Our ability to meet these financial ratios can be affected by events beyond our control, and we cannot assure that we will meet those ratios.

Our international operations involve risks that could increase our expenses, adversely affect our operating results and require increased time and attention of our management.

We have significant operations outside of the United States, including research and development, sales and customer support. We have engineering operations in Reading, England; Beijing, China and Ra’anana, Israel.

We plan to continue to expand our international operations, but such expansion is contingent upon the financial performance of our existing international operations as well as our identification of growth opportunities. Our international operations are subject to risks in addition to those faced by our domestic operations, including:

 

   

difficulties associated with managing a distributed organization located on multiple continents in greatly varying time zones;

 

   

potential loss of proprietary information due to misappropriation or laws that may be less protective of our intellectual property rights;

 

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requirements of foreign laws and other governmental controls, including trade and labor restrictions and related laws that reduce the flexibility of our business operations;

 

   

political unrest, war or terrorism, particularly in areas in which we have facilities;

 

   

difficulties in staffing, managing, and operating our international operations, including difficulties related to administering our stock plans in some foreign countries;

 

   

difficulties in coordinating the activities of our geographically dispersed and culturally diverse operations;

 

   

restrictions on our ability to repatriate cash from our international subsidiaries or to exchange cash in international subsidiaries into cash available for use in the United States; and

 

   

costs and delays associated with developing software in multiple languages.

Sales to customers outside the United States have accounted for a significant portion of our revenue, which exposes us to risks inherent in international sales.

We market and sell our products outside the United States through value-added resellers, distributors and other resellers. International sales represented 50% and 51% of our total revenues generated during the quarter and year to date period ended September 30, 2010, respectively. As a key component of our business strategy to generate new business sales, we intend to continue to expand our international sales, but success cannot be assured. In addition to the risks associated with our domestic sales, our international sales are subject to the following risks:

 

   

our ability to adapt to sales and marketing practices and customer requirements in different cultures;

 

   

our ability to successfully localize software products for a significant number of international markets;

 

   

the significant presence of some of our competitors in some international markets;

 

   

laws and business practices favoring local competitors;

 

   

dependence on foreign distributors and their sales channels;

 

   

longer payment cycles for sales in foreign countries and difficulties in collecting accounts receivable;

 

   

compliance with multiple, conflicting and changing governmental laws and regulations, including tax laws and regulations and consumer protection and privacy laws; and

 

   

regional economic and political conditions, including adverse economic conditions in emerging markets with significant growth potential.

These factors could have a material adverse effect on our international sales. Any reduction in international sales, or our failure to further develop our international distribution channels, could have a material adverse effect on our business, results of operations and financial condition.

We may not be able to develop acceptable new products or enhancements to our existing products at a rate required by our rapidly changing market.

Our future success depends on our ability to develop new products or enhancements to our existing products that keep pace with rapid technological developments and that address the changing needs of our customers. Although our products are designed to operate with a variety of network hardware and software platforms, we will need to continuously modify and enhance our products to keep pace with changes in Internet-related hardware, software, communication, browser and database technologies. We may not be successful in either developing such products or introducing them to the market in a timely fashion. In addition, uncertainties about the timing and nature of new network platforms or technologies, or modifications to existing platforms or technologies could increase our research and development expenses. The failure of our products to operate effectively with the existing and future network platforms and technologies will limit or reduce the market for our products, result in customer dissatisfaction and seriously harm our business, results of operations and financial condition.

 

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Because our products primarily manage access to URLs and executable files included in our databases, if our databases do not contain a meaningful portion of relevant content, the effectiveness of our Web filtering products will be significantly diminished. Any failure of our databases to keep pace with the rapid growth and technological change of the Internet, such as the increasing amount of multimedia content on the Internet that is not easily classified, will impair the market acceptance of our products.

We rely upon a combination of automated filtering technology and human review to categorize URLs and executable files in our proprietary databases. Our customers may not agree with our determinations that particular URLs and executable files should be included or not included in specific categories of our databases. In addition, it is possible that our filtering processes may place objectionable or security risk material in categories that are generally unrestricted by our users’ Internet and computer access policies, which could result in such material not being blocked from the network. Any errors in categorization could result in customer dissatisfaction and harm our reputation. Any failure to effectively categorize and filter URLs and executable files according to our customers’ expectations could impair the growth of our business. Our databases and database technologies may not be able to keep pace with the growth in the number of URLs and executable files, especially the growing amount of content utilizing foreign languages and the increasing sophistication of malicious code and the delivery mechanisms associated with spyware, phishing and other hazards associated with the Internet. The success of our dynamic Web categorization capabilities may be critical to our customers’ long term acceptance of our products.

We may spend significant time and money on research and development to design and develop our Triton management console, V-series appliances, content gateway products, DLP products and our SaaS security products. If these products fail to achieve broad market acceptance in our target markets, we may be unable to generate significant revenue from our research and development efforts. As a result, our business, results of operations and financial condition would be adversely impacted.

If we fail to maintain adequate operations infrastructure, we may experience disruptions of our SaaS offerings.

Any disruption to our technology infrastructure or the Internet could harm our operations and our reputation among our customers. Our technology and network infrastructure is extensive and complex, and could result in inefficiencies or operational failures. These potential inefficiencies or operational failures could diminish the quality of our products, services, and user experience, resulting in damage to our reputation and loss of current and potential subscribers, and could harm our operating results and financial condition. Any disruption to our computer systems could adversely impact the performance of our SaaS offerings and hybrid service offerings, our customer service, our delivery of products or our operations and result in increased costs and lost opportunities for business.

Failure of our products to work properly or misuse of our products could impact sales, increase costs, and create risks of potential negative publicity and legal liability.

Our products are complex, are deployed in a wide variety of network environments and manage content in a dramatically changing Web 2.0 world. Our products may have errors or defects that users identify after deployment, which could harm our reputation and our business. In addition, products as complex as ours frequently contain undetected errors when first introduced or when new versions or enhancements are released. We have from time to time found errors in versions of our products, and we expect to find such errors in the future. Because customers rely on our products to manage employee behavior to protect against security risks and prevent the loss of sensitive data, any significant defects or errors in our products may result in negative publicity or legal claims. For example, an actual or perceived breach of network or computer security at one of our customers, regardless of whether the breach is attributable to our products, could adversely affect the market’s perception of our security products. Moreover, parties whose Web sites or executable files are placed in security-risk categories or other categories with negative connotations may seek redress against us for falsely labeling them or for interfering with their business. The occurrence of errors could adversely affect sales of our products, divert the attention of engineering personnel from our product development efforts and cause significant customer relations or legal problems.

Our products may also be misused or abused by customers or non-customer third parties who obtain access to our products. These situations may arise where an organization uses our products in a manner that impacts their end users’ or employees’ privacy or where our products are misappropriated to censor private access to the Internet. Any of these situations could result in negative press coverage and negatively affect our reputation.

The amount of our debt outstanding may prevent us from taking actions we would otherwise consider in our best interest.*

In October 2007, we borrowed $210 million under the 2007 Senior Credit Agreement and $67 million remained outstanding as of September 30, 2010. On October 26, 2010 we announced that we had entered into a New Credit Agreement and that we intended to use the initial proceeds to repay the term loans and retire the 2007 Senior Credit Agreement. Under the New Credit Agreement, we can borrow up to $120 million and use proceeds to fund share repurchases or other corporate purposes. While we are subject to more

 

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flexible covenants under the New Credit Agreement, and we may borrow additional funds, the limitations our New Credit Agreement impose on us could have important consequences, including:

 

   

it may be difficult for us to satisfy our obligations under the New Credit Agreement;

 

   

we may be less able to obtain other debt financing in the future;

 

   

we could be less able to take advantage of significant business opportunities, including acquisitions or divestitures, as a result of debt covenants;

 

   

our vulnerability to general adverse economic and industry conditions could be increased; and

 

   

we could be at a competitive disadvantage to competitors with less debt.

We face risks related to customer outsourcing to system integrators.

Some of our customers have outsourced the management of their information technology departments to large system integrators. If this trend continues, our established customer relationships could be disrupted and our products could be displaced by alternative system and network protection solutions offered by system integrators. Significant product displacements could impact our revenue and have a material adverse effect on our business.

Other vendors may include products similar to ours in their hardware or software and render our products obsolete.

In the future, vendors of hardware and of operating system software or other software may continue to enhance their products or bundle separate products to include functions that are currently provided primarily by network security software. If network security functions become standard features of computer hardware or of operating system software or other software, our products may become obsolete and unmarketable, particularly if the quality of these network security features is comparable to that of our products. Furthermore, even if the network security and/or management functions provided as standard features by hardware providers or operating systems or other software is more limited than that of our products, our customers might accept this limited functionality in lieu of purchasing additional software. Sales of our products would suffer materially if we were then unable to develop new Web filtering, security and DLP products to further enhance operating systems or other software and to replace any obsolete products.

Our worldwide income tax provisions and other tax accruals may be insufficient if any taxing authorities assume taxing positions that are contrary to our positions and those contrary positions are sustained.

Significant judgment is required in determining our worldwide provision for income taxes and for our accruals for state, federal and international income taxes together with transaction taxes such as sales tax, VAT and GST. In the ordinary course of a global business, there are many transactions for which the ultimate tax outcome is uncertain. Some of these uncertainties arise as a consequence of intercompany arrangements to share revenue and costs. In such arrangements there are uncertainties about the amount and manner of such sharing, which could ultimately result in changes once the arrangements are reviewed by taxing authorities. Although we believe that our approach to determining the amount of such arrangements is consistent with prevailing legislative interpretation, no assurance can be given that the final tax authority review of these matters will agree with our historical income tax provisions and other tax accruals. Such differences could have a material effect on our income tax provisions or benefits, or other tax accruals, in the period in which such determination is made, and consequently, on our results of operations for such period.

From time to time, we are also audited by various state, federal and tax authorities of other countries in which we operate. Generally, the tax years 2005 through 2009 could be subject to examination by U.S. federal and most state tax authorities. We are currently under examination by the respective tax authorities for tax years 2005 to 2008 in the United States, for 2006 to 2007 in the United Kingdom and for 2006 to 2008 in Israel. The Company has various other on-going audits in various stages of completion. Our audits are in various stages of completion; however, no outcome for a particular audit can be determined with certainty prior to the conclusion of the audit and any appeals process.

As each audit progresses and is ultimately concluded, adjustments, if any, will be recorded in our financial statements from time to time in light of prevailing facts based on our and the taxing authority’s respective positions on any disputed matters. We provide for potential tax exposures by accruing for uncertain tax positions based on judgment and estimates including historical audit activity. If the reserves are insufficient or we are not able to establish a reserve under GAAP prior to completion or during the progression of any audits, there could be an adverse impact on our financial position and results of operations when an audit assessment is made. In addition, our external costs of contesting and settling any dispute with the tax authorities could be substantial and adversely impact our financial position and results of operation.

 

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During the first quarter of 2010, we were informed by the IRS that they had completed their audit for the tax years ended December 31, 2005 through December 31, 2007. Accordingly, the IRS issued us a 30-day letter which outlined all of their proposed audit adjustments and requires us to either accept the proposed adjustments, subject to future litigation, or file a formal administrative protest contesting those proposed adjustments within 30 days. The proposed adjustments relate primarily to the cost sharing arrangement between Websense, Inc. and our Irish subsidiary, including the amount of cost sharing buy-in, as well as to our claim of research and development tax credits and income tax deductions for equity compensation awarded to certain executive officers. The amount of additional tax proposed by the IRS totals approximately $19.0 million, of which $14.8 million relates to the amount of cost sharing buy-in, $2.5 million relates to research and development credits and $1.7 million relates to equity compensation awarded to certain executive officers. The total additional tax proposed excludes interest, penalties and state income taxes, each of which may be significant, and also excludes a potential reduction in tax on the Irish subsidiary. The proposed adjustments also do not include the future impact that changes in our cost sharing arrangement could have on our effective tax rate. We disagree with all of the proposed adjustments and have submitted a formal protest to the IRS for each matter. The IRS has acknowledged the receipt of our protest and we are now awaiting an appointment with the IRS Appeals Office. We intend to continue to defend our position on all of these matters, including through litigation if required. While the timing of the ultimate resolution of these matters cannot be reasonably estimated at this time, we may be required to make additional payments in order to resolve these matters.

In particular, the IRS has identified and is aggressively pursuing cost sharing arrangements between domestic and international subsidiaries, including the amount of the buy-in, as a potential area for audit exposure for many companies. If this matter is litigated and the position proposed by the IRS were sustained, our results of operations for periods when any new liability is incurred would be materially and adversely affected. We also cannot predict what impact an adverse result could have on our future income tax rate, which could adversely impact our results of operations.

Any failure to protect our proprietary technology would negatively impact our business.

Intellectual property is critical to our success, and we rely upon patent, trademark, copyright and trade secret laws in the United States and other jurisdictions as well as confidentiality procedures and contractual provisions to protect our proprietary technology and our Websense brands. We rely on trade secrets to protect technology where we believe patent protection is not appropriate or obtainable. However, trade secrets are difficult to protect. While we require employees, collaborators and consultants to enter into confidentiality agreements, we cannot assure that these agreements will not be breached or that we will have adequate remedies for any breach. We may not be able to adequately protect our trade secrets or other proprietary information in the event of any unauthorized use or disclosure, or the lawful development by others of such information. Any intentional disruption and/or the unauthorized use or publication of our trade secrets and other confidential business information, via theft or a cyber attack, could adversely affect our competitive position, reputation, brand and future sales of our products, and our customers may assert claims against us related to resulting losses of confidential or proprietary information.

We have registered our trademarks in several countries and have registrations for the Websense trademark pending in several other countries. Effective trademark protection may not be available in every country where our products are available. Furthermore, any of our trademarks may be challenged by others or invalidated through administrative process or litigation.

We currently have 22 patents issued in the United States and 28 patents issued internationally, and we may be unable to obtain further patent protection in the future. We have other pending patent applications in the United States and in other countries. We cannot ensure that:

 

   

we were the first to make the inventions covered by each of our pending patent applications;

 

   

we were the first to file patent applications for these inventions;

 

   

any of our pending patent applications are not obvious or anticipated such that they will not result in issued patents;

 

   

others will not independently develop similar or alternative technologies or duplicate any of our technologies;

 

   

any patents issued to us will provide us with any competitive advantages or will not be challenged by third parties;

 

   

we will develop additional proprietary technologies that are patentable; or

 

   

the patents of others will not have a negative effect on our ability to do business.

 

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Furthermore, legal standards relating to the validity, enforceability and scope of protection of intellectual property rights are uncertain and can change over time. Effective patent, trademark, copyright and trade secret protection may not be available to us in every country in which our products are available. The laws of some foreign countries may not be as protective of intellectual property rights as U.S. laws, and mechanisms for enforcement of intellectual property rights may be inadequate. As a result our means of protecting our proprietary technology and brands may not be adequate. Furthermore, despite our efforts, we may be unable to prevent third parties from infringing upon or misappropriating our intellectual property, including the misappropriation or misuse of the content of our proprietary databases of URLs and executable files, and our ability to police that misappropriation or infringement is uncertain, particularly in countries outside of the United States. Any such infringement or misappropriation could have a material adverse effect on our business, results of operations and financial condition.

Third parties claiming that we infringe their proprietary rights could cause us to incur significant legal expenses that reduce our operating margins and/or prevent us from selling our products.

The software and Internet industries are characterized by the existence of a large number of patents, trademarks and copyrights and by frequent litigation based on allegations of patent infringement or other violations of intellectual property rights. As we expand our product offerings in the data loss and security area where larger companies with large patent portfolios compete, the possibility of an intellectual property claim against us grows. We may receive claims that we have infringed the intellectual property rights of others, including claims regarding patents, copyrights and trademarks. For example, on July 12, 2010, Finjan, Inc. filed a complaint entitled Finjan, Inc. v. McAfee, Inc., Symantec Corp., Webroot Software, Inc., Websense, Inc. and Sophos, Inc. in the United States District Court for the District of Delaware. The complaint alleges that our Web filtering and Web Security Gateway products infringe a patent owned by Finjan and seeks damages and injunctive relief. Any such claim, including Finjan’s claim, with or without merit, could result in costly litigation and distract management from day-to-day operations and may result in us deciding to enter into license agreements to avoid ongoing patent litigation costs. If we are not successful in defending such claims, we could be required to stop selling or redesign our products, pay monetary amounts as damages, enter into royalty or licensing arrangements, or satisfy indemnification obligations that we have with some of our customers. Such arrangements may cause operating margins to decline.

Because we recognize revenue from subscriptions for our products ratably over the term of the subscription, downturns in sales may not be immediately reflected in our revenue.

Substantially all of our revenue comes from the sale of subscriptions to our products, including our SaaS offerings. Upon execution of a subscription agreement or receipt of royalty reports from OEM customers, we invoice our customers for the full term of the subscription agreement or for the period covered by the royalty report from OEM customers. We then recognize revenue from customers daily over the terms of their subscription agreements, or performance period under the OEM contract, as applicable, which, in the case of subscriptions, typically have durations of 12, 24 or 36 months. As a result, a majority of the revenue we report in each quarter is derived from deferred revenue from subscription agreements and OEM contracts entered into and paid for during previous quarters. Because of this financial model, the revenue we report in any quarter or series of quarters may mask significant downturns in sales and the market acceptance of our products, before these downturns are reflected by declining revenues.

Acquired companies or technologies can be difficult to integrate, disrupt our business, dilute stockholder value and adversely affect our operating results.

We may acquire additional companies, services and technologies in the future as part of our efforts to expand and diversify our business. Although we review the records of companies or businesses we are interested in acquiring, even an in-depth review may not reveal existing or potential problems or permit us to become familiar enough with a business to assess fully its capabilities and deficiencies. Integration of acquired companies may disrupt or slow the momentum of the activities of our business. As a result, if we fail to properly evaluate, execute and integrate future acquisitions, our business and prospects may be seriously harmed.

Acquisitions involve numerous risks, including:

 

   

difficulties in integrating operations, technologies, services and personnel of the acquired company;

 

   

potential loss of customers and OEM relationships of the acquired company;

 

   

diversion of financial and management resources from existing operations and core businesses;

 

   

risk of entering new markets;

 

   

potential loss of key employees of the acquired company;

 

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integrating personnel with diverse business and cultural backgrounds;

 

   

preserving the development, distribution, marketing and other important relationships of the companies;

 

   

assumption of liabilities of the acquired company, including debt and litigation;

 

   

inability to generate sufficient revenue from newly acquired products and/or cost savings needed to offset acquisition related costs; and

 

   

the continued use by acquired companies of accounting policies that differ from GAAP, such as policies related to the timing of revenue recognition.

Acquisitions may also cause us to:

 

   

issue equity securities that would dilute our current stockholders’ percentage ownership;

 

   

assume certain liabilities, including liabilities that were not detected at the time of the acquisition;

 

   

incur additional debt, such as the debt we incurred to partially fund the acquisition of SurfControl;

 

   

make large and immediate one-time write-offs for restructuring and other related expenses;

 

   

become subject to intellectual property or other litigation; and

 

   

create goodwill and other intangible assets that could result in significant impairment charges and/or amortization expense.

Our quarterly operating results may fluctuate significantly, and these fluctuations may cause our stock price to fall.

Our quarterly operating results have varied significantly in the past, and will likely vary in the future primarily as the result of macroeconomic driven fluctuations in our billings, operating expenses and tax provisions. Although a significant portion of our revenue in any quarter comes from previously deferred revenue, a meaningful portion of our revenue in any quarter depends on the number, size and length of subscriptions to our products that are sold in that quarter. The unpredictability of quarterly fluctuations is increased by the fact that a significant portion of our quarterly sales have historically been generated during the last month of each fiscal quarter, with many of the largest enterprise customers purchasing subscriptions to our products nearer to the end of the last month of each quarter.

We expect that our operating expenses will increase in the future as we expand our selling and marketing activities, increase our research and development efforts and potentially hire additional personnel which could impact our margins. In addition, our operating expenses historically have fluctuated, and may continue to fluctuate in the future, as the result of the factors described below and elsewhere in this quarterly report:

 

   

changes in currency exchange rates impacting our international operating expenses;

 

   

timing of marketing expenses for activities such as trade shows and advertising campaigns;

 

   

quarterly variations in general and administrative expenses, such as recruiting expenses and professional services fees;

 

   

increased research and development costs prior to new or enhanced product launches; and

 

   

fluctuations in expenses associated with commissions paid on sales of subscriptions to our products.

Consequently, our results of operations may not meet the expectations of current or potential investors. If this occurs, the price of our common stock may decline.

The market price of our common stock is likely to be highly volatile and subject to wide fluctuations.

The market price of our common stock has been and likely will continue to be highly volatile and could be subject to wide fluctuations in response to a number of factors that are beyond our control, including:

 

   

deteriorating or fluctuating world economic conditions;

 

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announcements of technological innovations or new products or services by our competitors;

 

   

demand for our products, including fluctuations in subscription renewals;

 

   

changes in the pricing policies of our competitors; and

 

   

changes in government regulations.

In addition, the market price of our common stock could be subject to wide fluctuations in response to:

 

   

announcements of technological innovations or new products or services by us;

 

   

changes in our pricing policies; and

 

   

quarterly variations in our revenues and operating expenses.

Further, the stock market has experienced significant price and volume fluctuations that have particularly affected the market price of the stock of many Internet-related companies, and that often have been unrelated or disproportionate to the operating performance of these companies. A number of publicly traded Internet-related companies have current market prices below their initial public offering prices. Market fluctuations such as these may seriously harm the market price of our common stock. In the past, securities class action suits have been filed following periods of market volatility in the price of a company’s securities. If such an action were instituted, we would incur substantial costs and a diversion of management attention and resources, which would seriously harm our business, results of operations and financial condition.

We are dependent on our management team, and the loss of any key member of this team may prevent us from implementing our business plan in a timely manner.

Our success depends largely upon the continued services of our executive officers and other key management personnel and our ability to recruit new personnel to executive and key management positions. We are also substantially dependent on the continued service of our existing engineering personnel because of the complexity of our products and technologies. We do not have employment agreements with a majority of our executive officers, key management or development personnel and, therefore, they could terminate their employment with us at any time without penalty. We do not maintain key person life insurance policies on any of our employees. The loss of one or more of our key employees could seriously harm our business, results of operations and financial condition. In such an event we may be unable to recruit personnel to replace these individuals in a timely manner, or at all, on acceptable terms.

Because competition for our target employees is intense, we may not be able to attract and retain the highly skilled employees we need to support our planned growth.

To execute our growth plan, we must attract and retain highly qualified personnel. Competition for these personnel is intense and we may not be successful in attracting and retaining qualified personnel. We have from time to time in the past experienced, and we expect to continue to experience in the future, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. In order to attract and retain personnel in a competitive marketplace, we believe that we must provide a competitive compensation package, including cash and equity-based compensation. The volatility of our stock price and our results of operations may from time to time adversely affect our ability to recruit or retain employees. Many of the companies with which we compete for experienced personnel have greater resources than we have. If we fail to attract new personnel or retain and motivate our current personnel, our business and future growth prospects could be severely harmed.

Compliance with regulation of corporate governance, accounting principles and public disclosure may result in additional expenses.

Compliance with laws, regulations and standards relating to corporate governance, accounting principles and public disclosure, including the Sarbanes-Oxley Act of 2002 regulations and NASDAQ listing rules, have caused us to incur higher compliance costs and we expect to continue to incur higher compliance costs as a result of our increased global reach and obligation to ensure compliance with these laws as well as local laws in the jurisdictions where we do business. These laws, regulations and standards are subject to varying interpretations in many cases due to their lack of specificity and, as a result, their application in practice may evolve over time. Further guidance by regulatory and governing bodies can result in continuing uncertainty regarding compliance matters and

 

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higher costs related to the ongoing revisions to accounting, disclosure and governance practices. Our efforts to comply with evolving laws, regulations and standards have resulted in, and are likely to continue to result in, increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities. If our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, our reputation may be harmed.

If we cannot effectively manage our internal growth, our business revenues, results of operations and prospects may suffer.

If we fail to manage our internal growth in a manner that minimizes strains on our resources, we could experience disruptions in our operations that could negatively affect our revenue, billings and results of operations. We are pursuing a strategy of organic growth through implementation of two-tier distribution, international expansion, introduction of new products and expansion of our product sales to the SMB segment. Each of these initiatives requires an investment of our financial and employee resources and involves risks that may result in a lower return on our investments than we expect. These initiatives also may limit the opportunities we pursue or investments we would otherwise make, which may in turn impact our prospects.

It may be difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders.*

Some provisions of our certificate of incorporation and bylaws, as well as some provisions of Delaware law, may discourage, delay or prevent third parties from acquiring us, even if doing so would be beneficial to our stockholders. For example, our certificate of incorporation provides that stockholders may not call stockholder meetings or act by written consent. Our bylaws provide that stockholders may not fill board vacancies and further provide that advance written notice is required prior to stockholder proposals. Each of these provisions makes it more difficult for stockholders to obtain control of our board or initiate actions that are opposed by the then current board. Additionally, we have authorized preferred stock that is undesignated, making it possible for the board to issue up to 5,000,000 shares of preferred stock with voting or other rights and preferences that could impede the success of any attempted change of control. Delaware law also could make it more difficult for a third party to acquire us. Section 203 of the Delaware General Corporation Law has an anti-takeover effect with respect to transactions not approved in advance by our board, including discouraging attempts that might result in a premium over the market price of the shares of common stock held by our stockholders.

Our 2007 Senior Credit Agreement and the New Credit Agreement also accelerate and become payable in full upon a change of control, which is defined generally as a person or group acquiring 35% of our voting securities or a proxy contest that results in changing a majority of our Board of Directors. These consequences may discourage third parties from attempting to acquire us.

We do not intend to pay dividends.

We have not declared or paid any cash dividends on our common stock since we have been a publicly traded company. We currently intend to retain any future cash flows from operations to fund growth, pay down our senior secured term loan and repurchase shares of our common stock, and therefore do not expect to pay any cash dividends in the foreseeable future. Moreover, we are not permitted to pay cash dividends under the terms of our senior secured credit facility.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

(a) Not applicable.

 

(b) Not applicable.

 

(c) Issuer Purchases of Equity Securities

 

Period

   Total
Number of
Shares
Purchased
     Average Price
Paid per Share
     Total Number of Shares
Purchased as Part of
Publicly Announced
Plans or Programs
     Maximum Number of
Shares that May Be
Yet Purchased Under
the Plans or Programs
 

July 1, 2010 to July 31, 2010

     142,934       $ 19.72         13,541,482         2,458,518   

August 1, 2010 to August 31, 2010

     637,258         18.75         14,178,740         1,821,260   

September 1, 2010 to September 30, 2010

     261,490         19.96         14,440,230         1,559,770   
                 

Total

     1,041,682         19.19         
                 

 

1. The purchases were made in open-market transactions.
2.

In April 2003, we announced that our Board of Directors authorized a stock repurchase program of up to 4,000,000 shares of our common stock. In August 2005, we announced that our Board of Directors increased the size of the stock repurchase program by an additional 4,000,000 shares, for a total program size of up to 8,000,000 shares. In July 2006, we announced that our Board of Directors increased the size of the stock repurchase program by an additional 4,000,000 shares, for a total program size of up

 

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to 12,000,000 shares. In January 2008, we adopted a 10b5-1 plan that provides for quarterly purchases of our common stock in open market transactions. In January 2010, our Board of Directors increased the size of the stock repurchase program by an additional 4,000,000 shares, for a total program size of up to 16,000,000 shares. The remaining shares authorized for repurchase under our stock repurchase program as of September 30, 2010 was 1,559,770. As of October 26, 2010, the Company increased the number of shares authorized for repurchase under the program by 8,000,000 shares.

 

Item 3. Defaults upon Senior Securities

None.

 

Item 4. (Removed and Reserved)

 

Item 5. Other Information

None.

 

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Item 6. Exhibits

Exhibits

 

    3.1(1)    Amended and Restated Certificate of Incorporation.
    3.2(1)    Amended and Restated Bylaws.
    4.1(2)    Specimen Stock Certificate of Websense, Inc.
  10.1(3)    Credit Agreement, dated October 22, 2010, among Websense, Inc. PortAuthority Technologies, Inc., Karabunga, Inc., Bank of America, N.A., and the other Lenders (as defined therein).
  31.1        Certification of Principal Executive Officer pursuant to Exchange Act Rules 13a-14(a) or 15d-14(a).
  31.2        Certification of Principal Financial Officer pursuant to Exchange Act Rules 13a-14(a) or 15d-14(a).
  32.1        Certification of Principal Executive Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350).
  32.2        Certification of Principal Financial Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350).
101.INS     XBRL Instance Document
101.SCH    XBRL Taxonomy Extension Schema Document
101.CAL    XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF    XBRL Taxonomy Extension Definition Document
101.LAB    XBRL Taxonomy Extension Label Linkbase Document
101.PRE    XBRL Taxonomy Extension Presentation Linkbase Document

 

(1) Filed as an exhibit to our Current Report on Form 8-K (No. 000-30093) filed on June 19, 2009.
(2) Filed as an exhibit to our Registration Statement on Form S-1/A (No 333-95619) filed on March 23, 2000.
(3) Filed as an exhibit to our Current Report on Form 8-K (No. 000-30093) filed on October 25, 2010.

 

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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.

 

    WEBSENSE, INC.
Date: November 5, 2010     By:   /s/    GENE HODGES        
      Gene Hodges
      Chief Executive Officer
Date: November 5, 2010     By:   /s/    ARTHUR S. LOCKE III        
      Arthur S. Locke III
      Chief Financial Officer

 

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EXHIBIT INDEX

Exhibits

 

    3.1(1)    Amended and Restated Certificate of Incorporation.
    3.2(1)    Amended and Restated Bylaws.
    4.1(2)    Specimen Stock Certificate of Websense, Inc.
  10.1(3)    Credit Agreement, dated October 22, 2010, among Websense, Inc., PortAuthority Technologies, Inc., Karabunga, Inc., Bank of America, N.A. and the other Lenders (as defined therein).
  31.1    Certification of Principal Executive Officer pursuant to Exchange Act Rules 13a-14(a) or 15d-14(a).
  31.2    Certification of Principal Financial Officer pursuant to Exchange Act Rules 13a-14(a) or 15d-14(a).
  32.1    Certification of Principal Executive Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350).
  32.2    Certification of Principal Financial Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350).
101.INS    XBRL Instance Document
101.SCH    XBRL Taxonomy Extension Schema Document
101.CAL    XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF    XBRL Taxonomy Extension Definition Document
101.LAB    XBRL Taxonomy Extension Label Linkbase Document
101.PRE    XBRL Taxonomy Extension Presentation Linkbase Document

 

(1) Filed as an exhibit to our Current Report on Form 8-K (No. 000-30093) filed on June 19, 2009.
(2) Filed as an exhibit to our Registration Statement on Form S-1/A (No 333-95619) filed on March 23, 2000.
(3) Filed as an exhibit to our Current Report on Form 8-K (No. 000-30093) filed on October 25, 2010.

 

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