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EX-31.2 - CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER - WEBSENSE INCdex312.htm
EX-31.1 - CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER - WEBSENSE INCdex311.htm
EX-32.1 - CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER - WEBSENSE INCdex321.htm
EX-32.2 - CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER - WEBSENSE INCdex322.htm
EX-21.1 - SUBSIDIARIES OF THE REGISTRANT - WEBSENSE INCdex211.htm
EX-10.12 - 2000 AMENDED AND RESTATED EMPLOYEE STOCK PURCHASE PLAN - WEBSENSE INCdex1012.htm
EX-23.1 - CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - WEBSENSE INCdex231.htm
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

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

For the fiscal year ended December 31, 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 Number)

10240 Sorrento Valley Road

San Diego, California 92121

858-320-8000

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

 

 

Securities registered pursuant to section 12(b) of the Act:

 

Title of Each Class

 

Name of Each Exchange on Which Registered

Common stock, $0.01 par value   NASDAQ Global Select Market

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  x    No  ¨

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

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 (§232.405 of this chapter) 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

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 definitions 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  ¨   Smaller reporting company  ¨
    (Do not check if a smaller reporting company)  

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

The aggregate market value of the voting stock held by non-affiliates of the registrant, as of June 30, 2010 was approximately $800 million (based on the closing price for shares of the registrant’s Common Stock as reported by the Nasdaq Global Select Market for that date). Shares of Common Stock held by each officer, director and holder of 10% or more of the outstanding Common Stock have been excluded in that such persons may be deemed affiliates. Exclusion of shares held by any person should not be construed to indicate that such person possesses the power, direct or indirect, to direct or cause the direction of management or policies of the registrant, or that such person is controlled by or under common control with the registrant.

The number of shares outstanding of the registrant’s Common Stock, $.01 par value, as of January 31, 2011 was 40,618,152.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Definitive Proxy Statement to be delivered to stockholders in connection with the Annual Meeting of Stockholders to be held June 7, 2011 are incorporated by reference into Part III. Such Definitive Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the conclusion of the registrant’s fiscal year ended December 31, 2010.

Certain exhibits filed with the registrant’s prior registration statements, periodic reports on forms 8-K, forms 10-K and forms
10-Q are incorporated herein by reference into Part IV of this Report.

 

 

 


Table of Contents

Websense, Inc.

Form 10-K

For the Fiscal Year Ended December 31, 2010

TABLE OF CONTENTS

 

          Page  

Part I

     
  

Restatement of Previously Issued Consolidated Financial Statements

     1   

Item 1.

  

Business

     2   

Item 1A.

  

Risk Factors

     15   

Item 1B.

  

Unresolved Staff Comments

     30   

Item 2.

  

Properties

     30   

Item 3.

  

Legal Proceedings

     31   

Item 4.

  

[Removed and Reserved]

     31   

Part II

     

Item 5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

     32   

Item 6.

  

Selected Financial Data

     33   

Item 7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     35   

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

     51   

Item 8.

  

Financial Statements and Supplementary Data

     53   

Item 9.

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

     81   

Item 9A.

  

Controls and Procedures

     81   

Item 9B.

  

Other Information

     83   

Part III

     

Item 10.

  

Directors, Executive Officers and Corporate Governance

     85   

Item 11.

  

Executive Compensation

     85   

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

     85   

Item 13.

  

Certain Relationships and Related Transactions, and Director Independence

     86   

Item 14.

  

Principal Accountant Fees and Services

     86   

Part IV

     

Item 15.

  

Exhibits and Financial Statement Schedules

     87   
  

Signatures

     90   


Table of Contents

PART I

Forward-Looking Statements

This report on Form 10-K may contain “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 and billings;

 

   

plans, strategies and objectives of management for future operations;

 

   

growth opportunities in domestic and international markets;

 

   

new and enhanced reliance on channels of distribution;

 

   

anticipated product enhancements or releases;

 

   

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 currency exchange rates;

 

   

the impact of macroeconomic 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 credit agreement;

 

   

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

 

   

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

 

   

risks related to changes in accounting interpretations;

 

   

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 I, 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.

Restatement of Previously Issued Consolidated Financial Statements

In this Annual Report on Form 10-K, we have restated our previously reported consolidated balance sheet at December 31, 2009 and the statement of stockholders’ equity at January 1, 2008 and related disclosures, to record the write-off of a $5.8 million tax asset that originated from an error in a calculation when we changed our tax method of accounting for deferred revenue in 2003.

The error resulted in our reporting overstated deferred tax assets of approximately $5.8 million in our financial statements for fiscal years 2003 through 2008. In 2009, we reclassified a portion of the error amount

 

1


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from deferred tax assets to income tax receivable because of a belief at the time that the error amount was related to monthly-to-daily revenue adjustments for fiscal years 2006 through 2008 and, therefore, would be recoverable by amending our tax returns for those years. We subsequently discovered the error amount was instead related to an error in the calculation of the deferred tax assets when we changed the tax method of accounting for deferred revenue in 2003. The statute of limitations to claim a refund for the 2003 tax year expired in September 2007. After evaluating various tax planning strategies, management determined that there is substantial uncertainty as to whether it will be able to recover the error amount based on case law. As a result, our 2007 financial statements should have reflected a write-off of the $5.8 million deferred tax asset and our 2009 and 2008 financial statements should have reflected the impact of the write-off on our deferred income taxes, income tax receivable and retained earnings balances.

Throughout this Annual Report on Form 10-K, amounts presented from prior periods and prior period comparisons have been revised and labeled as “restated” and reflect the balances and amounts on a restated basis.

The following table summarizes the effects of the restatements on the specific line items presented in our historical consolidated balance sheet as of December 31, 2009:

 

     December 31, 2009
(As previously
reported)
     December 31, 2009
(As restated)
 
     (In Thousands)  

Current assets:

     

Income tax receivable/prepaid income tax

   $ 11,446       $ 7,589   

Current portion of deferred income taxes

     36,538         35,269   

Total current assets

     225,103         219,977   

Deferred income taxes, less current portion

     11,795         11,106   

Total assets

     701,661         695,846   

Stockholders’ equity:

     

Retained earnings

     28,416         22,601   

Total stockholders’ equity

     162,730         156,915   

The restatements resulted in changes to the opening balances of retained earnings and total stockholders’ equity as of January 1, 2008 as follows:

 

     January 1, 2008
(As previously
reported)
     January 1, 2008
(As restated)
 
     (In Thousands)  

Retained earnings

   $ 65,892       $ 60,077   

Stockholders’ equity

   $ 192,437       $ 186,622   

The restatements had no impact on the financial statement amounts previously reported for the Company’s revenues, operating costs and expenses, net income (loss) and cash flows from operations for the years ended December 31, 2009 and 2008, or for the first nine months ended September 30, 2010, or any quarterly periods in the years ended December 31, 2009 and 2008.

 

Item 1. Business

Overview

We are a global provider of unified Web, data and email content security solutions that are designed to protect data and users from modern cyber-threats, information leaks, legal liability and productivity loss. We provide our solutions to our customers as software installed on standard server hardware, as software pre-installed on optimized appliances, as a cloud-based service (software as-a-service or “SaaS”) offering, or in a hybrid appliance/SaaS configuration. Our products and services are sold worldwide to public sector entities, enterprise customers, small and medium sized businesses (“SMBs”), and Internet service providers through a network of value-added resellers and original equipment manufacturer (“OEM”) arrangements.

 

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Organizations rely on the Internet and email to conduct business, and frequently send critical or confidential information outside their secure network perimeters as part of their established business processes. Accelerating use of rich Web-based applications with real-time interaction, social Web sites with user-generated content, and the rise of cloud-based services is increasing the volume and value of information transmitted across the Internet. At the same time, the cost and number of security breaches involving data loss has increased, and regulatory compliance requirements have become more stringent. These trends support the need for effective Web, data and email security solutions that include data loss prevention (“DLP”) capabilities and address the dynamic nature of user-generated content on Web 2.0 sites.

Over the past 16 years, Websense has evolved from a reseller of network security hardware solutions to a leading developer and provider of Information Technology (“IT”) security software solutions. We released our first Web filtering software product in 1996 to help customers prevent employee 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 including the rise of Web-based social and business applications and the growing incidence of Web-based criminal activity. In 2008, we introduced the Web Security Gateway with dynamic categorization of Web 2.0 content. In 2009, we introduced the V10000™ appliance for the Web Security Gateway. In 2010, we integrated our DLP functionality for the Web with our Web Security Gateway offering and added hybrid appliance and cloud-based capabilities, managed by the TRITON™ policy and reporting application. In 2011, we introduced Websense® TRITON Enterprise and Websense TRITON Security Gateway Anywhere, our solutions which provide unified content analysis, a unified platform, and unified management capabilities to deploy our Web, data and email security solutions in one architecture.

Today, our customers use our integrated content security solutions to protect their employees, networks and data from internal and external threats by automating the enforcement of Web, email and information security policies. Our products are designed to:

 

   

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;

 

   

protect from spam, inappropriate content and malware embedded in user-generated content on Web 2.0 sites;

 

   

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

 

   

identify and remove malware from incoming Web content;

 

   

filter spam from incoming email;

 

   

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;

 

   

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

 

   

protect against data loss by identifying and categorizing sensitive or confidential data, monitoring the movement of data throughout the network and enforcing pre-determined usage and movement policies.

We derive the majority of our revenue from our Web security and email security offerings and expect that a majority of our revenues will continue to come from these products for several years. The market for DLP solutions is still in the early phases of development, and an increasing number of our customers are deploying DLP as embedded functionality in their Web and email security solutions rather than as a separate solution.

We operate in one industry segment, as defined by U.S. generally accepted accounting principles (“GAAP”).

 

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We commenced operations in 1994 as NetPartners Internet Solutions, Inc., a reseller of computer security products. In 1999, we changed our name to Websense, Inc. to reflect the shift in our business focus to a developer of Web filtering solutions. Our principal offices are located at 10240 Sorrento Valley Road, San Diego, California 92121.

Industry Background

Many organizations use the Internet as an integral part of their computing infrastructure, expanding their use of the Web to enable mission-critical applications such as customer relationship management, accounting, employee benefits, collaborative research and development and more. Many employees also use their organization’s computing resources for recreational “Web-surfing,” peer-to-peer file sharing, instant messaging and other personal matters.

Additionally, as organizations create collaborative networks with their customers, suppliers, technology partners and other stakeholders, they increase the value of confidential and sensitive data that travels across the networks. The growing adoption of cloud-based applications and SaaS offerings further blurs the boundaries of organizations’ networks and has increased the amount of data leaving an organization. Securing this sensitive data from loss due to inadequate business process controls, employee error and malfeasance, as well as undetected data-stealing malicious code, has become a top priority for IT executives.

As the boundaries between internal and external computing resources and between work and personal Internet activity have blurred, the IT infrastructures and valuable corporate data have become more vulnerable to external threats such as spyware, viruses, Trojan horses and phishing and pharming exploits. At the same time, the rise of constantly updated user-generated content on the modern Web renders traditional security measures against these threats inadequate.

To provide effective IT security in this environment, organizations must be able to manage who uses what information, as well as where and how the information can be sent or shared. Real-time analysis and dynamic categorization of internal content, Web sites, and new threats are necessary to keep up with changing Web content, newly created internal information, and mutating threats. Enforcement policies must be user, content and destination aware to provide protection without hindering established business processes. As a result, we believe there is a significant opportunity for integrated real-time Web security, data security and email content security solutions that continuously monitor Web, data and email traffic and apply use policies based on deep content analysis and dynamic categorization.

Our Products and Services

Our products are designed to protect data and users from Web and email-based threats, data leaks and productivity loss and can be grouped into three categories: Web security (prevent Web-based attacks and access to inappropriate content), DLP (monitor outbound Web and email traffic and downloads to external devices for data leaks), and email security (spam and malware filtering for inbound email). Our Web and email security products are available as software installed on standard server hardware, as software installed on an optimized Websense V-series™ appliance, as a SaaS offering and as a hybrid appliance/SaaS configuration. Our data security technology is available as server-based software or as functionality integrated with our Web security solutions on our appliances. In April 2010, we integrated the management of these products on the TRITON™ management console to deliver unified content analysis and policy enforcement across Web, email and internal network communications. Collectively, these products provide customers with Essential Information Protection™, allowing IT administrators to mitigate the risks of data leaks, productivity loss and legal liability by managing who uses what information, where it can go and how.

We typically sell subscriptions to our products in 12, 24 or 36 month durations based on the number of seats or devices to be managed. Revenues from sales of subscriptions to Web filtering and security solutions and related add-on products accounted for the majority of our revenues in 2010, 2009 and 2008.

 

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Web Security

Our Web security solutions range from basic uniform record locator (“URL”) filtering that mitigates the productivity loss and legal exposure associated with unmanaged employee Web use, to our advanced network-based Web Security Gateway that dynamically scans Web traffic and sites for malicious code and inappropriate content in real-time.

Our Web security solutions are designed to work in networks of virtually any size and configuration and can support organizations ranging in size from large enterprise organizations to small and medium businesses. Our solutions are available as premises-based software (deployed on either standard server hardware or on a Websense appliance), as a SaaS offering or in a hybrid combination of both deployment options.

Our Web filtering and Web security solutions use our policy enforcement software in conjunction with our databases of categorized Web sites, protocols and malicious applications. Our Web Security Gateway solutions augment the databases with real-time scanning and categorization of unknown or unclassified content, including user-generated content (“Web 2.0 content”), and, using our Advanced Classification Engine (“ACE”), automatically scans for and removes malicious code embedded in Web traffic.

Our Websense Security LabsTM populates our databases of URLs, protocols and malicious applications using a proprietary process of automatic content assessment and classification, with manual verification. Our systems scan billions of Web sites and emails weekly for new Web-based and email-based threats. Additionally, our experience with the characteristics, behavior and reputations of malicious Web sites and applications allows us to dynamically categorize unclassified sites and content, including Web 2.0 content and new malicious applications embedded in Web traffic and sites.

Our software integrates with our customers’ directories of network users to give business managers the ability to automate the enforcement of highly customized Internet and application use policies for different users and groups within the business. Some examples of management options include:

 

   

Allow: The request is allowed to proceed, because the organization has chosen not to restrict access to the category applicable to the requested Web site.

 

   

Block: The requested Web site has been compromised with malicious code or is in a category that is not allowed to be accessed according to the organization’s policy.

 

   

Time-based Quotas: Users are allowed a specified amount of personal Web surfing time within categories that are determined by the administrator. Once the user reaches his or her quota time, he or she is no longer able to access sites in those categories.

 

   

Continue with Exception Report: The user is reminded about the organization’s Internet usage policy, but can choose to access the requested Web site.

 

   

Time of Day: Filtering options can be managed by time of day. For example, access to shopping sites could be blocked during business hours and permitted at all other times.

The software also provides multiple options for identifying, analyzing and reporting on Internet activity and the risks associated with employee computing.

Websense Web Filter. Websense Web Filter enables employers to proactively analyze, report and manage employee access to Web sites based on the content of the requested Web site. Our software application works in conjunction with network user directories and our database of categorized Web sites to provide patented flexibility for managers when customizing, implementing and modifying Internet access policies for various groups, user types and individuals. A graphical user interface simplifies policy definition and implementation. Once policies have been established, the filtering software examines each Internet access request, determines the category of the requested Web site and applies the user access policies that have been defined by the customer.

 

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The breadth and specificity of our Web site categorization provide flexibility in selecting which types of material should be allowed, blocked or reported. There are currently more than 90 categories in the basic Web filtering product.

Websense Web Filter integrates with an organization to provide flexibility in selecting which types of material should be allowed, blocked or reported:

 

   

on a separate server that is tightly integrated with the network gateway platform to offer pass-through filtering to maximize stability, scalability and performance; or

 

   

through stand-alone deployment utilizing a network agent to deliver filtering capabilities in a network environment.

Websense Web Security. Websense Web Security combines the functionality and database categories of the basic Websense Web Filter with additional security-specific categories as well as several additional services, including Real Time Security Updates™. Websense Web Security enables organizations to manage acceptable use policies and block access to sites associated with spyware, phishing, keylogging and other threats. Additionally, advanced application and network protocol controls mitigate risks associated with peer-to-peer and instant messaging applications, among others.

 

   

Security Categories. Security categories augment the basic Web filtering database categories with categories for spyware and phishing Web sites, as well as sites compromised with malicious code. Beyond sites identified as hosting known and potential exploit code, these categories also include sites likely to contain little or no useful content, sites that camouflage their true nature or identity, and sites that employees can access to utilize hacking tools.

 

   

Real Time Security Updates. Real Time Security Updates utilize cloud-based technology to deliver security category updates as new Web and application-based threats are identified and categorized by the Websense Security Labs. Our ThreatSeeker NetworkTM scans billions of Web sites and emails weekly to identify new Web-based and blended threats.

Websense Web Security can be deployed on standard server hardware, on a Websense-optimized appliance or as a SaaS offering. The SaaS deployment model eliminates the need for the customer to maintain an on-site server-based solution and provides centralized policy management for any type of IT environment, including those with remote locations, home offices, and mobile laptops. Both solutions are tightly integrated with the network gateway platform and provide filtering capabilities.

Web Security as a SaaS offering can be deployed as a complete Web filtering and security solution or it can be layered with existing on-premise Web security to provide additional layers of protection from Web-based malware.

Websense Web Security Gateway. Websense Web Security Gateway is a network-based Web security solution that combines traditional Web filtering with real-time, new site and dynamic content scanning and classification by the embedded Websense Advanced Content Engine (“ACE”). ACE uses advanced analytics, including rules, signatures, heuristics and application behaviors, to detect and block proxy avoidance, hacking sites, adult content, botnets, keyloggers, phishing attacks, spyware and other types of unsafe content. With Web Security Gateway, customers can proactively discover and mitigate new security risks, block dangerous malware and prevent access to inappropriate content while still enabling the use of Web-based tools and applications for business and other productive use.

Web Security Gateway is based on our TRITON security architecture for integrated content security and can be deployed on standard server hardware or on a Websense-optimized appliance.

 

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Websense Web Security Gateway Anywhere. Websense Web Security Gateway Anywhere expands the Web Security Gateway platform with the addition of fully integrated data loss prevention technology and hybrid deployment options, all managed from the TRITON management console. Integrated DLP technology protects against data leaks via the Web by enforcing customer-specific security policies. Hybrid appliance and SaaS deployment allows IT administrators to create and enforce unified policies across the organization, regardless of user location, which reduces administrative burden and lowers the total cost of ownership.

Reporting and Analysis. All Websense Web filtering and security solutions include several reporting modules to meet the information needs of different management groups.

 

   

Websense Reporter is a batch-based reporting application that can generate tabular and graphical reports and dynamically generate thousands of exploratory reports based on an organization’s historical Internet use. It analyzes information from Internet monitoring logs and builds visual charts in a variety of pre-set or customizable formats for easy distribution to and interpretation by managers.

 

   

Websense Real-Time Analyzer™ utilizes the network agent in Websense Web Filter to monitor and analyze network traffic in real-time. This allows IT managers to identify potential risks and bandwidth bottlenecks associated with different types of network traffic.

 

   

Websense Explorer is a browser-based forensics and analytics reporting tool for non-technical business managers that enables them to drill down on Internet use data by risk class, user group or individual.

V-Series Appliances

Our V-Series appliances, including our V10000 appliance which launched in 2009 and our V5000 appliance launched in 2010, are standard server hardware platforms optimized for our software products. They offer a combination of performance and flexibility that simplifies deployment for our customers by consolidating multiple security functions in a single hardware platform. V-Series appliances significantly reduce deployment time and operational costs for Websense Web Security Gateway customers, while meeting large enterprise scalability requirements. V-Series appliances also integrate with the Websense SaaS platform to offer customers the flexibility to deploy and manage their content security solutions how and where they need it.

Data Security

Our data security solutions protect against the loss of confidential information and data due to internal threats, such as inadequate business process controls, employee error and malfeasance, and theft, including undetected malicious code embedded in the network. We have integrated our data loss prevention policy controls with our Web security solutions to provide visibility into data use within the network as well as visibility into the data’s destination when it leaves the network via email, instant messaging, peer-to-peer networking or download to external device. This integrated approach allows managers to set comprehensive internal and external data use policies that enable critical business processes while preventing data loss through data transmission and exchange, including email, Web, USB, and other channels.

Websense Data Security Suite. Websense Data Security Suite is an integrated DLP solution that protects against data loss by identifying and categorizing sensitive or confidential data based on its characteristics, monitoring the movement of sensitive data throughout the network and enforcing pre-determined usage and movement policies. The Websense Data Security Suite leverages our knowledge of high-risk Web sites to prevent the transfer of sensitive or confidential data via email, Web, USB, and other channels and can be managed with the TRITON management console for an integrated content security solution that extends beyond the internal network.

Websense Data Security Suite:

 

   

discovers and identifies data stored on a network-connected device (data-at-rest);

 

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monitors and prevents sensitive data from unauthorized distribution in outgoing and internal communications, including email, instant messaging, Internet (FTP and http) and Web-based email (data-in-motion);

 

   

automates enforcement of policies for data-in-motion to authorized recipients;

 

   

monitors and prevents unauthorized copying of highly sensitive files to USB drives and other portable media, or being printed to hardcopy paper; and

 

   

audits and reports the distribution and use of confidential data against regulatory and internal security policy requirements.

The Websense Data Security Suite includes built-in policy templates for easy, out-of-the-box policy creation and a sophisticated policy engine to address the most common compliance requirements for United States federal and state regulations, as well as industry regulations such as the Payment Card Industry Data Security Standard (PCI DSS) and Check 21 Act, Canada’s Personal Information Protection and Electronic Documents Act (PIPEDA) and international government and banking regulations for the European Union, United Kingdom, Israel, South Africa, Australia and Singapore. These templates are automatically updated as regulations change.

The Websense Data Security Suite includes four modules which can also be purchased and deployed separately:

Data Discover. Websense Data Discover provides organizations with discovery and classification of confidential information stored on network desktops, laptops, and file servers. It includes digital fingerprinting technology to identify virtually any type of data (e.g., customer data, intellectual property and other confidential data), and robust reporting and incident workflow to manage data at rest. Websense Data Discover provides situational awareness of where confidential data is stored to assess whether it is at risk of leaking outside the organization, and helps manage compliance and risk.

Data Monitor. Websense Data Monitor provides enterprise-wide auditing of a broad array of communications channels, including the Web, email, network printing and instant messaging. It includes over more than 1,100 built-in policy templates for regulatory compliance and corporate governance, as well as digital fingerprinting technology to identify confidential data in motion. Websense Data Monitor helps organizations audit business processes with an advanced policy framework that identifies who is sending what data where, and how, providing actionable intelligence and a set of remediation tools to reduce risk of data leakage and manage compliance.

Data Protect. Websense Data Protect includes and supplements Websense Data Monitor with built-in, automated policy enforcement to secure how and where an organization’s data travels. Its policy framework maps data policies to business processes using real-time knowledge of the user, the data, the destination, and the communication channel (i.e., Web or email). Websense Data Protect provides automated policy controls for data in use and data in motion, with real-time reporting for global regulatory compliance and corporate governance. With Websense Data Protect, organizations can implement enforcement actions such as blocking, quarantining, forced encryption, and notification, in addition to incident management tools to prevent data leakage, improve business processes, and manage compliance and risk.

Data Endpoint. Websense Data Endpoint extends our DLP technology to the endpoint (i.e., the individual user device, such as a desktop computer, laptop computer or mobile data device), including the ability to discover, monitor, and protect confidential data whether the user is on or off the network. It includes the data fingerprinting and policy templates of the Data Monitor solutions and can prevent data loss even if the user is offline. The Websense Data Endpoint’s protection extends to mediums such as USB devices, local printing, instant messaging, and for such actions as copy/paste and print screen.

 

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Email Security

Our email and messaging security solutions include our on-premise and SaaS email filtering solutions to provide protection from spam and email-borne viruses, as well as basic inbound and outbound content filtering that enforces corporate governance policies. The threat intelligence we compile through our ThreatSeeker Network is used to detect and stop unwanted emails that contain inappropriate and malicious URLs.

Additionally, we have integrated our DLP technology with our email security solutions to allow organizations to prevent the loss of confidential data and block inappropriate content in outbound emails. In 2011, we anticipate that our email security solutions will be fully integrated with the TRITON management console and available on our V-series appliances.

Websense Hosted Email Security. Websense Hosted Email Security is a SaaS offering that directs customer email traffic to a centralized server hosted by Websense “in the cloud” that filters email traffic without the need for the customer to install software on an on-site server in order to protect against viruses, spam, and phishing before they reach the customers’ network. Our service will also encrypt sensitive email before forwarding such email to its destination. Websense Hosted Email Security can be deployed in one of four available modules, as a complete email filtering and security solution or layered with existing on-premise email filtering security to create a hybrid solution that provides additional layers of anti-spam protection and content filtering.

Websense Email Security. Websense Email Security is a software-based gateway solution that filters outbound and inbound email traffic to perform content filtering and policy enforcement within an organization. Our email software blocks threats such as spam, phishing, and viruses, and protects confidential data within email and attachments, providing out-of-the-box compliance and basic DLP. Websense Email Security also increases management visibility through email usage monitoring and interactive drill-down reports.

Websense TRITON Solutions

Websense TRITON Enterprise. Websense TRITON Enterprise provides security to organizations seeking a highly flexible, scalable, and effective solution designed to provide Web, data and email security across the enterprise. Websense TRITON Enterprise includes the entire Websense TRITON architecture consisting of unified content analysis, a unified platform and unified management capabilities. Its breadth and flexibility permits an organization to scale the solution to meet its changing business needs, reducing or eliminating the complexity and costs associated with deploying, managing and maintaining multiple security products.

Websense TRITON Security Gateway Anywhere. Websense TRITON Security Gateway Anywhere combines Web, email, and data security into one, consolidated gateway solution consisting of a unified platform, unified content analysis, and unified management capabilities. Security analytics powered by the ACE classification engine provides malware protection and DLP. Websense TRITON Security Gateway Anywhere is also available in a hybrid deployment which combines appliance and SaaS platforms to extend coverage across the organization’s network efficiently.

SurfControl Products

Through our acquisition of SurfControl plc (“SurfControl”) in October 2007, we acquired certain legacy products for which we do not have long-term plans.

We continue to sell renewal subscriptions to SurfControl® Web Filter and SurfControl Mobile Filter, and have enhanced these solutions by supplementing the SurfControl URL database with additional Web filtering and security coverage provided by Websense Security Labs and ThreatSeeker technology. We no longer accept new subscriptions to these products from customers. In addition, we continue to sell new and renewal subscriptions to SurfControl RiskFilter® within China.

 

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Additional Websense Services

 

   

Standard Technical Support. Standard Technical Support is included with every Websense subscription and includes phone and email access to technical support engineers during normal business hours and unlimited access to My Websense, our secure Web portal, and the Websense Knowledgebase. The Knowledgebase includes constantly updated product-support related documentation, tutorials, articles and frequently asked questions, as well as on-line customer forums and technical and security alerts.

 

   

Premium Technical Support. Premium Technical Support augments Standard Support with 24/7 access to global support centers via a toll free support hotline and priority email support. The service targets one-hour response time for the highest severity issues. Premium Technical Support is required for Websense Web Security Gateway and Websense Data Security Suite implementations.

 

   

Mission Critical Support. Mission Critical Support combines all the benefits of Premium Technical Support with superior technical response coordinated by a technical account manager. Mission Critical Support also includes architecture reviews, migration planning assistance, training recommendations and periodic account reviews.

 

   

Professional Services. Websense Professional Services assists customers through consulting engagements staffed by Websense certified engineers who assess, plan, design and optimize Websense Web, data or email security solutions for the customers’ business environment.

Customers

Our customers range from companies with as few as 10 employees to members of the Global 1,000 and to government agencies and educational institutions in over 150 countries around the world. Ingram Micro, one of our broad-line distributors for North America, accounted for approximately 31%, 30% and 23% of our revenue during 2010, 2009 and 2008, respectively. Ingram Micro sold subscriptions through approximately 1,300 resellers in North America in 2010.

Sales, Marketing and Distribution

Sales. Our sales strategy is to increase sales to new customers and increase subscription renewals, upgrades and other incremental business to existing customers by expanding our security offerings and increasing the number and productivity of the resellers and distributors that sell our products. We sell our products and services primarily through indirect channels with substantial support from our internal sales team and sales engineers. For 2010, 2009 and 2008, indirect channel sales comprised over 90% of total revenues. We expect that the majority of our revenue will continue to be derived from sales through indirect channels, including distributors and value-added resellers.

We sell our products in North America principally through a two-tier distribution system. We sell products to our distributors and our distributors market, distribute and support our software through value-added resellers. We also sell directly to resellers that specialize in security software through our Enterprise Alliance Partner program. These resellers work closely with a team of Websense territory managers and sales engineers to target potential customers and often build implementation services around our products, particularly our Web Security Gateway and Data Security Suite offerings.

Internationally, we sell our products through a multi-tiered distribution network of distributors and resellers in 130 countries, who in turn sell our products to customers located in more than 150 countries.

Our channel sales efforts are coordinated worldwide through an internal sales team of approximately 430 individuals located in our key markets. Our internal sales force focuses on new customer acquisitions, strategic account management and lead generation for our channel partners. Certain customers, who are typically large organizations, from time to time require that we sell directly to them. We also have several arrangements with OEMs that grant the OEM customers the right to incorporate our products or technologies into their products for resale to value-added resellers or end-users.

 

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In both 2010 and 2009, we generated 50% of our total revenue from customers outside of the United States. Revenue generated in the United Kingdom represented approximately 13% and 14% of our total revenue during 2010 and 2009, respectively. See Note 5 to the consolidated financial statements for further explanation of our revenue based on geography. Our current international efforts are focused on expanding our indirect sales channels in Europe, Asia/Pacific and Latin America. Our continuing reliance on sales in international markets exposes us to risks attendant to foreign sales. See “Item 1A. Risk Factors—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.”

Marketing. Our marketing efforts are designed to increase recognition of Websense as a leading provider of integrated content security, including our Web security, data security and email content security solutions; raise awareness of the potential risks to employees and data from unprotected use of the modern Web and generate qualified sales leads for our channel partners. We provide potential customers and channel partners with free trials of our security software and appliances, typically for 30-day periods.

Our marketing activities are targeted toward business executives, including information technology professionals, chief executives, upper level management and human resources personnel. We actively manage our public relations programs, communicating directly with technology professionals and the media, in an effort to promote greater awareness of the growing problems caused by external threats, such as viruses, spyware, phishing sites, and key logging, as well as internal threats such as the loss of confidential data and employee misuse of the Internet and other computing resources at work.

Our marketing initiatives include:

 

   

joint marketing programs with our distributors to recruit additional value-added resellers and drive awareness for Websense solutions with existing resellers;

 

   

advertising online and in high-technology trade magazines, management journals and other business- oriented periodicals;

 

   

participation in and sponsorship of trade shows and industry events;

 

   

free subscriptions to security alerts from Websense Security Labs, which inform subscribers of newly identified security threats, such as phishing sites and sites infected with spyware and malicious code;

 

   

regional and international seminars, webinars, and training sessions for our sales organization and reseller partners, as well as customers and prospects;

 

   

speaking engagements on topics of interest to our customers and prospects;

 

   

use of our Web properties to communicate with our channel sales partners and provide product and company information to interested parties; and

 

   

distribution of soft and hard-copy materials about our company, products, solutions, technologies, partnerships and benefits.

Ingram Micro. Ingram Micro, one of our broad-line distributors for North America, focuses its efforts on recruiting and servicing resellers focused on selling to the SMB segment, and on building awareness and demand within our existing North America channel partner base. Ingram Micro accounted for approximately 31%, 30% and 23% of our revenue during 2010, 2009 and 2008, respectively. Ingram Micro sold subscriptions through approximately 1,300 resellers in North America in 2010. Our agreement with Ingram Micro is not subject to any minimum sales obligations or obligations to market our products to its customers, the agreement is non-exclusive and either we or Ingram Micro can terminate the agreement at any time without cause.

Technology Integrations. Websense solutions integrate with a variety of network and information technology platforms. Our objective is for Websense security solutions to be effective in any network environment desired by a customer.

 

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Customer Service, Training and Support

We believe that superior customer support is critical to retaining and expanding our customer base. Our technical support group provides dependable and timely resolution of customer technical inquiries and is available to customers by telephone, email and over the Web. We also proactively update customers on a variety of topics, including release dates of new products, updates to existing products and other technical alerts. We monitor the performance of our technology and support on an ongoing basis and seek to enhance our performance levels.

Our training services group delivers education, training and pre-sales support to our resellers and customers. In 2010, we introduced the TRITON Solution Technical Enablement Program, an online and instructor-led training and certification program on Websense Web, data and email security solutions, to enable our partners to deliver superior service and value to our joint customers.

Research and Development

We maintain research and development facilities in San Diego and Los Gatos, California; Reading, England; Beijing, China and Ra’anana, Israel. Our research and development department is divided into several groups, which include content operations, security research, software development, quality and assurance, and documentation. Individuals in different locations are grouped along product lines and work as part of cross-disciplinary teams designed to provide a framework for defining and addressing the activities required to bring product concepts and development projects to market successfully. In 2010, 2009 and 2008, we spent approximately $54 million, $53 million and $53 million, respectively, on research and development activities.

Competition

The market for our products is fragmented, highly competitive, quickly evolving and subject to rapid technological change. Increased competition and pricing pressures generally could result in reduced sales, reduced renewals and/or declining seat counts from existing customers, reduced margins or failure of our products to achieve or maintain more widespread market acceptance. Competitors vary in size and in the scope and breadth of the products and services they offer. Currently, our principal competitors include:

 

   

companies offering Web filtering and Web security software solutions, such as Microsoft, McAfee (to be acquired by Intel Corporation), Trend Micro, Google, Webroot/BrightCloud, SafeNet/Aladdin, FaceTime, EdgeWave, M86 Security, Clearswift, Checkpoint, Sophos, Kaperskey Lab, AhnLab Inc., IBM, Panda Security, SafeNet, F-Secure, Commtouch and CA (formerly Computer Associates);

 

   

companies integrating Web filtering into specialized security appliances, such as Blue Coat Systems, Cisco Systems/Ironport, McAfee, Check Point Software, EdgeWave, Barracuda Networks, Trend Micro, SonicWALL, Sophos, IBM, Panda Software, Fortinet and M86 Security;

 

   

companies offering DLP solutions, such as Symantec, Verdasys, Trustwave, EMC, McAfee, IBM, Trend Micro, Proofpoint, Palisade Systems, CA, Raytheon, Intrusion, Fidelis, GTB Technologies, Workshare, Check Point Software and Code Green Networks;

 

   

companies offering messaging or email security solutions, such as McAfee, 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, Webroot/Bright Cloud, EdgeWave, Barracuda Networks, Zscaler, Trend Micro and Cisco Systems/ScanSafe;

 

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companies offering desktop security solutions, such as Check Point Software, Cisco Systems, McAfee, Microsoft, Symantec, CA, Sophos, Webroot, IBM and Trend Micro; and

 

   

companies offering Web gateway solutions, such as Microsoft, Blue Coat Systems, Cisco Systems, Trend Micro, Check Point Software, McAfee, Juniper Networks, Optinet, Safe Net/Aladdin, M86 Security, Clearswift, CA, FaceTime and Barracuda Networks.

We also face current and potential competition in Web filtering and Web security 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, Web security or other competitive products with their offerings. We compete against and expect increased competition from anti-virus software developers, traditional network management software developers and Web management service providers. In the DLP market, we face competition from anti-virus software developers, email filtering and security vendors, and providers of other software-based compliance solutions.

We believe that the principal competitive factors affecting the markets for our products include, but are not limited to:

 

•    performance

  

•    innovation

•    quality

  

•    customer support

•    introduction of new products

  

•    frequency of upgrades and updates

•    brand name recognition

  

•    reduction of production costs

•    price

  

•    manageability of products

•    functionality

  

•    reputation

We believe that we compete effectively in each of these areas. However, many of our current and potential competitors, such as Symantec, McAfee, Trend Micro, Cisco Systems, Google and Microsoft, have significantly greater financial, technical, marketing or other resources. They may have significantly greater name recognition, established marketing and channel relationships both in the United States and internationally, better access to SMB and enterprise customers, and a larger installed base of users. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the functionality of their products to address customer needs or may be acquired by a corporation with significantly greater resources. Accordingly, new competitors or alliances among competitors may emerge and rapidly acquire significant market share.

Intellectual Property Rights

Our intellectual property rights are important to our business. We rely on a combination of trademark, copyright, patent 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 the Websense brand. We generally distribute our products under subscription agreements that grant customers a right to use our products and receive daily database updates for a specified term and contain terms and conditions prohibiting the unauthorized reproduction or transfer of our products. In addition, our policy is to enter into confidentiality and invention assignment agreements with all employees and consultants, and nondisclosure agreements with all other parties to whom we disclose confidential information. These protections, however, may not be adequate to protect our intellectual property rights.

We have registered our Websense trademark in the United States, Japan, the European Union, Canada, Australia, China, Switzerland, Norway, Mexico, Colombia, Argentina, Singapore, South Africa, Taiwan, Brazil, Iceland, India, Morocco, Peru, Chile, Hong Kong, Jordan, New Zealand, Russia and Turkey. In addition, we have registrations for other Websense trademarks pending in several other countries. Effective trademark protection may not be available in every country where our products are available.

 

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We seek to protect the source code of our products as trade secrets and as unpublished copyrighted works. We currently have 22 patents issued in the United States, 21 patents issued internationally, 40 patent applications pending in the United States and 90 pending international patent applications that seek to protect our proprietary database and Web filtering technologies, ThreatSeeker Web security technology and DLP and content distribution technology, including our PreciseID™ digital fingerprinting. No assurance can be given that any pending patent applications will result in issued patents.

Employees

As of December 31, 2010, we had 1,442 employees worldwide, including 258 in cost of revenue departments, 592 in selling and marketing, 479 in research and development and 113 in administration. None of our employees are represented by a labor union, and we have never experienced a work stoppage. We believe that our relations with our employees are good.

Web Site Access to SEC Filings

We maintain an Internet Web site at www.websense.com. The content of our Web site is not part of this report. We make our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, or the Exchange Act, available free of charge on our Web site as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

Executive Officers

Our executive officers and their ages as of January 31, 2011 are as follows:

 

Name

   Age     

Position(s)

Gene Hodges

     59       Chief Executive Officer

John McCormack

     51       President

Douglas C. Wride

     57       Chief Operating Officer

Didier Guibal

     48       Executive Vice President, Worldwide Sales

Arthur S. Locke III

     47       Sr. Vice President and Chief Financial Officer

Michael A. Newman

     41       Sr. Vice President, General Counsel, Chief Administrative Officer and Secretary

Gene Hodges has been the Chief Executive Officer of Websense since January 2006, and was Websense’s President from January 2006 to April 2007. He has been a Director of Websense since January 2006. Prior to joining Websense, Mr. Hodges served as President of McAfee, Inc., a publicly-traded security software company, from November 2001 to January 2006. Mr. Hodges served as President of the McAfee Product Group from January 2000 to November 2001. From August 1998 to January 2000, he served as Vice President of Security Marketing. Mr. Hodges received a B.A. in Astronomy from Haverford College and completed the Harvard Advanced Management Program for business executives.

John McCormack has served as President of Websense since April 2009. Previously, Mr. McCormack served as Senior Vice President, Product Development from July 2006 to April 2009. From October 2005 until May 2006, Mr. McCormack was Vice President of Engineering for Symantec, a publicly-traded security software company. Mr. McCormack joined Symantec through the acquisition of Sygate Technologies, Inc., where he was Senior Vice President of Product Development from May 2004 to October 2005. From 1997 to 2004, Mr. McCormack served in various capacities with Cisco Systems, Inc., a publicly-traded computer hardware and software company, most recently as General Manager of the Secure Managed Networks Business Unit. Mr. McCormack received his Masters degree in Engineering Management from George Washington University and a B.S. in Computer Science from the University of New Hampshire.

 

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Douglas C. Wride became Websense’s Chief Operating Officer in January 2009. Mr. Wride previously served as Websense’s President from April 2007 to April 2009 and as Chief Financial Officer from June 1999 until August 2007 and again from March 2009 to July 2009. From March 1997 to December 1998, Mr. Wride served as Chief Financial Officer of Artios, Inc., a provider of hardware and software design solutions to companies in the packaging industry. Mr. Wride also served as Chief Operating Officer of Artios from July 1997 to December 1998. Mr. Wride is a C.P.A. (inactive) and received his B.S. in Business/Accounting from the University of Southern California. On February 1, 2011, Websense announced that Mr. Wride plans to retire as Chief Operating Officer of Websense effective on February 15, 2011.

Didier Guibal has served as Websense’s Executive Vice President, Worldwide Sales since July 2009. Mr. Guibal was previously President of Panda Security, a provider of IT security solutions from April to October 2008. From May 2000 to January 2007, Mr. Guibal was a Vice President of Sales at Rightnow Technologies, Inc., a publicly-traded provider of SaaS enterprise solutions. From April 1996 to April 2000, Mr. Guibal was employed by McAfee, Inc., ultimately serving as Vice President of Sales-Americas. Mr. Guibal received a Masters degree in business at Sup de Co-Business School in Montpellier, France.

Arthur S. Locke III has served as Senior Vice President, Chief Financial Officer of Websense since July 2009. Mr. Locke was previously employed by MicroStrategy Incorporated, a publicly-traded worldwide provider of business intelligence software and services, from January 2001 to March 2009, ultimately serving as Executive Vice President, Finance and Chief Financial Officer. Mr. Locke is a C.P.A. and received a Bachelor of Science in Business Administration (BSBA) in Accounting and Computer Systems from American University.

Michael A. Newman has served as Senior Vice President, General Counsel, Chief Administrative Officer and Secretary of Websense since December 2010, after serving as Websense’s Senior Vice President, General Counsel and Secretary since August 2007. Mr. Newman was previously Websense’s Vice President and General Counsel from September 2002 to August 2007. From April 1999 to September 2002, Mr. Newman served in the legal department of Gateway, Inc., a publicly-traded PC manufacturer, and prior to that, Mr. Newman practiced as an attorney in the San Diego offices of Cooley Godward, LLP and Latham & Watkins LLP, two of California’s leading law firms. Mr. Newman received his B.S. in Business Administration from Georgetown University, and a J.D. from Harvard Law School.

 

Item 1A. Risk Factors

You should carefully consider the following information in addition to other information in this report before you decide to purchase our common stock. 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.

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

The global economy has experienced 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 have negatively impacted the duration and scope of contract renewals and, in some cases, resulted in customer losses. Our average contract duration may be volatile as we seek contract renewals without eroding our

 

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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 additional financing or refinancing, if needed, on satisfactory terms or at all.

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 international sales grow 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 and Chinese Renminbi. Our revenue and deferred revenue for these currencies are recorded in U.S. dollars when the subscription begins based upon currency exchange rates in effect on the last day of the previous month before the subscription agreement is entered into. This accounting policy 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. If there is a strong U.S. dollar at the time a subscription begins, we 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. Because 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 years ended December 31, 2010, 2009 and 2008 was derived from new and renewal subscriptions to our Web filtering and Web security products primarily from enterprise customers, and we expect that a significant majority of our sales for 2011 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 solutions; and other products under development to comprise a relatively small portion of our revenue in 2011, but represent a meaningful portion of our sales growth in 2011. 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 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 loss prevention 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

 

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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.

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.

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 took 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. However, in the fourth quarter of 2010, we determined that we made an error in the fourth quarter of 2009 in identifying the accurate cause of a $5.8 million variance in our deferred tax assets. As a result, we reassessed the effectiveness of our disclosure controls and procedures for the year ended December 31, 2009 and the period from January 1, 2010 through September 30, 2010 and concluded that we continued to have a material weakness in the internal controls over the computation of our income tax provision. In the fourth quarter of 2010, we took additional remediation measures and tested the design and operating effectiveness of the newly implemented controls and concluded that the material weakness described above has been remediated as of December 31, 2010.

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 applicable to both future and past reporting periods. 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.

Failure of our newer 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 particularly if Web Filtering products continue to commoditize.

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 as our Web filtering products become more of a commodity. 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 and V5000 appliances pre-loaded with our software. We also sell the Websense Data Security Suite, our DLP offering for the data loss prevention market, Websense Hosted Web Security and Websense Hosted Email Security, our SaaS offerings, and Websense Email Security, our email filtering solution. We offer

 

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our products with TRITON, our unified Web, data and email security solution, which combines our products into a single platform. 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 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 fail to continue to upgrade and diversify our products, we could lose revenue from renewal subscriptions for our Web filtering products as these products continue to suffer from commoditization.

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 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 appliances. 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 platforms 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%, 30% and 23% of our revenues during fiscal years 2010, 2009 and 2008, respectively. In addition, we began using Arrow Electronics as an additional broadline distributor in North America in 2010. Should Ingram Micro or Arrow Electronics 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 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, our SaaS security products or our Websense TRITON solutions;

 

   

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.

 

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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.

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. Many of these variations come from macroeconomic and seasonal changes causing 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. In addition, we have become increasingly dependent upon large orders which have a significant effect on our operating results during the quarter in which we receive them. The timing of such orders or the loss of an order is difficult to predict and the timing of revenue recognition from such orders may affect period to period changes. Changes in revenue recognition rules regarding sales of our appliances may cause some unpredictability in our quarterly revenue results as revenue for sales of appliances and the related costs will generally be recognized when the appliances are sold as opposed to being recognized ratably over the subscription term. The unpredictability of quarterly fluctuations is further 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. Further, an increasing portion of our billings are attributable to larger subscriptions ($1 million or more), so delays in completing agreements before the end of a quarter may cause a material failure to meet our billings guidance for the quarter.

Our operating expenses may increase in the future if we expand our selling and marketing activities, increase our research and development efforts or 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 annual 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.

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

 

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products, which has resulted in pricing pressures on sales of our basic Web filtering products and email filtering products and potentially could result in the commoditization of these products. We depend on our more advanced security products to replace and grow revenue from Web filtering subscriptions that are not renewed. 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 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, McAfee (to be acquired by Intel Corporation), Trend Micro, Google, Webroot/BrightCloud, SafeNet/Aladdin, FaceTime, EdgeWave, M86 Security, Clearswift, Checkpoint, Sophos, Kaperskey Lab, AhnLab Inc., IBM, Panda Security SafeNet, F-Secure, Commtouch and CA (formerly Computer Associates);

 

   

companies integrating Web filtering into specialized security appliances, such as Blue Coat Systems, Cisco Systems/Ironport, McAfee, Check Point Software, EdgeWave, Barracuda Networks, Trend Micro, SonicWALL, Sophos, IBM, Panda Software, Fortinet and M86 Security;

 

   

companies offering DLP solutions, such as Symantec, Verdasys, Trustwave, EMC, McAfee, IBM, Trend Micro, Proofpoint, Palisade Systems, CA, Raytheon, Intrusion, Fidelis, GTB Technologies, Workshare, Check Point Software and Code Green Networks;

 

   

companies offering messaging or email security solutions, such as McAfee, 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, Webroot/Bright Cloud, EdgeWave, Barracuda Networks, Zscaler, Trend Micro and Cisco Systems/ScanSafe;

 

   

companies offering desktop security solutions, such as Check Point Software, Cisco Systems, McAfee, Microsoft, Symantec, CA, Sophos, Webroot, IBM and Trend Micro; and

 

   

companies offering Web gateway solutions, such as Microsoft, Blue Coat Systems, Cisco Systems, Trend Micro, Check Point Software, McAfee, Juniper Networks, Optinet, Safe Net/Aladdin, M86 Security, Clearswift, CA, 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 (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.

 

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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 or may be acquired by a corporation with significantly greater resources. 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 loss prevention 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 October 2010, we announced that we had entered into a senior credit facility (the “2010 Credit Agreement”) and used the initial proceeds to repay our term loan and retire the 2007 amended and restated senior secured credit facility (the “2007 Credit Agreement”). The 2010 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. An event of default under the 2010 Credit Agreement could allow the lenders to declare all amounts outstanding with respect to the agreement to be immediately due and payable. The 2010 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. If the amount outstanding under the 2010 Credit Agreement is accelerated, the lenders could proceed against those assets and stock. Any event of default, therefore, could have a material adverse effect on our business. Our 2010 Credit Agreement also requires 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;

 

   

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

 

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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% of our total revenues generated during both fiscal years 2010 and 2009, and 46% during 2008. 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 civil unrest and 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 enhance 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, including confidential and proprietary information, 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, any actual security breach could result in product liability and related claims. Our subscription agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims, however, it is possible, that such provisions may not be effective under the laws of certain jurisdictions, particularly in circumstances involving subscriptions without signed agreements from our customers.

 

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In addition to the risks above, 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 2010 we announced that we had entered into the 2010 Credit Agreement and that we used the initial proceeds to repay the term loans and retire the 2007 Credit Agreement. Under the 2010 Credit Agreement, we can borrow $120 million and use proceeds to fund share repurchases or other corporate purposes. We may increase the maximum aggregate commitment under the 2010 Credit Agreement to $200 million if certain conditions are satisfied, including that we are not in default under the 2010 Credit Agreement at the time of the increase and that we obtain the commitment of the lenders participating in the increase. If we should need to increase the aggregate commitment, it may not be possible to satisfy these conditions. The limitations our 2010 Credit Agreement imposes on us could have important consequences, including:

 

   

it may be difficult for us to satisfy our obligations under the 2010 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.

 

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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 2005 to 2008 in the United Kingdom and for 2006 to 2008 in Israel. We also have various other on-going audits in various stages of completion. 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.

During the first quarter of 2010, we were informed by the U.S. Internal Revenue Service (“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 required 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 has assigned our case to an IRS Appeals Officer. We are now awaiting an appointment with the assigned Appeals Officer. 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.

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

 

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companies. If this matter is litigated and the position proposed by the IRS is 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.

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 21 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.

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.

 

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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 software products ratably over the term of the subscription, downturns in software subscription sales may not be immediately reflected in our revenue.

Most of our revenue comes from the sale of subscriptions to our software 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. Even though new revenue recognition rules will result in our recognition of revenue from hardware sales in the current period that the sale is concluded, a majority of the revenue we report in each quarter will continue to be 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;

 

   

integrating personnel with diverse business and cultural backgrounds;

 

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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.

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.

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;

 

   

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. 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 our executive

 

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officers, key management or development personnel that would prevent them from terminating their employment with us at any time. 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.

The restatement of our historical financial statements has already consumed, and may continue to consume, a significant amount of our time and resources and may have a material adverse effect on our business and stock price.

We have restated our consolidated financial statements and related disclosures for fiscal years ended December 31, 2007, 2008 and 2009. The restatement process was highly time and resource-intensive and involved substantial attention from management and significant legal and accounting costs. Although we have now completed the restatement, we cannot guarantee that we will have no inquiries from the SEC or NASDAQ regarding our restated financial statements or matters relating thereto.

Any future inquiries from the SEC as a result of the restatement of our historical financial statements will, regardless of the outcome, likely consume a significant amount of our resources in addition to those resources already consumed in connection with the restatement itself.

Further, many companies that have been required to restate their historical financial statements have experienced a decline in stock price and stockholder lawsuits related to the restatement. We cannot guarantee that we will not be similarly affected.

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, Dodd-Frank Wall Street Reform and Consumer Protection Act, 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 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.

 

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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 2010 Credit Agreement accelerates and becomes 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 credit facility 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 1B. Unresolved Staff Comments

None.

 

Item 2. Properties

Our corporate headquarters and principal offices are located in San Diego, California, where we have leased approximately 122,000 square feet as of December 31, 2010. This lease expires in December 2013 with an option to extend the lease for an additional five years. Our international headquarters and offices are located in Dublin, Ireland. We lease additional office space in Los Gatos, California; Reading and Congleton, England; Ra’anana, Israel; Sydney, Australia and Shanghai, Guangzhou and Beijing, China and have executive suite arrangements on monthly or annual arrangements, depending on the local market, relating to office space in the United Kingdom, Brazil, Dubai, France, Germany, Hong Kong, India, Italy, Japan, Singapore, Spain, Sweden, the Netherlands, Turkey and Dallas, Texas.

 

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Item 3. 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 our 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. 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 lawyers, we believe 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 positions, 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 4. [Removed and Reserved]

 

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Part II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Our common stock is traded on the NASDAQ Global Select Market (“Nasdaq”) under the symbol “WBSN”. The following table sets forth the range of high and low closing prices on Nasdaq of our common stock for the periods indicated, as reported by Nasdaq. Such quotations represent inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions.

 

     Years Ended December 31,  
     2010      2009  
     High      Low      High      Low  

First Quarter

   $ 24.29       $ 17.46       $ 16.14       $ 9.77   

Second Quarter

     24.96         18.90         19.45         12.41   

Third Quarter

     21.38         17.73         18.09         14.64   

Fourth Quarter

     22.39         17.18         18.27         15.53   

To date, we have neither declared nor paid any cash dividends on our common stock. We currently intend to retain all future cash flows from operations, if any, for use in the operation and development of our business and for debt repayment and stock repurchases and, therefore, do not expect to declare or pay any cash dividends on our common stock in the foreseeable future. Moreover, we are not permitted to pay cash dividends under the terms of our 2010 Credit Agreement. As of February 1, 2011, there were approximately 6,500 holders of record of our common stock. See Item 12—“Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” for information regarding our equity compensation plans.

Issuer Purchases of Equity Securities

In April 2003, we announced that our Board of Directors authorized a stock repurchase program of up to 4 million 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 million shares, for a total program size of up to 8 million shares. In July 2006, we announced that our Board of Directors increased the size of the stock repurchase program by an additional 4 million shares, for a total program size of up to 12 million 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, Websense’s Board of Directors increased the size of its stock repurchase program by an additional 4 million shares, for a total program size of up to 16 million shares. In October 2010, our Board of Directors increased the number of shares authorized for repurchase under the program by 8 million shares, for a total program size of up to 24 million shares. We repurchased 4,090,495 shares in 2010, bringing the total number of shares repurchased as part of our stock repurchase program to 15,624,519.

The following table represents our purchases of equity securities during the fourth quarter of fiscal year 2010:

 

Month

   Number of
Shares
Purchased
During Month
     Average Price
Paid Per Share
     Cumulative
Number of Shares
Purchased as Part
of Publicly
Announced Plan
     Number of Shares
that May Be
Purchased Under the
Plan
 

October 2010

     183,931       $ 18.72         14,624,161         9,375,839   

November 2010

     792,223       $ 21.61         15,416,384         8,583,616   

December 2010

     208,135       $ 21.26         15,624,519         8,375,481   

Total

     1,184,289       $ 21.10         15,624,519         8,375,481   

 

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Item 6. Selected Financial Data

The following table summarizes certain historical financial information at the dates and for the periods indicated prepared in accordance with GAAP and gives effect to the restatements described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in Note 2 to our consolidated financial statements. The consolidated statement of operations data for the years ended December 31, 2010, 2009 and 2008, and the consolidated balance sheet data as of December 31, 2010 and 2009 (as restated), have been derived from our consolidated financial statements audited by Ernst & Young LLP, an independent registered public accounting firm, included elsewhere in this Annual Report on Form 10-K. The consolidated statement of operations data for the years ended December 31, 2007 (as restated) and 2006 and the consolidated balance sheet data as of December 31, 2008 (as restated), 2007 (as restated) and 2006 have been derived from our financial statements not included herein. The selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes thereto, which are included elsewhere in this Annual Report on Form 10-K. Our historical results are not necessarily indicative of operating results to be expected in the future.

 

    Years Ended December 31,  
    2010     2009     2008     2007     2006  
    (In thousands, except for per share data)  
                      (As Restated)(1)        

Statement of Operations Data:

         

Revenues

  $ 332,762      $ 313,713      $ 288,274      $ 210,307      $ 178,814   

Cost of revenues

    53,090        50,806        48,160        29,140        15,274   
                                       

Gross profit

    279,672        262,907        240,114        181,167        163,540   

Operating expenses:

         

Selling and marketing

    157,758        166,910        175,365        126,247        80,135   

Research and development

    54,325        52,643        53,274        40,913        22,663   

General and administrative

    36,779        40,295        45,343        32,708        21,279   
                                       

Total operating expenses

    248,862        259,848        273,982        199,868        124,077   
                                       

Income (loss) from operations

    30,810        3,059        (33,868     (18,701     39,463   

Interest expense

    (3,715     (7,084     (13,134     (4,308     —     

Other (expense) income, net

    (834     384        739        9,461        11,287   
                                       

Income (loss) before income taxes

    26,261        (3,641     (46,263     (13,548     50,750   

Provision (benefit) for income taxes

    7,609        7,056        (19,484     8,748        18,657   
                                       

Net income (loss)

  $ 18,652      $ (10,697   $ (26,779   $ (22,296   $ 32,093   
                                       

Net income (loss) per share:

         

Basic net income (loss) per share

  $ 0.44      $ (0.24   $ (0.59   $ (0.49   $ 0.69   

Diluted net income (loss) per share

  $ 0.43      $ (0.24   $ (0.59   $ (0.49   $ 0.68   

Weighted average shares—basic

    42,313        44,262        45,190        45,107        46,494   

Weighted average shares—diluted

    43,342        44,262        45,190        45,107        47,116   
    December 31,  
    2010     2009     2008     2007     2006  
    (In thousands)  
          (As Restated)(1)     (As Restated)(1)     (As Restated)(1)        

Balance Sheet Data:

         

Cash and cash equivalents (including restricted cash) and marketable securities

  $ 78,080      $ 83,296      $ 66,811      $ 87,733      $ 326,905   

Total assets

    661,943        695,846        718,848        774,924        424,257   

Deferred revenue

    394,304        380,112        341,784        288,043        220,343   

Long-term liabilities

    229,744        233,929        261,965        322,829        71,804   

Total stockholders’ equity

    131,663        156,915        170,845        186,622        180,725   

 

(1)

As more fully described in Note 2 to the consolidated financial statements contained in this Annual Report on Form 10-K, we have restated our previously reported consolidated statement of operations for 2007 and

 

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consolidated balance sheets as of December 31, 2009, 2008 and 2007 to record the write-off of a $5.8 million tax asset. The write-off of the tax asset had the following effect on our consolidated statement of operations for 2007 and consolidated balance sheets as of December 31, 2009, 2008 and 2007:

 

     Year Ended December 31, 2007  

Statement of Operations Data:

   (As Previously
Reported)
    (As Restated)  
     (In thousands)  

Loss before income taxes

   $ (13,548   $ (13,548

Provision for income taxes

     2,933        8,748   

Net loss

     (16,481     (22,296

Basic and diluted net loss per share

   $ (0.37   $ (0.49

 

     December 31,  
     2009      2008      2007  

Balance Sheet Data:

   (As Previously
Reported)
     (As Restated)      (As Previously
Reported)
     (As Restated)      (As Previously
Reported)
     (As Restated)  
     (In thousands)  

Income tax receivable/prepaid income tax

   $ 11,446       $ 7,589       $ 10,927       $ 10,927       $ 3,734       $ 3,734   

Deferred income taxes

     48,333         46,375         58,435         52,620         42,158         36,343   

Total assets

     701,661         695,846         724,663         718,848         780,739         774,924   

Retained earnings

     28,416         22,601         39,113         33,298         65,892         60,077   

Total stockholders’ equity

     162,730         156,915         176,660         170,845         192,437         186,622   

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. The information below has been adjusted solely to reflect the impact of the restatement of our financial results which is more fully described in Note 2 to the consolidated financial statements contained in this Annual Report on Form 10-K and under the paragraph “Restatement of Previously Issued Consolidated Financial Statements” below and does not reflect any subsequent information or events occurring after the date of the filing of our reports originally presenting the financial information being restated or update any disclosure herein to reflect the passage of time since the date of such filings. The following discussion contains forward-looking statements that involve risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. Our actual results could differ materially from those discussed here. Factors that might cause such a difference include, but are not limited to, those discussed below and elsewhere, including under Item 1A “Risk Factors” of this Annual Report on Form 10-K. The cautionary statements made in this Annual Report on Form 10-K should be read as applying to all related forward-looking statements wherever they appear in this Annual Report on Form 10-K.

Restatement of Previously Issued Consolidated Financial Statements

We have restated our previously reported consolidated balance sheet at December 31, 2009 and the statement of stockholders’ equity at January 1, 2008 and related disclosures, to record the write-off of a $5.8 million tax asset that originated from an error in a calculation when we changed our tax method of accounting for deferred revenue in 2003.

The error resulted in our reporting overstated deferred tax assets of approximately $5.8 million in our financial statements for fiscal years 2003 through 2008. In 2009, we reclassified a portion of the error amount from deferred tax assets to income tax receivable because of a belief at the time that the error amount was related to monthly-to-daily revenue adjustments for fiscal years 2006 through 2008 and, therefore, would be recoverable by amending our tax returns for those years. We subsequently discovered the error amount was instead related to an error in the calculation of the deferred tax assets when we changed the tax method of accounting for deferred revenue in 2003. The statute of limitations to claim a refund for the 2003 tax year expired in September 2007. After evaluating various tax planning strategies, management determined that there is substantial uncertainty as to whether it will be able to recover the error amount based on case law. As a result, we have concluded that we need to restate our 2007 financial statements to reflect the write-off of the $5.8 million deferred tax asset and our 2009 and 2008 financial statements to reflect the write-off of the tax asset and retained earnings balances. The restatements had no impact on the financial statement amounts previously reported for our revenues, operating costs and expenses, net income (loss) and cash flows from operations for the years ended December 31, 2009 and 2008, or for the nine months ended September 30, 2010, or any quarterly periods from January 1, 2008 through September 30, 2010.

Overview

We are a global provider of unified Web, data and email content security solutions designed to protect data and users from modern cyber-threats, information leaks, legal liability and productivity loss. We provide our solutions as software installed on standard server hardware, as software pre-installed on optimized appliances, as a cloud-based service (software as-a-service or SaaS) offering, or in a hybrid appliance/SaaS configuration. Our products and services are sold worldwide to public sector entities, enterprise customers, small and medium sized businesses (SMBs), and Internet service providers through a network of value-added resellers and original equipment manufacturer (OEM) arrangements.

 

 

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Our portfolio of Web security, data security and email content security solutions allows organizations to:

 

   

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 or other varieties of malicious code;

 

   

protect from spam, inappropriate content and malware embedded in user-generated content on Web 2.0 sites;

 

   

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

 

   

identify and remove malware from incoming Web content;

 

   

filter spam from incoming email;

 

   

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;

 

   

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 developer and provider of IT security software 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 including the rise of Web-based social and business applications and the growing incidence of Web-based criminal activity.

During both 2010 and 2009, we derived 50% of our revenue from international sales, and 46% during 2008, with the United Kingdom comprising approximately 13%, 14% and 15% of the revenue during 2010, 2009 and 2008, respectively. We believe international markets continue to represent a significant growth opportunity and we are continuing to expand our international operations, particularly in selected countries in the European, Asia/Pacific and Latin American markets.

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. Sales to Ingram Micro, one of our broad-line distributors for North America that sold our products through approximately 1,300 resellers in 2010, accounted for approximately 31%, 30% and 23% of our revenue in 2010, 2009 and 2008, respectively. 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, based on the number of seats or devices managed. As described elsewhere in this report, we recognize revenue from subscriptions to our software products 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 period the product and/or key are delivered. Our operating expenses in 2010 decreased as compared to 2009 primarily due to a reduction in the amortization of acquired intangible assets of approximately $12.8 million and to a lesser extent the overall favorable movement of currency exchange rates. These cost reductions were partially offset in 2010 by increased cost of sales related to our appliances of approximately $5.0 million and increased investments in product research and development.

 

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In October 2007, we closed our acquisition of SurfControl and as a result incurred a net loss under GAAP during the fourth quarter of 2007 and for fiscal years 2007, 2008 and 2009. Similar to Websense, SurfControl sold products primarily under subscriptions whereby revenues were recorded ratably over the term of the agreement. Under purchase accounting, we wrote off $101.1 million of the deferred revenue of SurfControl, leaving a balance of $19.7 million. This adjustment reflected the fair value of the post-contract technical support services that is recognized daily in accordance with our revenue recognition policy. In connection with the acquisition, we incurred restructuring costs primarily in connection with reducing SurfControl headcount and eliminating redundant facilities. As of the acquisition date, we also immediately started to incur the expenses of operating the SurfControl operations as well as recording the amortization of the acquired intangibles. Primarily as a result of our deferred revenue as of December 31, 2009, our new and renewed billings during 2010 and the significant reduction in the amortization charges of acquired intangible assets, we reported net income for fiscal 2010 and currently expect to report even higher net income for fiscal 2011.

Billings represent the amount of subscription contracts billed to customers during the period. Our subscription-based business model operates such that billings are recorded initially to our balance sheet as deferred revenue and then recognized to our income statement as revenue ratably over the subscription term or, in the case of OEM arrangements, over the contractual obligation period. Our billings are not a numerical measure that can be calculated in accordance with GAAP. We provide this measurement in reporting financial performance because this measurement provides a consistent basis for understanding our sales activities each period. We believe the billings measurement is useful because the GAAP measurements of revenue and deferred revenue in the current period include subscription contracts commenced in prior periods. We reported billings (net of distributor marketing payments, channel rebates and adjustments to the allowance for doubtful accounts) of $347.0 million during 2010 compared to $352.0 million during 2009. Billings from renewals of existing subscriptions declined from $249.2 million in 2009 to $238.6 million in 2010 and billings from OEM arrangements declined from $17.8 million in 2009 to $10.7 million in 2010. Billings from incremental sales including subscriptions to new customers and upgraded subscriptions increased from $85.0 million in 2009 to $97.7 million in 2010. We expect these trends to continue in 2011. During the fourth quarter of 2010, the momentum and mix of our business shifted to our TRITON-based Web security gateway family. The average annual value of each subscription sold during 2010 was $9,100 compared to $8,000 in 2009, reflecting our increased sale of Web security and Web security gateway products to larger enterprise customers. We expect our billings to grow in 2011 relative to 2010 billings. Our billings depend in part on the number of subscriptions up for renewal each quarter and are influenced by seasonal variations with our fourth quarter generally being the strongest quarter in billings, and our first quarter generally being the lowest quarter for billings each fiscal year. As a trend, the percentage of billings from subscriptions to our Web Security Gateway products, including those pre-installed on appliances is increasing and the percentage of billings from our pure Web filtering products is declining.

During 2010, we completed a global restructuring of our internal distribution operations. The restructuring became effective in 2011, and we anticipate that it will reduce the complexity and compliance risks associated with our global distribution activities. It may also result in a reduction in our GAAP effective tax rate depending on our results of operations, including our international revenue relative to our U.S. revenue.

We are required to implement new revenue recognition rules in 2011 under which revenue for sales of appliances and the related costs will generally be recognized when the appliances are sold. In general, this means we will no longer amortize the revenue and costs for appliance sales booked in 2011 over the software subscription period. Adoption of the new rules will not change recognition of subscription software revenue or how billings are reported. These new rules are not being adopted retroactively and approximately $20 million in deferred revenue and approximately $9 million in deferred costs as of December 31, 2010 associated with past appliance sales will be recognized ratably over the remaining subscription term.

 

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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, customers can order any number of products from Websense and 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. These products include on-premise software subscriptions, SaaS subscriptions, premium post-contract technical support and appliances. Additionally, Websense on-premise and SaaS subscriptions include updates/upgrades and standard post-contract technical support over the subscription term. Under software revenue recognition accounting guidance, vendor specific objective evidence (“VSOE”) of selling price is required in order to separate multiple elements in an arrangement including software. As Websense does not have adequate support for VSOE, all elements in a multiple element arrangement containing software are treated as a single unit of accounting. We recognize revenue for the entire arrangement as a single unit of accounting 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.

We are required to implement new revenue recognition rules beginning January 1, 2011. Under the new guidance on arrangements that include software elements, tangible products (e.g., appliances) 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 be subject to other relevant revenue recognition guidance. Additionally, when VSOE 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 requires significant management judgment when determining its best estimate of selling price (e.g., the selection of relevant market conditions and entity specific factors). Upon adoption of these rules, we will generally recognize revenue for sales of appliances and the related costs when sold. The adoption of these standards will not change the recognition of deferred revenue and deferred costs on our balance sheet as of December 31, 2010.

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

 

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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 generally on a straight-line basis over the term of the underlying subscription sale.

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 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.

 

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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 December 31, 2010, there was $37.5 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 1.7 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 historical 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 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 it is more-likely-than-not that all or a portion of the deferred tax assets 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.

 

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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 required 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 has assigned our case to an IRS Appeals Officer. We are now awaiting an appointment with the assigned Appeals Officer. 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

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

 

     Years Ended December 31,  
     2010     2009     2008  

Revenues

     100     100     100

Cost of revenues

     16        16        17   
                        

Gross profit

     84        84        83   

Operating expenses:

      

Selling and marketing

     48        53        61   

Research and development

     16        17        18   

General and administrative

     11        13        16   
                        

Total operating expenses

     75        83        95   
                        

Income (loss) from operations

     9        1        (12

Interest expense

     (1     (2     (4

Other (expense) income, net

     0        0        0   
                        

Income (loss) before income taxes

     8        (1     (16

Provision (benefit) for income taxes

     2        2        (7
                        

Net income (loss)

     6     (3 %)      (9 %) 
                        

Year ended December 31, 2010 compared with the year ended December 31, 2009

Revenues

Revenues increased to $332.8 million in 2010 from $313.7 million in 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 2009 to 2010. Revenue from products sold in the United States accounted for $165.3 million or 50% of 2010 revenue compared to $155.8 million or 50% in 2009. Revenue from products sold internationally accounted for $167.5 million or 50% of 2010 revenue compared to $157.9 million or 50% in 2009. We had current deferred revenue (which is revenue we expect to realize within the next twelve months) of $251.9 million as of December 31, 2010, compared to $239.0 million as of December 31, 2009, and we had total deferred revenue of $394.3 million as of December 31, 2010, compared to $380.1 million as of December 31, 2009. We expect our 2011 revenue to increase over 2010 revenue levels due to the level of current deferred revenue that will be recognized as revenue during 2011, subscriptions that are scheduled for renewal in 2011 that are expected to be renewed and expected new and incremental business during 2011, including sales to new customers, cross selling to existing customers and selling additional products on migrations from one product to another product, for which a ratable portion of revenue will be recognized during 2011, as well as the impact of new revenue recognition rules under which revenue for sales of appliances will generally be recognized when sold. Our revenue is impacted by the duration of contracts for renewal and new subscriptions, the timing of sales of renewal and new subscriptions, subscription renewal rates, the average annual contract value and per seat price, and the effect of currency exchange rates on new and renewal subscriptions and subscription renewal rates in international markets.

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 $53.1 million in 2010 from $50.8 million in 2009. The $2.3 million increase was primarily due to increased cost of sales related to our Websense appliances of $5.0 million, increased personnel costs of $0.5 million and increased allocated costs of $0.7 million offset by decreased amortization of acquired technology of $3.9 million. Amortization of acquired technology was $9.0 million in

 

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2010 compared to $12.9 million in 2009. The decrease of $3.9 million in amortization of acquired technology was primarily due to certain acquired technology being fully amortized in 2009. As of December 31, 2010, the acquired technology is being amortized over a remaining weighted average period of 2.7 years. Based on the existing acquired technology intangible assets as of December 31, 2010 we expect to record approximately $2.9 million of amortization of acquired technology during 2011. Our full-time employee headcount in cost of revenue departments increased from an average of 258 employees during 2009 to an average of 266 employees during 2010, and is expected to remain relatively flat in 2011. We allocate the costs for human resources, employee benefits, payroll taxes, information technology, facilities and fixed asset depreciation to each of our functional areas based on headcount data. As a percentage of revenue, cost of revenues was 16% for both 2010 and 2009. We expect that cost of revenue will increase in absolute dollars in 2011 and as a percentage of revenue will increase slightly for 2011 compared to 2010. As described above in the Revenues section, our cost of revenues will be impacted in 2011 by the new revenue recognition rules for sales of appliances under which the related costs will generally be recognized when the appliances are sold.

Gross Profit

Gross profit increased to $279.7 million in 2010 from $262.9 million in 2009. The increase was primarily due to increased revenue as described in the preceding Revenues section. As a percentage of revenue, gross profit was 84% for both 2010 and 2009. We expect that gross profit as a percentage of revenue will remain in excess of 80% of revenue for 2011.

Operating Expenses

Selling and marketing. Selling and marketing expenses consist primarily of salaries, commissions, personnel benefits, 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 decreased to $157.8 million in 2010 from $166.9 million in 2009. The decrease in selling and marketing expenses was primarily due to an $8.8 million reduction in amortization of acquired customer relationships from the acquisition of SurfControl in October 2007 and a $1.3 million decrease in allocated costs, offset by increased personnel costs of $1.0 million resulting from some executive level changes in the sales area during 2010. As of December 31, 2010, the acquired customer relationships intangible assets are being amortized over a remaining weighted average period of approximately 5.0 years. Based on our existing acquired intangible assets as of December 31, 2010, we expect amortization of selling and marketing related acquired intangibles of $12.6 million in 2011, which is a decrease of approximately $4.8 million compared to 2010. Our headcount in sales and marketing decreased slightly from an average of 594 during 2009 to an average of 589 during 2010. Headcount is expected to increase slightly in 2011. We expect overall selling and marketing expenses to increase in absolute dollars as we expand our selling and marketing activities but decrease as a percentage of revenue in 2011 primarily due to the expected increase in revenue. Fluctuations in foreign currencies may also impact our expenses in 2011, and the amount of sales commissions recognized during the year can vary based on the sales volume for our product subscriptions.

Research and development. Research and development expenses consist primarily of salaries and benefits for software developers and allocated costs. Research and development expenses increased to $54.3 million in 2010 from $52.6 million in 2009. The increase of $1.7 million in research and development expenses was primarily due to increased personnel costs of $2.4 million offset by a reduction in allocated costs of $0.9 million. Although our headcount increased in research and development from an average of 411 during 2009 to an average of 454 during 2010, the impact of the higher headcount was partially mitigated by the favorable movement in currency exchange rates in 2010 compared to 2009 and the majority of our increased number of employees were in relatively low cost foreign locations. We expect research and development expenses to increase in absolute dollars as we increase our research and development efforts, continue to expand our base of product offerings and incur the full year impact of hiring of personnel to support our existing and new products.

 

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As a percentage of revenue, research and development expenses are expected to decline due to the expected increase in revenues. Fluctuations in foreign currencies may also impact our expenses in 2011. We are managing the increase in our absolute 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 our operations in the United States.

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 services fees and allocated costs. General and administrative expenses decreased to $36.8 million in 2010 from $40.3 million in 2009. The $3.5 million decrease in general and administrative expenses was primarily due to a reduction in personnel costs and allocated costs. Our headcount decreased in general and administrative departments from an average of 127 during 2009 to an average of 114 during 2010. We expect general and administrative expenses to increase in absolute dollars as a result of expected higher personnel costs, but remain relatively flat as a percentage of revenue in 2011 due to the expected increase in revenue.

Interest Expense

Interest expense primarily represents the interest incurred on the outstanding loans under the 2007 Credit Agreement and 2010 Credit Agreement. Interest expense decreased to $3.7 million in 2010 compared to $7.1 million in 2009. The decrease was primarily due to a lower average outstanding loan balance under the respective 2007 Credit Agreement and 2010 Credit Agreement, of $73 million during 2010 compared to an average loan balance of $106 million during 2009 and lower interest rates due to the reduction in the notional amount of principal subject to an unfavorable fixed rate swap agreement that expired in September 2010. Also included in the interest expense is amortization of deferred financing fees of $1.0 million and $1.2 million for 2010 and 2009, respectively, that were capitalized as part of the respective 2007 Credit Agreement and 2010 Credit Agreement. During October 2010 we used the initial proceeds from our 2010 Credit Agreement to repay the term loan and retire the 2007 Credit Agreement. In connection with the pay-off of the term loan we wrote off approximately $0.4 million of unamortized deferred financing costs. We made principal payments on the debt outstanding under the respective 2007 Credit Agreement and 2010 Credit Agreement that reduced the outstanding balance from $87 million as of December 31, 2009 to $67 million as of December 31, 2010. As a result of more favorable terms in our 2010 Credit Agreement, our weighted average interest rate decreased from 3.9% at December 31, 2009 to 2.0% as of December 31, 2010. The amount of interest expense will fluctuate due to changes in the outstanding principal balance, changes in LIBOR and changes in our applicable spread to LIBOR based upon improvements in our consolidated leverage ratio in accordance with our 2010 Credit Agreement. We expect interest expense to decline in 2011 compared to 2010 due to the lower interest rate on the 2010 credit facility. Fluctuations in LIBOR could impact our marginal interest rate. See “Liquidity and Capital Resources” for a description of the 2010 Credit Agreement.

Other (Expense) Income, Net

Other (expense) income, net went from a net other income of $0.4 million in 2009 to a net other expense of $0.8 million in 2010. The change was due primarily to foreign exchange related net losses of $1.3 million in 2010 compared to net gains of $0.1 million in 2009 due to movements in the currency exchange rates during 2010 and 2009. We expect our net other (expense) income in 2011 will be consistent with or less than 2010 levels.

Provision for Income Taxes

In 2010, we recognized an income tax provision of $7.6 million compared to an income tax provision of $7.1 million for 2009. The annual effective income tax rate for 2010 was 29.0% compared to 193.8% for 2009. The 2010 effective tax rate variance from the statutory rate primarily relates to earnings recognized in lower tax jurisdictions, and the reduction of a valuation allowance related to net operating losses for one of our subsidiaries in the United Kingdom, partially offset by the write-down of a deferred tax asset relating to the net operating

 

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losses in the United Kingdom. The 2009 effective tax rate variance from the statutory rate was primarily related to an increase in reserves for uncertain tax positions and an increase in valuation allowance related to net operating losses for one of our subsidiaries in the United Kingdom, partially offset by income generated in low tax jurisdictions.

Our effective tax rate may change in future periods due to the composition of taxable income between domestic and international operations, any future acquisitions and any future changes or interpretations in tax rules and legislation, or corresponding accounting rules. During 2010, we completed a global restructuring of our internal distribution operations. The restructuring became effective in 2011, and we anticipate that it will reduce the complexity and compliance risks associated with our global distribution activities. It may also result in a reduction in our effective tax rate depending on our results of operations, including our international revenue relative to our US revenue.

Year ended December 31, 2009 compared with the year ended December 31, 2008

Revenues

Revenues increased to $313.7 million in 2009 from $288.3 million in 2008. The increase was a result primarily of increased revenue from new, renewed and upgraded product subscriptions including SaaS security products, DLP products and OEM contract revenue from 2008 to 2009 as well as the revenue from our Websense Web Security Gateway and V10000 appliance sales that commenced in 2009. Revenue from products sold in the United States accounted for $155.8 million or 50% of 2009 revenue compared to $155.7 million or 54% in 2008. Revenue from products sold internationally accounted for $157.9 million or 50% of 2009 revenue compared to $132.6 million or 46% in 2008.

Cost of Revenues

Cost of revenue increased to $50.8 million in 2009 from $48.2 million in 2008. The $2.6 million increase primarily consisted of $0.5 million of increased amortization of acquired technology primarily due to the acquisitions of technology in the latter part of 2008, $1.1 million related to increased personnel costs and $1.7 million related to sales of our appliance products, offset by a reduction in our allocated costs of $1.0 million. Our headcount in cost of revenue departments increased from an average of 225 during 2008 to an average of 258 during 2009. As of December 31, 2009, the acquired technology was being amortized over a remaining weighted average period of 2.5 years. As a percentage of revenue, cost of revenue decreased to 16% during 2009 from 17% in 2008 primarily due to reduced allocated costs as a result of the completion of SurfControl related integration activities during 2008.

Gross Profit

Gross profit increased to $262.9 million in 2009 from $240.1 million in 2008. The increase was primarily due to increased revenue. As a percentage of revenue, gross profit increased to 84% in 2009 from 83% in 2008 primarily due to the decrease in cost of revenues as a percentage of revenue described in the preceding Cost of Revenues section.

Operating Expenses

Selling and marketing. Selling and marketing expenses decreased to $166.9 million in 2009 from $175.4 million in 2008. The decrease in selling and marketing expenses was primarily due to an $11.1 million reduction in amortization of acquired customer relationships from the acquisition of SurfControl in October 2007 and a $1.4 million decrease in allocated costs, offset by increased personnel costs of $6.1 million as our headcount in

 

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sales and marketing increased from an average of 533 during 2008 to an average of 594 during 2009. As of December 31, 2009, the acquired customer relationships intangible assets were being amortized over a remaining weighted average period of approximately 5.4 years. Operating expenses in 2009 were reduced compared to 2008 as a result of strengthening U.S. currency exchange rates relative to the foreign currencies in which certain of our international expenses were incurred.

Research and development. Research and development expenses decreased to $52.6 million in 2009 from $53.3 million in 2008. The decrease of $0.7 million in research and development expenses was primarily due to a reduction in allocated costs of $0.8 million, offset by increased personnel costs of $0.1 million. Although our headcount increased in research and development from an average of 353 during 2008 to an average of 411 during 2009, the majority of whom were employed in foreign jurisdictions, the impact was significantly offset by the favorable movement in currency exchange rates in 2009 compared to 2008 and our increased hiring of employees in relatively low cost foreign locations.

General and administrative. General and administrative expenses decreased to $40.3 million in 2009 from $45.3 million in 2008. The $5.0 million decrease in general and administrative expenses was primarily due to a reduction in allocated costs of $1.5 million and a reduction in professional service fees of $2.8 million primarily related to the completion of SurfControl related integration activities during 2008. Although our headcount increased in general and administrative departments from an average of 112 during 2008 to an average of 127 during 2009, the impact was offset by the favorable movement in currency exchange rates and the mix of headcount in 2009 compared to 2008.

Interest Expense

Interest expense decreased to $7.1 million in 2009 compared to $13.1 million in 2008. The decrease was primarily due to a lower average outstanding loan balance on our senior secured term loan under the 2007 Credit Agreement of $106 million during 2009 compared to an average loan balance of $154 million during 2008 and lower interest rates. Also included in the interest expense is amortization of deferred financing fees of $1.2 million and $2.4 million for 2009 and 2008, respectively that were capitalized as part of the senior secured credit facility under the 2007 Credit Agreement. We made principal payments on the senior secured credit facility that reduced the outstanding balance from $125 million as of December 31, 2008 to $87 million as of December 31, 2009. As a result of reductions in the LIBOR interest rate and improvements in our leverage ratio, our weighted average interest rate decreased from 5.7% at December 31, 2008 to 3.9% as of December 31, 2009.

Other Income, Net

Net other income decreased to $0.4 million in 2009 from $0.7 million in 2008. The decrease was due primarily to lower interest rates on our balances of cash and cash equivalents and marketable securities during 2009 as compared to 2008. During 2009, we also used $38 million to make principal payments on our senior secured credit facility and approximately $34 million for stock repurchases, which reduced our cash balances.

Provision for Income Taxes

In 2009, we recognized an income tax provision of $7.1 million compared to an income tax benefit of $19.5 million for 2008. The annual effective income tax rate for 2009 was 193.8% compared to (42.1)% for 2008. The 2009 effective tax rate variance from the statutory rate was primarily related to an increase in reserves for uncertain tax positions and an increase in valuation allowance related to net operating losses for one of our subsidiaries in the United Kingdom, partially offset by income generated in low tax jurisdictions. The 2008 effective tax rate variance from the statutory rate was primarily related to losses generated in a low tax jurisdiction (Ireland) and the establishment of a valuation allowance related to net operating losses for one of our subsidiaries in the United Kingdom offset by release of a valuation allowance related to net operating losses in the United States.

 

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Recent Accounting Pronouncements

In October 2009, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance on revenue recognition that became effective for Websense beginning January 1, 2011. Under the new guidance on arrangements that include software elements, tangible products (e.g., appliances) 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 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 guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. Prior to the adoption of these standards, we have been amortizing appliance revenue and costs over the software subscription period. Upon adoption of these standards, we will recognize revenue for sales of appliances and the related costs when sold and all other revenue recognition criteria are met. The adoption of these standards will not change the recognition of deferred revenue and deferred costs on our balance sheet as of December 31, 2010.

Liquidity and Capital Resources

As of December 31, 2010, we had cash and cash equivalents of approximately $77.4 million and retained earnings of $41.3 million. As of December 31, 2009, we had cash and cash equivalents of $82.9 million and retained earnings of $22.6 million (as restated). During 2010, we used our cash to pay down a net $20 million of principal on our secured loan and an additional approximately $85 million to repurchase our common stock.

Net cash provided by operating activities was $90.1 million in 2010 compared with $92.9 million in 2009. The $2.8 million decrease in cash provided by operating activities in 2010 was primarily a result of decreased cash collections from our customers due to lower billings in 2010 compared to 2009. Our operating cash flow is significantly influenced by sales of new and renewal subscriptions, accounts receivable collections and cash operating expenses. A decrease in sales of subscriptions or accounts receivable collections will negatively impact our operating cash flow. We expect to continue to generate significant cash flow from operations in 2011.

Net cash used in investing activities was $9.5 million in 2010 compared with $10.1 million in 2009. The $0.6 million decrease in net cash used in investing activities was primarily a result of a $2.9 million reduction in the purchase of property and equipment primarily due to the completion of the build out of our facilities in Ireland and China during 2009, offset by a $2.5 million change in restricted cash.

Net cash used in financing activities was $85.6 million in 2010 compared with $64.4 million in 2009. The $21.2 million increase in net cash used in financing activities was primarily due to an increase in stock repurchases of $50.7 million and tax payments related to restricted stock unit issuances of $2.6 million, offset by a decrease in net principal payments on the secured loan of $18.0 million in 2010 compared to 2009 and increased proceeds from exercises of stock options and issuance of common stock under the employee stock purchase plan of $14.1 million.

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

 

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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 2010, we entered into our 2010 Credit Agreement and used the entire initial proceeds of $67 million to repay the term loan and retire the 2007 Credit Agreement. The 2010 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 2010 Credit Agreement up to $200 million if certain conditions are satisfied, including that we are not in default under the 2010 Credit Agreement at the time of the increase and that we obtain the commitment of the lenders participating in the increase. Loans under the 2010 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 filed this Annual Report on Form 10-K were 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

³1.25:1.0

     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 2010 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 2010 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 2010 Credit Agreement permits us to repurchase our securities so long as we are not in default under the 2010 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 2010 Credit Agreement does not require us to use excess cash to pay down debt.

The 2010 Credit Agreement provides for acceleration of our 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 our representations and warranties, failure to observe covenants, defaults on any other indebtedness, entering bankruptcy, existence of a judgment or decree against us or our 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 our outstanding common stock, or our board of directors ceasing to consist of a majority of continuing directors.

 

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Obligations and commitments. The following table summarizes our contractual payment obligations and commitments as of December 31, 2010 (in thousands):

 

     Payment Obligations by Year  
     2011      2012      2013      2014      2015      Thereafter      Total  

2010 Credit Agreement:

                    

Scheduled principal payments

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

Estimated interest and fees

     1,542         2,318         2,305         2,305         1,907         —           10,377   

Operating leases

     6,129         5,268         5,530         1,470         819         —           19,216   

Other commitments

     1,014         897         50         5         —           —           1,966   
                                                              

Total

   $ 8,685       $ 8,483       $ 7,885       $ 3,780       $ 69,726       $ —         $ 98,559   
                                                              

Obligations under our 2010 Credit Agreement represent the future minimum principal debt payments due under the secured revolving credit facility. Estimated interest and fees expected to be incurred on the secured revolving credit facility are based on known rates and scheduled principal payments, as well as the interest rate swap agreement, as of December 31, 2010 (see Note 7 to the consolidated 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. Our corporate headquarters lease includes 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 December 31, 2010, we are unable to make reasonably reliable estimates of the period of cash settlement with the respective taxing authorities. Therefore, $13.9 million of unrecognized tax benefits (as more fully described in Note 11 to the consolidated financial statements) have been excluded from the contractual payment obligations table above.

Off-Balance Sheet Arrangements. As of December 31, 2010 and 2009, we did not have any relationships with unconsolidated entities or financial partners, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

Share Repurchase Program. In 2003, we announced that our Board of Directors authorized a stock repurchase program of up to 4 million shares of our common stock. In 2005, we announced that our Board of Directors increased the size of the stock repurchase program by an additional 4 million shares, for a total program size of up to 8 million shares. In 2006, we announced that our Board of Directors increased the size of the stock repurchase program by an additional 4 million shares, for a total program size of up to 12 million shares. In January 2010, our Board of Directors increased the size of the stock repurchase program by an additional 4 million shares, for a total program size of up to 16 million shares. In October 2010, our Board of Directors increased the number of shares authorized for repurchase under the program by 8 million shares, for a total program size of up to 24 million shares. Repurchases may be made from time to time on the open market at prevailing market prices. In January 2008, we adopted a 10b5-1 plan that provides for quarterly purchases of our common stock in open market transactions. In November 2010, our Board of Directors increased the value of shares to be repurchased under our existing 10b5-1 plan to $25 million per quarter, or $100 million in aggregate for 2011. Depending on market conditions and other factors, purchases by our agent under this program may be

 

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commenced or suspended at any time, or from time to time, without prior notice to us. During 2010, we repurchased 4,090,495 shares of our common stock for an aggregate of approximately $85 million at an average price of $20.77 per share through both our 10b5-1 repurchase plan and through open market purchases. As of December 31, 2010, we had cumulatively repurchased 15,624,519 shares of our common stock under this program for an aggregate of $309.8 million at an average price of $19.83 per share. Our 2010 Credit Agreement permits us to repurchase our securities so long as we are not in default under the 2010 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. We intend to continue repurchasing shares during 2011.

Prospective Capital Needs. 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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Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Our market risk exposures are related to our cash and cash equivalents and secured revolving credit facility. We 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 secured loan and therefore impact our cash flows and results of operations.

We are exposed to changes in interest rates primarily from our money market funds and from our borrowings under our variable rate credit facility. In connection with our 2010 Credit Agreement we entered into an interest rate swap agreement to pay a fixed rate of interest (1.778% per annum) and receive a floating rate interest payment (based on three month LIBOR) on a principal amount of $50 million. The $50 million swap agreement becomes effective on December 30, 2011 and expires on October 29, 2015.

A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would materially affect our interest expense. However, the impact of this type of adverse movement would be partially mitigated by our interest rate swap agreement that becomes effective on December 30, 2011. Based on our revolving credit balance at December 31, 2010, our interest expense would increase on a pre-tax basis by approximately $622,000 during 2011 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 December 31, 2010. Changes in interest rates over time will, however, affect our interest income.

Foreign Currency Exchange Rate Risk

We sell our products through a distribution network in over 130 countries, and we bill certain international customers in Euros, British Pounds, Australian Dollars and Chinese Renminbi. Additionally, a significant portion of our foreign subsidiaries’ operating expenses are incurred in foreign currencies. As a result, our financial results could be significantly affected by factors such as changes in foreign currency exchange rates or weak economic conditions in the foreign markets in which we sell our products.

To mitigate the effect of changes in currency exchange rates, we utilize foreign currency forward contracts and zero-cost collar contracts to hedge foreign currency market exposures of underlying assets, liabilities and expenses. We also keep working funds necessary to facilitate the short-term operations of our subsidiaries in the local currencies in which they do business. As exchange rate fluctuations can significantly vary our sales and expense results when converted to U.S. dollars, 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 December 31, 2010 and 2009 are presented in the table below (in thousands):

 

     December 31, 2010      December 31, 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

     8,550       $ 11,405       $ 11,449         8,000       $ 11,647       $ 11,465   

British Pound

     1,250         1,938         1,958         500         807         808   

Australian Dollar

     —           —           —           600         518         539   
                                         

Total

      $ 13,343       $ 13,407          $ 12,972       $ 12,812   
                                         

 

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The approximate $0.2 million notional decrease in our Euro hedged position at December 31, 2010 compared to December 31, 2009 is primarily a result of the timing differences between when assets were acquired and/or liabilities incurred. All of the Euro hedging contracts in place on December 31, 2010 will be settled before April 2011. For 2010 and 2009, less than 20% of our total billings were denominated in the Euro. We do not expect Euro billings to represent more than 20% of our total billings during 2011.

The approximate $1.1 million notional increase in our British Pound hedged position at December 31, 2010 compared to December 31, 2009 is primarily the 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 December 31, 2010 will be settled before March 2011. For 2010 and 2009, less than 15% of our total billings were denominated in the British Pound. We do not expect British Pound billings to represent more than 15% of our total billings during 2011.

The approximate $0.5 million notional decrease in our Australian Dollar hedged position at December 31, 2010 compared to December 31, 2009 is primarily the result of the timing differences between when assets were acquired and/or liabilities incurred. There were no outstanding Australian Dollar hedging contracts as of December 31, 2010. For 2010 and 2009, 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 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 8. Financial Statements and Supplementary Data

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders of Websense, Inc.

We have audited the accompanying consolidated balance sheets of Websense, Inc. as of December 31, 2010 and 2009 (as restated) and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2010. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Websense, Inc. at December 31, 2010 and 2009, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

As discussed in Note 2 to the consolidated financial statements, the accompanying consolidated balance sheet at December 31, 2009 and the consolidated statement of stockholders’ equity at January 1, 2008 have been restated for the correction of an error in the computation of its deferred tax asset related to deferred revenue for periods prior to December 31, 2007.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Websense, Inc.’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 10, 2011 expressed an unqualified opinion thereon.

/s/ ERNST & YOUNG LLP

San Diego, California

February 10, 2011

 

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Websense, Inc.

Consolidated Balance Sheets

(In thousands, except par value amounts)

 

     December 31,  
     2010     2009  

Assets

    

Current assets:

    

Cash and cash equivalents

   $ 77,390      $ 82,862   

Cash and cash equivalents—restricted

     256        267   

Accounts receivable, net of allowance for doubtful accounts of $1,156 and $1,802 at December 31, 2010 and 2009

     82,182        82,529   

Income tax receivable / prepaid income tax

     2,760        7,589   

Current portion of deferred income taxes

     36,191        35,269   

Other current assets

     14,708        11,461   
                

Total current assets

     213,487        219,977   

Cash and cash equivalents—restricted, less current portion

     434        167   

Property and equipment, net

     16,944        16,494   

Intangible assets, net

     41,078        67,563   

Goodwill

     372,445        372,445   

Deferred income taxes, less current portion

     6,352        11,106   

Deposits and other assets

     11,203        8,094   
                

Total assets

   $ 661,943      $ 695,846   
                

Liabilities and stockholders’ equity

    

Current liabilities:

    

Accounts payable

   $ 6,858      $ 5,135   

Accrued compensation and related benefits

     22,168        21,953   

Other accrued expenses

     18,704        19,965   

Current portion of income taxes payable

     549        1,938   

Current portion of secured loan

     0        12,429   

Current portion of deferred tax liability

     367        4,572   

Current portion of deferred revenue

     251,890        239,010   
                

Total current liabilities

     300,536        305,002   

Other long term liabilities

     2,388        1,298   

Income taxes payable, less current portion

     16,065        15,988   

Secured loan, less current portion

     67,000        74,571   

Deferred tax liability, less current portion

     1,877        970   

Deferred revenue, less current portion

     142,414        141,102   
                

Total liabilities

     530,280        538,931   

Stockholders’ equity

    

Common stock—$0.01 par value; 100,000 shares authorized; 41,001 and 43,410 shares issued and outstanding at December 31, 2010 and 2009

     548        529   

Additional paid-in capital

     373,229        330,451   

Treasury stock, at cost

     (282,570     (194,672

Retained earnings

     41,253        22,601   

Accumulated other comprehensive loss

     (797     (1,994
                

Total stockholders’ equity

     131,663        156,915   
                

Total liabilities and stockholders’ equity

   $ 661,943      $ 695,846   
                

See accompanying notes

 

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Websense, Inc.

Consolidated Statements of Operations

(In thousands, except per share amounts)

 

     Years Ended December 31,  
     2010     2009     2008  

Revenues

   $ 332,762      $ 313,713      $ 288,274   

Cost of revenues

     53,090        50,806        48,160   
                        

Gross profit

     279,672        262,907        240,114   

Operating expenses:

      

Selling and marketing

     157,758        166,910        175,365   

Research and development

     54,325        52,643        53,274   

General and administrative

     36,779        40,295        45,343   
                        

Total operating expenses

     248,862        259,848        273,982   
                        

Income (loss) from operations

     30,810        3,059        (33,868

Interest expense

     (3,715     (7,084     (13,134

Other (expense) income, net

     (834     384        739   
                        

Income (loss) before income taxes

     26,261        (3,641     (46,263

Provision (benefit) for income taxes

     7,609        7,056        (19,484
                        

Net income (loss)

   $ 18,652      $ (10,697   $ (26,779
                        

Net income (loss) per share:

      

Basic net income (loss) per share

   $ 0.44      $ (0.24   $ (0.59

Diluted net income (loss) per share

   $ 0.43      $ (0.24   $ (0.59

Weighted average shares—basic

     42,313        44,262        45,190   

Weighted average shares—diluted

     43,342        44,262        45,190   

See accompanying notes

 

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Websense, Inc.

Consolidated Statements of Stockholders’ Equity

(In thousands)

 

     Common stock      Additional
paid-in capital
    Treasury
stock
    Retained
earnings
    Accumulated other
comprehensive

loss
    Total
stockholders’
equity
 
     Shares     Amount             

Balance at December 31, 2007 (as previously reported)

     45,394      $ 515       $ 267,142      $ (139,792   $ 65,892      $ (1,320   $ 192,437   

Adjustment to stockholders’ equity to reflect correction of prior period error (See Note 2)

     0        0         0        0        (5,815     0        (5,815
                                                         

Balance at January 1, 2008 (as restated)

     45,394        515         267,142        (139,792     60,077        (1,320     186,622   

Issuance of common stock upon exercise of options

     356        4         4,307        0        0        0        4,311   

Issuance of common stock for ESPP purchase

     347        3         5,318        0        0        0        5,321   

Issuance of common stock from restricted stock units, net

     30        0         0        (52     0        0        (52

Share-based compensation expense

     0        0         24,089        0        0        0        24,089   

Tax shortfall from share-based compensation

     0        0         (806     0        0        0        (806

Purchase of treasury stock

     (1,079     0         0        (19,998     0        0        (19,998

Components of comprehensive loss:

               

Net loss

     0        0         0        0        (26,779     0        (26,779

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

     0        0         0        0        0        (560     (560

Translation adjustments

     0        0         0        0        0        (1,303     (1,303
                     

Comprehensive loss

                  (28,642
                                                         

Balance at December 31, 2008

     45,048        522         300,050        (159,842     33,298        (3,183     170,845   

Issuance of common stock upon exercise of options

     205        3         2,430        0        0        0        2,433   

Issuance of common stock for ESPP purchase

     378        4         5,428        0        0        0        5,432   

Issuance of common stock from restricted stock units, net

     64        0         0        (330     0        0        (330

Share-based compensation expense

     0        0         24,765        0        0        0        24,765   

Tax shortfall from share-based compensation

     0        0         (2,222     0        0        0        (2,222

Purchase of treasury stock

     (2,285     0         0        (34,500     0        0        (34,500

Components of comprehensive loss:

               

Net loss

     0        0         0        0        (10,697     0        (10,697

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

     0        0         0        0        0        1,189        1,189   
                     

Comprehensive loss

                  (9,508
                                                         

Balance at December 31, 2009

     43,410        529         330,451        (194,672     22,601        (1,994     156,915   

Issuance of common stock upon exercise of options

     973        10         15,982        0        0        0        15,992   

Issuance of common stock for ESPP purchase

     440        5         5,986        0        0        0        5,991   

Issuance of common stock from restricted stock units, net

     268        4         0        (2,900     0        0        (2,896

Share-based compensation expense

     0        0         22,565        0        0        0        22,565   

Tax shortfall from share-based compensation

     0        0         (1,755     0        0        0        (1,755

Purchase of treasury stock

     (4,090     0         0        (84,998     0        0        (84,998

Components of comprehensive income:

               

Net income

     0        0         0        0        18,652        0        18,652   

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

     0        0         0        0        0        1,197        1,197   
                     

Comprehensive income

                  19,849   
                                                         

Balance at December 31, 2010

     41,001      $ 548       $ 373,229      $ (282,570   $ 41,253      $ (797   $ 131,663   
                                                         

See accompanying notes

 

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Websense, Inc.

Consolidated Statements of Cash Flows

(In thousands)

 

     Years Ended December 31,  
     2010     2009     2008  

Operating activities:

      

Net income (loss)

   $ 18,652      $ (10,697   $ (26,779

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

      

Depreciation and amortization

     37,873        51,374        63,133   

Share-based compensation

     22,565        24,765        24,089   

Deferred income taxes

     (264     (586     (28,230

Unrealized loss (gain) on foreign exchange

     490        512        (632

Excess tax benefit from share-based compensation

     (1,552     (208     (711

Changes in operating assets and liabilities:

      

Accounts receivable

     1,712        (535     (3,765

Other assets

     (5,121     (10,256     (1,074

Accounts payable

     2,346        2,659        (1,111

Accrued compensation and related benefits

     (274     3,431        (5,666

Other liabilities

     (2,246     (7,785     (2,378

Deferred revenue

     14,191        38,329        54,465   

Income taxes payable and receivable/prepaid

     1,747        1,852        (6,651
                        

Net cash provided by operating activities

     90,119        92,855        64,690   
                        

Investing activities:

      

Change in restricted cash and cash equivalents

     (199     2,347        (1,240

Purchase of property and equipment

     (9,259     (12,167     (8,256

Purchase of intangible assets

     0        (320     (2,061

Cash refunded from PortAuthority acquisition

     0        0        147   

Cash received from sale of CyberPatrol assets

     0        0        1,400   

Purchases of marketable securities

     0        0        (20,160

Maturities of marketable securities

     0        0        39,963   
                        

Net cash (used in) provided by investing activities

     (9,458     (10,140     9,793   
                        

Financing activities:

      

Proceeds from secured loan

     5,000        0        0   

Principal payments on secured loan

     (25,000     (38,000     (65,000

Principal payments on capital lease obligation

     (532     0        0   

Cash paid for deferred financings fees under secured loan

     (864     0        0   

Proceeds from exercise of stock options

     15,992        2,433        4,311   

Proceeds from issuance of common stock for employee stock purchase plan

     5,991        5,432        5,321   

Excess tax benefit from share-based compensation

     1,552        208        711   

Tax payments related to restricted stock unit issuances

     (2,896     (329     (51

Purchase of treasury stock

     (84,854     (34,158     (19,998
                        

Net cash used in financing activities

     (85,611     (64,414     (74,706
                        

Effect of exchange rate changes on cash and cash equivalents

     (522     465        (1,771

(Decrease) increase in cash and cash equivalents

     (5,472     18,766        (1,994

Cash and cash equivalents at beginning of year

     82,862        64,096        66,090   
                        

Cash and cash equivalents at end of year

   $ 77,390      $ 82,862      $ 64,096   
                        

Supplemental disclosures of cash flow information:

      

Income taxes paid, net of refunds

   $ 6,792      $ 9,899      $ 13,066   

Interest paid

   $ 3,571      $ 5,867      $ 10,778   

Increase in other accrued expenses for purchase of treasury stock

   $ 144      $ 342      $ 0   

Capital lease obligation incurred for a software license arrangement

   $ 1,688      $ 0      $ 0   

See accompanying notes

 

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Websense, Inc.

Notes to Consolidated Financial Statements

Restatement of Historical Financial Statements

The accompanying consolidated balance sheet as of December 31, 2009 and the consolidated statement of stockholders’ equity at January 1, 2008, have been restated in this report to reflect the write-off of a deferred tax asset in 2007 in connection with the correction of an error as more fully discussed in Note 2. While net cash provided by operating activities remained unchanged in the accompanying consolidated statements of cash flows, certain components within the operating activities were adjusted to reflect the correction of the error.

 

1. Summary of Significant Accounting Policies

Description of Business

Websense, Inc. (“Websense” or the “Company”) commenced operations in 1994. Websense is a global provider of unified Web, data and email content security solutions that are designed to protect data and users from modern cyber-threats, information leaks, legal liability and productivity loss. The Company provides its products to its customers as software installed on standard server hardware, as software pre-installed on optimized appliances, as a cloud-based service (software as-a-service or “SaaS”) offering, or in a hybrid appliance/SaaS configuration. The Company’s products and services are sold worldwide to public sector entities, enterprise customers, small and medium sized businesses, and Internet service providers through a network of value-added resellers and original equipment manufacturer (“OEM”) arrangements.

Reclassifications

Certain prior year amounts primarily relating to the classification of long-term obligations in the consolidated balance sheet and classification of certain income taxes related items in the consolidated statements of cash flows have been reclassified to conform to the current year presentation.

Use of Estimates

The preparation of the consolidated financial statements in conformity with generally accepted accounting principles (“GAAP”) in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries in Australia, Austria, Brazil, Canada, China, France, Germany, India, Ireland, Israel, Italy, Japan, Mauritius, the Netherlands, the United Kingdom and the United States. Significant intercompany accounts and transactions have been eliminated in consolidation.

The functional currency of the Company’s foreign subsidiaries is the U.S. dollar as the subsidiaries are generally considered direct and integral components or extensions of the Company’s operations. The Company recorded foreign currency transaction gains (losses) of ($1.3 million), $0.1 million and ($0.9 million) for the years ended December 31, 2010, 2009 and 2008, respectively, which are included in “Other income, net” on its consolidated statements of operations.

Revenue Recognition

The Company sells its products, including its appliance products, primarily on a subscription basis. A subscription is generally 12, 24 or 36 months in duration and for a fixed number of seats or devices. Under software revenue recognition accounting guidance, vendor specific objective evidence (“VSOE”) of selling price

 

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is required in order to separate multiple elements in an arrangement including software. As Websense does not have adequate support for VSOE, all elements in a multiple-element arrangement containing software are treated as a single unit of accounting. The Company recognizes revenue for the entire arrangement as a single unit of accounting 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, the Company electronically delivers access codes to users, and in the case of our appliance product the Company ships the product with its software pre-installed on the product, and then promptly invoices customers for the full amount of their subscriptions. Payment is due for the full term of the subscription, generally within 30 to 60 days of invoicing.

For the Company’s original equipment manufacturer (“OEM”) contracts, the Company grants its OEM customers the right to incorporate the Company’s products into the OEMs’ products for resale to end users. The OEM customer pays the Company a royalty fee for each resale of a subscription to the Company’s product to an end user over a specified period of time. The Company recognizes revenue associated with the OEM contracts ratably over the contractual period for which the Company is obligated to provide its services to the OEM. These services consist of software updates, technical support and database updates to the Company’s Web filtering products.

The Company records amounts billed to customers in excess of recognizable revenue as deferred revenue in the accompanying consolidated balance sheets. The Company amortizes deferred revenues over the term of the subscription agreement commencing with the day the agreement is signed and all other revenue recognition requirements have been met.

The Company records distributor marketing payments and channel rebates as an offset to revenue, unless the Company receives an identifiable benefit in exchange for the consideration and the Company can estimate the fair value of the benefit received. The Company recognizes distributor marketing payments as an offset to revenue in the period the marketing service is provided. The Company recognizes channel rebates as an offset to revenue on a straight-line basis over the term of the corresponding subscription agreement. During 2010, 2009 and 2008, the Company recorded distributor marketing payments of $3.1 million, $2.7 million and $2.4 million, respectively, and recorded channel rebates of $3.5 million, $3.2 million and $2.7 million, respectively.

Cash and Cash Equivalents (including restricted cash and cash equivalents)

The Company considers all highly liquid investments with a maturity of ninety days or less when purchased to be cash equivalents. The Company generally invests its excess cash in money market funds with strong credit ratings. Such investments are made in accordance with the Company’s investment policy, which establishes guidelines relative to diversification and maturities designed to maintain safety and liquidity. These guidelines are periodically reviewed and modified if necessary to take advantage of trends in yields and interest rates. The Company has not experienced any losses on its cash and cash equivalents. As of December 31, 2010, the Company’s restricted cash relates to certain lease guarantees in international locations.

Interest on Cash and Cash Equivalents

The Company’s interest on cash and cash equivalents, included as a component of other (expense) income, net, was $0.2 million for both years ended December 31, 2010 and 2009, and $1.6 million for the year ended December 31, 2008.

Acquisitions, Goodwill and Other Intangible Assets

The Company accounts for acquired businesses using the acquisition method of accounting, 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 estimated fair values of net assets acquired is recorded as

 

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goodwill. The Company reviews goodwill for impairment at least annually in the Company’s fourth fiscal quarter, or more frequently if an event occurs indicating the potential for impairment. Intangible assets with finite lives are carried at cost less accumulated amortization. The Company amortizes 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. The Company reviews intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. If the value of future undiscounted cash flows is less than the carrying amount of an asset, the Company records an impairment loss based on the excess of the carrying amount over the fair value of the asset. No impairment losses were recorded in 2010, 2009 or 2008.

Fair Value of Financial Instruments

The carrying value of cash and cash equivalents (including restricted cash and cash equivalents), accounts receivable, accounts payable, accrued liabilities and income tax receivable and payables approximate their fair values.

Deferred Financing Costs

The Company capitalizes deferred financing costs incurred in connection with its credit agreements and amortizes those costs over the respective term of the credit agreements.

Derivatives

The Company uses derivatives to manage foreign currency risk and interest rate risk and not 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. 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 Company utilizes 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 net 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 $0.4 million, $0.2 million and ($1.3 million) for 2010, 2009 and 2008, respectively. All of the fair value hedging contracts in place as of December 31, 2010 and 2009, will be settled before April 2011.

The Company utilizes Israeli Shekel zero-cost collar and 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 less than $0.1 million, $0.2 million and less than ($0.1 million) related to the contracts designated as cash flow hedges during 2010, 2009 and 2008, respectively, are included in the respective operating categories for which the Company hedges its Israeli Shekel expenditures. There were no outstanding Israeli Shekel hedging contracts in place as of December 31, 2010 and 2009.

 

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Notional and fair values of the Company’s hedging positions at December 31, 2010 and 2009 are presented in the table below (in thousands):

 

     December 31, 2010      December 31, 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

     8,550       $ 11,405       $ 11,449         8,000       $ 11,647       $ 11,465   

British Pound

     1,250         1,938         1,958         500         807         808   

Australian Dollar

     0         0         0         600         518         539   
                                         

Total

      $ 13,343       $ 13,407          $ 12,972       $ 12,812   
                                         

In connection with the 2007 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 as well as an interest rate cap agreement to limit the maximum interest rate on a portion of its senior secured credit facility to 6.5% per annum. Both the interest rate swap agreement and interest rate cap agreement expired on September 30, 2010. In connection with the 2010 Credit Agreement the Company entered into an interest rate swap agreement to pay a fixed rate of interest (1.778% per annum) and receive a floating rate interest payment (based on three month LIBOR) on a principal amount of $50 million. The $50 million swap agreement becomes effective on December 30, 2011 and expires on October 29, 2015.

Concentration of Credit Risk

The Company sells its products to customers primarily in the United States, Canada, Europe, Asia, Australia and Latin America (See Note 5). The Company maintains a reserve for potential credit losses and historically such losses have been within management’s estimates. One of the Company’s broad-line distributors in North America, Ingram Micro, accounted for approximately 31%, 30% and 23% of the Company’s revenues during 2010, 2009 and 2008, respectively.

Inventory

Inventory, which consists primarily of appliance hardware held at the Company’s fulfillment partner locations, is stated at lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first in, first out basis. Inventory balances are included in other current assets on the accompanying consolidated balance sheets and were $2.1 million and $1.7 million at December 31, 2010 and 2009, respectively.

Deferred Costs of Revenue

Deferred costs of revenue, which consist primarily of direct costs of materials that are associated with appliance revenues deferred over a service period, are included in the other current assets and other assets line items on the accompanying consolidated balance sheets. The Company recognizes such deferred costs ratably as revenue is recognized. At December 31, 2010 and 2009, the Company’s total deferred costs of revenue were $9.1 million and $4.8 million, respectively.

Shipping and Handling

The Company’s policy for shipping and handling is to classify the costs as a component of costs of revenues.

Property and Equipment

Property and equipment are stated at cost and are depreciated using the straight-line method over their estimated useful lives, ranging from three to seven years. Depreciation and amortization of leasehold improvements are computed using the shorter of the remaining lease term or the economic life.

 

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Computer Software Costs

Computer software development costs for the development of specific computer software products are capitalized, when significant, after establishment of technological feasibility and marketability. There have been no such costs capitalized to date as the costs incurred during the period between technological feasibility to general release have not been significant.

Advertising Expenses

Advertising costs are expensed as incurred. Total advertising costs for the years ended December 31, 2010, 2009 and 2008 were $6.0 million, $6.6 million and $7.8 million, respectively.

Share-Based Compensation

Share-based compensation expense (excluding tax effects) was recorded in the following expense categories of the consolidated statements of operations.

 

     Years Ended December 31,  
     2010      2009      2008  

Share-based compensation in:

        

Cost of revenue

   $ 1,270       $ 1,381       $ 1,318   
                          

Total share-based compensation in cost of revenue

     1,270         1,381         1,318   

Selling and marketing

     7,160         7,964         8,957   

Research and development

     5,285         5,206         4,734   

General and administrative

     8,850         10,214         9,080   
                          

Total share-based compensation in operating expenses

     21,295         23,384         22,771   
                          

Total share-based compensation

   $ 22,565       $ 24,765       $ 24,089   
                          

At December 31, 2010, there was $37.5 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. The Company expects to recognize that cost over a weighted average period of approximately 1.7 years.

The Company estimates the fair value of options granted using the Black-Scholes option valuation model and the assumptions shown in the tables below. The Company estimates the expected term of options granted based on the history of grants and exercises in the Company’s option database. The Company estimates the volatility of its common stock at the date of grant based on both the historical volatility as well as the implied volatility of publicly traded options on its common stock. The Company bases 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. The Company has never paid any cash dividends on its common stock and does not anticipate paying any cash dividends in the foreseeable future. Consequently, the Company uses an expected dividend yield of zero in the Black-Scholes option valuation model. The Company amortizes the fair value ratably over the vesting period of the awards, which is typically four years. The Company uses historical data to estimate pre-vesting option forfeitures and records share-based expense only for those awards that are expected to vest.

 

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The Company used the following assumptions to estimate the fair value of stock options granted for the years ended December 31, 2010, 2009 and 2008:

 

     Years Ended December 31,  
         2010             2009             2008      

Average expected life (years)

     3.4        3.1        3.0   

Average expected volatility factor

     42.4     45.4     35.3

Average risk-free interest rate

     1.4     1.4     2.5

Average expected dividend yield

     0        0        0   

The Company used the following assumptions to estimate the fair value of the semi-annual employee stock purchase plan share grants during the years ended December 31, 2010, 2009 and 2008:

 

     Years Ended December 31,  
         2010             2009             2008      

Average expected life (years)

     1.3        1.3        1.3   

Average expected volatility factor

     41.7     48.8     50.7

Average risk-free interest rate

     0.4     0.7     1.6

Average expected dividend yield

     0        0        0   

The Company’s determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by the Company’s stock price as well as assumptions regarding a number of complex and subjective variables. These variables include, but are not limited to the Company’s 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 the Company’s employee stock options have certain characteristics that are significantly different 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 the Company’s 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.

Share-based compensation expense related to restricted stock unit awards is calculated based on the market price of the Company’s common stock on the date of grant and is recognized ratably over the vesting period of the awards.

Comprehensive Income (Loss)

Comprehensive income is defined as the change in equity during a period from transactions and other events and circumstances from non-owner sources. Comprehensive income (loss) was as follows (in thousands):

 

     Years Ended December 31,  
     2010      2009     2008  

Net income (loss)

   $ 18,652       $ (10,697   $ (26,779

Net change in unrealized gain (loss) on derivative contracts, net of tax of $552, $796 and $(376), respectively

     1,197         1,189        (560

Translation adjustment

     0         0        (1,303
                         

Comprehensive income (loss)

   $ 19,849       $ (9,508   $ (28,642
                         

 

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

 

     Years Ended December 31,  
     2010     2009     2008  

Beginning balance

   $ (369   $ (1,558   $ (998

Net change during the period

     1,197        1,189        (560
                        

Ending balance

   $ 828      $ (369   $ (1,558
                        

Accumulated Other Comprehensive Loss

Accumulated other comprehensive loss consisted of the following (in thousands):

 

     December 31,  
     2010     2009  

Unrealized gain (loss) on interest rate derivatives

   $ 828      $ (369

Translation adjustment

     (1,625     (1,625
                
   $ (797   $ (1,994
                

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 net income per share 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 for all periods presented consist of dilutive stock options and restricted stock units. Dilutive securities include both dilutive stock options and dilutive restricted stock units and are calculated based on the average share price for each fiscal period using the treasury stock method.

Potentially dilutive securities totaling 5,519,000 shares for 2010 were excluded from the diluted EPS calculation because their exercise price was greater than the average market price of common shares during the year and, therefore, the effect would be anti-dilutive. As the Company reported a net loss in 2009 and 2008, basic and diluted net loss per share were the same. Potentially dilutive securities outstanding were not included in the computation of diluted net loss per share for 2009 and 2008 because to do so would have been anti-dilutive.

 

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The following is a reconciliation of the numerator and denominator of basic EPS to the numerator and denominator of diluted EPS for all periods presented.

 

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

For the Years Ended:

       

December 31, 2010:

       

Basic EPS

   $ 18,652        42,313       $ 0.44   

Effect of dilutive securities

     0        1,029       $ (0.01
                         

Diluted EPS

   $ 18,652        43,342       $ 0.43   
                         

December 31, 2009:

       

Basic EPS

   $ (10,697     44,262       $ (0.24

Effect of dilutive securities

     0        0         0   
                         

Diluted EPS

   $ (10,697     44,262       $ (0.24
                         

December 31, 2008:

       

Basic EPS

   $ (26,779     45,190       $ (0.59

Effect of dilutive securities

     0        0         0   
                         

Diluted EPS

   $ (26,779     45,190       $ (0.59
                         

Income Taxes

The Company applies the liability method of accounting for income taxes. Under the liability method, deferred taxes are determined based on the temporary differences between the financial statement and tax basis of assets and liabilities using tax rates expected to be in effect during the years in which the basis differences reverse. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized.

The Company uses 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. The Company considers many factors when evaluating and estimating its tax positions and tax benefits, which require periodic adjustments and which may not accurately anticipate actual outcomes. The Company recognizes potential accrued interest and penalties related to unrecognized tax benefits as income tax expense.

Allowance for Doubtful Accounts

The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability or unwillingness of the Company’s customers to pay their invoices. If the financial condition of the Company’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

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

 

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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. Prior to the adoption of these standards, the Company has been amortizing appliance revenue and costs over the software subscription period. Upon adoption of these standards, the Company will recognize revenue for sales of appliances and the related costs when sold and all other revenue recognition criteria are met. The adoption of these standards will not change the recognition of deferred revenue and deferred costs on the Company’s balance sheet as of December 31, 2010.

 

2. Restatement of Financial Statements

The Company’s consolidated financial statements contained herein include restatements of the previously reported consolidated balance sheet at December 31, 2009 and the statement of stockholders’ equity at January 1, 2008, and related disclosures to record the write-off of a $5.8 million tax asset that originated from an error in the calculation of the Internal Revenue Code Section 481(a) adjustment when the Company changed its tax method of accounting for deferred revenue in 2003. The error resulted in the Company reporting overstated deferred tax assets of approximately $5.8 million in its financial statements for fiscal years 2003 through 2008. In 2009, the Company reclassified a portion of the error amount from deferred tax assets to income tax receivable because of a belief at the time that the error amount was related to monthly-to-daily revenue adjustments for fiscal years 2006 through 2008 and, therefore, would be recoverable by amending the Company’s tax returns for those years. In combination with the implementation of revenue recognition software which helps track the tax attributes related to deferred revenue, the detailed analysis required to file amendments to our fiscal 2006 through 2008 tax returns in 2010 and the financial statement close process for the year ended December 31, 2010, the Company subsequently discovered the error amount was instead related to an error in the calculation of the deferred tax assets when it changed its tax method of accounting for deferred revenue in 2003. The statute of limitations to claim a refund for the 2003 tax year expired in September 2007. After evaluating various tax planning strategies, the Company determined that there is substantial uncertainty as to whether it will be able to recover the amounts based on case law. As a result, the Company has concluded that it needs to restate its 2007 results to reflect the write-off of the $5.8 million tax asset and adjust the 2009 and 2008 financial statements to reflect the write-off on the Company’s deferred income taxes, income tax receivable and retained earnings balances.

The following table summarizes the effects of the restatements on the specific line items presented in the Company’s historical consolidated balance sheet as of December 31, 2009:

 

     December 31, 2009
(As previously
reported)
     December 31, 2009
(As restated)
 
     (In Thousands)  

Current assets:

     

Income tax receivable/prepaid income tax

   $ 11,446       $ 7,589   

Current portion of deferred income taxes

     36,538         35,269   

Total current assets

     225,103         219,977   

Deferred income taxes, less current portion

     11,795         11,106   

Total assets

     701,661         695,846   

Stockholders’ equity:

     

Retained earnings

     28,416         22,601   

Total stockholders’ equity

     162,730         156,915   

 

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The restatements resulted in changes to the opening balances of retained earnings and total stockholders’ equity as of January 1, 2008 as follows:

 

     January 1, 2008
(As previously
reported)
     January 1, 2008
(As restated)
 
     (In Thousands)  

Retained earnings

   $ 65,892       $ 60,077   

Stockholders’ equity

   $ 192,437       $ 186,622   

The restatements had no impact on the financial statement amounts previously reported in the Company’s consolidated statements of operations for the years ended December 31, 2009 and 2008, or for the first nine months ended September 30, 2010, or any quarterly periods in the years ended December 31, 2009 and 2008. While net cash provided by operating activities remained unchanged in the statement of cash flows, certain components within the operating activities section were adjusted to reflect the correction of the error.

 

3. Property and Equipment

Property and equipment consisted of the following (in thousands):

 

     Estimated
Useful Lives
     December 31,  
      2010     2009  

Computer hardware and software

     3 years       $ 36,359      $ 42,962   

Leasehold improvements, office furniture and equipment

     3-7 years         10,779        9,174   
                   
        47,138        52,136   

Accumulated depreciation

        (30,194     (35,642
                   
      $ 16,944      $ 16,494   
                   

Depreciation expense, including amortization of assets recorded under capital leases, for 2010, 2009 and 2008 was $10.3 million, $10.7 million and $10.8 million, respectively. Included in property and equipment as of December 31, 2010 is a capital lease obligation for a software license arrangement that had a net book value of approximately $1.2 million as of December 31, 2010.

 

4. Intangible Assets

Intangible assets subject to amortization consisted of the following as of December 31, 2010 (in thousands):

 

     Remaining
Weighted Average
Life (in years)
     Cost      Accumulated
Amortization
    Net  

Technology

     2.7       $ 16,347       $ (10,418   $ 5,929   

Customer relationships

     5.0         126,200         (91,153     35,047   

Trade name

     1.0         510         (408     102   
                            

Total

     4.7       $ 143,057       $ (101,979   $ 41,078   
                            

Intangible assets subject to amortization consisted of the following as of December 31, 2009 (in thousands):

 

     Remaining
Weighted Average
Life (in years)
     Cost      Accumulated
Amortization
    Net  

Technology

     2.5       $ 32,598       $ (17,706   $ 14,892   

Customer relationships

     5.4         129,200         (76,733     52,467   

Trade name

     2.0         510         (306     204   
                            

Total

     4.8       $ 162,308       $ (94,745   $ 67,563   
                            

 

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Amortization expense of intangible assets for 2010, 2009 and 2008 was $26.5 million, $39.3 million and $49.9 million, respectively. As of December 31, 2010, amortization expense is expected to be as follows (in thousands):

 

Years Ending December 31,

  

2011

   $ 15,550   

2012

     8,329   

2013

     5,577   

2014

     4,545   

2015

     3,719   

Thereafter

     3,358   
        

Total expected amortization expense

   $ 41,078   
        

 

5. Geographic Information

The following illustrates revenues attributed to customers located in the Company’s country of domicile (the United States) and those attributed to foreign customers (in thousands):

 

     Years Ended December 31,  
     2010      2009      2008  

United States

   $ 165,272       $ 155,837       $ 155,720   

Europe, Middle East and Africa

     113,721         108,290         91,182   

Asia/Pacific

     25,785         22,684         18,556   

Canada and Latin America

     27,984         26,902         22,816   
                          
   $ 332,762       $ 313,713       $ 288,274   
                          

The United Kingdom represented $42.9 million, $45.2 million and $43.2 million of total revenue for the fiscal years 2010, 2009 and 2008, respectively. No other foreign country represented more than 5% of total revenue.

The net carrying values of the Company’s property and equipment assets are located in the following geographic areas (in thousands):

 

     December 31,  
         2010              2009      

United States

   $ 9,311       $ 8,474   

China

     2,643         2,697   

United Kingdom

     1,731         2,615   

Ireland

     1,845         1,863   

Other

     1,414         845   
                 
   $ 16,944       $ 16,494   
                 

 

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6. Deferred Revenue

The Company expects to recognize revenue related to contractual arrangements in existence as of December 31, 2010 as follows (in thousands):

 

Years Ending December 31,

  

2011

   $ 251,890   

2012

     97,064   

2013

     37,532   

2014

     5,192   

2015 and thereafter

     2,626   
        
   $ 394,304   
        

 

7. Credit Facility

In October 2007, the Company entered into an amended and restated senior credit agreement, which was subsequently amended in December 2007, June 2008 and February 2010 (the “2007 Credit Agreement”). The $225 million senior credit facility consisted of a five year $210 million senior secured term loan and a $15 million revolving credit facility. In October 2010, the Company entered into a new credit agreement (the “2010 Credit Agreement”) and repaid the term loan and retired the 2007 Credit Agreement. The 2010 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. The Company may increase the maximum aggregate commitment under the 2010 Credit Agreement up to $200 million if certain conditions are satisfied, including that it is not in default under the 2010 Credit Agreement at the time of the increase and that it obtains the commitment of the lenders participating in the increase. Loans under the 2010 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. As of December 31, 2010, the Company’s weighted average interest rate was 2.0%.

The applicable margins until the date that the Company files its Annual Report on 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

³1.25:1.0

     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 2010 Credit Agreement is secured by substantially all of the Company’s assets, including pledges of stock of certain of its subsidiaries (subject to limitations in the case of foreign subsidiaries) and by secured guarantees by its domestic subsidiaries. The 2010 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

 

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mergers and acquisitions, to make dispositions, to pay cash dividends or repurchase capital stock, and to make investments, subject to certain exceptions. The 2010 Credit Agreement does not require the Company to use excess cash to pay down debt.

The 2010 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 (as defined in the 2010 Credit Agreement).

The secured revolving credit facility under the 2010 Credit Agreement and the term loan under the 2007 Credit Agreement are included in the line item “secured loan” on our consolidated balance sheets. As of December 31, 2010, future remaining minimum principal payments under the secured loan will be as follows (in thousands):

 

Years Ending December 31,

  

2011

   $ 0   

2012

     0   

2013

     0   

2014

     0   

2015

     67,000   
        

Total

   $ 67,000   
        

 

8. 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.

The following table presents the balances of assets and liabilities measured at fair value on a recurring basis as of December 31, 2010 (in thousands):

 

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

Assets:

           

Cash equivalents—money market funds

   $ 13,197       $ 0       $ 0       $ 13,197   

Interest rate swap

     0         1,379         0         1,379   

Liabilities:

           

Foreign currency forward contracts not designated as hedges

     0         64         0         64   

 

(1)—quoted prices in active markets for identical assets or liabilities

(2)—observable inputs other than quoted prices in active markets for identical assets or liabilities

(3)—no observable pricing inputs in the market

 

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Included in other assets and in other accrued expenses in the consolidated balance sheet as of December 31, 2010 are derivative contracts, comprised of an interest rate swap as well as foreign 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 effects of derivative instruments on the Company’s financial statements were as follow as of December 31, 2010 and 2009 and for the years 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  
          December 31,  
    

Balance Sheet Location

   2010     2009  

Interest rate contracts designated as cash flow hedges

  

Other assets / (other accrued expenses)

   $ 1,379      $ (616

Currency contracts not designated as hedges

  

(Other accrued expenses) / other assets

     (64     160   
                   

Total derivatives

      $ 1,315      $ (456
                   

 

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

   Year Ended December 31,     Derivatives in Cash
Flow Hedging
Relationships
   Year Ended
December 31,
 
     2010      2009          2010     2009  

Interest rate contracts

   $ 1,991       $ 1,989      Interest expense    $ (625   $ (2,319

Currency contracts

     0         (4   R&D      14        150   
                                    

Total

   $ 1,991       $ 1,985         $ (611   $ (2,169