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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

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

For the quarterly period ended September 30, 2011

OR

 

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

For the Transition Period from                      to                     

Commission File Number 000-30093

 

 

Websense, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware   51-0380839

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

10240 Sorrento Valley Road

San Diego, California 92121

858-320-8000

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

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

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

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

 

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

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

The number of shares outstanding of the registrant’s Common Stock, $.01 par value, as of October 31, 2011 was 38,820,604.

 

 

 


Table of Contents

Websense, Inc.

Form 10-Q

For the Quarterly Period Ended September 30, 2011

TABLE OF CONTENTS

 

              Page  

Part I. Financial Information

  
 

Item 1.

   Consolidated Financial Statements (Unaudited):   
     Consolidated Balance Sheets as of September 30, 2011 and December 31, 2010      3   
     Consolidated Statements of Income for the three and nine months ended September 30, 2011 and 2010      4   
     Consolidated Statement of Stockholders’ Equity for the nine months ended September 30, 2011      5   
     Consolidated Statements of Cash Flows for the nine months ended September 30, 2011 and 2010      6   
     Notes to Consolidated Financial Statements      7   
 

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      17   
 

Item 3.

   Quantitative and Qualitative Disclosures About Market Risk      30   
 

Item 4.

   Controls and Procedures      32   

Part II. Other Information

  
 

Item 1.

   Legal Proceedings      32   
 

Item 1A.

   Risk Factors      32   
 

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds      45   
 

Item 3.

   Defaults upon Senior Securities      45   
 

Item 4.

   (Removed and Reserved)      45   
 

Item 5.

   Other Information      45   
 

Item 6.

   Exhibits      46   

Signatures

        47   

In this report, “Websense,” “the Company,” “we,” “us” and “our” refer to Websense, Inc., and our wholly owned subsidiaries, unless the context otherwise provides.

 

2


Table of Contents

Part I – Financial Information

 

Item 1. Consolidated Financial Statements (Unaudited)

Websense, Inc.

Consolidated Balance Sheets

(In thousands)

 

     September 30,
2011
    December 31,
2010
 
     (Unaudited)        

Assets

    

Current assets:

    

Cash and cash equivalents

   $ 75,550      $ 77,390   

Cash and cash equivalents – restricted

     —          256   

Accounts receivable, net

     59,765        82,182   

Income tax receivable / prepaid income tax

     2,648        2,760   

Current portion of deferred income taxes

     37,330        36,191   

Other current assets

     13,716        14,708   
  

 

 

   

 

 

 

Total current assets

     189,009        213,487   

Cash and cash equivalents – restricted, less current portion

     625        434   

Property and equipment, net

     17,087        16,944   

Intangible assets, net

     30,316        41,078   

Goodwill

     372,445        372,445   

Deferred income taxes, less current portion

     7,071        6,352   

Deposits and other assets

     10,324        11,203   
  

 

 

   

 

 

 

Total assets

   $ 626,877      $ 661,943   
  

 

 

   

 

 

 

Liabilities and stockholders’ equity

    

Current liabilities:

    

Accounts payable

   $ 9,102      $ 6,858   

Accrued compensation and related benefits

     22,629        22,168   

Other accrued expenses

     17,516        18,704   

Current portion of income taxes payable

     7,018        549   

Current portion of deferred tax liability

     662        367   

Current portion of deferred revenue

     238,590        251,890   
  

 

 

   

 

 

 

Total current liabilities

     295,517        300,536   

Other long term liabilities

     2,666        2,388   

Income taxes payable, less current portion

     16,973        16,065   

Secured loan

     73,000        67,000   

Deferred tax liability, less current portion

     3,988        1,877   

Deferred revenue, less current portion

     131,160        142,414   
  

 

 

   

 

 

 

Total liabilities

     523,304        530,280   

Stockholders’ equity:

    

Common stock

     564        548   

Additional paid-in capital

     406,828        373,229   

Treasury stock, at cost

     (360,390     (282,570

Retained earnings

     61,872        41,253   

Accumulated other comprehensive loss

     (5,301     (797
  

 

 

   

 

 

 

Total stockholders’ equity

     103,573        131,663   
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 626,877      $ 661,943   
  

 

 

   

 

 

 

See accompanying notes.

 

3


Table of Contents

Websense, Inc.

Consolidated Statements of Income

(Unaudited and in thousands, except per share amounts)

 

     Three Months Ended     Nine Months Ended  
     September 30,     September 30,     September 30,     September 30,  
     2011     2010     2011     2010  

Revenues:

        

Software and service

   $ 81,803      $ 81,152      $ 243,057      $ 238,388   

Appliance

     10,308        3,596        28,393        8,000   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

     92,111        84,748        271,450        246,388   

Cost of revenues:

        

Software and service

     10,234        11,395        30,993        33,869   

Appliance

     4,665        2,168        13,661        4,804   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total cost of revenues

     14,899        13,563        44,654        38,673   
  

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     77,212        71,185        226,796        207,715   

Operating expenses:

        

Selling and marketing

     38,445        36,428        121,285        116,134   

Research and development

     15,084        13,186        43,556        40,957   

General and administrative

     9,969        9,161        30,922        27,479   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     63,498        58,775        195,763        184,570   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

     13,714        12,410        31,033        23,145   

Interest expense

     (374     (791     (1,167     (2,834

Other income (expense), net

     204        (59     1,530        (949
  

 

 

   

 

 

   

 

 

   

 

 

 

Income before income taxes

     13,544        11,560        31,396        19,362   

Provision for income taxes

     5,426        5,779        10,777        9,626   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 8,118      $ 5,781      $ 20,619      $ 9,736   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income per share:

        

Basic net income per share

   $ 0.21      $ 0.14      $ 0.51      $ 0.23   

Diluted net income per share

   $ 0.20      $ 0.13      $ 0.50      $ 0.22   

Weighted average shares — basic

     39,575        42,200        40,081        42,622   

Weighted average shares — diluted

     40,428        42,907        41,273        43,613   

See accompanying notes.

 

4


Table of Contents

Websense, Inc.

Consolidated Statement of Stockholders’ Equity

(Unaudited and in thousands)

 

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

Balance at December 31, 2010

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

Issuance of common stock upon exercise of options

     840        9         14,452         —          —           —          14,461   

Issuance of common stock for ESPP purchase

     246        2         3,444         —          —           —          3,446   

Issuance of common stock from restricted stock units, net

     316        5         —           (2,829     —           —          (2,824

Share-based compensation expense

     —          —           14,433         —          —           —          14,433   

Net tax windfall from share-based compensation

     —          —           1,270         —          —           —          1,270   

Purchase of treasury stock

     (3,400     —           —           (74,991     —           —          (74,991

Components of comprehensive income:

                 

Net income

     —          —           —           —          20,619         —          20,619   

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

     —          —           —           —          —           (1,693     (1,693

Translation adjustments

     —          —           —           —          —           (2,811     (2,811
                 

 

 

 

Comprehensive income

                    16,115   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Balance at September 30, 2011

     39,003      $ 564       $ 406,828       $ (360,390   $ 61,872       $ (5,301   $ 103,573   
  

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

See accompanying notes.

 

5


Table of Contents

Websense, Inc.

Consolidated Statements of Cash Flows

(Unaudited and in thousands)

 

     Nine Months Ended  
     September 30,     September 30,  
     2011     2010  

Operating activities:

    

Net income

   $ 20,619      $ 9,736   

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

    

Depreciation and amortization

     19,716        28,037   

Share-based compensation

     14,433        17,496   

Deferred income taxes

     (360     (4,352

Unrealized gain on foreign exchange

     (47     (14

Excess tax benefit from share-based compensation

     (2,267     (1,220

Changes in operating assets and liabilities:

    

Accounts receivable

     21,149        30,939   

Other assets

     470        (3,863

Accounts payable

     2,244        2,914   

Accrued compensation and related benefits

     533        (1,577

Other liabilities

     (3,385     (3,152

Deferred revenue

     (24,575     (10,682

Income taxes payable and receivable/prepaid

     8,722        11,814   
  

 

 

   

 

 

 

Net cash provided by operating activities

     57,252        76,076   
  

 

 

   

 

 

 

Investing activities:

    

Change in restricted cash and cash equivalents

     33        (197

Purchase of property and equipment

     (7,176     (6,162

Purchase of intangible assets

     (500     —     
  

 

 

   

 

 

 

Net cash used in investing activities

     (7,643     (6,359
  

 

 

   

 

 

 

Financing activities:

    

Proceeds from secured loan

     87,000        —     

Principal payments on secured loan

     (81,000     (20,000

Principal payments on capital lease obligation

     (569     (532

Proceeds from exercise of stock options

     14,461        12,217   

Proceeds from issuance of common stock for stock purchase plan

     3,446        3,131   

Excess tax benefit from share-based compensation

     2,267        1,220   

Tax payments related to restricted stock unit issuances

     (2,824     (2,736

Purchase of treasury stock

     (73,998     (59,714
  

 

 

   

 

 

 

Net cash used in financing activities

     (51,217     (66,414
  

 

 

   

 

 

 

Effect of exchange rate changes on cash and cash equivalents

     (232     (427

(Decrease)/Increase in cash and cash equivalents

     (1,840     2,876   

Cash and cash equivalents at beginning of period

     77,390        82,862   
  

 

 

   

 

 

 

Cash and cash equivalents at end of period

   $ 75,550      $ 85,738   
  

 

 

   

 

 

 

Supplemental disclosures of cash flow information:

    

Income taxes paid, net of refunds

   $ 5,045      $ 2,850   

Interest paid

   $ 968      $ 2,332   

Change in operating assets and liabilities for unsettled purchase of treasury stock and exercise of stock options

   $ 994      $ 284   

Capital lease obligation incurred for a software license arrangement

   $ —        $ 1,688   

See accompanying notes.

 

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Table of Contents

Websense, Inc.

Notes To Consolidated Financial Statements (Unaudited)

1. Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in conformity with United States generally accepted accounting principles (“GAAP”) for interim financial statements and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information or footnote disclosures normally included in complete financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). In the opinion of management, the statements include all adjustments necessary, which are of a normal and recurring nature, for the fair presentation of our financial position and results of operations for the interim periods presented.

These financial statements should be read in conjunction with the audited consolidated financial statements and notes for the fiscal year ended December 31, 2010, included in Websense, Inc.’s Annual Report on Form 10-K filed with the SEC. Operating results for the three and nine months ended September 30, 2011 are not necessarily indicative of the results that may be expected for any other interim period or for the fiscal year ending December 31, 2011. The balance sheet at December 31, 2010 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by GAAP for complete financial statements.

Other than the adoption of new accounting standards related to revenue recognition and the change in functional currency designations for certain subsidiaries, each as discussed below, there have been no material changes to the Company’s significant accounting policies as compared to the significant accounting policies described in the Annual Report on Form 10-K for the fiscal year ended December 31, 2010.

Revenue Recognition

The Company is 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. The Company provides its solutions 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 majority of the Company’s revenues are derived from software and SaaS sold on a subscription basis. A subscription is generally 12, 24 or 36 months in duration and for a fixed number of seats. The Company recognizes revenues for the software and SaaS subscriptions, including any related technical support and professional services, 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 software access codes to customers 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 the invoice date.

In October 2009, the Financial Accounting Standards Board (“FASB”) amended the accounting standards for revenue recognition to remove from the scope of industry-specific software revenue recognition guidance any tangible products containing software components and non-software components that operate together to deliver the product’s essential functionality. In addition, the FASB amended the accounting standards for certain multiple element revenue arrangements to:

 

   

provide updated guidance on whether multiple elements exist, how the elements in an arrangement should be separated and how the arrangement consideration should be allocated to the separate elements; and

 

   

require an entity to allocate arrangement consideration to each element based on a selling price hierarchy, where the selling price for an element is based on vendor-specific objective evidence (“VSOE”), if available; third-party evidence (“TPE”), if available and VSOE is not available; or the best estimate of selling price (“BESP”), if neither VSOE nor TPE is available.

The Company adopted the amended standards as of January 1, 2011 on a prospective basis for transactions entered into or materially modified after December 31, 2010.

A portion of the Company’s revenues are generated from the sale of appliances, which are standard server hardware platforms optimized for the Company’s software products. These appliances contain software components such as operating systems that operate together with the hardware platform to provide the essential functionality of the appliance. Based on the amended accounting standards, when sold in a multiple element arrangement that includes software deliverables, the Company’s hardware appliances are considered non-software deliverables and are no longer accounted for under the industry-specific software revenue recognition guidance. When appliance orders are taken, the Company ships the product, invoices the customer and recognizes revenues when title/risk of loss passes to the buyer (typically upon delivery to a common carrier) and the other criteria of revenue recognition are met. The revenue recognized is based upon BESP, as outlined further below.

 

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Table of Contents

The Company also enters into multiple element revenue arrangements in which a customer may purchase a combination of software or SaaS subscriptions, appliances, appliance and software upgrades, technical support and professional services.

For transactions entered into prior to the adoption of the amended revenue standards on January 1, 2011, all elements in a multiple element arrangement containing software were treated as a single unit of accounting as the Company did not have adequate support for VSOE of undelivered elements. As a result, the Company deferred revenue on its multiple element arrangements until only the post-contract customer support (database updates and technical support) or other services not essential to the functionality of the software remained undelivered. At that point, the revenues were amortized over the remaining life of the software subscription or estimated delivery term of the services, whichever was longer.

For transactions entered into subsequent to the adoption of the amended revenue recognition standards that are multiple element arrangements, the Company allocates the arrangement fee to the software-related elements and the non-software-related elements based upon the relative selling price of such element. When applying the relative selling price method, the Company determines the selling price for each element using BESP, because VSOE and TPE are not available. The revenues allocated to the software-related elements are recognized based on the industry-specific software revenue recognition guidance that remains unchanged. The revenues allocated to the non-software-related elements are recognized based on the nature of the element provided the fee is fixed or determinable, persuasive evidence of an arrangement exists, delivery has occurred and collectability is reasonably assured. The manner in which the Company accounts for multiple element arrangements that contain only software and software-related elements remains unchanged.

The Company determines BESP for an individual element within a multiple element revenue arrangement using the same methods utilized to determine the selling price of an element sold on a standalone basis. The Company estimates the selling price by considering internal factors such as historical pricing practices and gross margin objectives. Consideration is also given to market conditions such as competitor pricing strategies, customer demands and geography. The Company regularly reviews BESP and maintains internal controls over the establishment and updates of these estimates.

During the three and nine month periods ended September 30, 2011, the Company recognized $10.3 million and $28.4 million, respectively, in revenues from appliance sales, of which $7.7 million and $19.1 million, respectively, represented the immediate recognition of revenues upon shipment and the remaining $2.6 million and $9.3 million, respectively, represented primarily the ratable recognition of deferred revenue from appliance sales recorded prior to the adoption of the amended revenue recognition rules. Had the Company not adopted the amended revenue recognition rules, the amount of revenues recognized from appliance sales would have been $5.3 million and $14.6 million for the three and nine month periods ended September 30, 2011, respectively. The new accounting guidance for revenue recognition is expected to continue to have a significant effect on total revenues in future periods, although the impact on the timing and pattern of revenues will vary depending on the nature and volume of new or materially modified contracts in any given period.

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 revenues associated with the OEM contracts ratably over the contractual period for which the Company is obligated to provide 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 distributor marketing payments and channel rebates as an offset to revenues, unless it receives an identifiable benefit in exchange for the consideration and it can estimate the fair value of the benefit received. The Company recognizes distributor marketing payments as an offset to revenues in the period the marketing service is provided and it recognizes channel rebates as an offset to revenues on a straight-line basis over the term of the corresponding subscription agreement.

Functional Currency Designations

As of December 31, 2010, the Company’s international subsidiaries used the U.S. dollar as their functional currencies. In connection with the completion of a global restructuring of the Company’s international distribution operations during 2010 that became effective at the beginning of 2011, the Company reassessed the functional currency designation of each of its subsidiaries and determined that a change in functional currency from the U.S. dollar to the respective local currency for certain of its subsidiaries was appropriate as the primary economic environment in which these entities operate changed as a result of the restructuring. The change in functional currency designation was made prospectively effective as of the beginning of fiscal year 2011 and the adjustment from translating these subsidiaries’ financial statements from the respective local currency to the U.S. dollar was recorded as a separate component of accumulated other comprehensive loss. Foreign currency translation adjustments generally reflect the translation of the balance sheet at period end exchange rates and the income statement at an average exchange rate in effect during the respective period. Upon the change in functional currency, the Company recorded a cumulative translation loss adjustment of approximately $1.4 million, which is included in the consolidated balance sheets.

 

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2. Net Income Per Share

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

Potentially dilutive securities totaling approximately 4,260,000 and 6,188,000 weighted average shares for the three months ended September 30, 2011 and 2010, respectively, and approximately 3,656,000 and 5,618,000 weighted average shares for the nine months ended September 30, 2011 and 2010, respectively, were excluded from the diluted EPS calculation because of their anti-dilutive effect.

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

 

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

For the Three Months Ended:

        

September 30, 2011:

        

Basic EPS

   $ 8,118         39,575       $ 0.21   

Effect of dilutive securities

     —           853         (0.01
  

 

 

    

 

 

    

 

 

 

Diluted EPS

   $ 8,118         40,428       $ 0.20   
  

 

 

    

 

 

    

 

 

 

September 30, 2010:

        

Basic EPS

   $ 5,781         42,200       $ 0.14   

Effect of dilutive securities

     —           707         (0.01
  

 

 

    

 

 

    

 

 

 

Diluted EPS

   $ 5,781         42,907       $ 0.13   
  

 

 

    

 

 

    

 

 

 

 

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

For the Nine Months Ended:

        

September 30, 2011:

        

Basic EPS

   $ 20,619         40,081       $ 0.51   

Effect of dilutive securities

     —           1,192         (0.01
  

 

 

    

 

 

    

 

 

 

Diluted EPS

   $ 20,619         41,273       $ 0.50   
  

 

 

    

 

 

    

 

 

 

September 30, 2010:

        

Basic EPS

   $ 9,736         42,622       $ 0.23   

Effect of dilutive securities

     —           991         (0.01
  

 

 

    

 

 

    

 

 

 

Diluted EPS

   $ 9,736         43,613       $ 0.22   
  

 

 

    

 

 

    

 

 

 

 

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3. Comprehensive Income

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

 

00000 00000 00000 00000
     Three Months Ended      Nine Months Ended  
     September 30,
2011
    September 30,
2010
     September 30,
2011
    September 30,
2010
 

Net income

   $ 8,118      $ 5,781       $ 20,619      $ 9,736   

Net change in unrealized gain on derivative contracts, net of tax (benefit)/expense of ($655), $80, ($1,128) and $255, respectively

     (983     152         (1,693     393   

Translation adjustment

     (1,122     —           (2,811     —     
  

 

 

   

 

 

    

 

 

   

 

 

 

Comprehensive income

   $ 6,013      $ 5,933       $ 16,115      $ 10,129   
  

 

 

   

 

 

    

 

 

   

 

 

 

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

 

00000 00000 00000 00000
     Three Months Ended     Nine Months Ended  
     September 30,
2011
    September 30,
2010
    September 30,
2011
    September 30,
2010
 

Beginning balance

   $ 118      $ (128   $ 828      $ (369

Net change during the period

     (983     152        (1,693     393   
  

 

 

   

 

 

   

 

 

   

 

 

 

Ending balance

   $ (865   $ 24      $ (865   $ 24   
  

 

 

   

 

 

   

 

 

   

 

 

 

The translation adjustments included in “Accumulated other comprehensive loss” were as follows (in thousands):

 

00000 00000 00000 00000
     Three Months Ended     Nine Months Ended  
     September 30,
2011
    September 30,
2010
    September 30,
2011
    September 30,
2010
 

Beginning balance

   $ (3,314   $ (1,625   $ (1,625   $ (1,625

Net change during the period

     (1,122     —          (2,811     —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Ending balance

   $ (4,436   $ (1,625   $ (4,436   $ (1,625
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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4. Intangible Assets

Intangible assets subject to amortization consisted of the following as of September 30, 2011 (in thousands):

 

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

Technology

     3.2       $ 16,469       $ (11,822   $ 4,647   

Customer relationships

     4.8         126,200         (100,556     25,644   

Trade name

     0.3         510         (485     25   
     

 

 

    

 

 

   

 

 

 

Total

     4.6       $ 143,179       $ (112,863   $ 30,316   
     

 

 

    

 

 

   

 

 

 

As of September 30, 2011, remaining amortization expense is expected to be as follows (in thousands):

 

Years Ending December 31,

  

2011

   $ 3,874   

2012

     8,477   

2013

     5,725   

2014

     4,693   

2015

     3,867   

Thereafter

     3,680   
  

 

 

 

Total expected amortization expense

   $ 30,316   
  

 

 

 

5. 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 used the proceeds to repay the term loan under the 2007 Credit Agreement 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 will borrow and make repayments under the revolving credit facility depending on its liquidity position. During the first nine months of 2011, the Company borrowed $87 million and made repayments of $81 million under its revolving credit facility. 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 (i) the highest of (a) the federal funds rate plus 0.5%, (b) the Eurodollar rate plus 1.00% and (c) Bank of America’s prime rate, plus (ii) 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 September 30, 2011, the Company’s weighted average interest rate was 1.98%.

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 0.25% of the unused portion of the credit facility.

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 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.

 

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Table of Contents

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 is included in the line item “Secured loan” on our consolidated balance sheets. As of September 30, 2011, future remaining minimum principal payments under the secured loan will be due in October 2015 when the revolving credit facility matures.

6. Fair Value Measurements and Derivatives

Fair Value Measurements on a Recurring Basis

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

The following table presents the values of balance sheet accounts measured at fair value on a recurring basis as of September 30, 2011 (in thousands):

 

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

Assets:

          

Cash equivalents - money market funds

   $ 1,558       $ —        $ —         $ 1,558   

Foreign currency forward contracts not designated as hedges

     —           623        —           623   

Liabilities:

          

Interest rate swap

     —           (1,443     —           (1,443

Foreign currency forward contracts not designated as hedges

     —           (514     —           (514

 

  (1)   –  

quoted prices in active markets for identical assets or liabilities

  (2)   –  

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

  (3)   –  

no observable pricing inputs in the market

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

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 the 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. The interest rate swap was designated as a cash flow hedge. Under hedge accounting, the effective portion of the derivative fair value gains or losses is deferred in accumulated other comprehensive loss.

        During the nine months ended September 30, 2011 and 2010, the Company utilized Euro, British Pound and Australian Dollar foreign currency forward contracts to hedge anticipated foreign currency denominated net monetary assets. All such contracts entered into were designated as fair value hedges and were not required to be tested for effectiveness as hedge accounting was not elected. The gains related to the contracts designated as fair value hedges are included in other income (expense), net, in the accompanying consolidated statements of income and amounted to approximately $155,000 and $(766,000) for the three months ended September 30, 2011 and 2010, respectively, and $166,000 and $405,000 for the nine months ended September 30, 2011 and 2010, respectively. All of the fair value hedging contracts in place as of September 30, 2011 are scheduled to be settled before January 2012.

 

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Table of Contents

Notional and fair values of the Company’s foreign currency hedging positions at September 30, 2011 and December 31, 2010 are presented in the table below (in thousands):

 

     September 30, 2011      December 31, 2010  
     Notional
Value
Local
Currency
     Notional
Value
USD
     Fair
Value
USD
     Notional
Value
Local
Currency
     Notional
Value
USD
     Fair
Value
USD
 

Fair Value Hedges

                 

Euro (net sold)

     7,250       $ 10,264       $ 9,735         8,550       $ 11,405       $ 11,449   

British Pound (net sold)

     —           —           —           1,250         1,938         1,958   

Australian Dollar (net purchased)

     6,243         6,428         5,945         —           —           —     

The effects of derivative instruments on the Company’s financial statements were as follows as of September 30, 2011 and December 31, 2010 and for the three and nine months ended September 30, 2011 and 2010 (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  
    

Balance Sheet Location

  September 30,
2011
    December 31,
2010
 

Interest rate contracts designated as cash flow hedges

   (Other accrued expenses)/
other assets
  $ (265   $ 1,379   
   (Other long term liabilities)     (1,178     —     

Currency contracts not designated as hedges

   Other assets /
(other accrued expenses)
    623        (64
   (Other accrued expenses)     (514     —     
    

 

 

   

 

 

 

Total derivatives

     $ (1,334   $ 1,315   
    

 

 

   

 

 

 

 

Amount of Gain (Loss) Recognized in

Accumulated OCI on Derivatives (Effective Portion)

    

Location and Amount of Gain (Loss) Reclassified from

Accumulated OCI into Income (Effective Portion)

 

Derivatives in Cash

Flow Hedging

Relationships

  
Three Months Ended September 30,
    

Derivatives in Cash

Flow Hedging

Relationships

  
Three Months Ended September 30,
 
   2011     2010         2011      2010  

Interest rate contracts

   $ (983   $ 73       Interest expense    $ —         $ (121

Currency contracts

     —          79       R&D      —           (18
  

 

 

   

 

 

       

 

 

    

 

 

 

Total

   $ (983   $ 152          $ —         $ (139
  

 

 

   

 

 

       

 

 

    

 

 

 

 

    

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

 
          Three Months Ended
September 30,
 

Derivatives Not Designated as Hedges

        2011      2010  

Currency forward contracts

   Other income (expense), net    $ 155       $ (766

 

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

  
Nine Months Ended September 30,
    

Derivatives in Cash

Flow Hedging

Relationships

  
Nine Months Ended September 30,
 
   2011     2010         2011      2010  

Interest rate contracts

   $ (1,693   $ 369       Interest expense    $ —         $ (625

Currency contracts

     —          24       R&D      —           (33
  

 

 

   

 

 

       

 

 

    

 

 

 

Total

   $ (1,693   $ 393          $ —         $ (658
  

 

 

   

 

 

       

 

 

    

 

 

 

 

    

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

 
          Nine Months Ended
September 30,
 

Derivatives Not Designated as Hedges

        2011      2010  

Currency forward contracts

   Other income, net    $ 166       $ 405   

 

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Table of Contents

Fair Value Measurements on a Nonrecurring Basis

During the nine months ended September 30, 2011, the Company did not re-measure any nonfinancial assets and liabilities measured at fair value on a nonrecurring basis (e.g., goodwill, intangible assets, property and equipment and nonfinancial assets and liabilities initially measured at fair value in a business combination). As of September 30, 2011, the Company’s secured loan, with a carrying value of $73.0 million, had an estimated fair value of $73.1 million which the Company determined using a discounted cash flow model with a discount rate of 2.0% which represents the Company’s estimated incremental borrowing rate.

7. Stockholders’ Equity

Share-Based Compensation

Employee Stock Plans

The following table summarizes the Company’s restricted stock unit activity since December 31, 2010:

 

     Number of
Shares
    Weighted
Average
Fair
Value
 

Balance at December 31, 2010

     1,348,147      $ 17.03   

Granted

     962,277        21.30   

Released

     (450,438     21.32   

Canceled

     (281,073     17.58   
  

 

 

   

Balance at September 30, 2011

     1,578,913        19.60   
  

 

 

   

The following table summarizes the Company’s stock option activity since December 31, 2010:

 

     Number of
Shares
    Weighted
Average
Exercise
Price
 

Balance at December 31, 2010

     7,880,754      $ 22.39   

Granted

     66,000        23.99   

Exercised

     (839,813     17.22   

Canceled

     (314,178     21.41   
  

 

 

   

Balance at September 30, 2011

     6,792,763        23.09   
  

 

 

   

The results of operations for the three and nine months ended September 30, 2011 and 2010 include share-based compensation expense in the following expense categories of the consolidated statements of income (in thousands):

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2011      2010      2011      2010  

Share-based compensation in:

           

Cost of revenues

   $ 276       $ 294       $ 829       $ 990   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total share-based compensation in cost of revenues

     276         294         829         990   

Selling and marketing

     1,333         1,569         4,311         5,449   

Research and development

     961         1,126         2,887         4,135   

General and administrative

     1,710         1,794         6,406         6,922   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total share-based compensation in operating expenses

     4,004         4,489         13,604         16,506   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total share-based compensation

   $ 4,280       $ 4,783       $ 14,433       $ 17,496   
  

 

 

    

 

 

    

 

 

    

 

 

 

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

 

    Three Months Ended September 30,     Nine Months Ended September 30,  
    2011     2010     2011     2010  

Average expected life (years)

    3.4        3.4        3.4        3.4   

Average expected volatility factor

    42.6     42.6     42.1     42.4

Average risk-free interest rate

    0.5     0.9     1.1     1.4

Average expected dividend yield

    —          —          —          —     

 

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Table of Contents

Treasury Stock

The Company repurchased shares of its common stock under its stock repurchase program during the first nine months of 2011 as follows:

 

     Number of
Shares
     Average
Price Per
Share
 

Shares repurchased through December 31, 2010

     15,624,519       $ 19.83   

Shares repurchased during the nine months ended September 30, 2011

     3,400,011         22.05   
  

 

 

    

Total shares repurchased through September 30, 2011

     19,024,530         20.23   
  

 

 

    

The remaining number of shares authorized for repurchase under the Company’s program as of September 30, 2011 was 4,975,470 shares. The 2010 Credit Agreement permits the Company to repurchase its securities so long as it is not in default under the 2010 Credit Agreement, has complied with all of its financial covenants, and has available cash and cash equivalents (including availability under the secured revolving loan) of at least $20 million; provided, however, if, after giving effect to any repurchase, the Company’s leverage ratio is greater than 1.75:1, such repurchase cannot exceed $10 million in the aggregate in any fiscal year.

8. Tax Matters

For the three months ended September 30, 2011 the Company recognized an income tax expense of $5.4 million which represents an effective tax rate of 40.1%. For the nine months ended September 30, 2011 the Company recognized an income tax expense of $10.8 million which represents an effective tax rate of 34.3%. The effective tax rate variance from the U.S. federal statutory rate for the three months ended September 30, 2011 is primarily related to the unfavorable impact of foreign withholding taxes, non-deductible share-based payments and increased earnings in higher tax rate jurisdictions. The effective tax rate variance from the U.S. federal statutory rate for the nine months ended September 30, 2011 is primarily related to the unfavorable impacts noted above, offset by a nonrecurring net discrete tax benefit of $2.8 million related primarily to our global distribution restructuring which was completed during 2010 and became effective at the beginning of 2011. This $2.8 million net tax benefit primarily relates to the nonrecurring tax effect from the transfer of customer relationship intangible assets and the related deferred tax liabilities from a higher tax rate jurisdiction to a lower tax rate jurisdiction. The entire net tax benefit of $2.8 million was reflected in the first quarter of 2011 upon completion of our global distribution restructuring and is not expected to recur.

The Company and its subsidiaries file tax returns which are routinely examined by tax authorities in the U.S. and in various state and foreign jurisdictions. The Company is currently under examination by the respective tax authorities for tax years 2005 to 2009 in the United States, for 2005 to 2008 in the United Kingdom and for 2006 to 2010 in Israel. The Company has various other on-going audits in various stages of completion. In general, the tax years 2005 through 2010 could be subject to examination by U.S. federal and most state tax authorities. In significant foreign jurisdictions, tax years 2005 through 2010 could be subject to examination by the respective tax authorities.

During the first quarter of 2010, the Company was informed by the U.S. Internal Revenue Service (the “IRS”) that they had completed their audit for the tax years ended December 31, 2005 through December 31, 2007. Accordingly, the IRS issued the Company a 30-day letter which outlined all of their proposed audit adjustments and required the Company to either accept the proposed adjustments, subject to future litigation, or file a formal administrative protest contesting those proposed adjustments within 30 days. The proposed adjustments relate primarily to the cost sharing arrangement between Websense, Inc. and its Irish subsidiary, including the amount of cost sharing buy-in, as well as to the Company’s claim of research and development tax credits and income tax deductions for equity compensation awarded to certain executive officers. The amount of additional tax proposed by the IRS totals approximately $19.0 million, of which $14.8 million relates to the amount of cost sharing buy-in, $2.5 million relates to research and development credits and $1.7 million relates to equity compensation awarded to certain executive officers. The total additional tax proposed excludes interest, penalties and state income taxes, each of which may be significant, and also excludes a potential reduction in tax on the Irish subsidiary. The proposed adjustments also do not include the future impact that changes in the Company’s cost sharing arrangement could have on the Company’s effective tax rate. The Company disagrees with all of the proposed adjustments and has submitted a formal protest to the IRS for each matter. The IRS assigned the Company’s case to an IRS Appeals Officer and the appeals process commenced during the second quarter of 2011. In the third quarter of 2011, the IRS withdrew the proposed adjustment relating to equity compensation of $1.7 million resulting in no additional tax liability. This reduces the amount of the additional tax proposed by the IRS for the tax years ended December 31, 2005 through December 31, 2007 to approximately $17.3 million. The Company intends to continue to defend its position on the remaining matters at the IRS Appeals Office, including through litigation if required. The timing of the ultimate resolution of these matters cannot be reasonably estimated at this time, however, the Company expects the appeals process to continue throughout the remainder of 2011.

 

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9. Litigation

On July 12, 2010, Finjan, Inc. filed a complaint entitled Finjan, Inc. v. McAfee, Inc., Symantec Corp., Webroot Software, Inc., Websense, Inc. and Sophos, Inc. in the United States District Court for the District of Delaware. The complaint alleges that the Company’s making, using, importing, selling and/or offering for sale Websense Web Filter, Websense Web Security and Websense Web Security Gateway infringes U.S. Patent No. 6,092,194 (“194 Patent”). Finjan, Inc. seeks an injunction from further infringement of the 194 Patent and damages. The court has set a date of January 30, 2012 for a hearing on the construction of the claims in the 194 Patent. The Company denies infringing any valid claims of the 194 Patent and intends to vigorously defend the lawsuit.

The Company is involved in various other legal actions in the normal course of business. Based on current information, including consultation with the Company’s attorneys, management believes it has adequately reserved for any ultimate liability that may result from these actions, including the Finjan litigation, such that any liability would not materially affect the Company’s consolidated financial position, results of operations or cash flows. It is reasonably possible that the ultimate liability for these matters will be greater than the amount the Company has accrued for; however, management is not able to estimate any amount over what it has already accrued for at this time. Management’s evaluation of the likely impact of these actions could change in the future and unfavorable outcomes and/or defense costs, depending upon the amount and timing, could have a material adverse effect on the Company’s results of operations or cash flows in a future period.

 

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

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

Forward-Looking Statements

This report on Form 10-Q 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 revenues 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 foreign 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;

 

   

risks related to compliance with the covenants in our credit agreement;

 

   

risks associated with launching new product offerings;

 

   

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

 

   

risks related to changes in accounting interpretations or accounting guidance;

 

   

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

 

   

the success of our brand development efforts.

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

 

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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 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. 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 Web 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 against 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 valuable computing resources, including unauthorized downloading of high-bandwidth content; and

 

   

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

Since we commenced operations in 1994, Websense has evolved from a reseller of computer security products to a leading developer and provider of information technology (“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 the three and nine months ended September 30, 2011, we derived 50% of our revenues from international sales, as compared to 50% and 51% during the three and nine months ended September 30, 2010, respectively. The United Kingdom comprised approximately 11% of our total revenues in the three and nine months ended September 30, 2011 compared to 12% and 13% in the three and nine months ended September 30, 2010, 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 multi-tiered distribution strategy globally to sell our products through distributors and value-added resellers. Sales through indirect channels currently account for more than 90% of our revenues. We also have several arrangements with OEMs that grant the OEM customers the right to incorporate our products into the OEM customers’ products for resale to end users.

We sell subscriptions to our software and SaaS 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 revenues from subscriptions to our software and SaaS 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 revenues 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 agreement and are fully expensed in the period the product and/or software activation key is delivered. Our operating expenses, including cost of revenues, in the first nine months of 2011 increased compared to the first nine months of 2010, primarily due to increased cost of revenues from the immediate recognition of appliance cost of sales as a result of the adoption of the new revenue recognition accounting standards and our increased headcount, partially offset by a reduction in the amortization of acquired intangible assets of $8.1 million.

Billings represent the amount of subscription contracts, OEM royalties and appliance sales billed to customers during the applicable period. Our primarily subscription-based business model operates such that subscription 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 United States generally accepted accounting principles (“GAAP”). We provide this measurement (net of distributor marketing payments, channel rebates and adjustments to the allowance for doubtful accounts) 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.

 

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Billings to end-user customers increased 15% year-over-year from $73.0 million in the third quarter of 2010 to $83.8 million in the third quarter of 2011. Billings from OEM arrangements declined from $4.4 million in the third quarter of 2010 to $0.5 million in the third quarter of 2011. Our total billings, including our OEM business, grew 9% from $77.4 million during the third quarter of 2010 to $84.3 million during the third quarter of 2011. Billings from our TRITON™ solution products accounted for 54% of total billings in the third quarter of 2011 and grew 50% year-over-year from $30.1 million in the third quarter of 2010 to $45.2 million in the third quarter of 2011, whereas billings from our non-TRITON solution products declined from $42.9 million in the third quarter of 2010 to $38.6 million in the third quarter of 2011. Our TRITON solutions include our TRITON family of security gateways for web, email and data security (including appliances), our standalone data security suite and our cloud-based security solutions. Our non-TRITON solutions include our Web filtering products, such as our Web security suite, on-premises e-mail security and related hardware. Our appliance billings increased from $5.2 million in the third quarter of 2010 to $8.0 million in the third quarter of 2011. Billings from incremental sales, which includes product purchases by new customers and the purchase of additional products or upgrades by existing customers, increased from $22.2 million in the third quarter of 2010 to $23.8 million in the third quarter of 2011, which increase was driven by increased sales of our TRITON solution products. Our international billings to end-user customers represented $37.0 million or 44% of our total billings for the third quarter of 2011 compared to $35.2 million or 48% of total billings for the third quarter of 2010. The decrease in the percentage of total billings represented by international billings to end-user customers from the third quarter of 2010 to the third quarter of 2011 was primarily due to strong billings performance in the U.S. in the third quarter of 2011 compared to slower billings growth in continental Europe. The average annual value of each subscription sold during the third quarter of 2011 was $10,700 compared to $8,700 during the third quarter of 2010, reflecting increased sales of our TRITON advanced security solutions, including Web Security Gateway and email and data security products to larger enterprise customers. Our average contract duration increased from 21.8 months for the third quarter of 2010 to 23.1 months for the third quarter of 2011, with approximately 51% of our billings in 12 month contracts, 8% in 24 month contracts and 41% in contracts with durations of 36 months or more. We expect our billings to grow for the remainder of 2011 relative to 2010 billings. Our billings depend in part on the number of subscriptions up for renewal each quarter and are affected by seasonal variations, with the fourth quarter generally being our strongest quarter in billings, and the first quarter generally being our lowest quarter for billings each fiscal year. As a trend, the percentage of billings from subscriptions to our TRITON advanced security 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 international distribution operations, which we anticipate will reduce the complexity and compliance risks associated with our global distribution activities. We expect that the restructuring will also reduce our GAAP effective tax rate relative to the GAAP effective tax rate that would have applied absent the restructuring because we expect to reduce our taxable income in certain foreign jurisdictions and expect to increase our taxable income in a foreign jurisdiction with a lower tax rate where we streamlined and consolidated the ownership of our intellectual property and distribution rights. The restructuring did not materially impact our U.S. business operations or the relative amount of taxable income in the U.S. versus outside the U.S. While we anticipate that our GAAP effective tax rate will be lower than it would have been without the restructuring, we cannot predict whether the GAAP effective tax rate in any particular period will be less than the GAAP effective tax rate in the immediately preceding prior period or in the comparable period of the prior fiscal year. The actual impact of the restructuring on our GAAP effective tax rate is highly dependent on our future results of operations.

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”). This $225 million senior credit facility consisted of a five year $210 million senior secured term loan and a $15 million revolving credit facility (the “2007 Credit Facility”). In October 2010, the Company entered into a new credit agreement (the “2010 Credit Agreement”) and used the proceeds to repay the term loan under the 2007 Credit Agreement and retired the 2007 Credit Facility. 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 “2010 Credit Facility”). See “Liquidity and Capital Resources” for further discussion of the terms of the 2010 Credit Agreement.

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. The majority of our revenues are derived from software and SaaS products sold on a subscription basis. A subscription is generally 12, 24 or 36 months in duration and for a fixed number of seats. We recognize revenues for the software and SaaS subscriptions, including any related technical support and professional services, 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 software access codes to customers and then promptly invoice 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.

In October 2009, the Financial Accounting Standards Board (“FASB”) amended the accounting standards for revenue recognition to remove from the scope of industry-specific software revenue recognition guidance any tangible products containing software components and non-software components that operate together to deliver the product’s essential functionality.

 

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In addition, the FASB amended the accounting standards for certain multiple element revenue arrangements to:

 

   

provide updated guidance on whether multiple elements exist, how the elements in an arrangement should be separated, and how the arrangement consideration should be allocated to the separate elements; and

 

   

require an entity to allocate arrangement consideration to each element based on a selling price hierarchy, where the selling price for an element is based on vendor-specific objective evidence (“VSOE”), if available; third-party evidence (“TPE”), if available and VSOE is not available; or the best estimate of selling price (“BESP”), if neither VSOE nor TPE is available.

We adopted the amended standards as of January 1, 2011 on a prospective basis for transactions entered into or materially modified after December 31, 2010.

A portion of our revenues are generated from the sale of appliances, which are standard server hardware platforms optimized for our software products. These appliances contain software components such as operating systems that operate together with the hardware platform to provide the essential functionality of the appliance. Based on the amended accounting standards, when sold in a multiple element arrangement that includes software deliverables, our hardware appliances are considered non-software deliverables and are no longer accounted for under the industry-specific software revenue recognition guidance. When appliance orders are taken, we ship the product, invoice the customer and recognize revenues when title/risk of loss passes to the buyer (typically upon delivery to a common carrier) and the other criteria of revenue recognition are met. The revenues recognized are based upon BESP, as outlined further below.

We also enter into multiple element revenue arrangements in which a customer may purchase a combination of software or SaaS subscriptions, appliances, appliance and software upgrades, technical support and professional services.

For transactions entered into prior to the adoption of the amended revenue standards on January 1, 2011, all elements in a multiple element arrangement containing software were treated as a single unit of accounting as we did not have adequate support for VSOE of undelivered elements. As a result, we deferred revenue on our multiple element arrangements until only the post-contract customer support (database updates and technical support) or other services not essential to the functionality of the software remained undelivered. At that point, the revenue was amortized over the remaining life of the software subscription or estimated delivery term of the services, whichever was longer.

For transactions entered into subsequent to the adoption of the amended revenue recognition standards that are multiple element arrangements, we allocate the arrangement fee to the software-related elements and the non-software-related elements based upon the relative selling price of such element. When applying the relative selling price method, we determine the selling price for each element using BESP, because VSOE and TPE are not available. The revenues allocated to the software-related elements are recognized based on the industry-specific software revenue recognition guidance that remains unchanged. The revenues allocated to the non-software-related elements are recognized based on the nature of the element provided the fee is fixed or determinable, persuasive evidence of an arrangement exists, delivery has occurred and collectability is reasonably assured. The manner in which we account for multiple element arrangements that contain only software and software-related elements remains unchanged.

We determine BESP for an individual element within a multiple element revenue arrangement using the same methods utilized to determine the selling price of an element sold on a standalone basis. We estimate the selling price by considering internal factors such as historical pricing practices and gross margin objectives. Consideration is also given to market conditions such as competitor pricing strategies, customer demands and geography. As there is a significant amount of judgment when determining BESP, we regularly review all of our assumptions and inputs around BESP and maintain internal controls over the establishment and updates of these estimates.

During the three and nine months ended September 30, 2011, we recognized $10.3 million and $28.4 million, respectively, in revenues from appliance sales, of which $7.7 million and $19.1 million, respectively, represented the immediate recognition of revenue upon shipment and the remaining $2.6 million and $9.3 million, respectively, represented primarily the ratable recognition of deferred revenue from appliance sales recorded prior to the adoption of the amended revenue recognition rules. We expect to recognize revenues throughout the remainder of 2011 of $2.1 million from appliance sales made prior to 2011 that are recorded in deferred revenue as of September 30, 2011. Had we not adopted the amended revenue recognition rules, the amount of revenues recognized from appliance sales would have been $5.3 million and $14.6 million for the three and nine months ended September 30, 2011, respectively. The new accounting guidance for revenue recognition is expected to continue to have a significant effect on total revenues in future periods, although the impact on the timing and pattern of revenues will vary depending on the nature and volume of new or materially modified contracts in any given period.

For our OEM contracts, we grant our OEM customers the right to incorporate our products into the OEMs’ products for resale to end users. The OEM customer pays us a royalty fee for each resale of our product to an end user over a specified period of time. We recognize revenues associated with the OEM contracts ratably over the contractual period for which we are obligated to provide our services to the OEM. The time period over which we recognize revenue associated with OEM contracts is determined by the contractual obligation period and will vary for each OEM depending on the information available, such as underlying end-user subscription periods. 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.

 

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We record distributor marketing payments and channel rebates as an offset to revenues, unless we receive an identifiable benefit in exchange for the consideration and we can estimate the fair value of the benefit received. We recognize distributor marketing payments as an offset to revenues in the period the marketing service is provided and we recognize channel rebates as an offset to revenues 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 roadmaps, 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. 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 generated by the asset. Our analysis is based on available information and on assumptions and projections that we consider to be reasonable and supportable. If necessary, we perform subsequent calculations to measure the amount of the impairment loss based on the excess of the carrying value over the fair value of the impaired assets.

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

At September 30, 2011, there was $39.8 million of total unrecognized compensation cost related to share-based compensation arrangements granted under all equity compensation plans (excluding tax effects). That total unrecognized compensation cost will be adjusted for estimated forfeitures as well as for future changes in estimated forfeitures. We expect to recognize that cost over a weighted average period of approximately 2.0 years.

 

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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 results of operations in the future.

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

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 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 assigned our case to an IRS Appeals Officer and the appeals process commenced during the second quarter of 2011. In the third quarter of 2011, the IRS withdrew the proposed adjustment relating to equity compensation of $1.7 million resulting in no additional tax liability. This reduces the amount of the additional tax proposed by the IRS for the tax years ended December 31, 2005 through December 31, 2007 to approximately $17.3 million. We intend to continue to defend our position on the remaining matters at the IRS Appeals Office, including through litigation if required. The timing of the ultimate resolution of these remaining matters cannot be reasonably estimated at this time, however, we expect the appeals process to continue throughout the remainder of 2011.

 

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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.

Results of Operations

Three months ended September 30, 2011 compared with the three months ended September 30, 2010

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

 

     Three Months Ended September 30,  
     2011     2010  

Revenues:

    

Software and service

     89     96

Appliance

     11        4   
  

 

 

   

 

 

 

Total revenues

     100        100   

Cost of revenues:

    

Software and service

     11        13   

Appliance

     5        3   
  

 

 

   

 

 

 

Total cost of revenues

     16        16   
  

 

 

   

 

 

 

Gross profit

     84        84   

Operating expenses:

    

Selling and marketing

     42        43   

Research and development

     16        15   

General and administrative

     11        11   
  

 

 

   

 

 

 

Total operating expenses

     69        69   
  

 

 

   

 

 

 

Income from operations

     15        15   

Interest expense

     0        (1

Other income (expense), net

     0        0   
  

 

 

   

 

 

 

Income before income taxes

     15        14   

Provision for income taxes

     6        7   
  

 

 

   

 

 

 

Net income

     9     7
  

 

 

   

 

 

 

Revenues

Software and service revenues. Software and service revenues increased to $81.8 million in the third quarter of 2011 from $81.2 million in the third quarter of 2010. The increase was primarily a result of increased incremental sales to new customers and upgrades to existing customers, as well as higher OEM revenues in the third quarter of 2011 as compared to the third quarter of 2010. Software and service revenues generated in the United States accounted for $40.6 million or 44.2% of third quarter 2011 revenues compared to $40.2 million or 47.5% of revenues in the third quarter of 2010. Software and service revenues generated internationally accounted for $41.2 million or 44.8% of third quarter 2011 revenues compared to $41.0 million or 48.5% in the third quarter of 2010. We had current deferred revenue relating to software and service revenues of $231.6 million as of September 30, 2011, compared to $224.9 million as of September 30, 2010. Of the $231.6 million in current deferred revenue as of September 30, 2011, $79.2 million is expected to be recognized as revenue in the fourth quarter of 2011. We expect our software and service revenues in the fourth quarter to exceed our revenues in the fourth quarter of 2010 due to the amount of current deferred revenue that will be recognized as revenue, subscriptions that are scheduled for renewal that are expected to be renewed and upgraded, and expected new business for which some revenues will be recognized during the fourth quarter. We expect our software and service revenues to decrease as a percentage of total revenues as appliance revenues increase at a faster rate than software and service revenues increase. Our software and service revenues in 2011 are impacted by the duration of contracts for renewal and new subscriptions, the timing of sales of renewal and new subscriptions, the average annual contract value and per seat price, the volume of OEM revenue activity and the effect of currency exchange rates on new and renewal subscriptions in international markets.

 

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Appliance revenues. Appliance revenues increased to $10.3 million in the third quarter of 2011 from $3.6 million in the third quarter of 2010. The increase was primarily a result of increased appliance sales in the third quarter of 2011 and our adoption of new revenue recognition rules (as more fully described in Note 1 to the Consolidated Financial Statements) starting January 1, 2011 under which revenues from sales of appliances are now generally recognized when sold. Accordingly, $2.6 million of the revenue recognized in the third quarter of 2011 represented primarily the ratable recognition of deferred revenue for appliance sales recorded prior to the adoption of the amended revenue recognition rules and the remaining $7.7 million represented revenues from sales of appliances sold in the third quarter of 2011. As of September 30, 2011, we had $11.6 million of remaining deferred revenue primarily for sales recorded prior to the adoption of the amended revenue recognition rules. Appliance revenues generated in the United States accounted for $5.6 million or 6.0% of third quarter 2011 revenues compared to $2.0 million or 2.3% of revenues in the third quarter of 2010. Appliance revenues generated internationally accounted for $4.7 million or 5.0% of third quarter 2011 revenues compared to $1.6 million or 1.8% in the third quarter of 2010. For the remainder of 2011, we expect our appliance revenues to increase in both absolute dollars and as a percentage of total revenues over 2010 revenue levels primarily as a result of the adoption of the new revenue recognition rules as of January 1, 2011 and expected increase in sales of our appliances.

Cost of Revenues

Software and service cost of revenues. Software and service cost of revenues consists of the costs of Web content review, amortization of acquired technology, technical support and infrastructure costs associated with maintaining our databases and costs associated with providing our hosted security services. Software and service cost of revenues decreased to $10.2 million in the third quarter of 2011 from $11.4 million in the third quarter of 2010. The $1.2 million decrease was primarily due to decreased amortization of acquired technology of $1.5 million and partially offset by increased personnel costs. The decrease in amortization of acquired technology from the third quarter of 2010 to the third quarter of 2011 was primarily due to certain acquired technology being fully amortized in 2010. As of September 30, 2011, the remaining acquired technology is being amortized over a remaining weighted average period of 3.2 years. We expect to incur $0.7 million in amortization expense of acquired technology during the remainder of 2011 and that full year 2011 levels will be lower than 2010 levels by approximately $5.9 million. Our full-time employee headcount in cost of revenues departments increased slightly from an average of 260 employees during the third quarter of 2010 to an average of 263 employees during the third quarter of 2011. We allocate the costs for human resources, employee benefits, payroll taxes, IT, facilities and fixed asset depreciation to each of our functional areas based on headcount data. As a percentage of total revenues, software and service cost of revenues decreased to 11% from 13% during the third quarter of 2011 compared to 2010. We expect software and service cost of total revenues will decrease in absolute dollars and as a percentage of revenues in 2011 as compared to 2010 primarily due to the expected increase in revenues and decreased amortization of acquired technology.

Appliance cost of revenues. Appliance cost of revenues consists of the costs associated with the sale of our appliance products. Appliance cost of revenues increased to $4.7 million in the third quarter of 2011 from $2.2 million in the third quarter of 2010. As described in the Appliance revenues section above, the $2.5 million increase was primarily due to our adoption of new revenue recognition rules under which the related costs are generally recognized when the appliances are sold. In appliance cost of revenues, we also recognized $1.1 million of the ratable cost of appliances sold prior to 2011 that were recognized in revenues in the third quarter of 2011. As a percentage of total revenues, appliance cost of revenues increased to 5% from 3% during the third quarter of 2011 compared to 2010. We expect appliance cost of revenues will increase in absolute dollars and as a percentage of total revenues in 2011 as compared to 2010 primarily due to the adoption of the new revenue recognition rules in 2011 under which the related costs are generally recognized when the appliances are sold as well as due to increased sales of our appliance products.

Gross Profit

Gross profit increased to $77.2 million in the third quarter of 2011 from $71.2 million in the third quarter of 2010 primarily as a result of increased revenues. As a percentage of total revenues, our gross profit was 84% in both the third quarter of 2011 and in the third quarter of 2010. We expect that gross profit as a percentage of total revenues will remain in excess of 80% for the remainder of 2011.

Operating Expenses

        Selling and marketing. Selling and marketing expenses consist primarily of salaries, commissions and benefits related to personnel engaged in selling, marketing and customer support functions, costs related to public relations, advertising, promotions and travel, amortization of acquired customer relationships, and other allocated costs. Selling and marketing expenses do not include payments to channel partners for marketing services and rebates as those are recorded as an offset to revenue. Selling and marketing expenses were $38.4 million, or 42% of revenues, in the third quarter of 2011, compared to $36.4 million, or 43% of revenues, in the third quarter of 2010. The $2.0 million increase in total selling and marketing expenses was primarily due to our increased personnel costs of $2.6 million and increased allocated costs of $0.6 million, partially offset by a reduction in the amortization of acquired intangibles (customer relationships) of approximately $1.2 million. Our headcount in sales and marketing increased from an average of 573 employees during the third quarter of 2010 to an average of 616 employees for the third quarter of 2011. As of September 30, 2011, the acquired customer relationships intangible assets are being amortized over a remaining weighted average period of approximately 4.8 years. We expect overall selling and marketing expenses to increase in absolute dollars for the remainder of 2011 as compared to 2010, with the reduction of amortization of acquired intangibles from the SurfControl acquisition due to the accelerated nature of the amortization being offset by additional sales and marketing personnel supporting our expanding selling and marketing efforts worldwide and increased sales resulting in higher overall sales commission expenses. If our sales exceed expectations, our sales commission expenses would also exceed our expectations and result in higher than expected selling and marketing expenses in 2011, while revenues from the higher sales of software and services would be recognized in future periods. We also expect that selling and marketing expenses as a percentage of revenues will decrease in 2011 compared to 2010 due to the expected increase in revenues. Based on the existing sales and marketing related intangible assets as of September 30, 2011, we expect amortization of sales and marketing related acquired intangibles of $3.2 million for the fourth quarter of 2011, which would be a reduction of approximately $1.2 million from 2010.

 

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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 $15.1 million, or 16% of revenues, in the third quarter of 2011 from $13.2 million, or 15% of revenues, in the third quarter of 2010. The increase of $1.9 million in research and development expenses was primarily due to increased personnel costs. Our headcount increased in research and development from an average of 456 employees for the third quarter of 2010 to an average of 495 employees for the third quarter of 2011. We expect research and development expenses to increase in absolute dollars in the fourth quarter of 2011 as compared to the fourth quarter of 2010 due to an expanded base of product offerings and increased headcount compared to 2010 to support our continued enhancements and new products. We are managing the increase in our absolute research and development expenses by operating research and development facilities in multiple international locations, including facilities in Beijing, China and Ra’anana, Israel, that have lower costs than our operations in the United States. We also have research and development facilities in Los Gatos and San Diego, California and Reading, England. While we expect research and development expenses to increase in absolute dollars for the remainder of 2011, we expect that research and development expenses as a percentage of revenues will remain relatively flat in 2011 compared to 2010 due to the expected increase in revenues.

General and administrative. General and administrative expenses consist primarily of salaries, benefits and related expenses for our executive, finance and administrative personnel, third-party professional service fees and allocated costs. General and administrative expenses increased to $10.0 million, or 11% of revenues, in the third quarter of 2011 from $9.2 million, or 11% of revenues, in the third quarter of 2010. The $0.8 million increase in general and administrative expenses was primarily due to increased personnel costs and an increase in third-party professional service fees which was largely related to the global restructuring of our international distribution operations. Our headcount in general and administrative departments decreased slightly from an average of 122 employees during the third quarter of 2010 to an average of 121 employees for the third quarter of 2011 relative to 2010. We expect general and administrative expenses to increase in absolute dollars primarily due to expected higher third-party professional service fees, but remain relatively flat as a percentage of revenues for the remainder of 2011 as compared to 2010 due to the expected increase in revenues.

Interest Expense

Interest expense decreased to $0.4 million in the third quarter of 2011 from $0.8 million in the third quarter of 2010. The decrease was primarily due to a lower average outstanding loan balance on our secured loan of $68.0 million during the third quarter of 2011 compared to an average loan balance of $69.0 million during the third quarter of 2010. In addition, the effective interest rate was lower in the third quarter of 2011 compared to 2010 primarily due to the reduction in the notional amount of principal subject to the unfavorable fixed rate swap agreement which expired on September 30, 2010 and the reduction in the margin as a result of the 2010 Credit Facility entered into in October 2010. Included in the interest expense for both the third quarter of 2011 and the third quarter of 2010 is $0.1 million of amortization of deferred financing fees that were capitalized as part of the 2010 Credit Facility and 2007 Credit Facility, as applicable. We borrowed a total of $10.0 million (net of principal payments) on the secured loan under the 2010 Credit Facility during the third quarter of 2011 and principal payments (net of borrowings) totaling $3.0 million on the secured loan under the 2007 Credit Facility during the third quarter of 2010. Primarily as a result of the reduction in the notional amount of principal subject to the unfavorable fixed rate swap agreement which expired on September 30, 2010 and the reduction in the margin as a result of the 2010 Credit Facility entered into in October 2010, our weighted average interest rate decreased from 2.51% at September 30, 2010 to 1.98% at September 30, 2011. Interest expense should decline in the remaining quarters of 2011 as compared to 2010 primarily due to the expected lower effective interest rate from our 2010 Credit Facility and the reduction in the notional amount of principal subject to the unfavorable fixed rate swap agreement which expired on September 30, 2010.

Other Income (Expense), Net

Other income (expense), net went from a net other expense of $0.1 million in the third quarter of 2010 to a net other income of $0.2 in the third quarter of 2011. Due to a continued low interest rate environment, we expect our net other income (expense) for the remainder of 2011 to be similar to 2010 levels.

 

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Provision for Income Taxes

For the three months ended September 30, 2011 we recognized an income tax expense of $5.4 million compared to an income tax expense of $5.8 million for the three months ended September 30, 2010. The effective tax rates were 40.1% for the three months ended September 30, 2011 and 50.0% for the three months ended September 30, 2010. For the third quarter of 2011, the effective tax rate variance from the U.S. federal statutory rate was primarily related to the unfavorable impact of foreign withholding taxes, non-deductible share-based payments and increased earnings in higher tax rate jurisdictions. For the third quarter of 2010, the effective tax rate variance from the U.S. federal statutory rate was primarily related to an increase in the valuation allowance related to net operating losses of one of our subsidiaries in the United Kingdom, the unfavorable impact on deferred tax amounts resulting from a California law change, a favorable state tax ruling, foreign withholding taxes and non-deductible share-based payments, which offset the benefit of income taxed at lower rates in foreign jurisdictions.

Our effective tax rate may change in future periods due to differences in the composition of taxable income between domestic and international operations along with the potential changes or interpretations in tax rules and legislation, or corresponding accounting rules. During 2010, we completed a global restructuring of our international distribution operations, which we anticipate will reduce the complexity and compliance risks associated with our global distribution activities. We expect that the restructuring will also reduce our GAAP effective tax rate relative to the GAAP effective tax rate that would have applied absent the restructuring because we expect to reduce our taxable income in certain foreign jurisdictions and expect to increase our taxable income in a foreign jurisdiction with a lower tax rate where we streamlined and consolidated the ownership of our intellectual property and distribution rights. The restructuring did not materially impact our U.S. business operations or the relative amount of taxable income in the U.S. versus outside the U.S. While we anticipate that our GAAP effective tax rate will be lower than it would have been without the global distribution restructuring, we cannot predict whether the GAAP effective tax rate in any particular period will be less than the GAAP effective tax rate in the immediately preceding prior period or in the comparable period of the prior fiscal year. The actual impact of the restructuring on our GAAP effective tax rate is highly dependent on our future results of operations.

We assess, on a quarterly basis, the ultimate realization of our deferred income tax assets. Realization of deferred income tax assets is dependent upon taxable income in prior carryback years, estimates of future taxable income, tax planning strategies and reversals of existing taxable temporary differences. Based on our assessment of these items during the third quarter of 2011, we believe that it is more-likely-than-not that we will fully realize the balance of the deferred tax assets currently reflected on our consolidated balance sheets.

Nine months ended September 30, 2011 compared with the nine months ended September 30, 2010

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

 

     Nine Months Ended September 30,  
     2011     2010  

Revenues:

    

Software and service

     90     97

Appliance

     10        3   
  

 

 

   

 

 

 

Total revenues

     100        100   

Cost of revenues:

    

Software and service

     11        14   

Appliance

     5        2   
  

 

 

   

 

 

 

Total cost of revenues

     16        16   
  

 

 

   

 

 

 

Gross profit

     84        84   

Operating expenses:

    

Selling and marketing

     45        47   

Research and development

     16        17   

General and administrative

     11        11   
  

 

 

   

 

 

 

Total operating expenses

     72        75   
  

 

 

   

 

 

 

Income from operations

     12        9   

Interest expense

     0        (1

Other income (expense), net

     0        0   
  

 

 

   

 

 

 

Income before income taxes

     12        8   

Provision for income taxes

     4        4   
  

 

 

   

 

 

 

Net income

     8     4
  

 

 

   

 

 

 

 

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Revenues

Software and service revenues. Software and service revenues increased to $243.1 million in the first nine months of 2011 from $238.4 million in the first nine months of 2010. The increase was primarily a result of increased incremental sales to new customers and upgrades to existing customers, as well as higher OEM revenues in the first nine months of 2011 as compared to the first nine months of 2010. Software and service revenues generated in the United States accounted for $121.8 million or 44.9% of the first nine months of 2011 revenues compared to $117.5 million or 47.7% of revenues in the first nine months of 2010. Software and service revenues generated internationally accounted for $121.3 million or 44.8% of the first nine months of 2011 revenues compared to $120.9 million or 49.1% in the first nine months of 2010.

Appliance revenues. Appliance revenues increased to $28.4 million in the first nine months of 2011 from $8.0 million in the first nine months of 2010. The increase was primarily a result of our adoption of new revenue recognition rules (as more fully described in Note 1 to the Consolidated Financial Statements) starting January 1, 2011 under which revenues from sales of appliances are now generally recognized when sold. Accordingly, $9.3 million of the revenues recognized in the first nine months of 2011 represented primarily the ratable recognition of deferred revenue for appliance sales recorded prior to the adoption of the amended revenue recognition rules and the remaining $19.1 million represented revenues from sales of appliances sold in the first nine months of 2011. Appliance revenues generated in the United States accounted for $14.7 million or 5.3% of the first nine months of 2011 revenues compared to $4.3 million or 1.7% of revenues in the first nine months of 2010. Appliance revenues generated internationally accounted for $13.7 million or 5.0% of the first nine months of 2011 revenues compared to $3.7 million or 1.5% in the first nine months of 2010.

Cost of Revenues

Software and service cost of revenues. Software and service cost of revenues decreased to $31.0 million in the first nine months of 2011 from $33.9 million in the first nine months of 2010. The $2.9 million decrease was primarily due to decreased amortization of acquired technology of $4.4 million and decreased allocated costs partially offset by increased personnel costs. The decrease in amortization of acquired technology from the first nine months of 2010 to the first nine months of 2011 was primarily due to certain acquired technology being fully amortized in 2010. Our full-time employee headcount in cost of revenues departments decreased from an average of 268 employees during the first nine months of 2010 to an average of 260 employees during the first nine months of 2011.

Appliance cost of revenues. Appliance cost of revenues increased to $13.7 million in the first nine months of 2011 from $4.8 million in the first nine months of 2010. As described in the Appliance revenues section above, the $8.9 million increase was primarily due to our adoption of new revenue recognition rules under which the related costs are generally recognized when the appliances are sold. In appliance cost of revenues, we also recognized $4.2 million of the ratable cost of appliances sold prior to 2011 that were recognized in revenues in the first nine months of 2011.

Gross Profit

Gross profit increased to $226.8 million in the first nine months of 2011 from $207.7 million in the first nine months of 2010 primarily as a result of increased revenues. As a percentage of total revenues, our gross profit was 84% in both the first nine months of 2011 and the first nine months of 2010.

Operating Expenses

Selling and marketing. Selling and marketing expenses were $121.3 million, or 45% of revenues, in the first nine months of 2011, compared to $116.1 million, or 47% of revenues, in the first nine months of 2010. The $5.2 million increase in total selling and marketing expenses was primarily due to our increased personnel costs of $6.8 million and increased allocated costs of $1.7 million offset by a reduction in the amortization of acquired intangibles (customer relationships) of approximately $3.6 million. Our headcount in sales and marketing increased from an average of 583 employees during the first nine months of 2010 to an average of 606 employees for the first nine months of 2011.

Research and development. Research and development expenses increased to $43.6 million, or 16% of revenues, in the first nine months of 2011 from $41.0 million, or 17% of revenues, in the first nine months of 2010. The increase of $2.6 million in research and development expenses was primarily due to increased personnel and allocated costs. Our headcount increased in research and development from an average of 447 employees for the first nine months of 2010 to an average of 488 employees for the first nine months of 2011.

 

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General and administrative. General and administrative expenses increased to $30.9 million, or 11% of revenues, in the first nine months of 2011 from $27.5 million, or 11% of revenues, in the first nine months of 2010. The $3.4 million increase in general and administrative expenses was primarily due to an increase in third-party professional service fees of $3.1 million and an increase in personnel costs of approximately $0.3 million. The increase in third-party professional service fees was primarily related to the global restructuring of our international distribution operations. Our headcount in general and administrative departments increased slightly from an average of 120 employees during the first nine months of 2010 to an average of 121 employees for the first nine months of 2011.

Interest Expense

Interest expense decreased to $1.2 million in the first nine months of 2011 from $2.8 million in the first nine months of 2010. The decrease was primarily due to a lower average outstanding loan balance on our secured loan of $66.5 million during the first nine months of 2011 compared to an average loan balance of $75.0 million during the first nine months of 2010. In addition, the effective interest rate was lower in the first nine months of 2011 compared to 2010 primarily due to the reduction in the notional amount of principal subject to the unfavorable fixed rate swap agreement which expired on September 30, 2010 and the reduction in the margin as a result of the 2010 Credit Facility entered into in October 2010. Included in the interest expense for the first nine months of 2011 and 2010 is $0.2 million and $0.6 million, respectively, of amortization of deferred financing fees that were capitalized as part of the 2010 Credit Facility and 2007 Credit Facility, as applicable. We borrowed a total of $6.0 million (net of principal payments) on the secured loan under the 2010 Credit Facility during the first nine months of 2011 and made net principal payments totaling $20.0 million on the secured loan under the 2007 Credit Facility during the first nine months of 2010.

Other Income (Expense), Net

Other income (expense), net changed from a net other expense of $0.9 million in the first nine months of 2010 to a net other income of $1.5 million in the first nine months of 2011. The change was due primarily to foreign exchange related gains of $1.3 million in the first nine months of 2011 compared to losses of $1.1 million in the first nine months of 2010 resulting from favorable movements in the foreign exchange rates during the first nine months of 2011.

Provision for Income Taxes

For the nine months ended September 30, 2011 we recognized an income tax expense of $10.8 million compared to an income tax expense of $9.6 million for the nine months ended September 30, 2010. The effective tax rates were 34.3% for the nine months ended September 30, 2011 and 49.7% for the nine months ended September 30, 2010. For the first nine months of 2011, the effective tax rate variance from the U.S. federal statutory rate was primarily related to the unfavorable impact of foreign withholding taxes, non-deductible share-based payments and increased earnings in higher tax jurisdictions, offset by a nonrecurring net discrete tax benefit of $2.8 million related primarily to our global distribution restructuring, which was completed during 2010 and became effective at the beginning of 2011. The entire net tax benefit of $2.8 million was reflected in the first quarter of 2011 upon completion of our global distribution restructuring and is not expected to recur. For the first nine months of 2010, the effective tax rate variance from the U.S. federal statutory rate was primarily related to an increase in the valuation allowance related to net operating losses of one of our subsidiaries in the United Kingdom, the unfavorable impact on deferred tax amounts resulting from a California law change, a favorable state tax ruling, foreign withholding taxes and non-deductible share-based payments, which offset the benefit of income taxed at lower rates in foreign jurisdictions.

Liquidity and Capital Resources

As of September 30, 2011, we had cash and cash equivalents of $75.6 million and retained earnings of $61.9 million. Of the $75.6 million of cash equivalents, $29.2 million was held by our foreign subsidiaries, and we plan to indefinitely reinvest the undistributed foreign earnings into our foreign operations. During the first nine months of 2011, we primarily used cash and cash equivalents in excess of cash required for operations for stock repurchases of approximately $74.0 million.

Net cash provided by operating activities was $57.3 million in the first nine months of 2011 compared with $76.1 million in the first nine months of 2010. The decrease in cash flow from operations for the first nine months of 2011 compared to the first nine months of 2010 was primarily a result of higher cash operating expenses resulting from higher headcount costs, third-party professional fees and increased cash tax payments in 2011. Our operating cash flow is significantly influenced by the timing of new and renewal subscriptions, accounts receivable collections and cash expenses. A decrease in sales of new and/or renewal subscriptions or accounts receivable collections, or an increase in our cash expenses, would negatively impact our operating cash flow.

Net cash used in investing activities was $7.6 million in the first nine months of 2011 compared with $6.4 million in the first nine months of 2010. The $1.2 million increase in net cash used in investing activities was primarily due to increased purchases of property and equipment during the first nine months of 2011 compared to the first nine months of 2010.

 

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Net cash used in financing activities was $51.2 million in the first nine months of 2011 compared with $66.4 million in the first nine months of 2010. In the first nine months of 2011, the Company used approximately $74.0 million to repurchase its common stock which was offset in part by $14.5 million in proceeds from the exercise of options and net borrowings of $6.0 million under the 2010 Credit Agreement. The decrease in cash used in financing activities was driven primarily by a reduction in net principal payments made under the Company’s credit facilities during the first nine months of 2011 compared to the first nine months of 2010.

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 its 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 assigned our case to an IRS Appeals Officer and the appeals process commenced during the second quarter of 2011. In the third quarter of 2011, the IRS withdrew the proposed adjustment relating to equity compensation of $1.7 million resulting in no additional tax liability. This reduces the amount of the additional tax proposed by the IRS for the tax years ended December 31, 2005 through December 31, 2007 to approximately $17.3 million. We intend to continue to defend our position on the remaining matters at the IRS Appeals Office, including through litigation if required. The timing of the ultimate resolution of these remaining matters cannot be reasonably estimated at this time however, we expect the appeals process to continue throughout the remainder of 2011.

In October 2010, the Company entered into the “2010 Credit Agreement” and used the proceeds to repay the term loan under the 2007 Credit Agreement 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 (i) the highest of (a) the federal funds rate plus 0.5%, (b) the Eurodollar rate plus 1.00%, and (c) Bank of America’s prime rate, plus (ii) 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 September 30, 2011, the total amount outstanding under the 2010 Credit Facility was $73 million and the weighted average interest rate was 1.98%.

The applicable margins are determined by reference to our leverage ratio, as set forth in the table below:

 

Consolidated Leverage Ratio

   Eurodollar Rate
    Loans    
  Base Rate
    Loans     

             <1.25:1.0

   1.75%   0.75%

             >1.25:1.0

   2.00%   1.00%

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 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).

 

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Obligations and commitments. The following table summarizes our contractual payment obligations and commitments as of September 30, 2011 (in thousands):

 

     Payment Obligations by Year  
     2011      2012      2013      2014      2015      Thereafter      Total  

2010 Credit Agreement:

                    

Scheduled principal payments

   $ —         $ —         $ —         $ —         $ 73,000       $ —         $ 73,000   

Estimated interest and fees

     820         2,419         2,406         2,406         1,991         —           10,042   

Operating leases

     2,299         7,615         6,806         2,066         1,145         —           19,931   

Other commitments

     66         937         93         19         —           —           1,115   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 3,185       $ 10,971       $ 9,305       $ 4,491       $ 76,136       $ —         $ 104,088   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Obligations under our 2010 Credit Agreement represent the future minimum principal debt payments due under this facility. Estimated interest and fees expected to be incurred on the 2010 Credit Facility are based on known rates and scheduled principal payments, as well as the interest rate swap agreement, as of September 30, 2011 (see Note 5 to the consolidated financial statements).

We lease our facilities under operating lease agreements that expire at various dates through 2015. Approximately 37% of our operating lease commitments are related to our corporate headquarters lease in San Diego, which extends through December 2013 and has escalating rent payments from 2011 to 2013. The rent expense related to our worldwide office space leases are generally recorded monthly on a straight-line basis in accordance with GAAP.

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

In addition, due to the uncertainty with respect to the timing of future cash flows associated with our unrecognized tax benefits at September 30, 2011, we are unable to make reasonably reliable estimates of the period of cash settlement with the respective taxing authorities. Therefore, $14.4 million of gross unrecognized tax benefits have been excluded from the contractual payment obligations table above.

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 2010, 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 16 million shares. In October 2010, we announced that our board of directors increased the size of the stock repurchase program by an additional 8 million shares, for a total program size of up to 24 million shares. The stock repurchase program does not have an expiration date, does not require us to purchase a specific number of shares and may be modified, suspended or terminated at any time by our board of directors.

In connection with the stock repurchase program, we adopted two 10b5-1 stock repurchase plans (the “2009 Repurchase Plans”) in August 2009. The 2009 Repurchase Plans initially provided for purchases of up to an aggregate of $7.5 million of our common stock per calendar quarter in open market transactions beginning in October 2009. In November 2010, our board of directors approved an increase to the value of shares to be repurchased under the 2009 Repurchase Plans from an aggregate of $7.5 million to $25 million per calendar quarter, effective as of January 1, 2011. Repurchases are made on the open market at prevailing market prices in accordance with timing conditions set forth in the 2009 Repurchase Plans. Depending on market conditions and other factors, including compliance with covenants in our 2010 Credit Agreement, purchases by our agents under the 2009 Repurchase Plans may be suspended at any time, or from time to time. During the nine months ended September 30, 2011, we repurchased 3,400,011 shares of our common stock for an aggregate of approximately $75.0 million at an average price of $22.05 per share. As of September 30, 2011, we have repurchased a total of 19,024,530 shares of our common stock under this stock repurchase program, for an aggregate of $384.8 million at an average price of $20.23 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 $10.0 million in the aggregate in any fiscal year. We intend to continue repurchasing shares during 2011.

        We believe that our cash and cash equivalents balances, accounts receivable, revolving credit balances and our ongoing cash flow from operations will be sufficient to satisfy our cash requirements, including our capital expenditures, debt repayment obligations and stock repurchases, if any, for at least the next 12 months. During the first nine months of 2011, we borrowed a net total of $6.0 million on our secured loan and repurchased approximately $75.0 million of our common stock, of which $1.5 million was settled in October 2011. 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 borrow under our 2010 Credit Agreement, raise funds for these purposes or 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.

Off-Balance Sheet Arrangements

As of September 30, 2011, we did not have any off-balance sheet arrangements.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk

Our market risk exposures are related to our cash and cash equivalents and our 2010 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 2010 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 September 30, 2011 and taking into consideration our interest rate swap agreement, our interest expense would increase on a pre-tax basis by approximately $0.3 million during the next 12 months if a 100 basis point adverse move in the interest rate yield curve occurred.

 

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A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest sensitive investments at September 30, 2011. 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 September 30, 2011 and December 31, 2010 are presented in the table below (in thousands):

 

     September 30, 2011      December 31, 2010  
      Notional
Value
Local
Currency
     Notional
Value
USD
     Fair
Value

USD
     Notional
Value
Local
Currency
     Notional
Value
USD
     Fair
Value

USD
 

Fair Value Hedges

                 

Euro (net sold)

     7,250       $ 10,264       $ 9,735         8,550       $ 11,405       $ 11,449   

British Pound (net sold)

     —           —           —           1,250         1,938         1,958   

Australian Dollar (net purchased)

     6,243         6,428         5,945         —           —           —     

The $1.1 million notional decrease in our Euro hedged position at September 30, 2011 compared to December 31, 2010 was primarily a result of timing differences in when assets were acquired and/or liabilities incurred. All of the Euro hedging contracts in place as of September 30, 2011 are scheduled to be settled before January 2012. For the nine months ended September 30, 2011, less than 15% of our total billings were denominated in the Euro. We expect Euro billings to represent less than 20% of our total billings during 2011.

The $1.9 million notional decrease in our British Pound hedge position at September 30, 2011 compared to December 31, 2010 was primarily due to the timing differences in when assets were acquired and/or liabilities incurred. There were no British Pound hedging contracts in place as of September 30, 2011. For the nine months ended September 30, 2011, less than 15% of our total billings were denominated in the British Pound. We expect British Pound billings to represent less than 15% of our total billings during 2011.

The $6.4 million notional increase in our Australian Dollar hedge position at September 30, 2011 compared to December 31, 2010 was primarily due to the incurrence of a large Australian Dollar denominated obligation in the first nine months of 2011 as a result of our global distribution restructuring. All of the Australian Dollar hedging contracts in place as of September 30, 2011 are scheduled to be settled before January 2012. For the nine months ended September 30, 2011, approximately 5% of our total billings were denominated in the Australian Dollar. We expect Australian Dollar billings to represent approximately 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 revenues under subscription contracts that are not denominated in U.S. dollars. Our revenues and deferred revenue for these foreign currencies are recorded in U.S. dollars when the subscription is entered into based upon currency exchange rates in effect on the last day of the previous month before the subscription agreement is entered into. We engage in currency hedging activities with the intent of limiting the risk of exchange rate fluctuations, but our foreign exchange hedging activities also involve inherent risks that could result in an unforeseen loss.

 

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Item 4. Controls and Procedures

Disclosure Controls and Procedures

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

Changes In Internal Control over Financial Reporting

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

Part II – Other Information

 

Item 1. Legal Proceedings

On July 12, 2010, Finjan, Inc. filed a complaint entitled Finjan, Inc. v. McAfee, Inc., Symantec Corp., Webroot Software, Inc., Websense, Inc. and Sophos, Inc. in the United States District Court for the District of Delaware. The complaint alleges that the Company’s making, using, importing, selling and/or offering for sale Websense Web Filter, Websense Web Security and Websense Web Security Gateway infringes U.S. Patent No. 6,092,194 (“194 Patent”). Finjan, Inc. seeks an injunction from further infringement of the 194 Patent and damages. The court has set a date of January 30, 2012 for a hearing on the construction of the claims in the 194 Patent. 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, including the Finjan litigation, such that any liability would not materially affect our consolidated financial position, results of operations or cash flows. It is reasonably possible that the ultimate liability for these matters will be greater than the amount we have accrued for; however, management is not able to estimate any amount over what it has already accrued for at this time. Our evaluation of the likely impact of these actions could change in the future and unfavorable outcomes and/or defense costs, depending upon the amount and timing, could have a material adverse effect on our results of operations or cash flows in a future period.

 

Item 1A. Risk Factors

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

We have marked with an asterisk (*) those risk factors that reflect material changes from the risk factors included in our Annual Report on Form 10-K for the year ended December 31, 2010, as filed with the SEC on February 10, 2011.

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

We expect 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 product sold with or without appliances. While we expect sales of our TRITON unified Web, data and email security solutions, data loss prevention (“DLP”) products, SaaS offerings, and other products under development to comprise a minority portion of our revenues in 2011, they should represent more than half of our sales and be a primary driver of our billings and revenue growth in 2011. Our billings and revenue growth are 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 to our 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.

 

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

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 in certain countries or regions in the world and, in some cases, resulted in customer losses. Our average contract duration may be volatile as we seek contract renewals without eroding our average contract price for our Web filtering products and seek to sell subscriptions to our TRITON and gateway security products which may have longer durations and may depend on product mix. 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.

If our security gateway products, DLP products, SaaS offerings and our V-series appliance platform are unable to achieve more widespread market acceptance, our business will be seriously harmed, 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, Websense Hosted Web Security and Websense Hosted Email Security, our SaaS offerings, and Websense Email Security, our email filtering solution. We offer 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 revenues 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 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 provides 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.

 

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

Our revenues have been derived almost entirely from sales through indirect channels, including value-added resellers, distributors and OEM customers 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 29% of our revenues during the first nine months of 2011. In addition, we began using Arrow Enterprise Computing Solutions as an additional broadline distributor in North America in 2010. Should Ingram Micro or Arrow Enterprise Computing Solutions or any of our other distributors experience financial difficulties, difficulties in collecting their accounts receivable or otherwise delay or prevent our collection of accounts receivable from them, our revenues 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 revenues 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 ensure 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 and email offerings, our SaaS offerings or our TRITON solutions;

 

   

providers of networking hardware, OEM customers and other value-added resellers that incorporate our products into, or bundle our products with, their products may fail to provide, or restrict us from providing, adequate support services to end users of these integrated product offerings, harming our reputation and brand, or may decide to develop or sell competing products instead of our products;

 

   

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

 

   

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

Our ability to meaningfully increase the amount of our products sold through our sales channels also depends on our ability to adequately and efficiently support these channel partners with, among other things, appropriate financial incentives to encourage pre-sales investment and development of sales tools, such as sales training, technical training and product materials needed to support their existing and prospective customers. 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, revenues, operating expenses and tax provisions. Our billings depend in part on the number of subscriptions up for renewal each quarter and are affected by seasonal variations, with the fourth quarter generally being our strongest quarter in billings, and the first quarter generally being our lowest quarter for billings each fiscal year. 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 as well as our appliance sales which are fully recognized in the quarter in which they are sold. 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. 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.

 

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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 quarterly report:

 

   

changes in currency exchange rates impacting our international operating expenses;

 

   

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

 

   

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

 

   

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

 

   

fluctuations in expenses associated with commissions paid on sales of subscriptions to our products which generally increase with billings growth in the short term because such expenses are recognized immediately upon sales of subscriptions while revenue is recognized ratably over the subscription term.

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.

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 revenues 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 revenues from these contracts, even though these foreign currencies may strengthen during the term of these subscriptions. Because currency exchange rates remain volatile, our future revenues 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.

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 revenues. In addition, as we increase our emphasis on our security-oriented products, we face competition from better-established security companies that have significantly greater resources.*

The market for our products is intensely competitive and is likely to become even more so in the future. Our current principal Web filtering competitors frequently offer their products at a significantly lower price than our products, which has resulted in pricing pressures on sales of our 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 revenues 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.

 

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Our current principal competitors include:

 

   

companies offering Web filtering and Web security solutions, such as Microsoft, McAfee (acquired by Intel in February 2011), Trend Micro, Google, Webroot Software/BrightCloud, SafeNet, Actiance (formerly FaceTime Communications), EdgeWave, M86 Security, Clearswift, Check Point Software Technologies, Sophos, Kaspersky Lab, AhnLab., IBM, Panda Security, F-Secure, Commtouch and CA Technologies (formerly Computer Associates);

 

   

companies integrating Web filtering into specialized security appliances, such as Blue Coat Systems, Cisco Systems/IronPort, McAfee, Check Point Software Technologies, 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 Technologies, Raytheon, Intrusion, Fidelis Security Systems, GTB Technologies, Workshare, Check Point Software Technologies 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, WatchGuard Technologies, M86 Security, Webroot Software and Fortinet;

 

   

companies offering on-demand email and Web security services, such as Google, Microsoft, Symantec/Message Labs, McAfee, Webroot Software/BrightCloud, EdgeWave, Barracuda Networks, Zscaler, Trend Micro and Cisco Systems/ScanSafe;

 

   

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

 

   

companies offering Web gateway solutions, such as Microsoft, Blue Coat Systems, Cisco Systems, Trend Micro, Check Point Software Technologies, McAfee, Juniper Networks, Symantec, Kaspersky Lab, Panda Security, Sophos, Black Box Network Services/Optinet, Safe Net, M86 Security, Clearswift, CA Technologies, Actiance 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, Trend Micro, Cisco Systems, Google and Microsoft enjoy substantial competitive advantages, including:

 

   

greater name recognition and larger marketing budgets and resources;

 

   

established marketing relationships and access to larger customer bases; and

 

   

substantially greater financial, technical and other resources.

As a result, we may be unable to gain sufficient traction as a provider of advanced content 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, email and data security solutions and sell the combined product at a lower cost which could essentially include, at no additional cost, the functionality of our stand-alone solutions. For all of the foregoing reasons, we may not be able to compete successfully against our current and future competitors.

The covenants in our 2010 Credit Agreement 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 the 2010 Credit Agreement and used the initial proceeds to repay our term loan and retire 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 ensure that we will meet those ratios.

 

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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 foreign 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;

 

   

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 the first nine months of 2011. 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.

 

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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 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.

Because our products primarily manage access to uniform record locators (“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 offerings. If these products fail to achieve broad market acceptance in our target markets, we may be unable to generate significant revenues 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.

Security threats to our IT infrastructure could expose us to liability, and damage our reputation and business.*

It is essential to our business strategy that our technology and network infrastructure remain secure and is perceived by our customers, distributors and resellers to be secure. Despite security measures, however, any network infrastructure may be vulnerable to attacks by hackers and other security threats. As a provider of security solutions designed to protect data and users, we may face cyber-attacks that attempt to penetrate our network security, including our data centers, to sabotage or otherwise disable our products and services, misappropriate our or our customers’ proprietary information, which may include personally identifiable information, or cause interruptions of our internal systems and services. If successful, any of these attacks could negatively affect our reputation as a provider of security solutions, damage our network infrastructure and our ability to deploy our products and services, harm our relationship with customers that are affected and expose us to financial liability.

 

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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.

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 loan and retire the 2007 Credit Agreement. Under the 2010 Credit Agreement, we can borrow up to $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 the following:

 

   

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 under the 2010 Credit Agreement;

 

   

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 IT 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 revenues 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, value added tax and goods and services tax. 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 revenues 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 2010 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 2009 in the United States, for 2005 to 2008 in the United Kingdom and for 2006 to 2010 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 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 assigned our case to an IRS Appeals Officer and the appeals process commenced during the second quarter of 2011. In the third quarter of 2011, the IRS withdrew the proposed adjustment relating to equity compensation of $1.7 million resulting in no additional tax liability. This reduces the amount of the additional tax proposed by the IRS for the tax years ended December 31, 2005 through December 31, 2007 to approximately $17.3 million. We intend to continue to defend our position on the remaining matters at the IRS Appeals Office, including through litigation if required. We expect the appeals process to continue throughout the remainder of 2011. While the timing of the ultimate resolution of these remaining 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 cost sharing buy-in, as a potential area for audit exposure for many companies. If this matter is litigated or the position proposed by the IRS is otherwise sustained, our results of operations for the periods when any additional tax liability is incurred could be materially and adversely affected particularly because we have not accrued for any potential liability relating to this matter based on GAAP. 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.

 

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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 31 patents issued in the United States and 26 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.

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

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

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

        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 allow us to recognize revenue from hardware sales in the current period that the sale is concluded, a majority of the revenues 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 revenues 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.

 

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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;

 

   

risks associated with entrance into new markets;

 

   

potential loss of key employees of the acquired company;

 

   

integrating personnel with diverse business and cultural backgrounds;

 

   

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

 

   

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

 

   

inability to generate sufficient revenues 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 in October 2007;

 

   

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.

 

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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. As we have publicly announced, our former Chief Financial Officer, Arthur S. Locke III, resigned in September 2011 and we are in the process of recruiting a new Chief Financial Officer who would assume those duties from our current General Counsel and Chief Administrative Officer, Michael A. Newman, who is now also serving as our interim Chief Financial Officer. 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 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 revenues may be negatively impacted and our business and future growth prospects could be severely harmed.

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. As a result of an error in identifying a variance in our deferred tax assets in the fourth quarter of 2010, 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 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.

The restatement of our historical financial statements may affect stockholder confidence, may 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. A restatement may affect investor confidence in the accuracy of our financial disclosures and may result in a decline in stock price and stockholder lawsuits related to the restatement. We cannot guarantee that we will not be affected in this way.

 

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The restatement process was also 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 not receive inquiries from the SEC or the Nasdaq Stock Market, Inc. (“NASDAQ”) regarding our restated financial statements or matters relating thereto. Any future inquiries from the SEC or NASDAQ 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.

Compliance with regulations relating to 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.

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 revenues, 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 amended and restated certificate of incorporation and amended and restated 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 amended and restated certificate of incorporation provides that stockholders may not call stockholder meetings or act by written consent. Our amended and restated bylaws provide that stockholders may not fill board of director 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 of directors or initiate actions that are opposed by the then current board of directors. Additionally, we have authorized preferred stock that is undesignated, making it possible for the board of directors 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 of directors, 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 2010 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 2010 Credit Facility.

 

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

 

(a) Not applicable.

 

(b) Not applicable.

 

(c) Issuer Purchases of Equity Securities

 

Period

   Total
Number of
Shares
Purchased (1)
     Average Price
Paid per Share
     Total
Number of  Shares
Purchased as Part
of Publicly
Announced Plans
or Programs
     Maximum Number
of Shares that May
be Purchased
Under the  Plans
or Programs (2)
 

July 1 - July 31, 2011

     320,500       $ 26.04         18,168,186         5,831,814   

August 1 - August 31, 2011

     400,000       $ 20.48         18,568,186         5,431,814   

September 1 - September 30, 2011

     456,344       $ 18.50         19,024,530         4,975,470   

Total

     1,176,844       $ 21.23         19,024,530         4,975,470   

 

1. All share purchases were made in open market transactions under our 10b5-1 stock repurchase plans.
2. 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 2010, 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 16 million shares. In October 2010, we announced that our board of directors increased the size of the stock repurchase program by an additional 8 million shares, for a total program size of up to 24 million shares. The stock repurchase program does not have an expiration date, does not require us to purchase a specific number of shares and may be modified, suspended or terminated at any time by our board of directors. In connection with the stock repurchase program, we adopted the 2009 Repurchase Plans in August 2009. The 2009 Repurchase Plans initially provided for purchases of up to an aggregate of $7.5 million of our common stock per calendar quarter in open market transactions beginning in October 2009. In November 2010, our board of directors approved an increase to the value of shares to be repurchased under the 2009 Repurchase Plans from an aggregate of $7.5 million to $25 million per calendar quarter effective as of January 1, 2011. Depending on market conditions and other factors, including compliance with covenants in our 2010 Credit Agreement, purchases by our agents under the 2009 Repurchase Plans may be suspended at any time, or from time to time. The remaining shares authorized for repurchase under our stock repurchase program as of September 30, 2011 was 4,975,470.

 

Item 3. Defaults upon Senior Securities

None.

 

Item 4. (Removed and Reserved)

 

Item 5. Other Information

None.

 

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Table of Contents
Item 6. Exhibits

 

Exhibit Number   Description of Document
3.1(1)   Amended and Restated Certificate of Incorporation.
3.2(1)   Amended and Restated Bylaws.
4.1(2)   Specimen Stock Certificate of Websense, Inc.
10.1(3)   Separation Agreement, dated September 6, 2011, by and between Websense, Inc. and Arthur S. Locke III.
31.1   Certification of Principal Executive Officer pursuant to Exchange Act Rules 13a-14(a) or 15d-14(a).
31.2   Certification of Principal Financial Officer pursuant to Exchange Act Rules 13a-14(a) or 15d-14(a).
32.1   Certification of Principal Executive Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350).
32.2   Certification of Principal Financial Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350).
101.INS   XBRL Instance Document
101.SCH   XBRL Taxonomy Extension Schema Document
101.CAL   XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF   XBRL Taxonomy Extension Definition Document
101.LAB   XBRL Taxonomy Extension Label Linkbase Document
101.PRE   XBRL Taxonomy Extension Presentation Linkbase Document

 

(1) Filed as an exhibit to our Current Report on Form 8-K filed on June 19, 2009.
(2) Filed as an exhibit to our Registration Statement on Form S-1/A (No 333-95619) filed on March 23, 2000.
(3) Filed as exhibit to our Current Report on Form 8-K filed on September 6, 2011.

 

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Table of Contents

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

    WEBSENSE, INC.
Date: November 4, 2011     By:   /s/    GENE HODGES
      Gene Hodges
      Chief Executive Officer
    By:   /s/    MICHAEL A. NEWMAN
Date: November 4, 2011       Michael A. Newman
      Chief Financial Officer

 

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Table of Contents

EXHIBIT INDEX

 

Exhibit Number   Description of Document
3.1(1)   Amended and Restated Certificate of Incorporation.
3.2(1)   Amended and Restated Bylaws.
4.1(2)   Specimen Stock Certificate of Websense, Inc.
10.1(3)   Separation Agreement, dated September 6, 2011, by and between Websense, Inc. and Arthur S. Locke III.
31.1   Certification of Principal Executive Officer pursuant to Exchange Act Rules 13a-14(a) or 15d-14(a).
31.2   Certification of Principal Financial Officer pursuant to Exchange Act Rules 13a-14(a) or 15d-14(a).
32.1   Certification of Principal Executive Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350).
32.2   Certification of Principal Financial Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350).
101.INS   XBRL Instance Document
101.SCH   XBRL Taxonomy Extension Schema Document
101.CAL   XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF   XBRL Taxonomy Extension Definition Document
101.LAB   XBRL Taxonomy Extension Label Linkbase Document
101.PRE   XBRL Taxonomy Extension Presentation Linkbase Document

 

(1) Filed as an exhibit to our Current Report on Form 8-K filed on June 19, 2009.
(2) Filed as an exhibit to our Registration Statement on Form S-1/A (No 333-95619) filed on March 23, 2000.
(3) Filed as exhibit to our Current Report on Form 8-K filed on September 6, 2011.

 

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