Table of Contents

 

 

 

**UNITED STATESSECURITIES 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, 2008**                                                  |
|                                                                                                        |
| **OR**                                                                                                      |
|                                                                                                        |
| **o****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 RoadSan Diego, California 92121858-320-8000**

(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 o

 

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 o               |
|------------------------------|--------|------------------------------------------------|--------|-----------------------------------|
| 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 o No x

 

The number of shares outstanding of the registrant’s Common Stock, $.01 par value, as of October 31, 2008 was 45,004,221.

 

 

 

----

Tableof Contents

 

**Websense, Inc.**

**Form 10-Q**

**For the Period Ended September 30, 2008**

 

**TABLE OF CONTENTS**

 
|                                     | **Page** |
|-------------------------------------|----------|
| Part I.  Financial Information |
|                                |     |   |   |   |
|                                |     | Item  1. | Consolidated  Financial Statements (Unaudited) |   |
|                                |     |   | Consolidated  Balance Sheets as of September 30, 2008 and December 31, 2007 | 3 |
|                                |     |   | Consolidated  Statements of Operations for the three and nine months ended  September 30, 2008 and 2007 | 4 |
|                                |     |   | Consolidated  Statement of Stockholders’ Equity for the nine months ended  September 30, 2008 | 5 |
|                                |     |   | Consolidated  Statements of Cash Flows for the nine months ended September 30, 2008  and 2007 | 6 |
|                                |     |   | Notes to  Consolidated Financial Statements | 7 |
|                                |     | Item 2. | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 15 |
|                                |     | Item 3. | Quantitative  and Qualitative Disclosures About Market Risk | 26 |
|                                |     | Item 4. | Controls and  Procedures | 27 |
|                                |     |   |   |   |
| Part II. Other  Information    |     |
|                                |     |   |   |   |
|                                |     | Item 1. | Legal Proceedings | 27 |
|                                |     | Item  1A. | Risk  Factors | 28 |
|                                |     | Item 2. | Unregistered  Sales of Equity Securities and Use of Proceeds | 39 |
|                                |     | Item 3. | Defaults  upon Senior Securities | 39 |
|                                |     | Item 4. | Submission  of Matters to a Vote of Security Holders | 39 |
|                                |     | Item 5. | Other Information | 39 |
|                                |     | Item  6. | Exhibits | 40 |
|                                |     |   |   |   |
| Signatures                          |     | 41 |

 

2

----

Tableof Contents

 

**Part I– Financial Information**

**Item 1. Consolidated Financial Statements (Unaudited)**

** **

**Websense, Inc.**Consolidated BalanceSheets (Unaudited and in thousands)

 
| ** **                                       | ** ** | **September 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|--------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                       | ** ** | ** **                   | ** ** | **(See Note 1)**  | ** ** |
| **Assets**                                       |       |                         |       |                        |       |
| Current assets:                                  |       |                         |       |                        |       |
| Cash and cash  equivalents                       |       | $                            | 63,364     |                        | $          | 66,383 |   |
| Marketable  securities                           |       | —                       |       | 19,781                      |       |
| Accounts  receivable, net                        |       | 64,649                       |       | 76,328                      |       |
| Prepaid income  taxes                            |       | 2,177                        |       | 3,734                       |       |
| Current portion  of deferred income taxes        |       | 30,476                       |       | 22,870                      |       |
| Other current  assets                            |       | 8,062                        |       | 10,109                      |       |
| Total current  assets                            |       | 168,728                      |       | 199,205                     |       |
|                                             |       |                         |       |                        |       |
| Property and  equipment, net                     |       | 15,691                       |       | 17,657                      |       |
| Intangible  assets, net                          |       | 117,748                      |       | 152,906                     |       |
| Goodwill                                         |       | 374,643                      |       | 385,916                     |       |
| Deferred income  taxes, less current portion     |       | 36,276                       |       | 19,048                      |       |
| Deposits and other  assets                       |       | 4,419                        |       | 5,798                       |       |
| Total assets                                     |       | $                            | 717,505    |                        | $          | 780,530 |   |
|                                             |       |                         |       |                        |       |
| **Liabilities  and stockholders’ equity**   |       |                         |       |                        |       |
| Current  liabilities:                            |       |                         |       |                        |       |
| Accounts payable                                 |       | $                            | 1,303      |                        | $          | 3,255 |   |
| Accrued  compensation and related benefits       |       | 18,156                       |       | 28,960                      |       |
| Other accrued  expenses                          |       | 26,763                       |       | 30,463                      |       |
| Current portion  of income taxes payable         |       | 12,837                       |       | 1,531                       |       |
| Current portion  of senior secured term loan     |       | 737                          |       | —                      |       |
| Current portion  of deferred revenue             |       | 206,058                      |       | 190,569                     |       |
| Current portion  of deferred tax liability       |       | 5,530                        |       | 10,399                      |       |
| Total current  liabilities                       |       | 271,384                      |       | 265,177                     |       |
| Income taxes  payable, less current portion      |       | 9,192                        |       | 12,264                      |       |
| Senior secured  term loan                        |       | 139,263                      |       | 190,000                     |       |
| Deferred  revenue, less current portion          |       | 101,281                      |       | 96,116                      |       |
| Deferred tax  liability, less current portion    |       | 10,334                       |       | 20,964                      |       |
| Other long term  liabilities                     |       | 1,410                        |       | 1,634                       |       |
| Total  liabilities                               |       | 532,864                      |       | 586,155                     |       |
|                                             |       |                         |       |                        |       |
| Stockholders’  equity:                      |       |                         |       |                        |       |
| Common stock                                     |       | 521                          |       | 515                         |       |
| Additional  paid-in capital                      |       | 291,292                      |       | 267,164                     |       |
| Treasury stock,  at cost                         |       | (154,836                     | )          | (139,792                    | )          |
| Retained  earnings                               |       | 49,881                       |       | 67,808                      |       |
| Accumulated  other comprehensive loss            |       | (2,217                       | )          | (1,320                      | )          |
| Total  stockholders’ equity                 |       | 184,641                      |       | 194,375                     |       |
| Total  liabilities and stockholders’ equity |       | $                            | 717,505    |                        | $          | 780,530 |   |

 

See accompanyingnotes.

 

3

----

Table of Contents

 

**Websense, Inc.**

**Consolidated Statements of Operations**

**(Unaudited) (inthousands, except per share amounts)**

 
| ** **                              | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                              | ** ** | **September 30,  2008**     | ** ** | **September 30,  2007**    | ** ** | **September 30,  2008** | ** ** | **September 30,  2007** | ** ** |
|                                    |       |                             |       |                            |       |   |   |   |   |
| Revenue                                 |       | $                                | 76,663     |                            | $          | 50,429 |   | $ | 216,605 |   | $ | 150,625 |   |
|                                    |       |                             |       |                            |       |   |   |   |   |
| Cost of  revenues:                      |       |                             |       |                            |       |   |   |   |   |
| Cost of revenues                        |       | 9,181                            |       | 4,466                           |       | 26,635 |   | 13,299 |   |
| Amortization of  acquired technology    |       | 3,108                            |       | 629                             |       | 9,261 |   | 1,887 |   |
| Total cost of  revenues                 |       | 12,289                           |       | 5,095                           |       | 35,896 |   | 15,186 |   |
| Gross margin                            |       | 64,374                           |       | 45,334                          |       | 180,709 |   | 135,439 |   |
|                                    |       |                             |       |                            |       |   |   |   |   |
| Operating  expenses:                    |       |                             |       |                            |       |   |   |   |   |
| Selling and  marketing                  |       | 42,952                           |       | 25,249                          |       | 130,109 |   | 75,289 |   |
| Research and  development               |       | 13,139                           |       | 8,338                           |       | 39,798 |   | 27,059 |   |
| General and  administrative             |       | 10,753                           |       | 6,828                           |       | 35,441 |   | 20,589 |   |
| Total operating  expenses               |       | 66,844                           |       | 40,415                          |       | 205,348 |   | 122,937 |   |
|                                    |       |                             |       |                            |       |   |   |   |   |
| (Loss) income  from operations          |       | (2,470                           | )          | 4,919                           |       | (24,639 | ) | 12,502 |   |
|                                    |       |                             |       |                            |       |   |   |   |   |
| Interest expense                        |       | (2,985                           | )          | —                          |       | (10,357 | ) | — |   |
| Other (expense)  income, net            |       | (94                              | )          | 3,928                           |       | 908 |   | 7,843 |   |
|                                    |       |                             |       |                            |       |   |   |   |   |
| (Loss) income  before income taxes      |       | (5,549                           | )          | 8,847                           |       | (34,088 | ) | 20,345 |   |
|                                    |       |                             |       |                            |       |   |   |   |   |
| (Benefit)  provision for income taxes   |       | (2,052                           | )          | 2,452                           |       | (16,161 | ) | 7,954 |   |
|                                    |       |                             |       |                            |       |   |   |   |   |
| Net (loss)  income                      |       | $                                | (3,497     | )                               | $          | 6,395 |   | $ | (17,927 | ) | $ | 12,391 |   |
|                                    |       |                             |       |                            |       |   |   |   |   |
| Net (loss) income  per share:           |       |                             |       |                            |       |   |   |   |   |
|                                    |       |                             |       |                            |       |   |   |   |   |
| Basic net (loss)  income per share      |       | $                                | (0.08      | )                               | $          | 0.14 |   | $ | (0.40 | ) | $ | 0.28 |   |
| Diluted net  (loss) income per share    |       | $                                | (0.08      | )                               | $          | 0.14 |   | $ | (0.40 | ) | $ | 0.27 |   |
| Weighted average  shares – basic   |       | 45,097                           |       | 45,194                          |       | 45,233 |   | 45,028 |   |
| Weighted average  shares – diluted |       | 45,097                           |       | 45,607                          |       | 45,233 |   | 45,517 |   |

 

See accompanyingnotes.

 

4

----

Table of Contents

 

**Websense, Inc.**

**Consolidated Statement of Stockholders’ Equity**

**(Unaudited and in thousands)**

 
| ** **                                                         | ** ** | **Common stock** | ** ** | **Additional** | ** ** | **Treasury**             | ** ** | **Retained** | ** ** | **Accumulated  other  comprehensive** | ** ** | **Total  stockholders’** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|--------------------------|------------|--------------|------------|---------------------------------------|------------|-------------------------------|------------|
| ** **                                                         | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **paid-in capital** | ** ** | **stock**    | ** ** | **earnings**                          | ** ** | **loss**                      | ** ** | **equity** | ** ** |
| Balance at  December 31, 2007                                 |       | 45,394                |       | $              | 515        |                     | $          | 267,164      |       | $                                     | (139,792   | )                             | $          | 67,808 |   | $ | (1,320 | ) | $ | 194,375 |   |
|                                                               |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Issuance of  common stock upon exercise of options                 |       | 294                   |       | 3              |       | 3,787                    |       | —       |       | —                                |       | —                        |       | 3,790 |   |
|                                                               |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Issuance of  common stock for ESPP purchase                        |       | 190                   |       | 2              |       | 2,901                    |       | —       |       | —                                |       | —                        |       | 2,903 |   |
|                                                               |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Issuance of  common stock from restricted stock units, net         |       | 29                    |       | 1              |       | —                   |       | (46          | )          | —                                |       | —                        |       | (45 | ) |
|                                                               |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Share-based  compensation expense                                  |       | —                |       | —         |       | 18,009                   |       | —       |       | —                                |       | —                        |       | 18,009 |   |
|                                                               |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Tax shortfall  from stock option exercises                         |       | —                |       | —         |       | (569                     | )          | —       |       | —                                |       | —                        |       | (569 | ) |
|                                                               |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Purchase of  treasury stock                                        |       | (790                  | )          | —         |       | —                   |       | (14,998      | )          | —                                |       | —                        |       | (14,998 | ) |
|                                                               |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Other  comprehensive income (loss):                                |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
|                                                               |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Net loss                                                           |       | —                |       | —         |       | —                   |       | —       |       | (17,927                               | )          | —                        |       | (17,927 | ) |
|                                                               |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Net change in  unrealized gain on derivative contracts, net of tax |       | —                |       | —         |       | —                   |       | —       |       | —                                |       | 173                           |       | 173 |   |
|                                                               |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Cumulative  translation adjustments                                |       | —                |       | —         |       | —                   |       | —       |       | —                                |       | (1,070                        | )          | (1,070 | ) |
|                                                               |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Comprehensive  loss                                                |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       | (18,824 | ) |
|                                                               |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Balance at  September 30, 2008                                |       | 45,117                |       | $              | 521        |                     | $          | 291,292      |       | $                                     | (154,836   | )                             | $          | 49,881 |   | $ | (2,217 | ) | $ | 184,641 |   |

 

See accompanyingnotes.

 

5

----

Table of Contents

 

**Websense, Inc.**

**Consolidated Statements of Cash Flows**

**(Unaudited and in thousands)**

 
| ** **                                                                                                     | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                     | ** ** | **September 30,  2008**    | ** ** | **September 30,  2007** | ** ** |
| **Operating  activities:**                                                                                     |       |                            |       |   |   |
| Net (loss)  income                                                                                             |       | $                               | (17,927    | ) | $ | 12,391 |   |
| Adjustments to  reconcile net (loss) income to net cash provided by operating activities:                      |       |                            |       |   |   |
| Depreciation and  amortization                                                                                 |       | 47,156                          |       | 5,949 |   |
| In-process  research and development                                                                           |       | —                          |       | 1,270 |   |
| Share-based  compensation                                                                                      |       | 18,009                          |       | 16,087 |   |
| Deferred income  taxes                                                                                         |       | (34,108                         | )          | (5,997 | ) |
| Unrealized  (gain) loss on foreign exchange                                                                    |       | (211                            | )          | 162 |   |
| Tax (shortfall)  windfall from stock option exercises                                                          |       | 569                             |       | (1,174 | ) |
| Changes in  operating assets and liabilities, net of effects from purchases of  PortAuthority and SurfControl: |       |                            |       |   |   |
| Accounts  receivable                                                                                           |       | 11,784                          |       | 10,802 |   |
| Other assets                                                                                                   |       | 2,907                           |       | (8,158 | ) |
| Accounts payable                                                                                               |       | (1,874                          | )          | (1,453 | ) |
| Accrued  compensation and related benefits                                                                     |       | (8,450                          | )          | 1,133 |   |
| Other  liabilities                                                                                             |       | (3,283                          | )          | 4,253 |   |
| Deferred revenue                                                                                               |       | 21,380                          |       | (1,402 | ) |
| Income taxes  payable                                                                                          |       | 7,337                           |       | 3,762 |   |
| Net cash  provided by operating activities                                                                     |       | 43,289                          |       | 37,625 |   |
|                                                                                                           |       |                            |       |   |   |
| **Investing  activities:**                                                                                     |       |                            |       |   |   |
| Purchases of  property and equipment                                                                           |       | (6,289                          | )          | (4,362 | ) |
| Cash paid for  purchased technology (intangible assets)                                                        |       | (1,815                          | )          | — |   |
| Cash refunded  (paid) for acquisition of PortAuthority, net of cash acquired                                   |       | 147                             |       | (81,988 | ) |
| Net cash paid  for option contract on SurfControl acquisition                                                  |       | —                          |       | (646 | ) |
| Cash received  from sale of CyberPatrol assets                                                                 |       | 1,400                           |       | — |   |
| Purchases of  marketable securities                                                                            |       | (20,160                         | )          | (472,607 | ) |
| Maturities of  marketable securities                                                                           |       | 39,963                          |       | 678,044 |   |
| Net cash  provided by investing activities                                                                     |       | 13,246                          |       | 118,441 |   |
|                                                                                                           |       |                            |       |   |   |
| **Financing  activities:**                                                                                     |       |                            |       |   |   |
| Principal  payments on senior secured term loan                                                                |       | (50,000                         | )          | — |   |
| Repayment of  PortAuthority loan                                                                               |       | —                          |       | (4,214 | ) |
| Proceeds from  exercise of stock options                                                                       |       | 3,790                           |       | 3,046 |   |
| Proceeds from  issuance of common stock for stock purchase plan                                                |       | 2,903                           |       | 2,212 |   |
| Tax (shortfall)  windfall from stock option exercises                                                          |       | (569                            | )          | 1,174 |   |
| Purchase of  treasury stock                                                                                    |       | (14,998                         | )          | — |   |
| Net cash (used  in) provided by financing activities                                                           |       | (58,874                         | )          | 2,218 |   |
| Effect of  exchange rate changes on cash and cash equivalents                                                  |       | (680                            | )          | — |   |
| (Decrease)  increase in cash and cash equivalents                                                              |       | (3,019                          | )          | 158,284 |   |
| Cash and cash  equivalents at beginning of period                                                              |       | 66,383                          |       | 83,523 |   |
| Cash and cash  equivalents at end of period                                                                    |       | $                               | 63,364     |   | $ | 241,807 |   |
|                                                                                                           |       |                            |       |   |   |
| **Supplemental  cash flow information:**                                                                       |       |                            |       |   |   |
| Income taxes  paid                                                                                             |       | $                               | 6,821      |   | $ | 11,476 |   |
| Unrealized gain  on marketable securities                                                                      |       | $                               | —     |   | $ | 81 |   |

 

See accompanyingnotes.

 

6

----

Tableof Contents

 

**Websense, Inc.**

 

**Notes To Consolidated FinancialStatements (Unaudited)**

 

1. *Basis of Presentation*

 

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

 

These financial statements should be read inconjunction with the audited consolidated financial statements and notes forthe fiscal year ended December 31, 2007, included in Websense, Inc.’s(“Websense” or the “Company”) Annual Report on Form 10-K filed with theSecurities and Exchange Commission. Operating results for the three and ninemonths ended September 30, 2008 are not necessarily indicative of theresults that may be expected for any other interim period or for the fiscalyear ending December 31, 2008. The balance sheet at December 31, 2007has been derived from the audited financial statements at that date but doesnot include all of the information and footnotes required by GAAP for completefinancial statements. Certain prior period amounts have been reclassified toconform to the current period presentation.

 

2. *Net (Loss)Income Per Share*

 

Websensecomputes net (loss) income per share (“EPS”) as permitted by the FinancialAccounting Standards Board (“FASB”) with Statement of Financial AccountingStandards (“SFAS”) No. 128, *Earnings Per Share*(“SFAS 128”). Under the provisions of SFAS 128, basic EPS is computed bydividing the net (loss) income for the period by the weighted average number ofcommon shares outstanding during the period. Diluted EPS is computed bydividing the net income for the period by the weighted average number of commonand common equivalent shares outstanding during the period. Common equivalentshares consist of dilutive stock options and restricted stock units. Dilutivestock options and dilutive restricted stock units are calculated based on theaverage share price for each fiscal period using the treasury stock method. Inaccordance with SFAS 128, if, however, the Company reports a net loss, thediluted EPS is computed in the same manner as the basic EPS.

 

As the Company reported a net loss for the three andnine months ended September 30, 2008, basic and diluted EPS were the same.During the three and nine months ended September 30, 2007, the differencebetween the weighted average shares used in determining basic EPS versus dilutedEPS is due to dilutive securities which totaled 413,000 and 489,000 shares,respectively. Potentially dilutive securities totaling 8,389,000 and 7,112,000shares for the three months ended September 30, 2008 and 2007,respectively, were excluded from the diluted EPS calculation because of theiranti-dilutive effect. Potentially dilutive securities totaling 8,492,000 and6,232,000 shares for the nine months ended September 30, 2008 and 2007,respectively, were excluded from the diluted EPS calculation because of theiranti-dilutive effect.

 

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

 
| ** **                       | ** ** | **Net (Loss)  Income  (Numerator)**                              | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
|----------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------|------------|----------------------------|------------|
| ** **                       | ** ** | **(In thousands, except per share amounts)** | ** ** |
| **For the  Three Months Ended:** | ** ** | ** **                                                            | ** ** | ** **                | ** ** | ** **                 | ** ** |
| **September 30,  2008:**    | ** ** | ** **                                                            | ** ** | ** **                | ** ** | ** **                 | ** ** |
| Basic EPS                        |       | $                                                                     | (3,497     | )                         | 45,097     |                       | $          | (0.08 | ) |
| Effect of  dilutive securities   |       | —                                                                |       | —                    |       | —                     |       |
| Diluted EPS                      |       | $                                                                     | (3,497     | )                         | 45,097     |                       | $          | (0.08 | ) |
| ** **                       | ** ** | ** **                                                            | ** ** | ** **                | ** ** | ** **                 | ** ** |
| **September 30,  2007:**    | ** ** | ** **                                                            | ** ** | ** **                | ** ** | ** **                 | ** ** |
| Basic EPS                        |       | $                                                                     | 6,395      |                      | 45,194     |                       | $          | 0.14 |   |
| Effect of  dilutive securities   |       | —                                                                |       | 413                       |       | —                     |       |
| Diluted EPS                      |       | $                                                                     | 6,395      |                      | 45,607     |                       | $          | 0.14 |   |
| ** **                       | ** ** | ** **                                                            | ** ** | ** **                | ** ** | ** **                 | ** ** |
| **For the  Nine Months Ended:**  | ** ** | ** **                                                            | ** ** | ** **                | ** ** | ** **                 | ** ** |
| **September 30,  2008:**    | ** ** | ** **                                                            | ** ** | ** **                | ** ** | ** **                 | ** ** |
| Basic EPS                        |       | $                                                                     | (17,927    | )                         | 45,233     |                       | $          | (0.40 | ) |
| Effect of  dilutive securities   |       | —                                                                |       | —                    |       | —                     |       |
| Diluted EPS                      |       | $                                                                     | (17,927    | )                         | 45,233     |                       | $          | (0.40 | ) |
| ** **                       | ** ** | ** **                                                            | ** ** | ** **                | ** ** | ** **                 | ** ** |
| **September 30,  2007:**    | ** ** | ** **                                                            | ** ** | ** **                | ** ** | ** **                 | ** ** |
| Basic EPS                        |       | $                                                                     | 12,391     |                      | 45,028     |                       | $          | 0.28 |   |
| Effect of  dilutive securities   |       | —                                                                |       | 489                       |       | (0.01                      | )          |
| Diluted EPS                      |       | $                                                                     | 12,391     |                      | 45,517     |                       | $          | 0.27 |   |

 

7

----

Tableof Contents

 

3. *Comprehensive (Loss) Income*

 

The components of comprehensive (loss) income, asrequired to be reported by SFAS No. 130, *ReportingComprehensive Income*, were as follows (in thousands):

 
| ** **                                                                                     | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                     | ** ** | **September 30,  2008**     | ** ** | **September 30,  2007**    | ** ** | **September 30,  2008** | ** ** | **September 30,  2007** | ** ** |
| Net (loss)  income                                                                             |       | $                                | (3,497     | )                               | $          | 6,395 |   | $ | (17,927 | ) | $ | 12,391 |   |
| Net change in  unrealized gain on marketable securities, net of tax                            |       | —                           |       | 67                              |       | — |   | 81 |   |
| Net change in  unrealized (loss) gain on fair value of foreign currency contracts, net of  tax |       | —                           |       | (10                             | )          | — |   | 9 |   |
| Net change in  unrealized gain on derivative contracts, net of tax                             |       | 241                              |       | —                          |       | 173 |   | — |   |
| Cumulative  translation adjustment                                                             |       | (425                             | )          | —                          |       | (1,070 | ) | — |   |
| Comprehensive  (loss) income                                                                   |       | $                                | (3,681     | )                               | $          | 6,452 |   | $ | (18,824 | ) | $ | 12,481 |   |

 

4. *Acquisitions*

 

**SurfControl**

 

In October 2007, the Company completed theacquisition of SurfControl plc (“SurfControl”), a U.K.-based provider of Weband email security solutions. The total purchase price of the acquisition wasas follows (in thousands):

 
| Cash paid for  SurfControl |   |   |   |   |   | $      | 448,760 |   |   |   |
|----------------------------|--------|--------|--------|--------|--------|--------|---------|--------|--------|--------|
| Transaction  costs         |   |   |   |   |   | 12,114 |    |   |   |
| Total purchase  price      |   |   |   |   |   | $      | 460,874 |   |   |   |

 

8

----

Tableof Contents

 

The purchase priceallocation as of September 30, 2008 is as follows (in thousands):

 
| Fair value of net tangible assets acquired and  liabilities assumed: |   |   |   |    |   |    |    |
|----------------------------------------------------------------------|--------|--------|--------|---------|--------|---------|---------|
| Cash and cash  equivalents                                           |   |   |   | $       | 65,995 |    |    |   |
| Accounts  receivable                                                 |   |   |   | 16,825  |   |    |    |
| Other current  assets                                                |   |   |   | 3,550   |   |    |    |
| Property and  equipment                                              |   |   |   | 10,666  |   |    |    |
| Deferred income  taxes                                               |   |   |   | (33,051 | )      |    |    |
| Accounts payable  and accrued expenses                               |   |   |   | (45,436 | )      |    |    |
| Deferred revenue                                                     |   |   |   | (19,729 | )      |    |    |
|                                                                 |   |   |   |    |   | (1,180  | )       |
| Fair value of identifiable intangible assets  acquired:              |   |   |   |    |   |    |    |
| Technology                                                           |   |   |   | 29,265  |   |    |    |
| Customer  relationships                                              |   |   |   | 128,500 |   |    |    |
|                                                                 |   |   |   |    |   | 157,765 |    |
| Goodwill                                                             |   |   |   |    |   | 304,289 |    |
| Total purchase price                                                 |   |   |   |    |   | $       | 460,874 |   |
|                                                                      |        |        |        |         |        |         |         |  |  |

 

In connection with theacquisition, the Company’s management approved plans to restructure theoperations of the acquired company by terminating 320 of SurfControl’semployees and exiting certain SurfControl facilities. As of September 30,2008, all of the 320 employees originally identified for termination have beenterminated and all the severance costs have been paid. These workforcereductions were across all functions and geographies and affected employeeswere provided cash severance packages. Additionally, the Company hasconsolidated facilities and has exited, or will be exiting, leases in certainlocations as well as reducing the square footage required to operate somelocations. As of September 30, 2008, the Company has finalized itsfacility exit plans. The Company has accrued the estimated costs associatedwith the employee severance and facility exit obligations as liabilitiesassumed in the acquisition of SurfControl and accordingly, these estimatedcosts are included as part of the purchase price of SurfControl. Changes to theestimates of the facility exit costs after September 2008 will be recordedas a reduction to goodwill or as an expense to the results of operations, asappropriate, in accordance with Emerging Issues Task Force Issue No. 95-3,*Recognition of Liabilities in Connection with aPurchase Business Combination*. As of September 30, 2008, $5.2million of facility exit obligations remain accrued for payments in futureperiods as follows (in thousands):

 
| ** **           | ** ** | **Balance at  December 31,  2007** | ** ** | **Cash  Payments** | ** ** | **Adjustments** | ** ** | **Foreign Exchange  Adjustments** | ** ** | **Balance at September 30,  2008** | ** ** |
|----------------------|------------|----------------------------------------------|------------|--------------------|------------|-----------------|------------|----------------------------------------|------------|---------------------------------------------------|------------|
|                 |       |                                         |       |               |       |            |       |                                   |       |                                              |       |
| Severance costs      |       | $                                            | 6,761      |               | $          | (4,760          | )          | $                                      | (2,011     | )                                                 | $          | 10 |   | $ | — |   |
| Facility exit  costs |       | 9,379                                        |       | (903               | )          | (3,098          | )          | (214                                   | )          | 5,164                                             |       |
| Total                |       | $                                            | 16,140     |               | $          | (5,663          | )          | $                                      | (5,109     | )                                                 | $          | (204 | ) | $ | 5,164 |   |

 

The accruals for facilityexit costs at September 30, 2008 represent the remaining fair value oflease obligations net of estimated sublease income for exiting locations, asdetermined at the expected cease-use dates of those facilities, and will bepaid out over the remaining lease terms, the last of which ends in fiscal year2011.

 

5. *Intangible**Assets andGoodwill*

 

Intangible assets subjectto amortization consisted of the following as of September 30, 2008 (inthousands):

 
| ** **              | ** ** | **Weighted Average Life  (years)** | ** ** | **Cost** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|-------------------------|------------|----------------------------------------------|------------|----------|------------|-------------------------------|------------|---------|------------|
|                    |       |                                         |       |     |       |                          |       |    |       |
| Technology              |       | 2.7                                          |       | $        | 43,995     |                          | $          | (14,643 | )          | $ | 29,352 |   |
| Customer  relationships |       | 5.8                                          |       | 129,200  |       | (41,135                       | )          | 88,065  |       |
| Trade name              |       | 3.3                                          |       | 510      |       | (179                          | )          | 331     |       |
| Total                   |       |                                         |       | $        | 173,705    |                          | $          | (55,957 | )          | $ | 117,748 |   |

 

9

----

Tableof Contents

 

As of September 30,2008, remaining amortization expense is expected to be as follows (inthousands):

 
| **Years Ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2008                                         |       | $          | 12,527     |   |
| 2009                                         |       | 38,827     |       |
| 2010                                         |       | 26,018     |       |
| 2011                                         |       | 15,083     |       |
| 2012                                         |       | 8,290      |       |
| Thereafter                                   |       | 17,003     |       |
| Total                                        |       | $          | 117,748    |   |

 

The following tablesummarizes the activity related to the carrying value of the Company’s goodwillduring the nine months ended September 30, 2008 (in thousands):

 
| ** **                                         | ** ** | **Nine Months Ended  September 30, 2008** | ** ** |
|----------------------------------------------------|------------|---------------------------------------------------------------|------------|
| Balance at  December 31, 2007                 |       | $                                                             | 385,916    |   |
| Reduction from  sale of CyberPatrol assets         |       | (2,148                                                        | )          |
| Refund related  to PortAuthority acquisition       |       | (147                                                          | )          |
| PortAuthority  deferred income tax adjustment      |       | (1,655                                                        | )          |
| SurfControl  deferred income tax adjustment        |       | (4,681                                                        | )          |
| Facility exit  accrual adjustment                  |       | (3,098                                                        | )          |
| Severance cost  adjustment                         |       | (2,011                                                        | )          |
| Tax contingency  adjustment                        |       | 1,572                                                         |       |
| Other  SurfControl purchase accounting adjustments |       | 895                                                           |       |
| Balance at  September 30, 2008                |       | $                                                             | 374,643    |   |

 

**6*. Senior Secured CreditFacility***

** **

In connection with the acquisition of SurfControl in October 2007,the Company entered into an amended and restated senior credit agreement (the “SeniorCredit Agreement”). The $225 million senior secured credit facility consists ofa five year $210 million senior secured term loan and a $15 million revolvingcredit facility. The senior secured term loan was fully funded on October 11,2007, and the revolving line of credit remains unused. At September 30,2008, the outstanding balance under the senior secured term loan was $140million as a result of the Company making optional prepayments totaling $50million in the nine months ended September 30, 2008, including $15 millionin the quarter ended September 30, 2008, as well as an optional $20million prepayment on December 31, 2007. In October 2008, the Companymade an additional optional prepayment of $5 million. The senior secured creditfacility is secured by substantially all of the assets of the Company,including pledges of stock of some of its subsidiaries (subject to limitationsin the case of foreign subsidiaries) and by secured guarantees by the Company’sdomestic subsidiaries. The senior secured term loan initially amortized at aminimum rate of 2.5%, 10%, 12.5%, and 15%, respectively, during the first fouryears of the term and 60% during the fifth year. In conjunction with theCompany’s optional $20 million prepayment on December 31, 2007, the Companyamended its Senior Credit Agreement to eliminate any additional mandatorypayments until September 30, 2009. The senior secured term loan bearsinterest at a spread above LIBOR with the spread determined based upon theCompany’s total leverage ratio, as defined in the Senior Credit Agreement.Prior to the third quarter 2008, the annual interest rate was LIBOR plus 250basis points (5.28% at June 30, 2008), and was subject to a potential stepdown in the spread over LIBOR based upon potential future improvements in theCompany’s total leverage ratio. The unused portion of the revolving creditfacility required a 50 basis points fee per annum, also subject to a step downbased upon potential future improvements in the Company’s total leverage ratio.Based on the total leverage ratio as of June 30, 2008, the spread on boththe senior secured term loan and revolving credit facility was reset for thethird quarter of 2008 to LIBOR plus 225 basis points (6.01% as of September 30,2008) per annum for the senior secured term loan and reduced by 25 basis pointsper annum for the unused portion of the revolving credit facility. The SeniorCredit Agreement contains financial covenants, including a consolidatedleverage ratio and a consolidated interest coverage ratio, as well asaffirmative and negative covenants. Among the negative covenants arerestrictions on the Company’s ability to borrow money, including restrictionson (a) the incurrence of more than $15 million of new debt, including capitalleases (subject to certain exceptions), (b) the incurrence of more than $7.5million in letters of credit, (c) the incurrence of more than $50 to $75million of new debt, depending on the Company’s leverage ratio, to financefuture acquisitions or (d) the assumption of more than $15 million of new debtin connection with acquisitions.

 

10

----

Tableof Contents

 

As of September 30, 2008, future remainingminimum principal payments under the senior secured term loan will be asfollows (in thousands):

 
| **Years Ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2008                                         |       | $          | —     |   |
| 2009                                         |       | 4,605      |       |
| 2010                                         |       | 19,342     |       |
| 2011                                         |       | 23,211     |       |
| 2012                                         |       | 92,842     |       |
| Total                                        |       | $          | 140,000    |   |

 

The Senior CreditAgreement provides that the Company must maintain hedge agreements so that atleast 50% of the aggregate principal amount of the senior secured creditfacility is subject to fixed interest rate protection for a period of not lessthan 2.5 years. On October 11, 2007 in conjunction with the funding of thesenior secured term loan, the Company entered into an interest rate swapagreement to pay a fixed rate of interest (4.85% per annum) and receive afloating rate interest payment (based on three month LIBOR) on an equivalentamount. The initial notional amount of the swap agreement was $105 million on October 11,2007 and it amortizes each quarter down to $11 million on September 30,2010. In addition, on October 11, 2007 the Company entered into aninterest rate cap agreement to limit the maximum interest rate on a portion ofits senior secured term loan to 6.5% per annum. The amount of principalprotected by this agreement increases from $5 million at December 31, 2007to $74.3 million on September 30, 2010. Both the interest rate swap andcap expire on September 30, 2010.

 

7. *Foreign Currency Hedges*

 

TheCompany uses derivative financial instruments to manage foreign currency riskrelating to foreign exchange rates, fluctuations arising from the sale of productsinternationally in foreign currencies, and from expenses in foreign currenciesto support those sales. The Company does not use these instruments forspeculative or trading purposes. The Company’s objective is to reduce the riskto earnings and cash flows associated with changes in foreign currency exchangerates. Derivative instruments are recognized as either assets or liabilities inthe accompanying financial statements and are measured at fair value. Gains andlosses resulting from changes in the fair values of those derivativeinstruments are recorded to earnings or other comprehensive (loss) incomedepending on the use of the derivative instrument and whether it qualifies forhedge accounting.

 

During the three and nine months ended September 30, 2008 and 2007, the Company utilized Euro foreign currency forward contracts to hedge anticipated Euro denominated accounts receivable. 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. Net realized gains (losses) related to the contracts designated as fair value hedges settled during the three and nine months ended September 30, 2008 and 2007 are included in other income, net, in the accompanying consolidated statements of operations and amounted to approximately $45,000 and $(87,000) for the three months ended September 30, 2008 and 2007, respectively and $(449,000) and $(235,000) for the nine months ended September 30, 2008 and 2007, respectively. There were no Euro contracts outstanding as of September 30, 2007.

 

During the three months ended September 30, 2008, the Company utilized British Pound foreign currency forward contracts to hedge anticipated British Pound denominated accounts receivable. 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. Net realized gains related to the contracts designated as fair value hedges settled during the three months ended September 30, 2008 are included in other income, net, in the accompanying consolidated statements of operations and amounted to approximately $2,000. There were no British Pound contracts outstanding as of September 30, 2008.

 

During the three months ended September 30, 2008, the Company utilized Israeli Shekel zero-cost collar contracts to hedge anticipated operating expenses. All such contracts entered into were designated as cash flow hedges and were considered effective as defined by SFAS No. 133, *Accounting for Derivative Instruments and Hedging Activities* (“SFAS 133”), as amended. None of the contracts were terminated prior to settlement. Net realized losses of approximately $9,000 related to the contracts designated as cash flow hedges during the three months ended September 30, 2008 are included in the respective operating categories the Company hedges its Israeli Shekel expenditures against. There were no Israeli Shekel contracts outstanding prior to the quarter ended September 30, 2008.

 

11

----

Tableof Contents

 

Notional and fair values of the Company’s Euro and Israeli Shekel hedging positions at September 30, 2008 and 2007 are presented in the table below (in thousands):

 
| ** **     | ** ** | **September 30, 2008**     | ** ** | **September 30, 2007** | ** ** |
|----------------|------------|--------------------------------------|------------|----------------------------------|------------|
| ** **     | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD**         | ** ** | **Fair Value  USD** | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD** | ** ** | **Fair Value  USD** | ** ** |
| Euro           |       | €                               | 2,500      |                             | $          | 3,735 |   | $ | 3,948 |   | € | — |   | $ | — |   | $ | — |   |
| Israeli Shekel |       | ILS                                  | 2,150      |                             | 617        |   | 623 |   | ILS | — |   | — |   | — |   |
| Total          |       |                                 |       | $                                | 4,352      |   | $ | 4,571 |   |   |   | $ | — |   | $ | — |   |
|                |            |                                      |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

8.*Fair Value Measurements*

 

*SFAS No. 157*

 

SFAS No. 157, *FairValue Measurements* (“SFAS 157”) defines fair value, establishes aframework for measuring fair value and establishes a hierarchy that categorizesand prioritizes the sources to be used to estimate fair value. SFAS 157 alsoexpands financial statement disclosures about fair value measurements. On February 12,2008, the FASB issued FASB Staff Position 157-2 (“FSP 157-2”), which delays theeffective date of SFAS 157 for one year for all nonfinancial assets andnonfinancial liabilities, except those that are recognized or disclosed at fairvalue in the financial statements on a recurring basis. The Company elected apartial deferral of SFAS 157 under the provisions of FSP 157-2 related to themeasurement of fair value used when evaluating nonfinancial assets andliabilities. The Company is currently evaluating the impact of FSP 157-2 on itsfinancial statements. The impact of partially adopting SFAS 157 effective January 1,2008 was not material to the Company’s financial statements.

 

*Fair Value Measurements on aRecurring Basis*

 

Financial assets and liabilities are classified intheir entirety based on the lowest level of input that is significant to thefair value measurements. The Company’s assessment of the significance of aparticular input to the fair value measurements requires judgment, and may affectthe valuation of the assets and liabilities being measured and their placementwithin the fair value hierarchy.

 

The following table presents the balances of assetsand liabilities measured at fair value on a recurring basis as of September 30,2008 (in thousands):

 
| ** **                          | ** ** | **Level 1****(1)** | ** ** | **Level 2****(2)** | ** ** | **Level 3****(3)** | ** ** | **Total** | ** ** |
|-------------------------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------|------------|-----------|------------|
| Assets:                             |       |                    |       |                    |       |                    |       |      |       |
| Interest rate  cap                  |       | $                       | —     |                    | $          | 63                      |       | $         | —     |   | $ | 63 |   |
| Foreign currency  forward contracts |       | —                  |       | 213                     |       | —                  |       | 213       |       |
| Zero-cost collar  contracts         |       | —                  |       | 6                       |       | —                  |       | 6         |       |
|                                |       |                    |       |                    |       |                    |       |      |       |
| Liabilities:                        |       |                    |       |                    |       |                    |       |      |       |
| Interest rate  swaps                |       | $                       | —     |                    | $          | 1,399                   |       | $         | —     |   | $ | 1, 399 |   |

 

----

(1) – quotedprices in active markets for identical assets or liabilities

(2) – observableinputs other than quoted prices in active markets for identical assets andliabilities

(3) – noobservable pricing inputs in the market

 

Included in Other assets and in Other accrued expensesare derivative contracts, comprised of interest rate swaps and an interest ratecap as well as foreign currency forward contracts and zero-cost collar contracts,that are valued using models based on readily observable market parameters forall substantial terms of the Company’s derivative contracts and thus areclassified within Level 2.

 

*Fair Value Measurements on aNonrecurring Basis*

 

As permitted by FSP 157-2, the Company elected todefer the fair value measurement disclosure of its nonfinancial assets andliabilities.

 

*SFAS No. 159*

 

SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities—Including an Amendment of SFAS 115*(“SFAS 159”), permits but does not require companies to measure financialinstruments and certain other items at 

 

12

----

Tableof Contents

 

fair value. Unrealized gains and losses on items forwhich the fair value option has been elected are reported in earnings. As theCompany did not elect to fair value any of its financial instruments under theprovisions of SFAS 159, the adoption of this statement effective January 1,2008 did not have an impact on the Company’s financial statements.

 

9.*Stockholders’ Equity*

 

**Share-Based Compensation**

 

*Employee Stock Option Plans*

 

The following tablesummarizes the Company’s stock option activity since December 31, 2007:

 
| ** **                          | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|-------------------------------------|------------|----------------------------|------------|--------------------------------------------|------------|
| Balance at  December 31, 2007  |       | 9,086,786                  |       | $                                          | 22.62      |   |
| Granted                             |       | 2,593,950                  |       | 19.14                                      |       |
| Exercised                           |       | (293,655                   | )          | 12.91                                      |       |
| Cancelled                           |       | (815,039                   | )          | 22.46                                      |       |
| Balance at  September 30, 2008 |       | 10,572,042                 |       | 22.04                                      |       |
|                                     |            |                            |            |                                            |            |  |

 

The results of operations for the three and ninemonths ended September 30, 2008 and 2007 include share-based compensationexpense in the following expense categories of the consolidated statements ofoperations (in thousands):

 
| ** **                                            | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                            | ** ** | **September 30,  2008**     | ** ** | **September 30,  2007**    | ** ** | **September 30,  2008** | ** ** | **September 30,  2007** | ** ** |
| Share-based  compensation in:                         |       |                             |       |                            |       |   |   |   |   |
| Cost of revenues                                      |       | $                                | 314        |                            | $          | 380 |   | $ | 991 |   | $ | 1,097 |   |
| Total  share-based compensation in cost of revenues   |       | 314                              |       | 380                             |       | 991 |   | 1,097 |   |
|                                                  |       |                             |       |                            |       |   |   |   |   |
| Selling and  marketing                                |       | 2,072                            |       | 2,231                           |       | 6,638 |   | 6,436 |   |
| Research and  development                             |       | 1,204                            |       | 1,083                           |       | 3,527 |   | 2,969 |   |
| General and  administrative                           |       | 2,240                            |       | 1,857                           |       | 6,853 |   | 5,585 |   |
| Total  share-based compensation in operating expenses |       | 5,516                            |       | 5,171                           |       | 17,018 |   | 14,990 |   |
| Total  share-based compensation                       |       | $                                | 5,830      |                            | $          | 5,551 |   | $ | 18,009 |   | $ | 16,087 |   |

 

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

 
| ** **                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | **September 30,  2008**     | ** ** | **September 30,  2007**    | ** ** | **September 30,  2008** | ** ** | **September 30,  2007** | ** ** |
|                                |       |                             |       |                            |       |   |   |   |   |
| Average expected  life (years)      |       | 3.0                              |       | 3.0                             |       | 3.0 |   | 3.1 |   |
| Average expected  volatility factor |       | 35.1                             | %          | 35.9                            | %          | 34.9 | % | 35.3 | % |
| Average risk-free  interest rate    |       | 2.7                              | %          | 4.3                             | %          | 2.6 | % | 4.6 | % |
| Average expected  dividend yield    |       | —                           |       | —                          |       | — |   | — |   |

 

*Treasury Stock*

 

The Company resumedrepurchasing shares of its common stock during the first nine months of 2008 asfollows.

 

13

----

Tableof Contents

 
| ** **                                                               | ** ** | **Shares** | ** ** | **Average Price  Per Share** | ** ** |
|--------------------------------------------------------------------------|------------|------------|------------|----------------------------------------|------------|
| Shares  repurchased through December 31, 2007                       |       | 8,170,060  |       | $                                      | 20.86      |   |
| Shares  repurchased during the nine months ended September 30, 2008 |       | 790,292    |       | $                                      | 18.96      |   |
| Total shares  repurchased through September 30, 2008                |       | 8,960,352  |       | $                                      | 20.69      |   |

 

Under the terms of theCompany’s Senior Credit Agreement, the Company is restricted from repurchasingits common stock for an aggregate purchase price that exceeds the sum of $25million plus 50% of the aggregate amount of its consolidated net income, asdefined in the Senior Credit Agreement, during the period from the effectivedate of the facility through the most recent quarter end for which quarterlyfinancial statements have been filed. The remaining shares authorized forrepurchase under the Company’s stock repurchase program as of September 30,2008 was 3,039,648 shares. As of September 30, 2008, $34.6 millionremained authorized for repurchase under the Company’s Senior Credit Agreement.

 

10. *Tax Matters*

 

The Company adopted FASB Interpretation 48, *Accounting for Uncertainty in Income Taxes*(“FIN 48”), at the beginning of fiscal year 2007. At September 30, 2008,the Company had approximately $8.4 million of total gross unrecognized taxbenefits. Included in this balance are $5.2 million of unrecognized taxbenefits that, if recognized, would reduce the Company’s annual effective taxrate. Estimated interest and penalties related to the underpayment of incometaxes are classified as a component of provision for income taxes in theconsolidated statements of operations. The Company accrued potential penaltiesand interest of $0.3 million related to these unrecognized tax benefits duringthe nine months ended September 30, 2008, and in total, as of September 30,2008, the Company has recorded a liability for potential penalties and interestof $0.8 million.

 

The Company and itssubsidiaries are subject to U.S. federal income tax as well as income tax ofmultiple state and foreign jurisdictions. The Company has substantiallyconcluded all U.S. federal and state income tax audits for years through 2003.Substantially all material foreign income tax audits have been concluded foryears through 2002. The federal income tax return for 2005 and Californiaincome tax returns for 2003 and 2004 are currently under examination. At September 30,2008, the Company had net deferred tax assets of $50.9 million.

 

During the quarter ended March 31,2008, the Company received a favorable ruling regarding unrecognized stateincome tax benefits, resulting in the reduction of the gross uncertain taxliability of $4.2 million. This favorable ruling resulted in approximately $2.7million of net tax benefit being recognized in the consolidated statement ofoperations in the nine months ended September 30, 2008 with the remaining$1.5 million being recorded as a reduction to the related deferred tax asset.In addition, due to the potential resolution of federal, state and foreign taxexaminations, and the expiration of various statutes of limitations, it isreasonably possible that the Company’s gross unrecognized tax benefits balancemay change within the next twelve months by a range of zero to $0.7 million.

 

11*. Litigation*

 

The Company is involvedin various legal actions in the normal course of business. Based on currentinformation, including consultation with the Company’s lawyers, the Companybelieves that it has adequately reserved for any ultimate liability that mayresult from these actions such that any liability would not materially affectthe Company’s consolidated financial position, results of operations or cashflows. The Company’s evaluation of the likely impact of these actions couldchange in the future and unfavorable outcomes and/or defense costs, dependingupon the amount and timing, could have a material adverse effect on the Company’sresults of operations or cash flows in a future period.

 

12. *RecentlyIssued Accounting Standards*

 

In March 2008 theFASB issued SFAS No. 161, *Disclosures aboutDerivative Instruments and Hedging Activities, an Amendment of FASB Statement No. 133*(“SFAS 161”), which requires additional disclosures about the objectives of thederivative instruments and hedging activities, the method of accounting forsuch instruments under SFAS 133 and its related interpretations, and a tabulardisclosure of the effects of such instruments and related hedged items on theCompany’s financial position, financial performance and cash flows. SFAS 161 iseffective for the Company beginning January 1, 2009. The Company iscurrently assessing the potential impact that adoption of SFAS 161 may have onits financial statements.

 

14

----

Table of Contents

 

In December 2007 theFASB issued SFAS No. 141R, *BusinessCombinations* (“SFAS 141R”). SFAS 141R establishesprinciples and requirements for how the acquirer of a business recognizes andmeasures in its financial statements the identifiable assets acquired, theliabilities assumed and any noncontrolling interest in the acquiree. Thestatement also provides guidance for recognizing and measuring the goodwillacquired in the business combination and establishes what information todisclose to enable users of the financial statements to evaluate the nature andfinancial effects of the business combination. SFAS 141R is effective forfinancial statements issued for fiscal years beginning after December 15,2008. Accordingly, any business combinations the Company engages in will berecorded and disclosed following existing GAAP until January 1, 2009. TheCompany expects SFAS 141R may have an impact on its consolidated financialstatements when effective, but the nature and magnitude of the specific effectswill depend upon the nature, terms and size of the acquisitions, if any,consummated after the effective date. The Company is currently assessing the potentialimpact that adoption of SFAS 141R may have on its financial statements.

 

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

** **

**The following discussion and analysis should be read inconjunction with the financial statements and related notes contained elsewherein this report. See “Risk Factors” under Part II, Item 1A below regardingcertain factors known to us that could cause reported financial information notto be necessarily indicative of future results.**

** **

**Forward-LookingStatements**

** **

**This report on Form 10-Q may contain “forward-lookingstatements” within the meaning of the federal securities laws made pursuant tothe safe harbor provisions of the Private Securities Litigation Reform Act of1995. These statements, which represent our expectations or beliefs concerningvarious future events, may contain words such as “may,” “will,” “expects,” “anticipates,”“intends,” “plans,” “believes,” “estimates” or other words indicating futureresults. Such statements may include but are not limited to statementsconcerning the following:**

** **

·                  anticipatedtrends in revenue;

 

·                  plans,strategies and objectives of management for future operations;

 

·                  growthopportunities in domestic and international markets;

 

·                  new and enhancedchannels of distribution;

 

·                  customeracceptance and satisfaction with our products;

 

·                  risks associatedwith fluctuations in foreign currency exchange rates;

 

·                  expected trendsin operating and other expenses;

 

·                  anticipated cashand intentions regarding usage of cash;

 

·                  risks associatedwith integrating acquired businesses and launching new product offerings;

 

·                  changes ineffective tax rates; and

 

·                  anticipatedproduct enhancements or releases.

 

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

** **

**Overview**

 

Since we commencedoperations in 1994 as a reseller of computer security products, Websense hasevolved from a Web filtering company into a leading provider of integratedcontent security software solutions, including Web security, email andmessaging security and data loss prevention (“DLP”) solutions. Our customersuse our software products to provide employees, business partners and customerswith a secure and productive computing environment that protects essentialinformation and enables safe Internet access, online collaboration andelectronic commerce.

 

15

----

Table of Contents

 

In today’s computingenvironments, customers must deploy integrated Web, email and data securityproducts to achieve effective protection against blended Web and email attacks,as well as from inadvertent data leaks due to faulty business processes.  To meet our customers’ requirements forcomprehensive protection from these internal and external security risks, in2006, we began expanding our product offering beyond Web filtering through bothinternal development and through acquisitions. In January 2007, we enteredthe emerging market for DLP through our acquisition of PortAuthorityTechnologies, Inc. (“PortAuthority”), a technology leader in the segmentand our technology development partner for DLP solutions. In October 2007,we acquired SurfControl plc (“SurfControl”), a leading provider of Web andemail security software solutions, which expanded our product portfolio toinclude email security software and hosted Web and email security solutions.Additionally, we have developed new Web security gateway software capable ofdynamic Web content categorization and real-time detection and removal ofmalware from incoming Web traffic.

 

Today, we offercomprehensive suites of Web, email and data security products, available aslayered software or hosted (on-demand) solutions. We have focused onintegrating the intelligence and functionality from each of these productsuites to provide more effective protection. Our products allow organizationsto:

 

·                 prevent access to undesirable anddangerous elements on the Web, such as Web 2.0 sites that contain inappropriatecontent or sites that download an ever-increasing variety of malicious code;

 

·                 filter unwanted emails or “spam” outof incoming email traffic;

 

·                 filter viruses and other maliciousattachments from email and instant messages;

 

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

 

·                 restrict the unauthorized use and lossof sensitive data, such as customer or employee information; and

 

·                 control misuse of an organization’svaluable computing resources, including unauthorized downloading ofhigh-bandwidth content.

 

Collectively, oursoftware products secure an organization’s confidential data and increase theproductivity of its employees so they can safely conduct businesselectronically with partners and over the Internet.  Fundamental to our products are:

 

·                 proactive discovery of Web andinternal content, which is classified into highly granular database categories;

 

·                 proactive discovery and identificationof Web-based threats, including spyware, hacking tools, keyloggers, phishingand pharming exploits;

 

·                 dynamic classification ofuncategorized, high-risk Web content, including user-generated Web 2.0 content,based on our knowledge of the Web, email attack vectors and malicious codecharacteristics; and

 

·                 policy software that automatesenforcement of pre-defined business policies regarding acceptable users anduses of various Web and internal content categories.

 

During the nine monthsended September 30, 2008, we derived approximately 44% of our revenue frominternational sales, compared with approximately 40% for the nine months ended September 30,2007, with the United Kingdom comprising approximately 14% and 10% of our totalrevenue for the nine months ended September 30, 2008 and 2007,respectively. We believe international markets continue to represent asignificant growth opportunity and we are continuing to expand ourinternational operations, particularly in selected countries in the European,Asia/Pacific, Latin American and Australian markets.

 

We sell our productsprimarily through two tier distribution channels.  On occasion, we do sell products directly tovalue-added resellers or to customers, but sales through indirect channelscurrently account for more than 90% of our revenue.

 

As described elsewhere inthis report, we recognize revenue from subscriptions to our products on a dailystraight-line basis over the term of the subscription agreement, commencing onthe first day of the subscription term. We recognize the operating expensesrelated to these sales as they are incurred. These operating expenses includesales commissions, which are based on the total amount of the subscriptioncontract and are fully expensed in the period the subscription term begins.Operating expenses have continued to increase as compared with prior periodsdue to expanded selling and marketing efforts, continued product research anddevelopment and investments in administrative infrastructure to supportsubscription sales that we will recognize as revenue in subsequent periods.

 

16

----

Table of Contents

 

In October 2007, wecompleted our acquisition of SurfControl. As a result of expenses related tothe combination and certain accounting adjustments, we are incurring operatinglosses under U.S. generally accepted accounting principles (“GAAP”). Similar toWebsense, SurfControl sold products primarily under subscriptions wherebyrevenues were initially recorded as deferred revenue and recognized ratablyover the term of the agreement. Under GAAP purchase accounting, we wrote off$97.4 million of SurfControl’s deferred revenue, leaving a balance of $19.7million as the fair value of the obligation. This adjustment reflects the fairvalue of the post-contract technical support services that will be recognizeddaily in accordance with our revenue recognition policy. We did not expect togenerate significant revenue from the installed SurfControl customer base untilexisting SurfControl subscriptions were renewed and we expected revenue fromthe SurfControl revenue base to increase over time as subscriptions wererenewed. In connection with the acquisition, we have incurred restructuringcosts primarily in connection with reducing SurfControl headcount andeliminating redundant facilities.  Wealso started to incur the expenses of managing the SurfControl operations aswell as recording the amortization of the acquired intangibles.  As a result, we expect to continue to operateat a loss under GAAP until we generate sufficient revenue from the renewal ofsubscriptions of the installed SurfControl customer base.  Given the average remaining term of theSurfControl subscriptions, we do not expect to operate at a profit under GAAPin fiscal year 2008.  Our ability toretain SurfControl customers and maintain our overall pricing levels for ourproducts will impact our results of operations and the timing of our return toprofitability.

 

In connection with theacquisition of SurfControl, we approved plans to restructure the operations ofthe acquired company by terminating 320 of SurfControl’s employees and exitingcertain SurfControl facilities. As of September 30, 2008, all of the 320employees that we identified as being subject to the involuntary terminationhave been terminated and all the severance costs have been paid. These workforcereductions were across all functions and geographies and affected employeeswere provided cash severance packages. Additionally, we have consolidatedfacilities and have exited, or will be exiting, leases in certain locations aswell as reducing the square footage required to operate some locations. Ourfacility exit plans were finalized in September 2008. We have accrued theestimated costs associated with the employee severance and facility exitobligations as liabilities assumed in the acquisition of SurfControl and,accordingly, included the costs as part of the purchase price of SurfControl.Changes to the estimates of the facility exit costs after September 2008will be recorded either as a reduction to goodwill or as an expense to theresults of operations, as appropriate.

 

**Critical Accounting Policies and Estimates**

** **

We believe the followingcritical accounting policies affect our more significant judgments andestimates used in the preparation of our consolidated financial statements.

 

*Revenue Recognition.* When apurchase decision is made for our products, customers enter into a subscriptionagreement, which is generally 12, 24 or 36 months in duration and for a fixednumber of users. Other services such as upgrades/enhancements and standard post-contracttechnical support services are sold together with our product subscription andprovided throughout the subscription term. We recognize revenue on a daily straight-line basis commencing on thedate the term of the subscription begins, and continuing over the term of thesubscription agreement, provided the fee is fixed or determinable, persuasiveevidence of an arrangement exists and collectability is reasonably assured.Upon entering into a subscription arrangement for a fixed or determinable fee,we electronically deliver access codes to users and then promptly invoicecustomers for the full amount of their subscriptions. Payment is due for thefull term of the subscription, generally within 30 to 60 days of the invoice.We record amounts billed to customers in excess of recognizable revenue asdeferred revenue on our balance sheet. For our U.S. dollar functional currencyentities, when we enter into a subscription agreement that is denominated andpaid in a currency other than U.S. dollars, we record the subscription billingand deferred revenue in U.S. dollars based upon the currency exchange rate ineffect on the last day of the previous month before the subscription agreementis signed.

 

We record distributormarketing payments and channel rebates as an offset to revenue. We recognizedistributor marketing payments as an offset to revenue as the marketing serviceis provided. We recognize channel rebates as an offset to revenue on astraight-line basis over the term of the subscription agreement.

 

*Acquisitions, Goodwill and Other Intangible Assets.* We account for acquired businesses using thepurchase method of accounting in accordance with SFAS No. 141, *Business Combinations*, which requires that the assetsacquired and liabilities assumed be recorded at the date of acquisition attheir respective fair values.  Any excessof the purchase price over the estimated fair values of net assets acquired isrecorded as goodwill.  The fair value ofintangible assets, including acquired technology and customer relationships, isbased on significant judgments made by management and accordingly we obtain theassistance from third party valuation specialists.  The valuations anduseful life assumptions are based on information available near the acquisitiondate and are based on expectations and assumptions that are consideredreasonable 

 

17

----

Table of Contents

 

by management.  The judgments made in determining estimatedfair values assigned to assets acquired and liabilities assumed, as well asasset lives, can materially impact our results of operations.

 

In accordance with SFAS No. 142,*Goodwill and Other Intangible Assets*, wereview goodwill that has an indefinite useful life for impairment at leastannually in our fourth fiscal quarter, or more frequently if an event occursindicating the potential for impairment. We amortize the cost of identified intangible assets using amortizationmethods that reflect the pattern in which the economic benefits of the intangible assets are consumed orotherwise used up.  In accordance withSFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets* (“SFAS 144”), we reviewintangible assets that have finite useful lives when an event occurs indicatingthe potential for impairment.  We reviewfor 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 tolong-lived assets based on the amount by which the carrying amounts of theseassets exceed their fair values.  Wemeasure fair value under SFAS 144, which is generally based on the estimatedfuture cash flows. Our analysis is based on available information and onassumptions and projections that we consider to be reasonable andsupportable.  If necessary, we performsubsequent calculations to measure the amount of the impairment loss based onthe excess of the carrying value over the fair value of the impaired assets.

 

*Share-Based Compensation.***Effective January 1, 2006, weadopted the provisions of SFAS No. 123(R), *Share-Based Payment*(“SFAS 123R”) and Staff Accounting Bulletin No. 107 (“SAB 107”) requiringthe measurement and recognition of all share-based compensation under the fairvalue method.  Share-based compensationexpense related to stock options is recorded based on the fair value of theaward on its grant date which we estimate using the Black-Scholesvaluation model in accordance with the provisions prescribed under SFAS 123Rand SAB 107.  Share-based compensationexpense related to restricted stock unit awards is calculated based on themarket price of our common stock on the date of grant.

 

*Income Tax Provision and Uncertain Tax Positions.*Significant judgment is required in determining our consolidated income taxprovision and evaluating our U.S. and foreign tax positions. We adopted FASBInterpretation 48, *Accounting forUncertainty in Income Taxes* (“FIN 48”) beginning in 2007. FIN 48addresses the determination of how tax benefits claimed, or expected to beclaimed, on a tax return should be recorded in the financial statements. UnderFIN 48, we must recognize the tax benefit from an uncertain tax position onlyif it is more likely than not that the tax position will be sustained onexamination by the taxing authorities, based on the technical merits of theposition. The tax benefits recognized in the financial statements from such aposition are measured based on the largest benefit that has a greater thanfifty percent likelihood of being realized upon resolution. We consider manyfactors when evaluating and estimating our tax positions and tax benefits,which may require periodic adjustments and which may not accurately anticipateactual outcomes.

 

18

----

Table of Contents

 

# **Resultsof Operations**

#  

***Three months ended September 30, 2008 compared with thethree months ended September 30, 2007***

 

Thefollowing table summarizes our operating results as a percentage of totalrevenue for each of the periods shown.

 
| ** **                            | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|
| ** **                            | ** ** | **September 30,  2008**     | ** ** | **September 30,  2007** | ** ** |
| ** **                            | ** ** | **(Unaudited)**                  | ** ** |
| ** **                            | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Revenue                               |       | 100                              | %          | 100 | % |
|                                  |       |                             |       |   |   |
| Cost of revenues:                     |       |                             |       |   |   |
| Cost of revenues                      |       | 12                               |       | 9 |   |
| Amortization of  acquired technology  |       | 4                                |       | 1 |   |
| Total cost of  revenues               |       | 16                               |       | 10 |   |
|                                  |       |                             |       |   |   |
| Gross margin                          |       | 84                               |       | 90 |   |
|                                  |       |                             |       |   |   |
| Operating expenses:                   |       |                             |       |   |   |
| Selling and  marketing                |       | 56                               |       | 50 |   |
| Research and  development             |       | 17                               |       | 17 |   |
| General and  administrative           |       | 14                               |       | 13 |   |
| Total operating  expenses             |       | 87                               |       | 80 |   |
|                                  |       |                             |       |   |   |
| (Loss) income  from operations        |       | (3                               | )          | 10 |   |
|                                  |       |                             |       |   |   |
| Interest expense                      |       | (4                               | )          | — |   |
| Other income,  net                    |       | —                           |       | 8 |   |
|                                  |       |                             |       |   |   |
| (Loss) income  before income taxes    |       | (7                               | )          | 18 |   |
|                                  |       |                             |       |   |   |
| (Benefit)  provision for income taxes |       | (2                               | )          | 5 |   |
|                                  |       |                             |       |   |   |
| Net (loss)  income                    |       | (5                               | )%         | 13 | % |

 

# **Revenue**

#  

Revenue increased to$76.7 million in the third quarter of 2008 from $50.4 million in the thirdquarter of 2007. The increase was a result primarily of additional customerseats in new, renewed and upgraded subscriptions (including $18.7 million fromnew or renewed SurfControl seat subscriptions and $1.9 million of revenue recognizedfrom the deferred revenue acquired from SurfControl in October 2007). Thenumber of seats under subscription increased by 62% from September 30, 2007 toSeptember 30, 2008 primarily due to the SurfControl acquisition. Revenue fromDLP products initally acquired from PortAuthority contributed $1.2 million forthe third quarter of 2008 compared to $0.6 million for the third quarter of2007. For the remainder of 2008, we expect our revenue to increase over 2007due to the addition of our acquired SurfControl business, our deferred revenueunder existing subscriptions, our renewal business and planned growth in sales,partially offset by increased channel marketing payments and channel rebates,which are recorded as reductions to revenue.

 

# **Cost of Revenues**

#  

*Cost ofrevenues.* Cost of revenues consists of the costs of contentreview, technical support and infrastructure costs associated with maintainingour databases and costs associated with providing our hosted security services.Cost of revenues increased to $9.2 million in the third quarter of 2008 from$4.5 million in the third quarter of 2007. The $4.7 million increase primarily consistedof $1.3 million related to increased personnel costs in our technical supportand database groups, including the increased headcount attributable to theacquisition of SurfControl, $0.8 million related to the addition of hostedservices through the acquisition of SurfControl and $1.4 million related to increasedallocated costs. Our headcount in cost of revenue departments increased from164 employees at September 30, 2007 to 239 employees at September 30,2008. We allocate the costs for human resources, employee benefits, payrolltaxes, information technology, facilities and fixed asset depreciation to 

 

19

----

Table of Contents

 

each of our functionalareas based on headcount data. As a percentage of revenue, cost of revenuesincreased to 12% from 9% during the third quarter of 2008 compared to2007.  We expect cost of revenue toremain higher in absolute dollars for the remainder of 2008 as compared to 2007in order to support the growth and maintenance of our databases and due to costsassociated with providing our hosted security services as well as the technicalsupport needs of our customers.

 

*Amortization of acquiredtechnology.* Amortization of acquired technology primarilyrelates to the developed technology acquired from the PortAuthority acquisitionin January 2007 and SurfControl acquisition in October 2007. Theincrease of $2.5 million in amortization of acquired technology from the thirdquarter of 2007 to the third quarter of 2008 was primarily due to theacquisition of SurfControl in October 2007. The acquired technology isbeing amortized over a weighted average period of 2.7 years. We expect to incur$3.1 million in amortization expense of acquired technology during theremainder of 2008.

 

# **GrossMargin**

# ** **

Gross margin increased to$64.4 million in the third quarter of 2008 from $45.3 million in the thirdquarter of 2007. As a percentage of revenue, gross margin decreased to 84% inthe third quarter of 2008 from 90% in the third quarter of 2007 due to theincreased costs described in the preceding Cost of Revenues section. We expectthat gross margin as a percentage of revenue will remain in excess of 80% ofrevenue for the remainder of 2008.

 

# **OperatingExpenses**

# ** **

*Sellingand marketing*. Selling and marketing expenses consist primarilyof salaries, commissions and benefits related to personnel engaged in selling,marketing and customer support functions, including costs related to publicrelations, advertising, promotions and travel, amortization of acquiredcustomer relationships as well as allocated costs. Selling and marketingexpenses do not include payments to channel partners for marketing services andrebates.  Selling and marketing expensesincreased to $43.0 million, or 56% of revenue, in the third quarter of 2008,from $25.2 million, or 50% of revenue, in the third quarter of 2007.Approximately $9.3 million of the increase was due to the amortization ofacquired intangibles (customer relationships) which resulted from theacquisition of SurfControl in October 2007. The acquired customer relationshipsintangible assets are being amortized over a weighted average period ofapproximately 5.8 years. In addition to the amortization of acquired intangibleassets, the increase in selling and marketing expenses was primarily due toincreased personnel costs of $6.2 million and related travel of $0.6 million,including new personnel added from the SurfControl acquisition in October 2007and $1.6 million of increased allocated costs. Our headcount in sales andmarketing increased from 400 employees at September 30, 2007 to 531 employeesat September 30, 2008. We expect overall selling and marketing expenses to decreasein absolute dollars for the remainder of 2008 as compared to 2007 primarily dueto a reduction of $3.7 million in the amount of amortization of acquiredintangibles from the SurfControl acquisition due to the accelerated nature ofthe amortization, offset by having additional sales and marketing personnel tosupport our expanding selling and marketing efforts worldwide and increasedsales resulting in higher overall sales commission expenses. We expectamortization of acquired intangibles of $9.4 million for the remainder of 2008as a result of the amortization of acquired intangibles from the SurfControland PortAuthority acquisitions.

 

*Research and development.* Research and development expensesconsist primarily of salaries and benefits for software developers andallocated costs. Research and development expenses increased to $13.1 million,or 17% of revenue, in the third quarter of 2008 from $8.3 million, or 17% ofrevenue, in the third quarter of 2007. The increase of $4.8 million in researchand development expenses was primarily due to $3.2 million of increasedpersonnel cost, including adding new full time employees due to the SurfControlacquisition in October 2007, and increased hiring to support our release of ourWeb content gateway, data loss prevention endpoint module and enhancements toour other products as well as to support our expanding list of technologypartners and $1.4 million of increased allocated costs. Our headcount increasedin research and development from 211 employees at September 30, 2007 to 353employees at September 30, 2008. We expect future research and developmentexpenses to increase in absolute dollars for the remainder of 2008 as comparedto 2007 due to having an expanded base of product offerings and the personneland facilities required to develop and maintain the expanded product offerings.  We are managing the increase in our absoluteresearch and development expenses by operating research and developmentfacilities in multiple international locations, including a facility in Beijing,China that we are in the process of expanding, that have lower costs than ouroperations in the United States. As a result of the PortAuthority andSurfControl acquisitions, we now have research and development facilities inRa’anana, Israel; Sydney, Australia; Los Gatos, California and Reading,England, that have contributed to our increased research and developmentexpenses.

 

*Generaland administrative*. General and administrative expensesconsist primarily of salaries, benefits and related expenses for our executive,finance and administrative personnel, third party professional service fees andallocated costs. General and administrative expenses increased to $10.8million, or 14% of revenue, in the third quarter of 2008 from $6.8 

 

20

----

Table of Contents

 

million, or 13% ofrevenue, in the third quarter of 2007. The $4.0 million increase in general andadministrative expense was primarily due to $1.4 million of increased personnelcosts needed to support our growing operations, including the acquisition ofSurfControl in October 2007 and $0.8 million of increased allocatedcosts.  Our headcount increased ingeneral and administrative departments from 75 employees at September 30,2007 to 115 employees at September 30, 2008.  We expect general and administrative expensesto decrease in absolute dollars for the remainder of 2008 as compared to 2007due to the reduction of the legacy SurfControl personnel in the general andadministrative areas.

 

**Interest Expense**

** **

Interest expenseincreased to $3.0 million in the third quarter of 2008 from zero in the thirdquarter of 2007. Interest expense represents the interest incurred on oursenior secured term loan that we utilized to pay for a portion of theSurfControl purchase price in October 2007.  Also included in the interest expense is$513,000 of amortization of deferred financing fees that were capitalized aspart of the senior secured credit facility. The amount of interest expense will fluctuate due to changes in theoutstanding principal balance and due to changes in LIBOR and changes in ourapplicable spread to LIBOR based upon improvements in our leverage ratio inaccordance with our senior secured credit facility agreement. Interest expenseshould decline in the fourth quarter of 2008 as compared to the fourth quarterof 2007 due to the lower outstanding principal amount and the expected lowermarginal interest rate on the non-fixed rate component of our senior securedcredit facility due to the reduction in our spread over LIBOR. Fluctuations inLIBOR could impact our marginal interest rate.

 

# **Other (Expense) Income, Net**

#  

Other(expense) income, net decreased to a net expense of $0.1 million in the thirdquarter of 2008 from net other income of $3.9 million in the third quarter of2007. The decrease was due primarily to reduced interest income ofapproximately $2.3 million in the third quarter of 2008 compared to the thirdquarter of 2007 as a result of our use of approximately $245 million in cash,cash equivalents and marketable securities to fund the acquisition ofSurfControl in October 2007, and foreign exchange re-measurement losses ofapproximately $1.8 million due to unfavorable movements in the foreign exchangerates during the third quarter of 2008 compared to the third quarter of2007.  Due to the reduced cash, cashequivalents and marketable securities as a result of the acquisition ofSurfControl as well as the prepayments on our senior secured term loan andstock repurchases, we expect other income, net to decrease in absolute dollarsduring the remainder of 2008 as compared to 2007.

 

# **Provision for Income Taxes**

#  

Werecognized an income tax benefit of $2.1 million and an income tax expenseof $2.5 million for the three months ended September 30, 2008 and2007, respectively. Our effective tax rates were a tax benefit of 37.0% and atax provision of 27.7% for the three months ended September 30, 2008 and September 30,2007, respectively. Our effective tax rate increased from the third quarter of2007 to the third quarter of 2008 primarily due to our results of operations inforeign jurisdictions, including the allocation of profit among jurisdictionswith varying tax rates and an increase in foreign withholding taxes, as well asthe impact that non-deductible items, primarily share-based compensation, hadon the amount of tax benefit recorded on our losses from operations. Inaddition, our effective tax rate in the third quarter of 2007 was impacted bythe unrealized loss on a foreign currency option contract purchased inconnection with the SurfControl acquisition and certain tax exempt interestincome that did not recur in 2008.

 

Oureffective tax rate may change in future periods due to the composition oftaxable income between domestic and international operations along with thepotential changes or interpretations in tax rules and legislation, orcorresponding accounting rules.

 

Inaccordance with the provisions of SFAS 109, we assess, on a quarterly basis,the realizability of our deferred income tax assets. Realization of deferredincome tax assets is dependent upon taxable income in prior carryback years,estimates of future taxable income, tax planning strategies and reversals ofexisting taxable temporary differences. Based on our assessment of these itemsduring the third quarter of 2008, it is more likely than not that we will beable to fully utilize our deferred tax assets.

 

21

----

Table of Contents

 

***Nine months ended September 30, 2008 compared with thenine months ended September 30, 2007***

 

Thefollowing table summarizes our operating results as a percentage of totalrevenue for each of the periods shown.

 
| ** **                            | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------|------------|---------------------------------|------------|
| ** **                            | ** ** | **September 30,  2008**    | ** ** | **September 30,  2007** | ** ** |
| ** **                            | ** ** | **(Unaudited)**                 | ** ** |
| ** **                            | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Revenue                               |       | 100                             | %          | 100 | % |
|                                  |       |                            |       |   |   |
| Cost of revenues:                     |       |                            |       |   |   |
| Cost of revenues                      |       | 12                              |       | 9 |   |
| Amortization of  acquired technology  |       | 4                               |       | 1 |   |
| Total cost of  revenues               |       | 16                              |       | 10 |   |
|                                  |       |                            |       |   |   |
| Gross margin                          |       | 84                              |       | 90 |   |
|                                  |       |                            |       |   |   |
| Operating  expenses:                  |       |                            |       |   |   |
| Selling and  marketing                |       | 60                              |       | 50 |   |
| Research and  development             |       | 19                              |       | 18 |   |
| General and  administrative           |       | 16                              |       | 14 |   |
| Total operating  expenses             |       | 95                              |       | 82 |   |
|                                  |       |                            |       |   |   |
| (Loss) income  from operations        |       | (11                             | )          | 8 |   |
|                                  |       |                            |       |   |   |
| Interest expense                      |       | (5                              | )          | — |   |
| Other income,  net                    |       | —                          |       | 5 |   |
|                                  |       |                            |       |   |   |
| (Loss) income  before income taxes    |       | (16                             | )          | 13 |   |
|                                  |       |                            |       |   |   |
| (Benefit)  provision for income taxes |       | (8                              | )          | 5 |   |
|                                  |       |                            |       |   |   |
| Net (loss)  income                    |       | (8                              | )%         | 8 | % |

 

# **Revenue**

#  

Revenue increasedto $216.6 million in the first nine months of 2008 from $150.6 million in thefirst nine months of 2007. The increase was a result primarily of additionalcustomer seats in new, renewed and upgraded subscriptions (including $44.6million from new or renewed SurfControl seat subscriptions and $8.9 million ofrevenue recognized from the deferred revenue acquired from SurfControl in October 2007).The number of seats under subscription increased by 62% from September 30, 2007to September 30, 2008 primarily due to the SurfControl acquisition. Revenuefrom DLP products initially acquired from PortAuthority contributed $3.2million for the first nine months of 2008 compared to $1.2 million for thefirst nine months of 2007.

 

# **Cost of Revenues**

#  

*Cost ofrevenues.* Cost of revenues increased to $26.6 million in thefirst nine months of 2008 from $13.3 million in the first nine months of 2007.The $13.3 million increase primarily consisted of $4.3 million related toincreased personnel costs in our technical support and database groups,including the increased headcount attributable to the acquisition ofSurfControl, and the addition of DLP products, $2.7 million related to theaddition of hosted services through the acquisition of SurfControl and $3.1million related to increased allocated costs. Our headcount in cost of revenuedepartments increased from 164 employees at September 30, 2007 to 239employees at September 30, 2008.

 

*Amortizationof acquired technology.* Amortization of acquired technologyprimarily relates to the developed technology acquired from the PortAuthorityacquisition in January 2007 and SurfControl acquisition in October 2007.The increase of $7.4 million in amortization of acquired technology from thefirst nine months of 2007 to the first nine months of 2008 was primarily due tothe acquisition of SurfControl in October 2007.

 

22

----

Table of Contents

 

# **Gross Margin**

 

Grossmargin increased to $180.7 million in the first nine months of 2008 from $135.4million in the first nine months of 2007. As a percentage of revenue, grossmargin decreased to 84% in the first nine months of 2008 from 90% in the firstnine months of 2007 due to the increased costs described in the preceding Costof Revenues section.

 

# **Operating Expenses**

#  

*Selling and marketing*. Selling andmarketing expenses increased to $130.1 million, or 60% of revenue, in the firstnine months of 2008, from $75.3 million, or 50% of revenue, in the first ninemonths of 2007. Approximately $27.9 million of the increase was due to theamortization of acquired intangibles (customer relationships) which resultedfrom the acquisition of SurfControl in October 2007. In addition to theamortization of acquired intangible assets, the increase in selling andmarketing expenses was primarily due to increased personnel costs of $18.9million and related travel of $2.2 million, including new personnel added fromthe SurfControl acquisition in October 2007 and $5.4 million of increasedallocated costs. Our headcount in sales and marketing increased from 400employees at September 30, 2007 to 531 employees at September 30, 2008.

 

*Researchand development.* Researchand development expenses increased to $39.8 million, or 19% of revenue, in thefirst nine months of 2008 from $27.1 million, or 18% of revenue, in the firstnine months of 2007. The increase of $12.7 million in research and developmentexpenses was primarily due to $7.4 million of increased personnel costs,including adding new full time employees due to the SurfControl acquisition in October 2007,and increased hiring for our release of our Web content gateway, data lossprevention endpoint module and developing enhancements to our other products,as well as to support our expanding list of technology partners and $4.6million of increased allocated costs. Included in research and development forthe first nine months of September 30, 2007 was $1.3 million of in-processresearch and development related to our PortAuthority acquisition in January 2007.Our headcount increased in research and development from 211 employees at September 30,2007 to 353 employees at September 30, 2008.

 

*General and administrative*. General andadministrative expenses increased to $35.4 million, or 16% of revenue, in thefirst nine months of 2008 from $20.6 million, or 14% of revenue, in the firstnine months of 2007. The $14.8 million increase in general and administrativeexpense was primarily due to $5.6 million of increased personnel costs neededto support our growing operations, including the acquisition of SurfControl in October 2007and $1.8 million of increased allocated costs. Our headcount increased in general and administrative departments from75 employees at September 30, 2007 to 115 employees at September 30,2008.

 

**Interest Expense**

** **

Interest expenseincreased to $10.4 in the first nine months of 2008 compared to zero in the firstnine months of 2007. Interest expense represents the interest incurred on oursenior secured term loan that we utilized to pay for a portion of theSurfControl acquisition in October 2007. Also included in the interest expense is $1.9 million of amortization ofdeferred financing fees that were capitalized as part of the senior securedcredit facility.

 

# **Other Income, Net**

#  

Otherincome, net decreased to $0.9 million in the first nine months of 2008 from$7.8 million in the first nine months of 2007. The decrease was due primarilyto reduced interest income of approximately $6.4 million in the first ninemonths of 2008 compared to the first nine months of 2007 as a result of our useof approximately $245 million in cash, cash equivalents and marketable securitiesto fund the acquisition of SurfControl in October 2007.

 

# **Provision for Income Taxes**

#  

Werecognized an income tax benefit of $16.2 million and an income taxexpense of $8.0 million for the nine months ended September 30, 2008and 2007, respectively. Our effective tax rates were a tax benefit of 47.4% anda tax provision of 39.1% for the nine months ended September 30, 2008 and September 30,2007, respectively. The significant changes in our effective tax rate reflectthe favorable impact of a ruling regarding unrecognized state income taxes andthe release of a valuation allowance plus the unfavorable impact of less taxexempt interest income and a higher effective state income tax rate.

 

Inaccordance with the provisions of SFAS 109, we assess, on a quarterly basis,the realizability of our deferred income tax assets. A valuation allowance mustbe established when, based upon the evaluation of all available evidence, it ismore likely than not that all or a portion of the deferred income tax asset willnot be realized. During fiscal year 2007, a $4.7 

 

23

----

Table of Contents

 

million valuationallowance was recorded against the deferred tax assets of SurfControl atacquisition and an additional $4.3 million was recorded related to the increaseof deferred tax assets arising from the operations of SurfControl reflected inour fiscal year 2007 consolidated statement of operations. Realization ofdeferred income tax assets is dependent upon taxable income in prior carrybackyears, estimates of future taxable income, tax planning strategies andreversals of existing taxable temporary differences. Based on our assessment ofthese items during the first nine months of 2008, it is more likely than notthat we will be able to fully utilize our deferred tax assets. Accordingly, wereleased the valuation allowance and recorded a credit to goodwill of $4.7million and a credit to income tax provision of approximately $4.3 million.

 

# **Liquidity****and Capital Resources**

#  

As of September 30,2008, we had cash and cash equivalents of $63.4 million and retained earningsof $49.9 million.  During the first ninemonths of 2008, we used our cash, cash equivalents and marketable securitiesprimarily to pay down $50.0 million on our senior secured term loan as optionalprepayments and approximately $15.0 million for stock repurchases.

 

Netcash provided by operating activities was $43.3 million in the first ninemonths of 2008 compared with $37.6 million in the first nine months of 2007.The increase in cash provided by operating activities was primarily due to thenet increase in the change in operating assets and liabilities offset by thenet loss with higher non-cash items recorded in the first nine months of 2008compared to the first nine months of 2007. The first nine months of 2008 cashflows from operations were negatively impacted by cash payments of $11.3million for restructuring related items as well as payment of $2.9 million fora class-action litigation that was settled in the first quarter of 2008. Ouroperating cash flow is significantly influenced by new and renewedsubscriptions, accounts receivable collections and changes in deferredrevenue.  A future decrease insubscription renewals or accounts receivable collections, or a lower deferredrevenue balance, would negatively impact our operating cash flow.

 

Netcash provided by investing activities was $13.2 million in the first nine months of 2008 compared with$118.4 million in the first nine monthsof 2007. The $105.2 million decrease of net cash provided by investingactivities was primarily due to a $185.6 million net decrease in maturitiesover purchases of marketable securities during the first nine months of 2008compared to the first nine months of 2007 offset by the $82.0 million used in January 2007to purchase PortAuthority.

 

Netcash used in financing activities was $58.9 million in the first nine months of 2008 compared with $2.2million provided by financing activities in the first nine months of 2007. The $61.1 million increase of net cash usedin financing activities was primarily due to optional principal prepayments of$50.0 million on our senior secured term loan and stock repurchases of $15.0million in the first nine months of 2008 compared to none in the first ninemonths of 2007, partially offset by the repayment of $4.2 million of thePortAuthority loan in the first nine months of 2007.

 

In connection with the acquisition of SurfControl in October 2007,we entered into an amended and restated senior credit agreement (the “SeniorCredit Agreement”).  The $225 millionsenior secured credit facility consists of a five year $210 million seniorsecured term loan and a $15 million revolving credit facility. The seniorsecured term loan was fully funded on October 11, 2007, and the revolvingline of credit remains unused. Through September 30, 2008, we have madeoptional prepayments totaling $70 million on our senior secured term loan,including prepayments of $15 million in the quarter ended September 30,2008, reducing the outstanding balance to $140 million. In October 2008,we made an additional optional prepayment of $5 million. The senior securedcredit facility is secured by substantially all of our assets, includingpledges of stock of some of our subsidiaries (subject to limitations in thecase of foreign subsidiaries) and by secured guarantees by our domesticsubsidiaries. The senior secured term loan initially amortized at a minimumrate of 2.5%, 10%, 12.5%, and 15%, respectively, during the first four years ofthe term and 60% during the fifth year. In conjunction with our optional $20million prepayment on December 31, 2007, we amended our Senior CreditAgreement to eliminate any additional mandatory payments until September 30,2009.  The senior secured term loan bearsinterest at a spread above LIBOR with the spread determined based upon ourtotal leverage ratio, as defined in the Senior Credit Agreement. Prior to thethird quarter 2008, the annual interest rate was LIBOR plus 250 basis points(5.28% as of June 30, 2008), and was subject to a potential step down inthe spread over LIBOR based upon potential future improvements in our totalleverage ratio. The unused portion of the revolving credit facility required a50 basis points fee per annum, also subject to a step down based upon potentialfuture improvements in our total leverage ratio. Based on the total leverageratio as of June 30, 2008, the spread on both the senior secured term loanand revolving credit facility was reset for the third quarter of 2008 to LIBORplus 225 basis points (6.01% as of September 30, 2008) per annum for thesenior secured term loan and reduced by 25 basis points per annum for theunused portion of the revolving credit facility. The Senior Credit Agreementcontains financial covenants, including a consolidated leverage ratio and aconsolidated interest coverage ratio, as well as affirmative and negativecovenants. Among the negative covenants are restrictions on our ability toborrow money, including restrictions on (a) the incurrence of more than $15million of new debt, including capital leases (subject to certain exceptions),(b) the incurrence of more than $7.5 million in letters of credit, (c) theincurrence of more than $50 to $75 million of new debt, depending on ourleverage ratio, to finance future acquisitions or (d) the assumption of morethan $15 million of new debt in connection with acquistions.

 

24

----

Table of Contents

 

The Senior CreditAgreement provides that we must maintain hedge agreements so that at least 50%of the aggregate principal amount of the senior secured credit facility issubject to fixed interest rate protection for a period of not less than 2.5years. On October 11, 2007 in conjunction with the funding of the seniorsecured term loan, we entered into an interest rate swap agreement to pay afixed rate of interest (4.85% per annum) and receive a floating rate interestpayment (based on three month LIBOR) on an equivalent amount. The initialnotional amount of the swap agreement was $105 million on October 11, 2007and it amortizes each quarter down to $11 million on September 30, 2010.In addition, on October 11, 2007 we entered into an interest rate capagreement to limit the maximum interest rate on a portion of our senior securedterm loan to 6.5% per annum. The amount of principal protected by thisagreement increases from $5 million at December 31, 2007 to $74.3 millionon September 30, 2010. Both the interest rate swap and cap expire on September 30,2010.

 

As of September 30,2008 and 2007, we did not have any relationships with unconsolidated entitiesor financial partners, such as entities often referred to as structured financeor special purpose entities, which would have been established for the purposeof facilitating off-balance sheet arrangements or other contractually narrow orlimited purposes. As such, we are not exposed to any financing, liquidity,market or credit risk that could arise if we had engaged in such relationships.

 

*Obligations and commitments.*  The following table summarizes our contractualpayment obligations and commitments as of September 30, 2008 (inthousands):

 
| ** **                                               | ** ** | **Payment Obligation by Year** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                               | ** ** | **2008**                                      | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **2012** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| Senior secured  term loan                                |       | $                                             | —     |   | $ | 4,605 |   | $ | 19,342 |   | $ | 23,211 |   | $ | 92,842 |   | $ | — |   | $ | 140,000 |   |
| Estimated  interest and fees on senior secured term loan |       | 2,383                                         |       | 9,250 |   | 8,036 |   | 6,621 |   | 3,624 |   | — |   | 29,914 |   |
| Operating leases                                         |       | 1,608                                         |       | 5,170 |   | 4,768 |   | 4,159 |   | 3,972 |   | 4,996 |   | 24,673 |   |
| Facility exit  obligations                               |       | 485                                           |       | 3,509 |   | 839 |   | 331 |   | — |   | — |   | 5,164 |   |
| Software  licenses                                       |       | 146                                           |       | 585 |   | 97 |   | — |   | — |   | — |   | 828 |   |
| Total                                                    |       | $                                             | 4,622      |   | $ | 23,119 |   | $ | 33,082 |   | $ | 34,322 |   | $ | 100,438 |   | $ | 4,996 |   | $ | 200,579 |   |

 

Obligationsunder our Senior Credit Agreement represent the future minimum principal debtpayments due under the senior secured term loan.  Estimated interest and fees representinterest and fees expected to be incurred on the senior secured term loan basedon known rates as of September 30, 2008 (see Note 6 to the financialstatements).

 

Welease our facilities under operating lease agreements that expire at variousdates through 2015.  Approximatelyone-half of our operating lease commitments are related to our corporateheadquarters lease, which extends through December 2013.  Our corporate headquarters lease includesescalating rent payments from 2008 to 2013.

 

Facilityexit obligations represent estimated future lease and operating costs fromfacilities acquired from SurfControl that are being exited.  These costs will be paid over the respectivelease terms through 2011.  These amountsare included in our consolidated balance sheet.

 

Softwarelicense obligations represent purchase commitments for software licenses madein the ordinary course of business.

 

Inaddition, due to the uncertainty with respect to the timing of future cashflows associated with our unrecognized tax benefits at September 30, 2008,we are unable to make reasonably reliable estimates of the period of cashsettlement with the respective taxing authorities. Therefore, $8.4 million ofunrecognized tax benefits have been excluded from the contractual paymentobligations table above.

 

In2003, we announced that our Board of Directors authorized a stock repurchaseprogram of up to 4 million shares of our common stock.  In 2005, we announced that our Board ofDirectors increased the size of the stock repurchase program by an additional 4million shares, for a total program size of up to 8 million shares. In 2006, weannounced that our Board of Directors increased the size of the stockrepurchase program by an additional 4 million shares, for a total program sizeof up to 12 million shares. Repurchases may be made from time to time on theopen market at prevailing market prices or in privately negotiatedtransactions. In January 2008, we adopted a 10b5-1 plan that provides forquarterly purchases of up to $5 million in stock in open market transactions.Depending on market conditions and other factors, purchases under this programmay be commenced or suspended at any time, or from time to time, without priornotice. During the nine months 

 

25

----

Table of Contents

 

ended September 30,2008, we repurchased 790,292 shares of our common stock for an aggregate ofapproximately $15.0 million at an average price of $18.96 per share. As of September 30,2008, we have repurchased a total of 8,960,352 shares of our common stock underthis program, for an aggregate of $185.4 million at an average price of $20.69per share. Under the terms of the Senior Credit Agreement, we are restrictedfrom repurchasing our common stock for an aggregate purchase price that exceedsthe sum of $25 million plus 50% of the aggregate amount of our consolidated netincome, as defined in our Senior Credit Agreement, during the period from theeffective date of the facility through the most recent quarter end for which wehave filed quarterly financial statements. As of September 30, 2008, wecan repurchase up to $34.6 million of our common stock under our Senior CreditAgreement. We intend to repurchase shares during the remainder of 2008.

 

We believe that our cash and cash equivalents balances, 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 2008, we made voluntary prepayments on our senior secured term loan of $50 million and repurchased approximately $15 million of our common stock. In October 2008 we made an additional optional prepayment of $5 million on our senior secured term loan. Our cash requirements may increase for reasons we do not currently foresee or we may make acquisitions as part of our growth strategy that increase our cash requirements. We may elect to raise funds for these purposes or to reduce our cost of capital through capital markets transactions or debt or private equity transactions as appropriate. We intend to continue to invest our cash in excess of current operating and capital requirements in interest-bearing, investment-grade securities.

 

**Off-BalanceSheet Arrangements**

 

As of September 30, 2008, we did not have any material off-balance sheet arrangements as defined in Regulation S-K Item 303(a)(4).

 

**Item 3. Quantitative and Qualitative DisclosuresAbout Market Risk**

 

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

 

We are exposed to changes in interest rates primarilyfrom our short-term available-for-sale investments and from our borrowingsunder our variable rate senior secured term loan used in connection with theacquisition of SurfControl in October 2007.  Our Senior Credit Agreement provides that wemust maintain hedge agreements so that at least 50% of the aggregate principalamount of the senior secured term loan is subject to fixed interest rateprotection for a period of not less than 2.5 years from the date of the initialfunding of the loan.

 

A hypothetical 100 basis point adverse move ininterest rates along the entire interest rate yield curve would materiallyaffect our interest expense. Based on our outstanding senior secured term loanbalance at September 30, 2008 and taking into consideration our interestrate swap and cap, our interest expense would increase by approximately$576,000 during the next 12 months if there were a 100 basis point adverse movein the interest rate yield curve.

 

A hypothetical 100 basis point adverse move ininterest rates along the entire interest rate yield curve would not materiallyaffect the fair value of our interest sensitive investments at September 30,2008. Changes in interest rates over time will, however, affect our interestincome.

 

Weutilize foreign currency forward contracts to hedge foreign currency marketexposures of underlying assets and liabilities. We bill certain international customers in Euros, British Pounds,Australian Dollars, Chinese Yuan Renminbi and Japanese Yen.  We also keep working funds necessary tofacilitate the short-term operations of our subsidiaries in the localcurrencies in which they do business. Our objective is to reduce the risk toearnings and cash flows associated with changes in foreign currency exchangerates. We do not use foreign currency contracts for speculative or trading purposes.

 

26

----

Table of Contents

 

Notionaland fair values of our Euro and Israeli Shekel hedging positions at September 30,2008 and 2007 are presented in the table below (in thousands):

 
| ** **     | ** ** | **September 30, 2008**     | ** ** | **September 30, 2007** | ** ** |
|----------------|------------|--------------------------------------|------------|----------------------------------|------------|
| ** **     | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD**         | ** ** | **Fair Value  USD** | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD** | ** ** | **Fair Value  USD** | ** ** |
| Euro           |       | €                               | 2,500      |                             | $          | 3,735 |   | $ | 3,948 |   | € | — |   | $ | — |   | $ | — |   |
| Israeli Shekel |       | ILS 2,150                            |       | 617                              |       | 623 |   | ILS | — |   | — |   | — |   |
| Total          |       |                                 |       | $                                | 4,352      |   | $ | 4,571 |   |   | ** ** | $ | — |   | $ | — | ** ** |
|                |            |                                      |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Theapproximate $3.7 million notional increase in our Euro hedged position at September 30,2008 compared to September 30, 2007 is primarily due to the increase inEuro billings in 2008 compared to 2007. As of September 30, 2007, no Eurocontracts were outstanding. For the nine months ended September 30, 2008,less than 15% of our total billings were denominated in the Euro. We do notexpect Euro billings to represent more than 15% of our total billings during2008.

 

We started to hedge the Israeli Shekel during thethird quarter of 2008 primarily due to the increase in Israeli Shekeloperating expenditures in 2008. There were no Israeli Shekel contractsoutstanding prior to the quarter ended September 30, 2008.

 

Givenour foreign exchange position at September 30, 2008, a 10% change inforeign exchange rates upon which these foreign exchange contracts are basedwould result in exchange gains and losses. In all material aspects, these exchange gains and losses would be fullyoffset by exchange gains and losses on the underlying net monetary exposuresfor which the contracts are designated as hedges.  We do not expect material exchange rate gainsand losses from un-hedged foreign currency exposures.

 

**Item 4. Controls and Procedures**

 

**Disclosure Controls andProcedures**

** **

**Wemaintain disclosure controls and procedures (as defined in Rules 13a — 15(e) and15d — 15(e) of the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) designed to ensure that the information required to be disclosed in thereports we file under the Exchange Act is (a) recorded, processed, summarizedand reported within the time periods specified in the rules and forms ofthe Securities and Exchange Commission and (b) accumulated andcommunicated to management, including our Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow timely decisions regarding requireddisclosure.**OurChief Executive Officer and Chief Financial Officer evaluated our disclosurecontrols and procedures as of the end of the period covered by this report.Based on their evaluation, our Chief Executive Officer and Chief FinancialOfficer have concluded that these controls and procedures are effective as ofthe end of the period covered by this Quarterly Report.

** **

**Changes In Internal ControlOver Financial Reporting**

** **

There have been no changes in our internal control overfinancial reporting or in other factors that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting, including any corrective actions with regard to significantdeficiencies and material weaknesses, during the period covered by thisQuarterly Report.

 

**Part II - Other Information**

 

**Item 1. Legal Proceedings**

 

We are involved invarious legal actions in the normal course of business. Based on currentinformation, including consultation with our lawyers, we believe we haveadequately reserved for any ultimate liability that may result from theseactions such that any liability would not materially affect our consolidatedfinancial position, results of operations or cash flows. Our evaluation of thelikely impact of these actions could change in the future and unfavorableoutcomes and/or defense costs, depending upon the amount and timing, could havea material adverse effect on our results of operations or cash flows in afuture period.

 

27

----

Table of Contents

 

**Item 1A. Risk Factors**

 

Youshould carefully consider the following information in addition to otherinformation in this report in evaluating our business and our prospects.  The risks and uncertainties described beloware those that we currently deem to be material and that we believe arespecific to our company and our industry. In addition to these risks, our business may be subject to riskscurrently unknown to us.  If any of theseor other risks actually occur, our business may be adversely affected, thetrading price of our common stock could decline, and you may lose all or partof your investment in Websense.

 

Wehave marked with an asterisk (*) those risk factors that reflect materialchanges from the risk factors included in our Quarterly Report on Form 10-Qfiled with the Securities and Exchange Commission on August 8, 2008.

 

*Recent volatility in theworld capital markets and the financial services industry may adversely impactour business, results of operations, financial condition or liquidity.**

* *

Recently,the world capital markets and the financial services industry have beenexperiencing a period of unprecedented volatility characterized by thebankruptcy, failure, collapse or sale of various financial institutions and anunprecedented level of intervention from governments and regulatory agenciesworldwide. The recent economic crisis could cause our customers to chooseshorter contract durations or to not renew their contract at all, reducing ourcash flow, and also could negatively affect our ability to maintain or expandthe number of seats and/or product offerings to large customers upon renewaldue to adverse developments within the customer’s organization.  Inaddition, recent events in the global financial markets may****make it difficult for us to access thecredit markets or to obtain financing or refinancing, if needed, onsatisfactory terms or at all.

 

*We have experienceddeclining growth rates, particularly for Web filtering sales to largeenterprises in North America and Western Europe, and therefore need to increaseour sales to small and medium sized business customers.*

* *

Our growth plans for newsales in North America and Western Europe are largely dependent on our abilityto increase sales in the small and medium sized business (“SMB”) segment andmaintain our subscription base in the large enterprise market throughsubscription renewals.  We sell a productspecifically targeted at the SMB segment, Websense Express, though we cannotassure that this product will ultimately increase sales to the SMBsegment.  We also need to increase salesthrough our two-tier distribution channel in North America and our two-tierdistribution arrangements in Western Europe that target SMB customers. Inaddition, we sell Websense Hosted Security to SMB customers.  This is a new service offering for Websensein a relatively new market segment. Numerous competitors target the SMB segmentfor Web filtering and security sales, many of whom are different competitorsfrom our primary competitors in the large enterprise market segment. IfWebsense Express and the Websense Hosted Security do not meet our customers’expectations in the SMB segment or if we fail to compete effectively for volumebusiness through our two-tier distribution model, our financial results andgrowth will be negatively affected.

 

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

* *

Our revenue has beenderived almost entirely from sales through indirect channels, includingvalue-added resellers, distributors that sell our products to end-users,providers of managed Internet services and other resellers. Although we relyupon these indirect channels of distribution, we also depend upon our internalsales force to generate sales leads and sell products through the resellernetwork. Ingram Micro, one of our broad-line distributors in North America,accounted for approximately 22% of our revenue during the nine months ended September 30,2008.  Should Ingram Micro experiencefinancial difficulties or otherwise delay or prevent our collection of accountsreceivable from them, our revenue and cash flow would be significantlyadversely affected. Also, should our resellers be subject to credit limits orhave financial difficulties that limit financing terms available to them, ourrevenue and cash flow could be significantly adversely affected.  Our indirect sales model involves a number ofadditional risks, including:

 

·             ourresellers and distributors, including Ingram Micro, are not subject to minimumsales requirements or any obligation to market our products to their customers;

 

·             wecannot control the level of effort our resellers and distributors expend or theextent to which any of them will be successful in marketing and selling ourproducts;

 

·             wecannot assure that our channel partners will market and sell our newer productofferings such as our security-oriented offerings, our data loss prevention (“DLP”)offerings or our hosted security services;

 

28

----

Table of Contents

 

·             ourreseller and distributor agreements are generally nonexclusive and may beterminated at any time without cause; and

 

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

 

Our ability tomeaningfully increase the amount of our products sold through our saleschannels also depends on our ability to adequately and efficiently supportthese channel partners with, among other things, appropriate financialincentives to encourage pre-sales investment and sales tools, such as salestraining, technical training and product collateral needed to support theircustomers and prospects. The diversity and sophistication of our product offeringshave required us to focus on additional sales and technical training, and weare making increased investments in this area. Additionally, we are continuallyevaluating the changes to our internal ordering and partner management systemsin order to effectively execute our two-tier distribution strategy. Any failureto properly and efficiently support our sales channels will result in lostsales opportunities.

 

*We face increasingcompetition from much larger software and hardware companies, which places pressureon our pricing and which could prevent us from increasing revenue or returningto profitability. In addition, as we increase our emphasis on oursecurity-oriented products, we face competition from better-establishedsecurity companies that have significantly greater resources.**

* *

The market for ourproducts is intensely competitive and is likely to become even more so in thefuture.  Our current principal Webfiltering competitors frequently offer their products at a significantly lowerprice than our products, which has resulted in pricing pressures on sales ofour product and potentially could result in the commoditization of products inour space. We also face current and potential competition from vendors ofInternet servers, operating systems and networking hardware, many of which now,or may in the future, develop and/or bundle Web filtering or other competitiveproducts with their products. Increased competition may cause price reductionsor a loss of market share, either of which could have a material adverse effecton our business, results of operations and financial condition. If we areunable to maintain the current pricing on sales of our products or increase ourpricing in the future, our results of operations could be negatively impacted.Even if our products provide greater functionality and are more effective thancertain other competitive products, potential customers might accept thislimited functionality. In addition, our own indirect sales channels may decideto develop or sell competing products instead of our products. Pricingpressures and increased competition generally could result in reduced sales,reduced margins or the failure of our products to achieve or maintainwidespread market acceptance, any of which could have a material adverse effecton our business, results of operations and financial condition.

 

Our currentprincipal competitors include:

 

·                  companies offering Web filtering and Web securitysolutions, such as Microsoft, Symantec/Vontu, McAfee, Cisco Systems, JuniperNetworks, MessageLabs (acquisition pending by Symantec), Trend Micro,Google/Postini, BrightCloud, ScanSafe, Blue Coat Systems, Secure Computing(acquisition pending by McAfee), Aladdin, Finjan, FaceTime, Mi5 Networks, St.Bernard Software, 8e6 Technologies, Marshal, Clearswift, Sophos, Barracuda,Digital Arts and Computer Associates;

 

·                  companies integrating Web filtering into specializedsecurity appliances, such as Blue Coat Systems, Cisco Systems, McAfee,WatchGuard, Secure Computing (acquisition pending by McAfee), Check PointSoftware, St. Bernard Software, Barracuda, Juniper Networks, Trend Micro, Mi5Networks, SonicWALL, Sophos, Network Box and 8e6 Technologies;

 

·                  companies offering data loss prevention solutions,such as Symantec/Vontu, Verdasys, Vericept, EMC/Tablus, Secure Computing(acquisition pending by McAfee), IBM, Reconnex, Trend Micro/Provilla,Proofpoint, Palisade Systems, Orchestria, Raytheon, McAfee, Intrusion, Fidelis,GTB Technologies, Workshare, Check Point Software and Code Green Networks;

 

·                  companies offering messaging security, such as McAfee,Symantec/Brightmail, Google/Postini, Cisco/Ironport, Barracuda, SecureComputing (acquisition pending by McAfee), SonicWALL, Trend Micro,Axway/Tumbleweed, MessageLabs (acquisition pending by Symantec), MX Logic,Sophos, Microsoft, Proofpoint, Clearswift and Borderware;

 

·                  companies offering on-demand email and Web securityservices, such as Google/Postini, MessageLabs (acquisition pending bySymantec), McAfee, Symantec/Vontu, MX Logic, Email Systems/Webroot, St. BernardSoftware, Purewire, BrightCloud, Zscaler, Trend Micro and Scansafe;

 

29

----

Table of Contents

 

·                  companies offering desktop security solutions such asCheck Point Software, Cisco Systems, McAfee, Microsoft, Symantec/Vontu,Computer Associates, Sophos, Webroot, Internet Security Systems (IBM) and TrendMicro; and

 

·                  companies offering web or network gateway basedsolutions such as Microsoft, Blue Coat Systems, Cisco Systems, Trend Micro,Check Point Software, McAfee and Juniper Networks.

 

As we develop and marketour products with an increasing security-oriented emphasis, we also facegrowing competition from security solutions providers. Many of our competitorswithin the Web security market, such as Symantec, McAfee, Trend Micro,Cisco Systems and Microsoft enjoy substantial competitive advantages,including:

 

·                  greatername recognition and larger marketing budgets and resources;

 

·                  establishedmarketing relationships and access to larger customer bases; and

 

·                  substantiallygreater financial, technical and other resources.

 

As a result, we may be unable to gain sufficienttraction as a provider of Web security solutions, and our competitors may beable to respond more quickly and effectively than we can to new or emergingtechnologies and changes in customer requirements, or devote greater resourcesto the development, marketing, promotion and sale of their products than wecan. Current and potential competitors have established or may establishcooperative relationships among themselves or with third parties to increasethe functionality and market acceptance of their products. In addition, ourcompetitors may be able to replicate our products, make more attractive offersto existing and potential employees and strategic partners, develop newproducts or enhance existing products and services more quickly. Accordingly,new competitors or alliances among competitors may emerge and rapidly acquiresignificant market share. In addition, many of our competitors made recentacquisitions in some of our product areas, and, we expect competition toincrease as a result of this industry consolidation. Through an acquisition, acompetitor could bundle separate products to include functions that arecurrently provided primarily by our Web and data security solutions and sellthe combined product at a lower cost than our stand-alone solutions. For all ofthe foregoing reasons, we may not be able to compete successfully against ourcurrent and future competitors.

 

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

** **

**In connection with ouracquisition of SurfControl in October 2007, we entered into an amended andrestated senior secured credit facility to provide financing for a substantialportion of the acquisition purchase price. Our senior secured credit facility contains covenants that restrict,among other things, our ability to borrow money, make particular types ofinvestments, including investments in our subsidiaries, make other restrictedpayments, pay down subordinated debt, swap or sell assets, merge or consolidateor make acquisitions.  An event ofdefault under our senior secured credit facility could allow the lenders todeclare all amounts outstanding with respect to the senior secured creditfacility to be immediately due and payable. As collateral for the loan, we pledged substantially all of ourconsolidated assets and the stock of some of our subsidiaries (subject to limitationswith respect to foreign subsidiaries) to secure the debt under our seniorsecured credit facility.  If the amountsoutstanding under the senior secured credit facility were accelerated, thelenders could proceed against those consolidated assets and the stock of oursubsidiaries.  Any event of default,therefore, could have a material adverse effect on our business.  Our senior secured credit facility alsorequires us to maintain specified financial ratios.  Our ability to meet these financial ratioscan be affected by events beyond our control, and we cannot assure that we willmeet those ratios.**

** **

***The amount of our debtoutstanding may prevent us from taking actions we would otherwise consider inour best interest.***

** **

In October 2007, weborrowed $210 million under the senior credit agreement and $140 millionremained outstanding as of September 30, 2008.  As a result, we are incurring interestexpense for the amounts we borrowed under the senior secured term loan, and ourincome from our cash, cash equivalents and marketable securities has declinedas we used a significant portion of our cash and marketable securities to funda portion of the acquisition cost.  Thisdebt and the limitations our senior secured credit facility impose on us couldhave important consequences, including:

 

·                  it may be difficult for us to satisfyour obligations under the senior secured credit facility;

 

·                  we will have to use much of our cashflow for scheduled debt service rather than for potential investments;

 

·                  we may be less able to obtain otherdebt financing in the future;

 

30

----

Table of Contents

 

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

 

·      ourvulnerability to general adverse economic and industry conditions could beincreased; and

 

·      wecould be at a competitive disadvantage to competitors with less debt.

 

*Our future successdepends on our ability to sell new, renewal and upgraded Web filtering and Websecurity subscriptions.**

* *

Substantially all of ourrevenue for the third quarter ended September 30, 2008 was derived fromnew and renewal subscriptions to our Web filtering and Web security products,and we expect that a significant majority of our sales for the remainder of2008 will continue to be derived from our Web filtering and Web securityproducts. We expect sales of our DLP products, hosted security services andother products under development to comprise a relatively small portion of ouroverall sales in 2008. If our Web filtering and Web security products fail tomeet the needs of our existing and target customers, or if they do not comparefavorably in price, features and performance to competing products, ouroperating results and our business will be significantly impaired.  If we cannot sufficiently increase ourcustomer base with the addition of new customers, particularly in the SMBsegment, increase seats under subscriptions from existing customers or renew asufficient number of SurfControl’s Web filtering customers or migrate them toour Web filtering product, we will not be able to grow our business to meetexpectations.

 

Subscriptions for our Webfiltering and security products typically have durations of 12, 24 or 36months. Our customers have no obligation to renew their subscriptions uponexpiration, and if they renew, they may elect to renew for a shorter durationthan the previous subscription period. As a result of macroeconomic conditions,our Websense and SurfControl customers may elect to renew subscriptions forshorter durations and may not add seats or product offerings due tocontractions of work forces of their respective organizations. Our revenue alsodepends upon maintaining a high rate of sales of renewal subscriptions and inselling further subscriptions to existing customers in order to add additionalseats or product offerings within their respective organizations. This mayrequire increasingly costly sales efforts targeting senior management and othermanagement personnel associated with our customers’ Internet and securityinfrastructure. We may not be able to maintain or continue to generateincreasing revenue from existing customers*.*

 

*Failure of our securityproducts, including our DLP products and hosted security solutions, to achievemore widespread market acceptance will seriously harm our business.**

* *

Our future financial performance depends on ourability to diversify our offerings by successfully developing, introducing andgaining customer acceptance of our new products and services, particularly oursecurity offerings. We now sell the Websense Data Security Suite, our DLPoffering for the data security market, Websense Hosted Web Security andWebsense Hosted Email Security, our hosted security services, and WebsenseEmail Security, our email filtering solution. During the third quarter of 2008,we released our next generation Web content gateway to address emerging Web 2.0threats, Websense Web Security Gateway, and our new DLP endpoint module,Websense Data Security Suite, and we are continuing to develop and releaseproducts in accordance with our announced product roadmap. We may not besuccessful in achieving market acceptance of these or any new products that wedevelop.  Moreover, our recent increasedemphasis on the development, marketing and sale of our security offerings andDLP products could distract us from sales of our core Web filtering and Websecurity offerings, negatively impacting our overall sales. Any failure ordelay in diversifying our existing offerings, or diversification at thedetriment to our core Web filtering and Web security offerings, could harm ourbusiness, results of operations and financial condition and our growth.

 

*Our internationaloperations involve risks that could increase our expenses, adversely affect ouroperating results and require increased time and attention of our management.**

* *

We have significantoperations outside of the United States, including research and development,sales and customer support. We have established or acquired engineeringoperations in Reading, England; Beijing, China; Sydney, Australia and Ra’anana,Israel.

 

We plan to continue toexpand our international operations, but such expansion is contingent upon thefinancial performance of our existing international operations as well as ouridentification of growth opportunities. Our international operations are subject to risks in addition to thosefaced by our domestic operations, including:

 

·                  difficultiesassociated with managing a distributed organization located on multiplecontinents in greatly varying time zones;

 

·                  potentialloss of proprietary information due to misappropriation or laws that may beless protective of our intellectual property rights;

 

31

----

Tableof Contents

 

·                  requirementsof foreign laws and other governmental controls, including trade and laborrestrictions and related laws that reduce the flexibility of our businessoperations;

 

·                  politicalunrest, war or terrorism, particularly in areas in which we have facilities;

 

·                  difficultiesin staffing, managing, and operating our international operations, includingdifficulties related to administering our stock plans in some foreigncountries;

 

·                  difficultiesin coordinating the activities of our geographically dispersed and culturallydiverse operations;

 

·                  seasonalreductions in business activity in the summer months in Europe and in otherperiods in other countries;

 

·                  restrictionson our ability to repatriate cash from our international subsidiaries or toexchange cash in international subsidiaries into cash available for use in theUnited States;

 

·                  costsand delays associated with developing software in multiple languages; and

 

·                  foreigncurrency exchange risks.

 

All of our foreign subsidiaries’ operating expensesare incurred in foreign currencies so if the dollar weakens, our consolidatedoperating expenses would increase. Should the dollar strengthen, our productsmay become more expensive for our international customers and, as a result, ourresults of operations and net cash flows from international operations may beadversely affected, especially if the trend continues of international salesgrowing as a percentage of our total sales.

 

*Sales to customers outside the United States haveaccounted for a significant portion of our revenue, which exposes us to risksinherent in international sales.*

* *

We market and sellour products outside the United States through value-added resellers,distributors and other resellers. International sales represented 49% of ourtotal revenue generated during the quarter ended September 30, 2008compared with 41% of our total revenue during the quarter ended September 30,2007. As a key component of our business strategy to generate new businesssales, we intend to continue to expand our international sales, but successcannot be assured. In addition to the risks associated with our domestic sales,our international sales are subject to the following risks:

 

·                  ourability to adapt to sales and marketing practices and customer requirements indifferent cultures;

 

·                  ourability to successfully localize software products for a significant number ofinternational markets;

 

·                  thesignificant presence of some of our competitors in some international markets;

 

·                  lawsand business practices favoring local competitors;

 

·                  dependenceon foreign distributors and their sales channels;

 

·                  longerpayment cycles for sales in foreign countries and difficulties in collectingaccounts receivable;

 

·                  compliancewith multiple, conflicting and changing governmental laws andregulations, including tax laws and regulations and consumer protectionand privacy laws; and

 

·                  regionaleconomic and political conditions.

 

These factorscould have a material adverse effect on our international sales. Any reductionin international sales, or our failure to further develop our internationaldistribution channels, could have a material adverse effect on our business,results of operations and financial condition.

 

Some of our internationalrevenue is denominated in U.S. dollars. In these markets, fluctuations in thevalue of the U.S. dollar and foreign currencies may make our products moreexpensive for international customers, which could harm our business. We alsocurrently bill certain international customers in U.S. dollars, Euros, BritishPounds, Australian Dollars, Chinese Yuan Renminbi and Japanese Yen. This mayincrease our risks associated with fluctuations in foreign currency exchangerates since we cannot be assured of receiving the same U.S. dollar equivalentas when we bill exclusively in U.S. dollars. We engage in currency hedgingactivities with the intent of limiting the risk of exchange rate fluctuation,but our foreign exchange hedging activities also involve inherent risks thatcould result in an unforeseen loss. If we fail to properly forecast ratefluctuations these activities could have a negative impact.

 

*We may not be able to develop acceptable new productsor enhancements to our existing products at a rate required by our rapidlychanging market.*

* *

Our future successdepends on our ability to develop new products or enhancements to our existingproducts that keep pace with rapid technological developments and that addressthe changing needs of our customers. Although our products are 

 

32

----

Table of Contents

 

designed to operate with a variety of network hardwareand software platforms, we will need to continuously modify and enhance ourproducts to keep pace with changes in Internet-related hardware, software,communication, browser and database technologies. We may not be successful ineither developing such products or introducing them to the market in a timelyfashion. In addition, uncertainties about the timing and nature of new networkplatforms or technologies, or modifications to existing platforms or technologycould increase our research and development expenses. The failure of ourproducts to operate effectively with the existing and future network platformsand technologies will limit or reduce the market for our products, result incustomer dissatisfaction and seriously harm our business, results of operationsand financial condition.

 

We may spend significanttime and money on research and development to design and develop our DLPproducts and our hosted security services and our content gateway products. Ifthese products fail to achieve broad market acceptance in our target markets,we may be unable to generate significant revenue from our research anddevelopment efforts. As a result, our business, results of operations andfinancial condition would be adversely impacted.

 

*Acquired companies or technologies can be difficult tointegrate, disrupt our business, dilute stockholder value and adversely affectour operating results.**

* *

In October 2007 weacquired SurfControl plc (“SurfControl”) and, as a result of the acquisition, Websensebecame an unprofitable operating business under GAAP after more than five yearsas a profitable operating business under GAAP. Given our subscription model, we expect to continue to operate at a lossunder GAAP until we generate sufficient revenue from the subsequent renewal ofsubscriptions from the installed SurfControl customer base to offset theexpenses we began to incur as of the close of the SurfControl acquisition tooperate the SurfControl business. Although we expect to continue to compete effectively for subscriptionrenewals from the SurfControl customers, we face substantial competition and wemay not retain as high a percentage of the SurfControl customer base as weexpect.

 

Acquisitions involve numerous risks, including:

 

·                  difficultiesin integrating operations, technologies, services and personnel of the acquiredcompany;

 

·                  potentialloss of customers and original equipment manufacturing relationships of theacquired company;

 

·                  diversionof financial and management resources from existing operations and corebusinesses;

 

·                  riskof entering new markets;

 

·                  potentialloss of key employees of the acquired company;

 

·                  integratingpersonnel with diverse business and cultural backgrounds;

 

·                  preservingthe development, distribution, marketing and other important relationships ofthe companies;

 

·                  assumptionof liabilities of the acquired company, including debt and litigation; and

 

·                  inabilityto generate sufficient revenue from newly acquired products and/or cost savingsneeded to offset acquisition related costs.

 

Acquisitions may also cause us to:

 

·                  issueequity securities that would dilute our current stockholders’ percentageownership;

 

·                  assumecertain liabilities;

 

·                  incuradditional debt, such as the debt we incurred to partially fund the acquisitionof SurfControl;

 

·                  makelarge and immediate one-time write-offs for restructuring and other relatedexpenses;

 

·                  becomesubject to intellectual property or other litigation; and

 

·                  creategoodwill and other intangible assets that could result in significantimpairment charges and/or amortization expense.

 

We may acquire additionalcompanies, services and technologies in the future as part of our efforts toexpand and diversify our business. Although we review the records of companiesor businesses we are interested in acquiring, even an in-depth review may notreveal existing or potential problems or permit us to become familiar enoughwith a business to assess fully its capabilities and deficiencies. Integrationof acquired companies may disrupt or slow the momentum of the activities 

 

33

----

Table of Contents

 

of our business. As a result, if we fail to properlyevaluate, execute and integrate future acquisitions, our business and prospectsmay be seriously harmed.

 

*Our products may fail to keep pace with the rapidgrowth and technological change of the Internet in accordance with ourcustomers’ expectations.*

* *

The ongoing evolution ofthe Internet and computing environments will require us to continually improvethe functionality, features and reliability of our databases. Because ourproducts primarily manage access to URLs and executable files included in ourdatabases, if our databases do not contain a meaningful portion of relevantcontent, the effectiveness of our Web filtering products will be significantlydiminished. Any failure of our databases to keep pace with the rapid growth andtechnological change of the Internet, such as the increasing amount ofmultimedia content on the Internet that is not easily classified, will impairthe market acceptance of our products, unless our Web content gateway productwith dynamic Web categorization capabilities can achieve market acceptance.

 

We rely upon acombination of automated filtering technology and human review to categorizeURLs and executable files in our proprietary databases. Our customers may notagree with our determinations that particular URLs and executable files shouldbe included or not included in specific categories of our databases. Inaddition, it is possible that our filtering processes may place objectionableor security risk material in categories that are generally unrestricted by ourusers’ Internet and computer access policies, which could result in suchmaterial not being blocked from the network. Any errors in categorization couldresult in customer dissatisfaction and harm our reputation. Any failure toeffectively categorize and filter URLs and executable files according to ourcustomers’ expectations could impair the growth of our business. Our databasesand database technologies may not be able to keep pace with the growth in thenumber of URLs and executable files, especially the growing amount of contentutilizing foreign languages and the increasing sophistication of malicious codeand the delivery mechanisms associated with spyware, phishing and other hazardsassociated with the Internet. The success of our dynamic Web categorizationcapabilities may be critical to our customers’ long term acceptance of ourproducts.

 

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

* *

Our products are complex,are deployed in a wide variety of network environments and manage content in adramatically changing Web 2.0 world. Our products may have errors or defectsthat users identify after deployment, which could harm our reputation and ourbusiness. In addition, products as complex as ours frequently containundetected errors when first introduced or when new versions or enhancementsare released. We have from time to time found errors in versions of ourproducts, and we expect to find such errors in the future. Because customersrely on our products to manage employee behavior to protect against securityrisks and prevent the loss of sensitive data, any significant defects or errorsin 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 ourcustomers, regardless of whether the breach is attributable to our products,could adversely affect the market’s perception of our security products. Moreover,parties whose Web sites or executable files are placed in security-riskcategories or other categories with negative connotations may seek redressagainst us for falsely labeling them or for interfering with their business.The occurrence of errors could adversely affect sales of our products, divertthe attention of engineering personnel from our product development efforts andcause significant customer relations or legal problems.

 

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

 

*Weface risks related to customer outsourcing to system integrators.*

* *

Some of our customershave outsourced the management of their information technology departments tolarge system integrators. If this trend continues, our established customerrelationships could be disrupted and our products could be displaced byalternative system and network protection solutions offered by system integrators.Significant product displacements could impact our revenue and have a materialadverse effect on our business.

 

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

* *

In the future, vendors ofhardware and of operating system software or other software may continue toenhance their products or bundle separate products to include functions thatare currently provided primarily by network security software. 

 

34

----

Table of Contents

 

If network security functions become standard featuresof computer hardware or of operating system software or other software, ourproducts may become obsolete and unmarketable, particularly if the quality ofthese network security features is comparable to that of our products.Furthermore, even if the network security and/or management functions providedas standard features by hardware providers or operating systems or othersoftware is more limited than that of our products, our customers might acceptthis limited functionality in lieu of purchasing additional software. Sales ofour products would suffer materially if we were then unable to develop new Webfiltering, security and DLP products to further enhance operating systems orother software and to replace any obsolete products.

 

*Our worldwide income tax provisions and other taxaccruals may be insufficient if any taxing authorities assume taxing positionsthat are contrary to our positions.*

* *

Significant judgment is required in determining ourworldwide provision for income taxes and for our accruals for other state,federal and international taxes such as sales and VAT taxes. In the ordinarycourse of a global business, there are many transactions for which the ultimatetax outcome is uncertain. Some of these uncertainties arise as a consequence ofintercompany arrangements to share revenue and costs. In such arrangementsthere are uncertainties about the amount and manner of such sharing, whichcould ultimately result in changes once the arrangements are reviewed by taxingauthorities. Although we believe that our approach to determining the amount ofsuch arrangements is reasonable, no assurance can be given that the final taxauthority review of these matters will not be materially different than thatwhich is reflected in our historical income tax provisions and other taxaccruals. Such differences could have a material effect on our income taxprovisions or benefits, or other tax accruals, in the period in which suchdetermination is made, and consequently, on our results of operations for suchperiod.

 

From time to time, we are also audited by variousstate, federal and international authorities relating to tax matters. We fullycooperate with all audits. Our audits are in various stages of completion;however, no outcome for a particular audit can be determined with certaintyprior to the conclusion of the audit and appeals process. As each audit isconcluded, adjustments, if any, are appropriately recorded in our financialstatements in the period determined. To provide for potential tax exposures, weaccrue for uncertain tax positions according to our accounting policies basedon judgment and estimates including historical audit activity. We believesufficient accruals have been recorded for these tax exposures. However, if thereserves are insufficient upon completion of any audits, there could be anadverse impact on our financial position and results of operations.

 

*Anyfailure to protect our proprietary technology would negatively impact ourbusiness.*

* *

Intellectual property is critical to our success, andwe rely upon patent, trademark, copyright and trade secret laws in the United Statesand other jurisdictions as well as confidentiality procedures and contractualprovisions to protect our proprietary technology and our Websense brands. Werely on trade secrets to protect technology where we believe patent protectionis not appropriate or obtainable. However, trade secrets are difficult toprotect. While we require employees, collaborators and consultants to enterinto confidentiality agreements, we cannot assure that these agreements willnot be breached or that we will have adequate remedies for any breach. We maynot be able to adequately protect our trade secrets or other proprietaryinformation in the event of any unauthorized use or disclosure or the lawfuldevelopment by others of such information.

 

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

 

We currently have eleven issued patents in the UnitedStates and fifteen patents issued internationally, and we may be unable toobtain further patent protection in the future. We have other pending patentapplications in the United States and in other countries. We cannot ensurethat:

 

·                  wewere the first to make the inventions covered by each of our pending patentapplications;

 

·                  wewere the first to file patent applications for these inventions;

 

·                  any of ourpending patent applications are not obvious or anticipated such that they willnot result in issued patents;

 

·                  otherswill not independently develop similar or alternative technologies or duplicateany of our technologies;

 

35

----

Table of Contents

 

·                  anypatents issued to us will provide us with any competitive advantages or willnot be challenged by third parties;

 

·                  wewill develop additional proprietary technologies that are patentable; or

 

·                  thepatents of others will not have a negative effect on our ability to dobusiness.

 

Furthermore, legal standards relating to the validity,enforceability and scope of protection of intellectual property rights areuncertain and can change over time. Effective patent, trademark, copyright andtrade secret protection may not be available to us in every country in whichour products are available. The laws of some foreign countries may not be asprotective of intellectual property rights as U.S. laws, and mechanisms forenforcement of intellectual property rights may be inadequate. As a result ourmeans of protecting our proprietary technology and brands may not be adequate.Furthermore, despite our efforts, we may be unable to prevent third partiesfrom infringing upon or misappropriating our intellectual property, includingthe misappropriation or misuse of the content of our proprietary databases ofURLs and executable files. Any such infringement or misappropriation could havea material adverse effect on our business, results of operations and financialcondition.

 

*Third parties claiming that we infringe theirproprietary rights could cause us to incur significant legal expenses andprevent us from selling our products.*

* *

The software and Internet industries are characterizedby the existence of a large number of patents, trademarks and copyrights and byfrequent litigation based on allegations of patent infringement or otherviolations of intellectual property rights. As we expand our product offeringsin the data loss and security area where larger companies with large patentportfolios compete, the possibility of an intellectual property claim againstus grows. We could receive claims that we have infringed the intellectualproperty rights of others, including claims regarding patents, copyrights andtrademarks. Any such claim, with or without merit, could result in costly litigationand distract management from day-to-day operations. If we are not successful indefending such claims, we could be required to stop selling our products, paymonetary amounts as damages, enter into royalty or licensing arrangements, orsatisfy indemnification obligations that we have with some of our customers.

 

*Because we recognize revenue from subscriptions forour products ratably over the term of the subscription, downturns in sales maynot be immediately reflected in our revenue.*

* *

Substantially all of our revenue comes from the saleof subscriptions to our products, including our hosted services. Upon executionof a subscription agreement, we invoice our customers for the full term of thesubscription agreement. We then recognize revenue from customers daily over theterms of their subscription agreements, which typically have durations of 12,24 or 36 months. As a result, a majority of the revenue we report in eachquarter is derived from deferred revenue from subscription agreements enteredinto and paid for during previous quarters. Because of this financial model,the revenue we report in any quarter or series of quarters may mask significantdownturns in sales and the market acceptance of our products, before thesedownturns are reflected by declining revenues. In addition, under GAAP purchase accounting, $97.4 million of thedeferred revenue of SurfControl on the date of acquisition was written off withrespect to the subscriptions to SurfControl products that were delivered priorto our acquisition of SurfControl. Therefore, the revenue that will berecognized post acquisition will be associated only with the fair value ofpost-acquisition technical services under these remaining subscriptions. As aresult, the company can achieve short-term increases in revenue under GAAP evenif subscription renewals for SurfControl customers decline in comparison topre-acquisition periods, since the company will be able to recognize all of therevenue associated with any renewing SurfControl customer subscriptions.

 

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

* *

Our quarterly operating results have variedsignificantly in the past, and will likely vary in the future primarily as theresult of fluctuations in our billings, operating expenses and tax provisions.Although a significant portion of our revenue in any quarter comes frompreviously deferred revenue, a meaningful portion of our revenue in any quarterdepends on the number, size and length of subscriptions to our products thatare sold in that quarter. The risk of quarterly fluctuations is increased bythe fact that a significant portion of our quarterly sales have historicallybeen generated during the last month of each fiscal quarter, with many of thelargest enterprise customers purchasing subscriptions to our products nearer tothe end of the last month of each quarter. Due to the unpredictability of theseend-of-period buying patterns, quarterly results may vary.

 

36

----

Table of Contents

 

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

 

·                  timingof marketing expenses for activities such as trade shows and advertisingcampaigns;

 

·                  quarterlyvariations in general and administrative expenses, such as recruiting expensesand professional services fees;

 

·                  increasedresearch and development costs prior to new or enhanced product launches;

 

·                  timingof expenses associated with commissions paid on sales of subscriptions to ourproducts; and

 

·                  amortizationof acquired intangible assets associated with our PortAuthority and SurfControlacquisitions in 2007.

 

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

 

*Themarket price of our common stock is likely to be highly volatile and subject towide fluctuations.*

* *

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

 

·                  announcementsof technological innovations or new products or services by our competitors;

 

·                  demandfor our products, including fluctuations in subscription renewals;

 

·                  changesin the pricing policies of our competitors; and

 

·                  changesin government regulations.

 

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

 

·                  announcementsof technological innovations or new products or services by us;

 

·                  changesin our pricing policies; and

 

·                  quarterlyvariations in our revenues and operating expenses.

 

Further, the stock market has experienced significantprice and volume fluctuations that have particularly affected the market priceof the stock of many Internet-related companies, and that often have been unrelatedor disproportionate to the operating performance of these companies. A numberof publicly traded Internet-related companies have current market prices belowtheir initial public offering prices. Market fluctuations such as these mayseriously harm the market price of our common stock. In the past, securitiesclass action suits have been filed following periods of market volatility inthe price of a company’s securities. If such an action were instituted, wewould incur substantial costs and a diversion of management attention andresources, which would seriously harm our business, results of operations andfinancial condition.

 

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

* *

Our success depends largely upon the continuedservices of our executive officers and other key management personnel and ourability to recruit new personnel to executive and key managementpositions.  We are also substantiallydependent on the continued service of our existing engineering personnelbecause of the complexity of our products and technologies. We do not haveemployment agreements with a majority of our executive officers, key managementor development personnel and, therefore, they could terminate their employmentwith us at any time without penalty. We do not maintain key person lifeinsurance policies on any of our employees. The loss of one or more of our keyemployees could 

 

37

----

Table of Contents

 

seriously harm our business, results of operations andfinancial condition. In such an event we may be unable to recruit personnel toreplace these individuals in a timely manner, or at all, on acceptable terms.

 

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

* *

To execute our growth plan, we must attract and retainhighly qualified personnel. We need to hire additional personnel in virtuallyall operational areas, including selling and marketing, research anddevelopment, operations and technical support and administration. Competitionfor these personnel is intense, especially for engineers with high levels ofexperience in designing and developing software and Internet-related products.We may not be successful in attracting and retaining qualified personnel. Wehave from time to time in the past experienced, and we expect to continue toexperience in the future, difficulty in hiring and retaining highly skilledemployees with appropriate qualifications. In order to attract and retainpersonnel in a competitive marketplace, we believe that we must provide acompetitive compensation package, including cash and equity-based compensation.The volatility of our stock price may from time to time adversely affect ourability to recruit or retain employees. Many of the companies with which wecompete for experienced personnel have greater resources than we have. If wefail to attract new personnel or retain and motivate our current personnel, ourbusiness and future growth prospects could be severely harmed.

 

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

* *

Compliance with laws, regulations and standardsrelating to corporate governance, accounting principles and public disclosure,including the Sarbanes-Oxley Act of 2002, regulations and NASDAQ Global SelectMarket rules, have caused us to incur higher compliance costs and we expect tocontinue to incur higher compliance costs as a result of our increased globalreach and obligation to ensure compliance with these laws as well as local lawsin the jurisdictions where we do business. These laws, regulations andstandards are subject to varying interpretations in many cases due to theirlack of specificity and, as a result, their application in practice may evolveover time. Further guidance by regulatory and governing bodies can result incontinuing uncertainty regarding compliance matters and higher costs related tothe ongoing revisions to accounting, disclosure and governance practices. Ourefforts to comply with evolving laws, regulations and standards have resultedin, and are likely to continue to result in, increased general andadministrative expenses and a diversion of management time and attention fromrevenue-generating activities to compliance activities. In particular, ourefforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”)and the related regulations regarding our required assessment of our internalcontrol over financial reporting has required the commitment of significantfinancial and managerial resources and we expect to incur expenses in 2008 inconnection with achieving Section 404 compliance with respect to theSurfControl operations we acquired. If our efforts to comply with new orchanged laws, regulations and standards differ from the activities intended byregulatory or governing bodies due to ambiguities related to practice, ourreputation may be harmed.

 

***If wecannot effectively manage our internal growth, our business revenues, resultsof operations and prospects may suffer.****

** **

**If we fail to manage our internalgrowth in a manner that minimizes strains on our resources, we could experiencedisruptions in our operations that could negatively affect our revenue,billings and results of operations.  Weare pursuing a strategy of organic growth through implementation of two-tierdistribution, international expansion, introduction of new products andexpansion of our product sales to the small and medium sized businesses. Wehave also opened or acquired engineering centers in China, Israel, the UnitedKingdom and Australia.  Each of theseinitiatives requires an investment of our financial and employee resources andinvolves risks that may result in a lower return on our investments than weexpect. These initiatives also may limit the opportunities we pursue orinvestments we would otherwise make, which may in turn impact our prospects.**

** **

***It maybe difficult for a third party to acquire us, even if doing so would bebeneficial to our stockholders***.

** **

**Some provisions of ourcertificate of incorporation and bylaws, as well as some provisions of Delawarelaw, may discourage, delay or prevent third parties from acquiring us, even ifdoing so would be beneficial to our stockholders. For example, our certificateof incorporation provides for a classified board, with each board memberserving a staggered three-year term. It also provides that stockholders may notfill board vacancies, call stockholder meetings or act by written consent. Ourbylaws further provide that advance written notice is required prior tostockholder proposals. Each of these provisions makes it more difficult forstockholders to obtain control of our board or initiate actions that areopposed by the then current board. Additionally, we have authorized preferredstock that is undesignated, making it possible for the board to issue up to5,000,000 shares of preferred stock with voting or other rights and preferencesthat could impede the success of any**

 

38

----

**Table of Contents**

** **

**attemptedchange of control. Delaware law also could make it more difficult for a thirdparty to acquire us. Section 203 of the Delaware General Corporation Lawhas an anti-takeover effect with respect to transactions not approved inadvance by our board, including discouraging attempts that might result in apremium over the market price of the shares of common stock held by ourstockholders.**

** **

Our senior secured creditfacility also accelerates and becomes payable in full upon our change ofcontrol, which is defined generally as a person or group acquiring 35% of ourvoting securities or a proxy contest that results in changing a majority of ourboard of directors.  These consequencesmay discourage third parties from attempting to acquire us.

 

*Wedo not intend to pay dividends.*

* *

We have not declared orpaid any cash dividends on our common stock since we have been a publiclytraded company. We currently intend to retain any future cash flows fromoperations to fund growth, pay down our senior secured term loan and repurchaseshares of our common stock, and therefore do not expect to pay any cashdividends in the foreseeable future. Moreover, we are not permitted to pay cash dividends under the terms ofour senior secured credit facility.

 

**Item 2. Unregistered Sales ofEquity Securities and Use of Proceeds**

 

(a) Notapplicable.

 

(b) Notapplicable.

 

(c) Issuer Purchases of Equity Securities

 
| **Month**           | ** ** | **Number of  Shares  Purchased  During Month** | ** ** | **Average Price  Paid Per Share** | ** ** | **Cumulative  Number of Shares  Purchased as Part  of Publicly  Announced Plan** | ** ** | **Maximum Number of  Shares that May Be  Purchased Under the  Plan** | ** ** |
|---------------------|------------|----------------------------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|
| July 2008      |       | 129,990                                                  |       | $                                                | 17.34      |                                                                                                           | 8,837,954  |                                                                                                    | 3,162,046  |   |
| August 2008    |       | 38,500                                                   |       | $                                                | 22.35      |                                                                                                           | 8,876,454  |                                                                                                    | 3,123,546  |   |
| September 2008 |       | 83,898                                                   |       | $                                                | 22.41      |                                                                                                           | 8,960,352  |                                                                                                    | 3,039,648  |   |
| Total               |       | 252,388                                                  |       | $                                                | 19.79      |                                                                                                           | 8,960,352  |                                                                                                    | 3,039,648  |   |

 

----

| 1. | The  purchases were made in open-market transactions.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2. | On  April 3, 2003, we announced that our Board of Directors authorized a  stock repurchase program of up to 4 million shares of our common stock.  On August 15, 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. On  July 25, 2006, we announced that our Board of Directors increased the  size of the stock repurchase program by an additional 4 million shares,  for a total program size of up to 12 million shares. In January 2008,  we adopted a 10b5-1 plan that provides for quarterly purchases of up to $5  million in stock in open market transactions. The remaining shares authorized for repurchase under our stock  repurchase program as of September 30, 2008 was 3,039,648 shares. |

 

**Item 3. Defaults uponSenior Securities**

** **

**None.**

** **

**Item 4. Submission ofMatters to a Vote of Security Holders**

** **

**None.**

** **

**Item 5. OtherInformation**

** **

**None.**

 

39

----

**Table of Contents**

** **

**Item 6. Exhibits**

** **

**Exhibits**

** **
| 3.1(1)  | Amended and Restated Certificate of Incorporation.                                                                                                                                                               |
|---------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2(2)  | Amended and Restated Bylaws.                                                                                                                                                                                     |
| 4.1(3)  | Specimen Stock Certificate of Websense, Inc.                                                                                                                                                                |
| 10.1(4) | Officer Change in Control Severance Benefit Plan.                                                                                                                                                                |
| 10.2(4) | Form of Severance Plan Participation Agreement  for Tier One Officers.                                                                                                                                      |
| 10.3(4) | Form of Severance Plan Participation Agreement  for Tier Two Officers.                                                                                                                                      |
| 10.4(4) | Form of Severance Plan Participation Agreement  for Tier Three Officers.                                                                                                                                    |
| 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). |

 

----

(1)             Filedas an Exhibit to our Registration Statement on Form S-1/A (No333-95619) filed on March 3, 2000.

(2)             Filedas an Exhibit to our Current Report on Form 8-K (No 000-30093) filedon October 28, 2008.

(3)             Filedas an Exhibit to our Registration Statement on Form S-1/A (No333-95619) filed on March 23, 2000.

(4)             Filedas an Exhibit to our Current Report on Form 8-K (No 000-30093) filedon July 23, 2008.

 

40

----

##### Table ofContents

 

##### **SIGNATURES**

#####  

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

 
|                        | **WEBSENSE, INC.** |
|-----------------------------|--------------------|
|                        |               |   |
| Date: November 7, 2008 | By:           |  /s/ GENE HODGES |
|                        |               |   Gene Hodges |
| * *                    | * *           | *  Chief Executive Officer* |
|                        |               |   |
| Date: November 7, 2008 | By:           |  /s/ DUDLEY MENDENHALL |
|                        |               |   Dudley Mendenhall |
| * *                    | * *           | *  Chief Financial Officer* |

 

41

----

Table of Contents

 

**EXHIBIT INDEX**

 
| 3.1(1)  | Amended and Restated Certificate of Incorporation.                                                                                                                                                               |
|---------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2(2)  | Amended and Restated Bylaws.                                                                                                                                                                                     |
| 4.1(3)  | Specimen Stock Certificate of Websense, Inc.                                                                                                                                                                |
| 10.1(4) | Officer Change in Control Severance Benefit Plan.                                                                                                                                                                |
| 10.2(4) | Form of Severance Plan Participation Agreement  for Tier One Officers.                                                                                                                                      |
| 10.3(4) | Form of Severance Plan Participation Agreement  for Tier Two Officers.                                                                                                                                      |
| 10.4(4) | Form of Severance Plan Participation Agreement  for Tier Three Officers.                                                                                                                                    |
| 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). |

 

----

(1)             Filedas an Exhibit to our Registration Statement on Form S-1/A (No333-95619) filed on March 3, 2000.

(2)             Filedas an Exhibit to our Current Report on Form 8-K (No 000-30093) filedon October 28, 2008.

(3)             Filedas an Exhibit to our Registration Statement on Form S-1/A (No333-95619) filed on March 23, 2000.

(4)             Filedas an Exhibit to our Current Report on Form 8-K (No 000-30093) filedon July 23, 2008.

 

----