** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**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, 2007**

**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 Road**

**San Diego, California 92121**

**858-320-8000**

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one):
| Large Accelerated Filer x |   | Accelerated Filer o |   | Non —Accelerated Filer o |
|---------------------------|--------|---------------------|--------|-------------------------------|

 

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, 2007 was 45,376,906.

 

 

 

**Websense, Inc.**

**Form 10-Q**

**For the Period Ended September 30, 2007**

**TABLE OF CONTENTS**
|                           |   |      |   |                                                                                               | Page   |
|--------------------------------|--------|-----------|--------|----------------------------------------------------------------------------------------------------|--------|
| Part  I. Financial Information |   |
|                           |   |      |   |                                                                                               |   |
|                           |   | Item 1.   |   | Consolidated  Financial Statements (Unaudited)                                                     |   |
|                           |   |      |   | Consolidated Balance Sheets as of September 30, 2007  and December 31, 2006                        | 3      |
|                           |   |      |   | Consolidated Statements of Income for the three and  nine months ended September 30, 2007 and 2006 | 4      |
|                           |   |      |   | Consolidated Statement of Stockholders’ Equity for the  nine months ended September 30, 2007  | 5      |
|                           |   |      |   | Consolidated Statements of Cash Flows for the nine  months ended September 30, 2007 and 2006       | 6      |
|                           |   |      |   | Notes to Consolidated Financial Statements                                                         | 7      |
|                           |   | Item 2.   |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations        | 17     |
|                           |   | Item 3.   |   | Quantitative  and Qualitative Disclosures About Market Risk                                        | 26     |
|                           |   | Item 4.   |   | Controls and  Procedures                                                                           | 27     |
|                           |   |      |   |                                                                                               |   |
| Part  II. Other Information    |   |
|                           |   |      |   |                                                                                               |   |
|                           |   | Item 1.   |   | Legal Proceedings                                                                                  | 28     |
|                           |   | Item  1A. |   | Risk  Factors                                                                                      | 28     |
|                           |   | Item 2.   |   | Unregistered  Sales of Equity Securities and Use of Proceeds                                       | 40     |
|                           |   | Item 3.   |   | Defaults upon  Senior Securities                                                                   | 40     |
|                           |   | Item 4.   |   | Submission of  Matters to a Vote of Security Holders                                               | 40     |
|                           |   | Item 5.   |   | Other Information                                                                                  | 40     |
|                           |   | Item  6.  |   | Exhibits                                                                                           | 41     |
|                           |   |      |   |                                                                                               |   |
| Signatures                     | 42     |
|                                |        |           |        |                                                                                                    |        |  |  |  |  |

 

2

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Part I — FinancialInformation

**Item 1. ConsolidatedFinancial Statements (Unaudited)**

**Websense, Inc.**Consolidated BalanceSheets (Unaudited and in thousands)
| ** **                                       | ** ** | **September 30,** | ** ** | **December 31,**      | ** ** |
|--------------------------------------------------|------------|-------------------|------------|----------------------------|------------|
| ** **                                       | ** ** | **2007**          | ** ** | **2006**                   | ** ** |
| ** **                                       | ** ** | ** **        | ** ** | **(See Note 1)** | ** ** |
| **Assets**                                       |       |              |       |                       |       |
| Current assets:                                  |       |              |       |                       |       |
| Cash and cash  equivalents                       |       | $                 | 45,645     |                       | $          | 83,523 |   |
| Cash and cash  equivalents-restricted            |       | 196,162           |       | —                     |       |
| Marketable  securities                           |       | 15,035            |       | 243,382                    |       |
| Marketable  securities-restricted                |       | 22,991            |       | —                     |       |
| Accounts  receivable, net                        |       | 42,643            |       | 52,740                     |       |
| Prepaid income  taxes                            |       | 2,357             |       | —                     |       |
| Current portion  of deferred income taxes        |       | 18,052            |       | 18,179                     |       |
| Other current  assets                            |       | 5,167             |       | 3,943                      |       |
| Total current  assets                            |       | 348,052           |       | 401,767                    |       |
|                                             |       |              |       |                       |       |
| Property and  equipment, net                     |       | 7,592             |       | 5,793                      |       |
| Intangible  assets, net                          |       | 13,138            |       | 1,067                      |       |
| Goodwill                                         |       | 73,625            |       | —                     |       |
| Deferred income  taxes, less current portion     |       | 21,608            |       | 13,806                     |       |
| Deposits and  other assets                       |       | 7,386             |       | 1,824                      |       |
| Total assets                                     |       | $                 | 471,401    |                       | $          | 424,257 |   |
|                                             |       |              |       |                       |       |
| **Liabilities  and stockholders’ equity**   |       |              |       |                       |       |
| Current  liabilities:                            |       |              |       |                       |       |
| Accounts payable                                 |       | $                 | 1,425      |                       | $          | 2,712 |   |
| Accrued payroll  and related benefits            |       | 13,216            |       | 9,164                      |       |
| Other accrued  expenses                          |       | 12,414            |       | 7,084                      |       |
| Current portion  of income taxes payable         |       | 1,105             |       | 4,229                      |       |
| Current portion  of deferred revenue             |       | 145,742           |       | 148,539                    |       |
| Total current  liabilities                       |       | 173,902           |       | 171,728                    |       |
|                                             |       |              |       |                       |       |
| Income taxes  payable, less current portion      |       | 9,522             |       | —                     |       |
| Deferred  revenue, less current portion          |       | 73,528            |       | 71,804                     |       |
|                                             |       |              |       |                       |       |
| Stockholders’  equity:                      |       |              |       |                       |       |
| Common stock                                     |       | 514               |       | 509                        |       |
| Additional paid-in  capital                      |       | 258,958           |       | 237,302                    |       |
| Treasury stock,  at cost                         |       | (139,786          | )          | (139,744                   | )          |
| Retained  earnings                               |       | 94,763            |       | 82,748                     |       |
| Accumulated  other comprehensive loss            |       | —            |       | (90                        | )          |
| Total  stockholders’ equity                 |       | 214,449           |       | 180,725                    |       |
| Total  liabilities and stockholders’ equity |       | $                 | 471,401    |                       | $          | 424,257 |   |

 

See accompanying notes.

 

3

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**Websense, Inc.Consolidated Statements of Income(Unaudited) (in thousands, except per share amounts)**
| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                        | ** ** | **2007**               | ** ** | **2006**              | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenue                                           |       | $                      | 50,429     |                  | $          | 45,742 |   | $ | 150,625 |   | $ | 131,489 |   |
|                                              |       |                   |       |                  |       |   |   |   |   |
| Cost of revenues                                  |       |                   |       |                  |       |   |   |   |   |
| Cost of revenues                                  |       | 4,466                  |       | 3,873                 |       | 13,299 |   | 10,955 |   |
| Amortization of  acquired technology              |       | 629                    |       | —                |       | 1,887 |   | — |   |
| Total cost of  revenues                           |       | 5,095                  |       | 3,873                 |       | 15,186 |   | 10,955 |   |
| Gross margin                                      |       | 45,334                 |       | 41,869                |       | 135,439 |   | 120,534 |   |
|                                              |       |                   |       |                  |       |   |   |   |   |
| Operating  expenses:                              |       |                   |       |                  |       |   |   |   |   |
| Selling and  marketing                            |       | 25,249                 |       | 21,309                |       | 75,289 |   | 58,245 |   |
| Research and  development                         |       | 8,338                  |       | 5,954                 |       | 25,789 |   | 16,932 |   |
| General and  administrative                       |       | 6,828                  |       | 5,535                 |       | 20,589 |   | 15,968 |   |
| Write off of  in-process research and development |       | —                 |       | —                |       | 1,270 |   | — |   |
| Total operating  expenses                         |       | 40,415                 |       | 32,798                |       | 122,937 |   | 91,145 |   |
|                                              |       |                   |       |                  |       |   |   |   |   |
| Income from  operations                           |       | 4,919                  |       | 9,071                 |       | 12,502 |   | 29,389 |   |
|                                              |       |                   |       |                  |       |   |   |   |   |
| Other income,  net                                |       | 3,928                  |       | 2,784                 |       | 7,843 |   | 8,240 |   |
|                                              |       |                   |       |                  |       |   |   |   |   |
| Income before  income taxes                       |       | 8,847                  |       | 11,855                |       | 20,345 |   | 37,629 |   |
|                                              |       |                   |       |                  |       |   |   |   |   |
| Provision for  income taxes                       |       | 2,452                  |       | 3,550                 |       | 7,954 |   | 13,313 |   |
|                                              |       |                   |       |                  |       |   |   |   |   |
| Net income                                        |       | $                      | 6,395      |                  | $          | 8,305 |   | $ | 12,391 |   | $ | 24,316 |   |
|                                              |       |                   |       |                  |       |   |   |   |   |
| Net income per  share:                            |       |                   |       |                  |       |   |   |   |   |
|                                              |       |                   |       |                  |       |   |   |   |   |
| Basic net income  per share                       |       | $                      | 0.14       |                  | $          | 0.18 |   | $ | 0.28 |   | $ | 0.52 |   |
| Diluted net  income per share                     |       | $                      | 0.14       |                  | $          | 0.18 |   | $ | 0.27 |   | $ | 0.51 |   |
| Weighted average  shares – basic             |       | 45,194                 |       | 45,796                |       | 45,028 |   | 47,102 |   |
| Weighted average  shares – diluted           |       | 45,607                 |       | 46,401                |       | 45,517 |   | 47,926 |   |

 

See accompanyingnotes.

 

4

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**Websense, Inc.** Consolidated Statement of Stockholders’ Equity (Unaudited and in thousands)
| ** **                                                                                                                | ** ** | ** **        | ** ** | ** **     | ** ** | ** **               | ** ** | ** **   | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|----------------|------------|--------------------------|------------|--------------|------------|-------------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                                                | ** ** | ** **        | ** ** | ** **     | ** ** | ** **               | ** ** | ** **   | ** ** | ** **        | ** ** | **other**              | ** ** | **Total**  | ** ** |
| ** **                                                                                                                | ** ** | **Common  stock** | ** ** | **Additional** | ** ** | **Treasury**             | ** ** | **Retained** | ** ** | **comprehensive** | ** ** | **stockholders’** | ** ** |
| ** **                                                                                                                | ** ** | **Shares**        | ** ** | **Amount**     | ** ** | **paid-in capital** | ** ** | **stock**    | ** ** | **earnings**      | ** ** | **income  (loss)**     | ** ** | **equity** | ** ** |
| Balance at  December 31, 2006                                                                                             |       | 44,785            |       | $              | 509        |                     | $          | 237,302      |       | $                 | (139,744   | )                      | $          | 82,748     |       | $ | (90 | ) | $ | 180,725 |   |
| Cumulative impact  of change in accounting for uncertainties in income taxes – upon adoption of  FIN 48 (see note 8) |       | —            |       | —         |       | (858                     | )          | —       |       | (376              | )          | —                 |       | (1,234     | )          |
| Balance at  January 1, 2007 upon adoption of FIN 48                                                                       |       | 44,785            |       | 509            |       | 236,444                  |       | (139,744     | )          | 82,372            |       | (90                    | )          | 179,491    |       |
|                                                                                                                      |       |              |       |           |       |                     |       |         |       |              |       |                   |       |       |       |
| Issuance of  common stock upon exercise of options                                                                        |       | 320               |       | 4              |       | 3,042                    |       | —       |       | —            |       | —                 |       | 3,046      |       |
|                                                                                                                      |       |              |       |           |       |                     |       |         |       |              |       |                   |       |       |       |
| Issuance of  common stock for ESPP purchase                                                                               |       | 105               |       | 1              |       | 2,211                    |       | —       |       | —            |       | —                 |       | 2,212      |       |
|                                                                                                                      |       |              |       |           |       |                     |       |         |       |              |       |                   |       |       |       |
| Issuance of  common stock from restricted stock units, net                                                                |       | 30                |       | —         |       | —                   |       | (42          | )          | —            |       | —                 |       | (42        | )          |
|                                                                                                                      |       |              |       |           |       |                     |       |         |       |              |       |                   |       |       |       |
| Share-based  compensation expense                                                                                         |       | —            |       | —         |       | 16,087                   |       | —       |       | —            |       | —                 |       | 16,087     |       |
|                                                                                                                      |       |              |       |           |       |                     |       |         |       |              |       |                   |       |       |       |
| Excess tax  benefit of share-based compensation                                                                           |       | —            |       | —         |       | 1,174                    |       | —       |       | —            |       | —                 |       | 1,174      |       |
|                                                                                                                      |       |              |       |           |       |                     |       |         |       |              |       |                   |       |       |       |
| Net income                                                                                                                |       | —            |       | —         |       | —                   |       | —       |       | 12,391            |       | —                 |       | 12,391     |       |
|                                                                                                                      |       |              |       |           |       |                     |       |         |       |              |       |                   |       |       |       |
| Net change in  unrealized gain on marketable securities, net of tax                                                       |       | —            |       | —         |       | —                   |       | —       |       | —            |       | 81                     |       | 81         |       |
|                                                                                                                      |       |              |       |           |       |                     |       |         |       |              |       |                   |       |       |       |
| Net change in  unrealized gain on fair market valuation of foreign currency contracts, net  of tax                        |       | —            |       | —         |       | —                   |       | —       |       | —            |       | 9                      |       | 9          |       |
|                                                                                                                      |       |              |       |           |       |                     |       |         |       |              |       |                   |       |       |       |
| Comprehensive  income                                                                                                     |       |              |       |           |       |                     |       |         |       |              |       |                   |       | 12,481     |       |
| Balance at  September 30, 2007                                                                                            |       | 45,240            |       | $              | 514        |                     | $          | 258,958      |       | $                 | (139,786   | )                      | $          | 94,763     |       | $ | — |   | 214,449 |   |
|                                                                                                                           |            |                   |            |                |            |                          |            |              |            |                   |            |                        |            |            |            |  |  |  |  |  |  |

 

See accompanyingnotes.

 

5

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**Websense, Inc.Consolidated Statements of Cash Flows(Unaudited and in thousands)**
| ** **                                                                                    | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                    | ** ** | **September 30,**          | ** ** | **September 30,** | ** ** |
| ** **                                                                                    | ** ** | **2007**                   | ** ** | **2006** | ** ** |
| **Operating  activities:**                                                                    | ** ** | ** **                 | ** ** | ** ** | ** ** |
| Net income                                                                                    |       | $                          | 12,391     |   | $ | 24,316 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:            |       |                       |       |   |   |
| Depreciation                                                                                  |       | 3,309                      |       | 2,432 |   |
| Write-off of  in-process research and development                                             |       | 1,270                      |       | — |   |
| Amortization of  intangible assets                                                            |       | 2,640                      |       | — |   |
| Share-based  compensation                                                                     |       | 16,087                     |       | 15,032 |   |
| Deferred revenue                                                                              |       | (1,402                     | )          | 13,554 |   |
| Deferred income  taxes                                                                        |       | (5,997                     | )          | (6,496 | ) |
| Unrealized gain  on foreign exchange contracts                                                |       | (49                        | )          | 76 |   |
| Excess tax  benefit of share-based compensation                                               |       | (1,174                     | )          | (2,889 | ) |
| Unrealized loss  on option contracts on SurfControl acquisition.                              |       | 645                        |       | — |   |
| Realized gain on  option contracts on SurfControl acquisition.                                |       | (434                       | )          | — |   |
| Changes in  operating assets and liabilities, net of effects from purchase of  PortAuthority: |       |                       |       |   |   |
| Accounts receivable                                                                           |       | 10,802                     |       | 9,897 |   |
| Prepaid income  taxes                                                                         |       | (2,357                     | )          | 1,962 |   |
| Other current  assets                                                                         |       | (349                       | )          | (1,131 | ) |
| Deposits and  other assets                                                                    |       | (5,452                     | )          | (23 | ) |
| Accounts payable                                                                              |       | (1,453                     | )          | 67 |   |
| Accrued payroll  and related benefits                                                         |       | 1,133                      |       | 171 |   |
| Other accrued  expenses                                                                       |       | 4,253                      |       | 2,106 |   |
| Income taxes  payable                                                                         |       | 3,762                      |       | 2,486 |   |
| Net cash  provided by operating activities                                                    |       | 37,625                     |       | 61,560 |   |
| ** **                                                                                    | ** ** | ** **                 | ** ** | ** ** | ** ** |
| **Investing  activities:**                                                                    | ** ** | ** **                 | ** ** | ** ** | ** ** |
| Purchase of  intangible assets                                                                |       | —                     |       | (1,200 | ) |
| Cash paid to  acquire PortAuthority, net of cash acquired                                     |       | (81,988                    | )          | — |   |
| Purchases of  property and equipment                                                          |       | (4,362                     | )          | (3,132 | ) |
| Change in  restricted cash and cash equivalents.                                              |       | (196,162                   | )          | — |   |
| Purchases of  marketable securities                                                           |       | (308,929                   | )          | (472,950 | ) |
| Maturities of  marketable securities                                                          |       | 324,219                    |       | 477,867 |   |
| Purchases of  marketable securities- restricted                                               |       | (163,678                   | )          | — |   |
| Maturities of  marketable securities- restricted                                              |       | 353,825                    |       | — |   |
| Cash received from  sale of the option contracts on SurfControl acquisition                   |       | 5,104                      |       | — |   |
| Cash paid for  option contracts on SurfControl acquisition                                    |       | (5,750                     | )          | — |   |
| Net cash (used  in) provided by investing activities                                          |       | (77,721                    | )          | 585 |   |
| ** **                                                                                    | ** ** | ** **                 | ** ** | ** ** | ** ** |
| **Financing  activities:**                                                                    | ** ** | ** **                 | ** ** | ** ** | ** ** |
| Proceeds from  exercise of stock options                                                      |       | 3,046                      |       | 8,786 |   |
| Proceeds from  issuance of common stock for stock purchase plan                               |       | 2,212                      |       | 1,988 |   |
| Repayment of  PortAuthority loan                                                              |       | (4,214                     | )          | — |   |
| Excess tax  benefit of share-based compensation                                               |       | 1,174                      |       | 2,889 |   |
| Purchases of  treasury stock                                                                  |       | —                     |       | (91,404 | ) |
| Net cash  provided by (used in) financing activities                                          |       | 2,218                      |       | (77,741 | ) |
|                                                                                          |       |                       |       |   |   |
| Decrease in cash  and cash equivalents                                                        |       | (37,878                    | )          | (15,596 | ) |
| Cash and cash  equivalents at beginning of period                                             |       | 83,523                     |       | 61,629 |   |
| Cash and cash  equivalents at end of period                                                   |       | $                          | 45,645     |   | $ | 46,033 |   |
| ** **                                                                                    | ** ** | ** **                 | ** ** | ** ** | ** ** |
| **Supplemental  cash flow information:**                                                      | ** ** | ** **                 | ** ** | ** ** | ** ** |
| Income taxes  paid                                                                            |       | $                          | 11,476     |   | $ | 11,908 |   |
| Unrealized gain  on marketable securities                                                     |       | $                          | 81         |   | $ | 480 |   |
| Amount  transferred from marketable securities to marketable securities-restricted            |       | $                          | 213,138    |   | $ | — |   |

 

See accompanying notes.

 

6

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** **

**Websense,Inc.**

**Notes ToConsolidated Financial Statements (Unaudited)**

1. *Basis ofPresentation*

The accompanying unaudited consolidated financialstatements have been prepared in conformity with United States generallyaccepted accounting principles for interim financial statements and with theinstructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly,certain information or footnote disclosures normally included in completefinancial statements prepared in accordance with United States generally acceptedaccounting principles have been condensed or omitted pursuant to the rules andregulations of the Securities and Exchange Commission. In the opinion of management,the statements include all adjustments necessary, which are of a normal and recurringnature, for the fair presentation of our financial position and of the resultsfor the interim periods presented.

These financial statements should be read inconjunction with the audited consolidated financial statements and notesthereto for the year ended December 31, 2006, included in Websense, Inc.’s (“Websense”or the “Company”) Annual Report on Form 10-K filed with the Securities andExchange Commission. Operating results for the three and nine months endedSeptember 30, 2007 are not necessarily indicative of the results that may beexpected for any other interim period or for the year ending December 31, 2007.The balance sheet at December 31, 2006 has been derived from the audited financialstatements at that date but does not include all of the information andfootnotes required by United States generally accepted accounting principlesfor complete financial statements.

These financial statements do not reflect theoperating results or financial position of SurfControl plc, which Websense acquiredon October 3, 2007 (see Note 5. Acquisitions).

2. *Net Income Per Share*

Websensecomputes net income per share as permitted by the Financial AccountingStandards Board (“FASB”) with Statement of Financial Accounting Standards(“SFAS”) No. 128, *Earnings Per Share* (“EPS”) (“SFASNo. 128”). Under theprovisions of SFAS No. 128, basic net income per share is computed by dividingthe net income for the period by the weighted average number of common sharesoutstanding during the period. Diluted net income per share 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. Dilutivesecurities include both dilutive stock options and dilutive restricted stockunits and are calculated based on the average share price for each fiscalperiod using the treasury stock method.

During the three months ended September 30, 2007 and2006, the difference between the weighted average shares used in determiningbasic EPS versus diluted EPS related to dilutive securities totaled 413,318 and605,104 shares, respectively. Potentially dilutive securities totaling7,111,932 and 5,604,382 shares for the three months ended September 30, 2007and 2006, respectively, were excluded from the diluted earnings per sharecalculation because of their anti-dilutive effect.

Duringthe nine months ended September 30, 2007 and 2006, the difference between theweighted average shares used in determining basic EPS versus diluted EPSrelated to dilutive securities totaled 488,634 and 824,096 shares,respectively. Potentially dilutive securities totaling 6,232,064 and 4,412,343shares for the nine months ended September 30, 2007 and 2006, respectively,were excluded from the diluted earnings per share calculation because of theiranti-dilutive effect.

 

7

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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 Income (Numerator)**                                       | ** ** | **Shares (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
|----------------------------------|------------|-----------------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **(In thousands, except per share amounts)** | ** ** |
| **For the  Three Months Ended:** | ** ** | ** **                                                            | ** ** | ** **               | ** ** | ** **            | ** ** |
| **September  30, 2007:**         | ** ** | ** **                                                            | ** ** | ** **               | ** ** | ** **            | ** ** |
| Basic EPS                        |       | $                                                                     | 6,395      |                     | 45,194     |                  | $          | 0.14 |   |
| Effect of  dilutive securities   |       | —                                                                |       | 413                      |       | (0.00                 | )          |
| Diluted EPS                      |       | $                                                                     | 6,395      |                     | 45,607     |                  | $          | 0.14 |   |
| ** **                       | ** ** | ** **                                                            | ** ** | ** **               | ** ** | ** **            | ** ** |
| **September  30, 2006:**         | ** ** | ** **                                                            | ** ** | ** **               | ** ** | ** **            | ** ** |
| Basic EPS                        |       | $                                                                     | 8,305      |                     | 45,796     |                  | $          | 0.18 |   |
| Effect of  dilutive securities   |       | —                                                                |       | 605                      |       | (0.00                 | )          |
| Diluted EPS                      |       | $                                                                     | 8,305      |                     | 46,401     |                  | $          | 0.18 |   |
| ** **                       | ** ** | ** **                                                            | ** ** | ** **               | ** ** | ** **            | ** ** |
| **For the  Nine Months Ended:**  | ** ** | ** **                                                            | ** ** | ** **               | ** ** | ** **            | ** ** |
| **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 |   |
| ** **                       | ** ** | ** **                                                            | ** ** | ** **               | ** ** | ** **            | ** ** |
| **September  30, 2006:**         | ** ** | ** **                                                            | ** ** | ** **               | ** ** | ** **            | ** ** |
| Basic EPS                        |       | $                                                                     | 24,316     |                     | 47,102     |                  | $          | 0.52 |   |
| Effect of  dilutive securities   |       | —                                                                |       | 824                      | ** ** | (0.01                 | )          |
| Diluted EPS                      |       | $                                                                     | 24,316     |                     | 47,926     |                  | $          | 0.51 |   |

 

 

3. *Comprehensive Income*

Thecomponents of comprehensive income, as required to be reported by SFAS No. 130,*Reporting Comprehensive Income*, were asfollows (in thousands):

 
| ** **                                                                                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                         | ** ** | **September 30,  2007**     | ** ** | **September 30,  2006**    | ** ** | **September 30,  2007** | ** ** | **September 30,  2006** | ** ** |
| Net income                                                                                         |       | $                                | 6,395      |                            | $          | 8,305 |   | $ | 12,391 |   | $ | 24,316 |   |
| Net change in  unrealized gain on marketable securities, net of tax                                |       | 67                               |       | 278                             |       | 81 |   | 480 |   |
| Net change in  unrealized gain on fair market valuation of foreign currency contracts, net  of tax |       | (10                              | )          | (40                             | )          | 9 |   | 76 |   |
| Comprehensive  income                                                                              |       | $                                | 6,452      |                            | $          | 8,543 |   | $ | 12,481 |   | $ | 24,872 |   |
|                                                                                                    |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

8

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4.*Stockholders’ Equity*

 

**Share-Based Compensation**

*Employee Stock Purchase Plan*

Shares available for issuance under the Company’sEmployee Stock Purchase Plan are as follows:
| ** **                                                                                 | ** ** | **Number of   Shares** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| Shares reserved  for issuance at December 31, 2006                                         |       | 1,483,241                        |       |
| Shares reserved  for issuance during 2007 based on automatic increase in shares authorized |       | 447,845                          |       |
| Shares issued  during the nine months ended September 30, 2007                             |       | (105,321                         | )          |
| Shares reserved  for issuance at September 30, 2007                                        |       | 1,825,765                        |       |

 

The Company usedthe following assumptions to estimate the fair value of the semi-annualemployee stock purchase plan share grants during the nine months endedSeptember 30, 2007 and 2006:

 
| ** **                          | ** ** | **Nine Months Ended**  | ** ** |
|-------------------------------------|------------|------------------------|------------|
| ** **                          | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** |
| Average expected  life (years)      |       | 1.3                    |       | 1.3 |   |
| Average expected  volatility factor |       | 32.5                   | %          | 36.1 | % |
| Average  risk-free interest rate    |       | 4.8                    | %          | 4.9 | % |
| Average expected  dividend yield    |       | —                 |       | — |   |

 

*Employee Stock Option Plans*

TheAmended and Restated 2000 Stock Incentive Plan (the “2000 Plan”) provides forthe grant of stock options to the Company’s directors, employees and consultants.The 2000 Plan provides for the grant of incentive and non-statutory stockoptions, restricted stock units and rights to purchase stock to employees,directors or consultants of the Company. The 2000 Plan provides that incentivestock options will be granted only to employees and are subject to certainlimitations as to fair value during a calendar year.  To date, only non-statutory stock options andrestricted stock units have been granted under the 2000 Plan. Through September30, 2007, the Company has granted 120,000 restricted stock units. The unvestedrestricted stock units have a weighted average grant date fair value of $29.48and an aggregate intrinsic value (the amount by which the fair value exceedsthe award price) of $1.8 million as of September 30, 2007.

 

Inaddition, the 2000 Plan provides for automatic annual increases in the numberof shares authorized and reserved for issuance thereunder equal to the lesserof (i) 4% of the Company’s outstanding shares on the last business day inDecember of the calendar year immediately preceding or (ii) 3,000,000 shares.At September 30, 2007, a total of 21,349,542 shares have been authorized forissuance under the 2000 Plan, of which 227,262 remain available for grant.

On January8, 2007, the Compensation Committee of Websense’s Board of Directors adoptedthe Websense, Inc. 2007 Stock Incentive Assumption Plan (the “2007 Plan”).  In connection with the acquisition ofPortAuthority Technologies, Inc. (“PortAuthority”), the Company agreed tosubstitute unvested stock options to purchase PortAuthority common stock thatwere granted under PortAuthority’s 2004 Global Share Option Plan (the “PortAuthorityOption Plan”) and outstanding immediately prior to the effective time of theacquisition with options to purchase an aggregate of 74,891 shares of Websensecommon stock (the “Substitute Options”). The Substitute Options have the same contractual lives and vestingperiods as they did under the PortAuthority Option Plan.  The number of shares and exercise prices ofthe Substitute Options were determined based on the conversion ratio as definedby the merger agreement with PortAuthority.

 

9

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Thefollowing table summarizes the Company’s stock option activity since December31, 2006:
| ** **                     | ** ** | **Number of  Shares** | ** ** | **Weighted Average   Exercise Price** | ** ** |
|--------------------------------|------------|----------------------------|------------|-------------------------------------------------|------------|
| Balance at  December 31, 2006  |       | 7,038,259                  |       | $                                               | 22.61      |   |
| Granted                        |       | 2,861,134                  |       | 21.96                                           |       |
| Exercised                      |       | (320,808                   | )          | 9.49                                            |       |
| Cancelled                      |       | (620,588                   | )          | 23.43                                           |       |
| Balance at  September 30, 2007 |       | 8,957,997                  |       | 22.82                                           |       |
|                                |            |                            |            |                                                 |            |  |

 

The results for the three and nine months endedSeptember 30, 2007 include share-based compensation expense of $5.6 million(excluding tax effects) and $16.1 million (excluding tax effects),respectively, in the following expense categories of the consolidated statementsof income (in thousands).

 
| ** **                                                   | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**   | ** ** |
|--------------------------------------------------------------|------------|----------------------------------|------------|-------------------------|------------|
| ** **                                                   | ** ** | **September 30,  2007**          | ** ** | **September 30,  2006** | ** ** | **September 30,  2007** | ** ** | **September 30,  2006** | ** ** |
| Share-based  compensation in:                                |       |                             |       |                    |       |   |   |   |   |
| Cost of revenues                                             |       | $                                | 380        |                    | $          | 392 |   | $ | 1,097 |   | $ | 1,088 |   |
| Total  share-based compensation in cost of revenues          |       | 380                              |       | 392                     |       | 1,097 |   | 1,088 |   |
|                                                         |       |                             |       |                    |       |   |   |   |   |
| Selling and  marketing                                       |       | 2,231                            |       | 2,204                   |       | 6,436 |   | 6,208 |   |
| Research and  development                                    |       | 1,083                            |       | 927                     |       | 2,969 |   | 2,659 |   |
| General and  administrative                                  |       | 1,857                            |       | 1,797                   |       | 5,585 |   | 5,077 |   |
| Total  share-based compensation in  operating  expenses |       | 5,171                            |       | 4,928                   |       | 14,990 |   | 13,944 |   |
| Total  share-based compensation                              |       | $                                | 5,551      |                    | $          | 5,320 |   | $ | 16,087 |   | $ | 15,032 |   |

 

The Company used thefollowing assumptions to estimate the fair value of stock options granted underthe 2000 plan for thethree and nine months ended September 30, 2007 and 2006:

 
| ** **                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**   | ** ** |
|-------------------------------------|------------|----------------------------------|------------|-------------------------|------------|
| ** **                          | ** ** | **September 30,  2007**          | ** ** | **September 30,  2006** | ** ** | **September 30,  2007** | ** ** | **September 30,  2006** | ** ** |
| Average expected  life (years)      |       | 3.0                              |       | 3.9                     |       | 3.1 |   | 4.3 |   |
| Average expected  volatility factor |       | 35.9                             | %          | 47.5                    | %          | 35.3 | % | 54.6 | % |
| Average  risk-free interest rate    |       | 4.3                              | %          | 5.0                     | %          | 4.6 | % | 4.8 | % |
| Average expected  dividend yield    |       | —                           |       | —                  |       | — |   | — |   |

 

The Company used the followingassumptions to estimate the fair value of the options granted under the 2007Plan for the nine months ended September 30, 2007: average expected life — 5.5years; average expected volatility factor — 55.7%; average risk free interestrate — 4.7% and average expected dividend yield — zero.  No options were granted under the 2007 Planduring the third quarter of 2007.

 

10

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**Treasury Stock**

As of September 30, 2007,the Company had repurchased 8,170,060 shares of its common stock since April2003 under the Board of Directors’ authorized stock repurchase program, for anaggregate of $170.4 million at an average price of $20.86 per share.  The Company did not repurchase any shares ofits common stock during the quarter ended September 30, 2007, and does notintend to repurchase additional shares for the remainder of 2007.  Under the terms of the Company’s new seniorcredit facility, the Company is restricted from repurchasing its common stockfor an aggregate purchase price that exceeds the sum of $25 million plus 50% ofaggregate amount of its consolidated net income during the period from theeffective date of the facility through the most recent quarter end for whichquarterly financial statements have been filed. Remaining shares authorized for repurchase under the Company’s stockrepurchase program as of September 30, 2007 were as follows:

 
| ** **                                  | ** ** | **September 30, 2007** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|
| Shares  authorized for stock repurchase     |       | 12,000,000                       |       |
| Shares  repurchased to date                 |       | 8,170,060                        |       |
| Remaining shares  authorized for repurchase |       | 3,829,940                        |       |

 

 

 

5. *Acquisitions*

**PortAuthority**

On January 8, 2007, theCompany acquired all of the outstanding stock of PortAuthority, a providerof information leak prevention technology. The Companyacquired PortAuthority to combine the two companies’ technologies to helpcustomers prevent unauthorized use or disclosure of confidential data whilesimultaneously protecting users and data from external malicious threats.  The Company expects to benefit from theacquisition by expandingits current product offerings and increasing its revenues.  These areamong the factors that contributed to a purchase price for the PortAuthorityacquisition that resulted in the recognition of goodwill of $73.6 million.PortAuthority’s operations were assumed as of the date of the acquisition andare included in the Company’s results of operations beginning on January 9,2007 and, as a result, are not reflected in the Company’s results of operationsfor the three and nine months ended September 30, 2006.

 

Pursuant to the terms ofthe agreement, the Company acquired all of PortAuthority’s outstanding capitalstock for $88.2 million in cash, funded with existing cash resources. Thepurchase price includes $5.0 million which is held in an escrow account andwill be available to satisfy any Company claims for indemnification from theformer stockholders of PortAuthority until the escrow is scheduled to bereleased on January 8, 2008. The total purchase price, including transactioncosts of approximately $1.9 million, has been allocated to tangible andintangible assets acquired based on estimated fair values, with the remainderclassified as goodwill.

 

The total purchase price of the acquisition was asfollows (in thousands):

 

 
| Cash paid for PortAuthority  business |   | $     | 88,334 |   |
|---------------------------------------|--------|-------|--------|--------|
| Transaction costs                     |   | 1,897 |   |
| Total purchase price                  |   | $     | 90,231 |   |

 

The transaction costs incurred by the Companyprimarily consist of fees for attorneys, financial advisors, accountants, debtprepayment penalty and other advisors directly related to the transaction.

 

 

 

11

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The total purchase price has been allocated as followsbased on the assets and liabilities acquired as of January 8, 2007 (inthousands):

 

 
| Fair value of net tangible  assets acquired and liabilities assumed: |   |   |   |   |   |
|----------------------------------------------------------------------|--------|--------|--------|--------|--------|
| Cash and cash equivalents                                            |   | $      | 8,078  |   |   |   |
| Other assets                                                         |   | 2,682  |   |   |   |
| Other liabilities                                                    |   | (5,920 | )      |   |   |
| Long-term loan                                                       |   | (4,214 | )      |   |   |
|                                                                 |   |   |   | 626    |   |
| Fair value of  identifiable intangible assets acquired:              |   |   |   |   |   |
| Technology                                                           |   | 12,700 |   |   |   |
| Non-compete agreements                                               |   | 800    |   |   |   |
| Customer relationships                                               |   | 700    |   |   |   |
| Trade name                                                           |   | 510    |   |   |   |
|                                                                 |   |   |   | 14,710 |   |
| In-process research and  development                                 |   |   |   | 1,270  |   |
| Goodwill                                                             |   |   |   | 73,625 |   |
| Total purchase price                                                 |   |   |   | $      | 90,231 |   |
|                                                                      |        |        |        |        |        |  |  |

 

The $4.2 million of PortAuthority indebtedness assumedin the transaction was repaid in the first quarter of 2007.

 

The amount allocated toin-process technology represents the fair value of an acquired, to-be-completedresearch project. The estimated value of approximately $1.3 million of theresearch project was determined by estimating the costs to develop the acquiredtechnology into a commercially viable product, estimating the future net cashflows from the project once commercially viable, and discounting the net cashflows to their present value. As of the acquisition date, this project was notexpected to have reached technological feasibility and will have no alternativefuture use. Accordingly, the amount allocated to in-process technology wascharged to Websense’s statement of income for the nine months ended September30, 2007.

 

The accompanying consolidated statements of incomereflect the operating results of the PortAuthority business since January 8,2007.  Assuming the acquisition of PortAuthority had occurred on January1, 2006, the pro forma unaudited results of operations would have been asfollows (in thousands):

 
| ** **             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **             | ** ** | **September 30,  2007**          | ** ** | **September 30,  2006**    | ** ** | **September 30,  2007** | ** ** | **September 30,  2006** | ** ** |
| Revenue                |       | $                                | 50,429     |                       | $          | 45,988 |   | $ | 150,625 |   | $ | 132,067 |   |
| Net Income             |       | 6,395                            |       | 5,503                      |       | 12,285 |   | 16,586 |   |
| Net income per  share: |       |                             |       |                       |       |   |   |   |   |
| Basic                  |       | $                                | 0.14       |                       | $          | 0.12 |   | $ | 0.27 |   | $ | 0.35 |   |
| Diluted                |       | $                                | 0.14       |                       | $          | 0.12 |   | $ | 0.27 |   | $ | 0.35 |   |

 

The above pro formaunaudited results of operations do not include pro forma adjustments relatingto costs of integration or post-integration cost reductions that may beincurred or realized by the Company in excess of actual amounts incurred orrealized through September 30, 2007.

**SurfControl**

 

On October 3, 2007, theCompany completed the acquisition of all of the issued and to-be-issuedordinary shares, excluding treasury shares, of SurfControl plc (“SurfControl”),a U.K. based provider of on-demand and software-based Web and e-mail security solutions.  The acquisition was effected by means of aScheme of Arrangement under Section 425 of the UK Companies Act of 1985.  Pursuant to the acquisition, SurfControlbecame a wholly-owned subsidiary of Websense. At the closing, each outstanding share of SurfControl was converted intothe right to receive 700 pence in cash. In connection with the acquisition, the holders of outstandingSurfControl capital stock, options, and long term incentive plan awards receivedtotal net cash of approximately £204 million (approximately $416 million basedupon the exchange rate in effect on October 2, 2007, the date on which theacquisition was sanctioned by the U.K. courts).

 

 

12

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Since the Company wasobligated to pay the purchase price in British pounds, it entered into variousoption contracts to hedge against adverse foreign currency exchange ratemovements (see Note 7. Foreign Currency Hedges).

 

As of September 30, 2007,the Company had incurred approximately $6.4 million of transaction costs inconnection with this acquisition, which are reflected on the Company’sconsolidated balance sheet in deposits and other assets, accounts payable andother accrued expenses.

** **

On October 11, 2007, in order to finance a portion ofthe purchase price for SurfControl, Websense entered into an amended andrestated senior credit agreement (the “Senior Credit Agreement”).  The $225 million senior credit facilityconsists of a five year $210 million term loan and a $15 million revolvingcredit facility. The term loan was fully funded on October 11, 2007, and therevolving line of credit remains unused. The senior credit facility is securedby substantially all of the assets of Websense, including pledges of stock ofsome of its subsidiaries (subject to limitations in the case of foreignsubsidiaries) and by secured guarantees by Websense’s domestic subsidiaries.The term loan amortizes at a rate of 2.5%, 10%, 12.5%, and 15%, respectively,during the first four years of the term and 60% during the fifth year. Theinitial interest rate is LIBOR plus 250 basis points (7.62% for the firstmonth), and is subject to step downs in the spread over LIBOR based uponpotential future improvements in Websense’s total leverage ratio. The SeniorCredit Agreement contains financial covenants, including a consolidatedleverage ratio and a consolidated interest coverage ratio, as well asaffirmative and negative covenants. Websense did not borrow any amounts underthe original interim credit facility which it entered into on April 26, 2007and which was terminated by its terms when the Senior Credit Agreement wasexecuted.

 

6. *Goodwill and  Intangible Assets*

 

As of September 30, 2007, the Company’s goodwillbalance of $73.6 million solely related to the Company’s acquisition ofPortAuthority on January 8, 2007.

The Company recordsgoodwill when the purchase price of net tangible and intangible assets acquiredexceeds their fair value. In accordance with SFAS No. 142, *“Goodwill and Other Intangible Assets,”*the Company reviews goodwill that has an indefinite useful life for impairmentat least annually in its fourth fiscal quarter, or more frequently if an eventoccurs indicating the potential for impairment. Intangible assets are carriedat cost less accumulated amortization. The Company amortizes the cost ofidentified intangible assets on a straight-line basis over their expectedeconomic lives. In accordance with SFAS No. 144, “*Accounting for the Impairment or Disposal of Long-Lived Assets*,”the Company reviews intangible assets that have finite useful lives when anevent occurs indicating the potential for earlier impairment.

The Company reviews forimpairment using facts or circumstances, either internal or external,indicating that it may not recover the carrying value of the asset. The Companymeasures impairment losses related to long-lived assets based on the amount bywhich the carrying amounts of these assets exceed their fair values.  The Company measures fair value under SFASNo. 144, which is generally based on the present value of estimated future cashflows. The Company’s analysis is based on available information and onassumptions and projections it considers to be reasonable and supportable. Thecash flow analysis considers the likelihood of possible outcomes and is basedon the Company’s best estimate of projected future cash flows. If necessary,the Company performs subsequent calculations to measure the amount of theimpairment loss based on the excess of the carrying value over the fair valueof the impaired assets.

 

Intangible assets, subject to amortization, were asfollows as of September 30, 2007 (in thousands):

 

| ** **              | ** ** | **Weighted Average Life  (years)** | ** ** | **Cost** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|-------------------------|------------|-----------------------------------------|------------|----------|------------|-------------------------------|------------|---------|------------|
|                    |       |                                    |       |     |       |                          |       |    |       |
| Technology              |       | 5.7                                     |       | $        | 13,900     |                          | $          | (2,021  | )          | $ | 11,879 |   |
| Non-compete  agreements |       | 1                                       |       | 800      |       | (600                          | )          | 200     |       |
| Customer  relationships |       | 7                                       |       | 700      |       | (75                           | )          | 625     |       |
| Trade name              |       | 5                                       |       | 510      |       | (76                           | )          | 434     |       |
| Total                   |       |                                    |       | $        | 15,910     |                          | $          | (2,772  | )          | $ | 13,138 |   |

 

 

13

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 Remaining amortization expense, as ofSeptember 30, 2007, is expected to be as follows (in thousands):

 
| **Years Ending December 31:** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2007                                         |       | $          | 880        |   |
| 2008                                         |       | 2,719      |       |
| 2009                                         |       | 2,585      |       |
| 2010                                         |       | 2,319      |       |
| 2011                                         |       | 2,319      |       |
| Thereafter                                   |       | 2,316      |       |
| Total expected  amortization expense         |       | $          | 13,138     |   |

 

7.*Foreign Currency Hedges*

The Company uses derivativesto manage foreign currency risk and not for speculative or trading purposes.The Company’s objective is to reduce the risk to earnings and cash flowsassociated with changes in foreign currency exchange rates. Gains and lossesresulting from changes in the fair values of those derivative instruments willbe recorded to earnings or other comprehensive income depending on the use ofthe derivative instrument and whether it qualifies for hedge accounting.

During the three and nine months ended September 30, 2007 and 2006, 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. None of the contracts were terminated prior to settlement. Net realized losses related to the contracts designated as fair value hedges settled during 2007 and 2006 are included in other income, net, in the accompanying consolidated income statements and amounted to approximately $87,000 and $45,000 for the three months ended September 30, 2007 and 2006, respectively and $235,000 and $177,000 for the nine months ended September 30, 2007 and 2006, respectively.  There were no Euro contracts outstanding as of September 30, 2007.

During the three and nine months ended September 30, 2007 and 2006, the Company utilized British Pound 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 No. 133), as amended. None of the contracts were terminated prior to settlement. Net realized gains related to the contracts designated as cash flow hedges settled during the nine months ended September 30, 2007 and 2006 are included in the respective operating categories the Company hedges its British Pound expenditures against. These net realized gains amounted to approximately $33,000 and $57,000 for the three months ended September 30, 2007 and 2006, respectively and $19,000 and $106,000 for the nine months ended September 30, 2007 and 2006, respectively.  There were no British Pound contracts outstanding as of September 30, 2007.

Notional and fair values of the Company’s Euro and British Pound hedging positions at September 30, 2007 and 2006 are presented in the table below (in thousands):
| ** **    | ** ** | **September 30, 2007**               | ** ** | **September 30, 2006** | ** ** |
|---------------|------------|--------------------------------------|------------|-----------------------------|------------|
| ** **    | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD**    | ** ** | **Fair Value  USD** | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD** | ** ** | **Fair Value  USD** | ** ** |
| Euro          |       | €                               | —     |                        | $          | — |   | $ | — |   | € | 2,200 |   | $ | 2,818 |   | $ | 2,841 |   |
| British Pound |       | £                               | —     |                        | —     |   | — |   | £ | 1,000 |   | 1,871 |   | 1,858 |   |
| Total         |       |                                 |       | $                           | —     |   | $ | — |   |   |   | $ | 4,689 |   | $ | 4,699 |   |

 

During the three and ninemonths ended September 30, 2007, the Company utilized option and forwardcontracts to hedge against the £244.1 million funds certain purchase price forSurfControl under U.K. law.  Thesecontracts did not qualify for hedge accounting as they related to a forecastedbusiness combination.  During the threeand nine months ended September 30, 2007, the Company has incurred a net realized gain of $0.4million related to the sale of certain option contracts. During thethree and nine months ended September 30, 2007, the Company has incurred a net unrealized gain/(loss)of $0.4 and ($0.6) million, respectively, on outstanding option and forwardcontracts.  These unrealized gains and

 

 

14

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losses are reflected in other income, net on the consolidated statementof income and within deposits and other assets on the consolidated balancesheet. The Company subsequently sold £200 million in option contracts andentered into GBP forward contracts expiring on October 11, 2007 (See Note 11.Subsequent Events).

 

8. *Tax Matters*

The Company adopted FASB Interpretation 48, *Accounting for Uncertainty in Income Taxes*(FIN 48), at the beginning of fiscal year 2007. As a result of theimplementation the Company recognized a $1.2 million increase to reserves foruncertain tax positions. This increase was accounted for as an adjustment tothe January 1, 2007 balance of additional paid in capital and retained earningson the consolidated balance sheet. Including the cumulative effect increase, atthe beginning of 2007, the Company had approximately $9.2 million of totalgross unrecognized tax benefits. Of this total, $5.8 million (net of federal,state and foreign tax benefits) represents the amount of unrecognized taxbenefits that, if recognized, would decrease the effective income tax rate infuture periods. In addition, consistent with the provisions of FIN 48, theCompany determines the classification of uncertain tax liabilities as currentor non-current based on anticipated payment date. Accordingly, the Company hasreflected $9.5 million as non-current income taxes payable as of September 30,2007.

Estimated interest and penalties related to theunderpayment of income taxes are classified as a component of provision forincome taxes in the consolidated statements of income and totaled $103,000during the three months ended September 30, 2007 and $256,000 during the ninemonths ended September 30, 2007. Accrued interest and penalties were $434,000as of January 1, 2007.

 

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 2002.Substantially all material foreign income tax audits have been concluded foryears through 2002. California income tax returns for 2003 and 2004 and NewYork income tax returns for 2002 to 2005 are currently under examination. TheIRS will begin an audit of the 2005 tax year in the fourth quarter. AtSeptember 30, 2007, the Company had deferred tax assets of $39.7 million.

 

The Company has requesteda ruling regarding unrecognized state income tax benefits. It is reasonablypossible within 12 months of September 30, 2007 that the uncertain tax positionestablished for the 2006 tax year could be decided in the Company’s favorresulting in the reduction of the gross uncertain tax liability in an amount upto $1.7 million.  As a result of ongoingaudits or the expiration of the statutes of limitations, it is reasonablypossible that the liability associated with our unrecognized tax benefits willincrease or decrease within the next twelve months; at this time an estimate ofthe range of the reasonably possible outcomes cannot be made.

 

*9. Litigation*

 

On September 29,2006, Jason Tauber filed a putative class action against the Company and otherunidentified individuals in California Superior Court for the County of SanDiego, captioned Tauber v. Websense. The complaint alleges that the plaintiffand a putative class of certain software engineers and computer professionalswho worked for the Company as exempt employees during the period fromSeptember 15, 2002 through the present should have been classified asnon-exempt employees under California law and should have been paid forovertime. The complaint also alleges related wage and hour violations of theCalifornia Labor Code arising from the alleged misclassification and that thefailure to pay overtime constitutes an unfair business practice underCalifornia Business and Professions Code §17200. The complaint seeksunspecified damages for unpaid overtime, prejudgment interest, attorneys’ feesand other costs, statutory penalties for alleged violations, and other properrelief. The parties to the action have been granted preliminary court approvalto settle all claims made in the putative class action, and the claims administratorhas delivered notices to the alleged class members.   During the second quarter of 2007, theCompany charged the $3.2 million pending settlement amount between theoperating expense categories and cost of revenue on the consolidated statementof income, apportioned based upon the Company’s estimate of amounts payable toeligible individuals in the settlement. As of September 30, 2007, $3.2 millionremains as a reserve within other accrued expenses on the consolidated balancesheet relating to this settlement.

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, under generally accepted accounting principles,for any ultimate liability that may result from these actions such that anyliability would not materially affect the Company’s consolidated financialpositions, results of operation or cash flows. The Company’s

 

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evaluation of the likelyimpact of these actions could change in the future and unfavorable outcomesand/or defense costs, depending upon the amount and timing, could have amaterial adverse effect on the Company’s results of operations or cash flows ina future period.

10. *Recently Issued Accounting Standards*

InFebruary 2007, the FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets andFinancial Liabilities—Including an Amendment of FASB Statement No. 115 (“SFASNo. 159”).* This standard permits an entity to choose to measure manyfinancial instruments and certain other items at fair value. Most of theprovisions in SFAS No. 159 are elective; however, the amendment to SFASNo. 115, *Accounting for CertainInvestments in Debt and Equity Securities,* applies to all entitieswith available-for-sale and trading securities. The fair value optionestablished by SFAS No. 159 permits all entities to choose to measureeligible items at fair value at specified election dates. A business entitywill report unrealized gains and losses on items for which the fair valueoption has been elected in earnings at each subsequent reporting date. The fairvalue option: (a) may be applied instrument by instrument, with a fewexceptions, such as investments otherwise accounted for by the equity method;(b) is irrevocable (unless a new election date occurs); and (c) isapplied only to entire instruments and not to portions of instruments. Theaccounting provisions of SFAS No. 159 will be effective for the Companybeginning January 1, 2008. The Company is in the process of determiningthe effect the adoption of SFAS No. 159 will have on its financialstatements.

11.Subsequent Events

OnOctober 8, 2007, the Company sold the rights to a £200 million option contractthat it had purchased for the SurfControl acquisition for $204,000, recording arealized loss of approximately $876,000. The Company did not purchase any new option contracts on the BritishPounds as it had secured £195 million through open market forward contracts,all expiring on October 11, 2007 at an all in rate of $2.039 per British Pound.

         See Note 5, SurfControl, above for a description of theCompany’s acquisition of SurfControl on October 3, 2007 and the Company’sborrowing of a $210 million term loan on October 11, 2007.

 

 

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**Item 2. Management’sDiscussion and Analysis of Financial 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. Also note that because our acquisition of SurfControl plc was completedon October 3, 2007, there was no financial impact on our financial conditionand results of operations for our quarter ended September 30, 2007.**

**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;

•                  growthopportunities in domestic and international markets;

•                  newand enhanced channels of distribution;

•                  customeracceptance and satisfaction with our products;

•                  expectedtrends in operating and other expenses;

•                  anticipatedcash and intentions regarding usage of cash;

•                  changesin effective tax rates; and

•                  anticipated product enhancements orreleases.

**These forward-looking statements are subject to risks anduncertainties, including those risks and uncertainties described herein underPart II, Item 1A “Risk Factors,” that could cause actual results to differmaterially from those anticipated as of the date of this report. We assume noobligation to update any forward-looking statements to reflect events orcircumstances arising after the date of this report.**

**SurfControl Acquisition**

**        **The acquisition of SurfControlplc was completed on October 3, 2007. Our third quarter ended on September 30, 2007.  Accordingly, all quarterly and historicfinancial statements in this Form 10-Q are on a pre-acquisition basis.  All statements made in this Form 10-Qregarding current status or as of dates after October 3, 2007 include Websenseon a post-acquisition, consolidated basis, including the SurfControloperations.  In addition, all forward-lookingstatements, including but not limited to, trends, expectations oruncertainties, are made on a post-acquisition, consolidated basis.

**Overview**

Ourproducts help organizations manage their networks and computing resources toprovide a secure and productive computing environment. We provide Web filteringand Web security software products that enable organizations to protectemployees and confidential information from external Web-based attacks such asspyware and phishing, as well as analyze, report and manage how employees usecomputing resources and the Internet. In January 2007, we acquired ourtechnology development partner for information leak prevention (“ILP”)solutions, PortAuthority Technologies Inc. (“PortAuthority”). As a result,in addition to our Web filtering and Web security software products, we offerILP software that helps prevent the loss of confidential information frominternal threats, such as ineffective business process controls, employee errorand malfeasance.  On October 3, 2007, wecompleted our acquisition of SurfControl plc (“SurfControl”), whichsignificantly increased the size of our company and customer base, andaccelerates our strategic initiatives in the small and  medium size business markets, on-demanddelivery of web security products and threat research.

At the foundation of ourWeb filtering and Web security product offerings is the Websense Enterprise®software application, which serves as a central policy engine and managementand reporting platform for our Web filtering and related add-on Web security products.Websense Enterprise gives organizations the ability to enhance networksecurity, improve employee productivity, mitigate potential legal liability andconserve network bandwidth by allowing organizations to identify potential riskareas and implement and automate Web access and application usage policies thatreduce these risks.

 

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Whencombined with our Web security products that utilize our ThreatSeekerTMtechnology including Security Filtering, Remote Filtering and Client PolicyManagerTM, Websense Enterprise allows organizations to enhance network andcontent security by blocking access to malicious Web sites and preventing thetransmission of data to known spyware destination sites. To simplify thepurchase process for our value-added resellers and customers, we have includedWebsense Enterprise and our most popular add-on security products and services,within Websense® Web Security SuiteTM. In July 2007, we launched Websense®Express to provide similar Web filtering and Web security functionalitytargeted for small and mid-sized organizations of fewer than 1,000 users (“SMB”).We currently derive a significant percentage of our revenue from subscriptionsto our Web filtering and Web security solutions and expect this to continue inthe future.

The Websense Content Protection Suite is an integratedILP solution that protects organizations from information leaks and data lossby discovering the location of sensitive data inside the network, monitoringthe data as it attempts to travel inside or outside the organization, andprotecting the data, with policy-based controls that align to businessprocesses.  The Content Protection Suiteprovides protection for data at rest, data in use, and data in motion, and isavailable with two modules: the Content AuditorTM and the ContentEnforcerTM.  Content Auditor is aproactive solution that finds sensitive data in the network and identifies whois using it and how it is being used. Content Enforcer adds the ability to enforce user-defined data securitypolicies.  Sales of our ILP products andother products under development will comprise only a very small portion of ouroverall sales in 2007 and 2008.

Duringthe nine months ended September 30, 2007, we derived 40% of revenue frominternational sales, compared with 37% for the nine months ended September 30,2006, with the United Kingdom comprising approximately 10% of our total revenuein both periods. 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 and Latin American markets.

Wesell our products through both indirect channels and directly. Sales throughindirect channels currently account for more than 90% of our revenue, and weplan to increase the percentage of our revenue obtained through indirectchannels. Our strategy is to increase new and renewal customer sales throughindependent software distributors and resellers and increase the focus of ourinternal sales and marketing force on supporting our channel strategy. InAugust 2006, we announced a new two-tier distribution strategy in NorthAmerica and entered into a relationship with Ingram Micro to distribute, marketand support our Web security and Web filtering software in North America.Through joint marketing programs with Websense, Ingram Micro will focus itsefforts on recruiting new resellers, especially resellers focused on selling toSMBs, and on building awareness and demand within our existing North Americachannel partner base.  We also plan toincrease sales to SMB customers through our new Websense ExpressTM softwarewhich is targeted for organizations with under 1,000 users.

Wecompleted our acquisition of SurfControl on October 3, 2007.  SurfControl has historically participated intwo markets within content security, the Web security market with its Webfiltering and Web security solutions, and the Messaging security market withits e-mail filtering and anti-spam solutions.

SurfControl Web filtering solutions enablecompanies to monitor network use and abuse in an organization, across aspectrum of Web-based content, including instant messaging, peer-to-peer,streaming media, file downloads, and Web-based email.  We will support SurfControl Web Filter with acompletely staffed maintenance and support team through at least December 31,2011 and will enhance the solution by supplementing the SurfControl URLdatabase with additional Web filtering and security coverage provided byWebsense Security LabsTM and ThreatSeekerTM technology. Although Websense willrenew existing subscriptions, we have decided to end of sale this product fornew subscriptions on January 8, 2008.

SurfControl e-mail filter messaging protection software providescomprehensive content filtering for protection against inbound, outbound, andinternal e-mail threats, such as spam, viruses, malware, phishing and harmfulURLs.  SurfControl’s on-demand serviceoffering, BlackSpiderTM,is a managed security service provider and operates MailControlTM andWebDefenseTM on-demand services. MailControl services protect organizations fromincoming e-mail and Web-based threats, such as spam, viruses, spyware,phishing/pharming attacks, and inappropriate content before reaching anorganization’s in-house network. WebDefense services allow organizations tocontrol outbound employee Web access and encrypt e-mail for secure extendedenterprise communications.  These productlines are important to our long term growth strategy and we expect to integratethe technologies from these critical product lines more broadly across Websense’sofferings.

 

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**Critical Accounting Policies**

Webelieve the following critical accounting policies affect our more significantjudgments and estimates used in the preparation of our consolidated financialstatements.

***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 standardpost-contract technical support services are sold together with our productsand provided throughout the subscription term. We recognize revenue on a dailystraight-line basis, commencing with the day the subscription begins, over theterm of the subscription agreement, provided collectibility is reasonablyassured. Upon entering into a subscription arrangement for a fixed ordeterminable fee, we electronically deliver access codes to users and thenpromptly invoice customers for the full amount of their subscriptions. Paymentis due for the full term of the subscription, generally within 30 to 60 days ofthe invoice. Taxes invoiced, collected and remitted to governmental authoritiesare presented on a net basis in our consolidated statements of income. Werecord amounts billed to customers in excess of recognizable revenue asdeferred revenue on our balance sheet. Upon expiration of the subscription,customers who wish to re-subscribe typically must do so at the then currentrates to continue using our products. Our revenue is significantly influencedby new and renewal subscriptions.

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

***Goodwill and Intangible Assets.*** We record goodwill when the purchase price of net tangible andintangible assets we acquire exceeds their fair value. In accordance with SFASNo. 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. Intangible assets are carried at cost,less accumulated amortization. We amortize the cost of identified intangibleassets on a straight-line basis over their expected economic lives. Inaccordance with SFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets,* we review intangibleassets that have finite useful lives when an event occurs indicating thepotential for impairment.

**We reviewfor impairment by facts or circumstances, either internal or external,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 No. 144, which is generally based on the presentvalue of estimated future cash flows. Our analysis is based on availableinformation and on assumptions and projections that we consider to bereasonable and supportable. The discounted cash flow analysis considers thelikelihood of possible outcomes and is based on our best estimate of projectedcash flows. If necessary, we perform subsequent calculations to measure theamount of the impairment loss based on the excess of the carrying value overthe fair value of the impaired assets.**

*Share-Based Compensation.***On January 1, 2006, we adopted the provisionsof Statement No. 123R and SAB No. 107 requiring the measurement and recognitionof all share-based compensation under the fair value method.  Share-based compensation expense related tostock options is recorded based on the fair value of the award on its grantdate which we estimate using the Black-Scholes valuation model based on theprovisions prescribed under Statement No. 123R and SAB No. 107.  Share-based compensation expense related torestricted stock unit awards is calculated based on the market price of ourcommon stock on the grant date.

*Deferred Tax Assets.*   Asrequired by SFAS No. 109, we recognize tax assets on the balance sheet ifit is “more likely than not” that they will be realized on future tax returns.At September 30, 2007, we had deferred tax assets of $39.7 million. We believethat it is more likely than not that our deferred tax assets will be realized.Factors considered by us included: our earnings history, projected earningsbased on current operations, and projected future taxable income. However,should we determine that we would not be able to realize all or part of ourdeferred tax assets in the future, an adjustment to the deferred tax assetswould be charged against income in the period such determination was made.

*Income Tax Provision and Uncertain Tax Positions.*   Significantjudgment is required in determining our consolidated income tax provision andevaluating our U.S. and foreign tax positions. In July 2006, the FASB issuedInterpretation 48, *Accounting for Uncertaintyin Income Taxes* (“FIN 48”), which became effective for us beginningin 2007. FIN 48 addressed the determination of how tax benefits claimed orexpected to be claimed on a tax return should be recorded in the financial

 

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statements.  Under FIN 48, we must recognize the taxbenefit from an uncertain tax position only if it is more likely than not thatthe tax position will be sustained on examination by the taxing authorities,based on the technical merits of the position. The tax benefits recognized inthe financial statements from such a position are measured based on the largestbenefit that has a greater than fifty percent likelihood of being realized uponresolution. The impact of our reassessment of tax positions in accordance withFIN 48 did not have a material impact on the results of operations, financialcondition or liquidity.

 

# **Resultsof Operations**

***Three months ended September 30,2007 compared with the three months ended September 30, 2006***

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

| ** **                          | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|
| ** **                          | ** ** | **September 30,  2007**          | ** ** | **September 30,  2006** | ** ** |
| ** **                          | ** ** | **(Unaudited)**                  | ** ** |
| ** **                          | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Revenue                             |       | 100                              | %          | 100 | % |
|                                |       |                             |       |   |   |
| Cost of revenues:                   |       |                             |       |   |   |
| Cost of revenues                    |       | 9                                |       | 8 |   |
| Amortization of acquired technology |       | 1                                |       | — |   |
| Total cost of revenues              |       | 10                               |       | 8 |   |
|                                |       |                             |       |   |   |
| Gross margin                        |       | 90                               |       | 92 |   |
|                                |       |                             |       |   |   |
| Operating expenses:                 |       |                             |       |   |   |
| Selling and marketing               |       | 50                               |       | 47 |   |
| Research and development            |       | 17                               |       | 13 |   |
| General and administrative          |       | 13                               |       | 12 |   |
| Total operating expenses            |       | 80                               |       | 72 |   |
|                                |       |                             |       |   |   |
| Income from operations              |       | 10                               |       | 20 |   |
|                                |       |                             |       |   |   |
| Other income, net                   |       | 8                                |       | 6 |   |
|                                |       |                             |       |   |   |
| Income before income taxes          |       | 18                               |       | 26 |   |
|                                |       |                             |       |   |   |
| Provision for income taxes          |       | 5                                |       | 8 |   |
|                                |       |                             |       |   |   |
| Net income                          |       | 13                               | %          | 18 | % |

 

# **Revenue**

Revenue increased to $50.4 million in the thirdquarter of 2007 from $45.7 million in the third quarter of 2006. The increasewas a result of the addition of new, renewed and upgraded subscriptions fromour customers that resulted in a 2.2 million increase in the number of seatsunder subscription from 24.9 million at September 30, 2006 to 27.1 million atSeptember 30, 2007. As a percentage of subscription revenue, new businessincreased to 36% in the third quarter of 2007 from 33% in the third quarter of2006. We expect revenue to increase due to the addition of our recentlyacquired SurfControl business, growth of our ILP business, our deferred revenueunder existing subscriptions, our renewal business, expected growth in SMBbusiness and expected growth in international sales, partially offset byincreased channel marketing payments and channel rebates, which are recorded asreductions to revenue.  The expectedgrowth of revenue will be impacted by potential sales dis-synergies as a resultof the acquisition of SurfControl and by the expected significant write-down ofSurfControl’s deferred revenue to fair value at acquisition as required bypurchase accounting rules under generally accepted accounting principles.

 

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# **Cost of Revenues**

*Cost of revenues.* Cost of revenues consists of the costs ofcontent review, technical support and infrastructure costs associated withmaintaining our databases. Cost of revenues increased to $4.5 million in thethird quarter of 2007 from $3.9 million in the third quarter of 2006. Theincrease of $0.6 million was primarily due to additional personnel in ourtechnical support group and allocated costs. We allocate the total costs forhuman resources, employee benefits, payroll taxes, information technology,facilities, fixed asset depreciation and legal costs to each of our functionalareas based on salaries and headcount data. As a percentage of revenue, cost ofrevenues increased to 9% from 8% during the third quarters of 2007 and2006.  Although we expect to derivesubstantial costs savings from the restructuring of SurfControl, we expect ourfuture cost of revenues to increase in order to maintain the technical supportneeds of our growing customer base.  Weexpect that the increase in total cost of revenue will be proportional to theincrease in revenue in future periods.

 

*Amortizationof acquired technology.* Amortization of acquired technologyprimarily relates to the developed technology acquired from the PortAuthorityacquisition in January 2007.  Theacquired technology is being amortized on a straight-line basis over itsestimated weighted average economic life of 5.7 years.  Our acquisition of SurfControl closed afterthe end of the third quarter, so it did not contribute to amortization ofacquired technology.  We have not yetcompleted our purchase accounting analysis for the SurfControl acquisition, butthe acquisition of SurfControl will have a material increase in amortization ofacquired technology.

#  

# **Gross Margin**

Grossmargin increased to $45.3 million in the third quarter of 2007 from $41.9million in the third quarter of 2006. The increase was primarily due toincreased revenue. As a percentage of revenue, gross margin decreased to 90% inthe third quarter of 2007 from 92% in the third quarter of 2006 due to theincreased costs described in the Costs of Revenues section above.

#  

# **Operating Expenses**

*Selling and marketing*. Selling and marketingexpenses consist primarily of salaries, commissions and benefits related topersonnel engaged in selling, marketing and customer support functions,including costs related to public relations, advertising, promotions and travelas well as allocated costs. Selling and marketing expenses do not include paymentsto channel partners for marketing services and rebates.  Selling and marketing expenses increased to$25.2 million, or 50% of revenue, in the third quarter of 2007, from $21.3million, or 47% of revenue, in the third quarter of 2006. The increase inselling and marketing expenses of $3.9 million was primarily due to expensesassociated with our new channel strategy, increased personnel costs and relatedtravel, including new personnel added from the PortAuthority acquisition inJanuary 2007, and allocated costs. We expect selling and marketing expenses toincrease in absolute dollars in the future due to the addition of certain salesand marketing personnel of SurfControl, to support our expanding worldwideselling and marketing efforts, and due to increased sales resulting in higheroverall sales commission expenses.  Weexpect to achieve cost savings from the historical SurfControl selling andmarketing expense primarily as a result of a reduction in headcount.

 

*Researchand development.* Researchand development expenses consist primarily of salaries and benefits forsoftware developers and allocated costs. Research and development expensesincreased to $8.3 million, or 17% of revenue, in the third quarter of 2007 from$6.0 million, or 13% of revenue, in the third quarter of 2006. The increase of$2.3 million in research and development expenses was primarily due toincreased personnel, including new personnel added from the PortAuthorityacquisition in January 2007, needed to support our expanding list of technologypartners, enhancements to Websense Enterprise, the development of WebsenseExpress and enhancements to our new ILP products. We expect future research anddevelopment expenses to increase in absolute dollars as more personnel,including certain personnel from SurfControl, are added to support ourcontinued enhancements of our existing products and new products.  In addition, we have established engineeringcenters in China and Israel, which we believe will enable us to slow the rateof growth in research and development expenses.

*General and administrative*. General andadministrative expenses consist primarily of salaries, benefits and relatedexpenses for our executive, finance, administrative personnel, third partyprofessional service fees, and allocated costs. General and administrativeexpenses increased to $6.8 million, or 13% of revenue, in the third quarter of2007 from $5.5 million, or 12% of revenue, in the third quarter of 2006. The$1.3 million increase in general and administrative expense was primarily dueto additional personnel needed to support our growing operations, including theacquisitions of PortAuthority in January 2007 and SurfControl in October 2007,and allocated costs. We expect general and administrative expenses to increasein absolute dollars in the future periods due to our growth in operations andexpansion of our international

 

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operations, including the addition of certain personnel ofSurfControl.  We do not expect tocontinue the full historical SurfControl general and administrative expense dueto the elimination of the positions of the executive officers of SurfControland other headcount reductions, elimination of certain facilities andelimination of expenses relating to the maintenance of SurfControl as a publicUK company listed on the London Stock Exchange.

# **Other Income, Net**

Otherincome, net increased to $3.9 million in the third quarter of 2007 from $2.8million in the third quarter of 2006. The increase was primarily due to a netgain of $0.8 million for the foreign exchange option and forward contractspurchased to hedge against the SurfControl acquisition purchase price inBritish Pounds. We expect other income, net to decrease in absolute dollars inthe fourth quarter and subsequent periods as we used approximately $245 millionof our restricted and non-restricted cash equivalents and marketable securitiesto fund a portion of the purchase price of SurfControl.  We also incurred $210 million in term debtunder our senior secured credit facility, and the servicing of that debt willslow any potential future increase in our cash balances.

 

# **Provision for Income Taxes**

Inthe third quarter of 2007, United States and foreign income tax expense was$2.5 million, compared to $3.6 million for the third quarter of 2006.  The effective income tax rate decreased to28% in the third quarter of 2007 from 30% in the third quarter of 2006.  The decrease in the tax rate is primarilyrelated to the expiration of the statute of limitations for the assessment ofcertain taxes in various jurisdictions and the tax treatment of the foreigncurrency option contracts purchased for the SurfControl acquisition, partiallyoffset by less tax exempt interest income and an increase in FAS 123R expense in jurisdictions where a tax deduction isnot available. Included in income tax expense are the tax benefitof  $0.9 million and $0.2 million  for the third quarter of 2007 and 2006,respectively, related to the expiration of the statute of limitations for theassessment of taxes in various jurisdictions.  Our effective tax rate may change in future periods due to thecomposition of taxable income between domestic and international operations alongwith potential changes or interpretations in tax rules and legislation, orcorresponding accounting rules.

 

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***Nine months ended September 30, 2007 compared with the nine monthsended September 30, 2006***

 

The following tablesummarizes our operating results as a percentage of total revenue for each ofthe periods shown.

 

| ** **                                       | ** ** | **Nine Months  Ended**  | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|
| ** **                                       | ** ** | **September 30,  2007** | ** ** | **September 30,  2006** | ** ** |
| ** **                                       | ** ** | **(Unaudited)**         | ** ** |
|                                             |       |                    |       |   |   |
| Revenue                                          |       | 100                     | %          | 100 | % |
|                                             |       |                    |       |   |   |
| Cost of Revenues:                                |       |                    |       |   |   |
| Cost of revenue                                  |       | 9                       |       | 8 |   |
| Amortization of acquired technology              |       | 1                       |       | — |   |
| Total cost of revenues                           |       | 10                      |       | 8 |   |
|                                             |       |                    |       |   |   |
| Gross margin                                     |       | 90                      |       | 92 |   |
|                                             |       |                    |       |   |   |
| Operating expenses:                              |       |                    |       |   |   |
| Selling and marketing                            |       | 50                      |       | 44 |   |
| Research and development                         |       | 17                      |       | 13 |   |
| General and administrative                       |       | 14                      |       | 12 |   |
| Write off of in-process research and development |       | 1                       |       | — |   |
| Total operating expenses                         |       | 82                      |       | 69 |   |
|                                             |       |                    |       |   |   |
| Income from operations                           |       | 8                       |       | 22 |   |
|                                             |       |                    |       |   |   |
| Other income, net                                |       | 5                       |       | 6 |   |
|                                             |       |                    |       |   |   |
| Income before income taxes                       |       | 13                      |       | 28 |   |
|                                             |       |                    |       |   |   |
| Provision for income taxes                       |       | 5                       |       | 10 |   |
|                                             |       |                    |       |   |   |
| Net income                                       |       | 8                       | %          | 18 | % |

 

# **Revenue**

 

Revenue increased to$150.6 million in the first nine months of 2007 from $131.5 million in thefirst nine months of 2006. The increase was due to the addition of new, renewedand upgraded subscriptions from our customers that resulted in a 2.2 millionincrease in the number of seats under subscription from 24.5 million atSeptember 30, 2006 to 26.7 million at September 30, 2007. As a percentage ofsubscription revenue, new business increased to 37% in the first nine months of2007 from 35% in the first nine months of 2006.

# **Cost ofRevenue**

#  

*Cost of revenues.* Cost of revenues consists of the costs ofcontent review, technical support and infrastructure costs associated withmaintaining our databases. Cost ofrevenue increased to $13.3 million in the first nine months of 2007 from $11.0million in the first nine months of 2006. The increase of $2.3 million wasprimarily due to additional personnel in our technical support group andallocated costs. We allocate the total costs for human resources, employeebenefits, payroll taxes,

 

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information technology, facilities, fixed assetdepreciation and legal costs to each of our functional areas based on salariesand headcount data. As a percentage of revenue, costs of revenue increased to9% during the first nine months of 2007 from 8% in 2006.

#  

*Amortization of acquiredtechnology.* Amortization of acquired technology primarilyrelates to the developed technology acquired from the PortAuthority acquisitionin January 2007.  The acquired technologyis being amortized on a straight-line basis over its estimated weighted averageeconomic life of 5.7 years.

 

# **GrossMargin**

#  

# Gross margin increased to$135.4 million in the first nine months of 2007 from $120.5 million in thefirst nine months of 2006. The increase was primarily due to increased revenue.As a percentage of revenue, gross margin decreased to 90% in the first ninemonths of 2007 from 92% in the first nine months of 2006 primarily due to theincreased costs as described in the Costs of Revenue section above.

#  

# **OperatingExpenses**

#  

*       Selling and marketing*. Selling andmarketing expenses consist primarily of salaries, commissions and benefitsrelated to personnel engaged in selling, marketing and customer supportfunctions, including costs related to public relations, advertising, promotionsand travel as well as allocated costs. Selling and marketing expenses do notinclude payments to channel partners for marketing services and rebates.  Sellingand marketing expenses increased to $75.3 million in the first nine months of2007 from $58.2 million in the first nine months of 2006. The increase inselling and marketing expenses of $17.1 million was primarily due toexpenses associated with our new channel strategy, increased personnel costsand related travel, including new personnel added from the PortAuthorityacquisition in January 2007, and allocated costs.

#  

*         Researchand development.* Researchand development expenses consist primarily of salaries and benefits forsoftware developers and allocated costs. Research and development expensesincreased to $25.8 million in the first nine months of 2007 from $16.9 millionin the first nine months of 2006. The increase of $8.9 million in research anddevelopment expenses was primarily due to the litigation settlement expense forthe putative class action entitled Tauber vs. Websense, increased personnel,including new personnel added from the PortAuthority acquisition in January2007, needed to support our expanding list of technology partners, theenhancements of Websense Enterprise, the development of Websense Express andenhancements to our new ILP products and allocated costs.

 

*         Generaland administrative*. General and administrative expenses consistprimarily of salaries, benefits and related expenses for our executive,finance, administrative personnel, third party professional service fees, andallocated costs. General and administrative expenses increased to $20.6 millionin the first nine months of 2007 from $16.0 million in the first nine months of2006. The $4.6 million increase in general and administrative expense wasprimarily due to additional personnel needed to support our growing operations,including the acquisition of PortAuthority in January 2007, and allocatedcosts.

*Write off of in-processresearch and development.* Write off of in-process research anddevelopment**represents the fair value of anacquired, to be completed research project obtained from the PortAuthorityacquisition that had not reached technological feasibility at the acquisitiondate and is not expected to have an alternative future use.  Accordingly, the $1.3 million of in-processresearch and development was charged to our statement of income during thefirst nine months of 2007.

#  

# **OtherIncome, Net**

#  

# Other income, net decreasedto $7.8 million in the first nine months of 2007 from $8.2 million in the firstnine months of 2006. The decrease was primarily due to a net loss of$0.2 million for the foreign exchange option and forward contracts purchased tohedge against the SurfControl acquisition purchase price in British Pounds andlower cash, cash equivalents and marketable securities balances during thefirst nine months of 2007 compared to the first nine months of 2006,principally related to the acquisition of PortAuthority for approximately $90million in January 2007, partially offset by higher interest rates during thefirst nine months of 2007 compared to the first nine months of 2006.

#  

# **Provisionfor Income Taxes**

 

In the first nine months of 2007, United States andforeign income tax expense decreased to $8.0 million compared to $13.3 millionin 2006. The effective income tax rate increased to 39% in the first ninemonths of 2007 from 35% in the first

 

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nine months of 2006. The increase in the tax ratewas primarily driven by a reduction in tax exempt interest income, an increasein FAS 123R expense in jurisdictions where a tax deduction is not available,and the write-off of non-deductible in- process research and developmentacquired in the PortAuthority acquisition, partially offset by income taxbenefits of $0.9 million and $0.2 million for the nine months ended 2007 and 2006,respectively, related to the expiration of the statute of limitations for theassessment of taxes in various jurisdictions.

 

**Liquidity and Capital Resources**

As of September 30, 2007, we had restricted andnon-restricted cash and cash equivalents of $241.8 million, restricted andnon-restricted investments in marketable securities of $38.0 million andretained earnings of $94.8 million. We used approximately $245 million of ourrestricted and non-restricted cash equivalents and marketable securities tofund the acquisition of SurfControl on October 3, 2007.  After the funding of the purchase price forSurfControl, none of our current cash, cash equivalents and marketablesecurities remain restricted.

**Net cashprovided by operating activities was $37.6 million in the first nine months of2007 compared with $61.6 million in the first nine months of 2006. The $24.0million decrease in cash provided by operating activities was primarily due todecreased net income of $11.9 million and decreased growth in deferred revenueas a result of higher growth in recognized revenue than growth in subscriptionamounts compared to the first nine months of 2006.  Our operating cash flow is significantlyinfluenced by subscription renewals and accounts receivable collections, anddeferred revenue.  A future decrease insubscription renewals or accounts receivable collections, or a lower deferredrevenue balance, would negatively impact our operating cash flow.**

Net cash used in investing activities was $77.7million in the first nine monthsof 2007 compared with net cash provided by investing activities of $0.6 millionin the first nine months of2006. The $78.3 million increase of net cash used in investing activities wasprimarily due to cash used of $82.0 million to purchase PortAuthority inJanuary 2007.

Net cash provided by financing activities was $2.2million in the first nine monthsof 2007 compared with net cash used in financing activities of $77.7 million inthe first nine months of 2006.The $79.9 million increase of net cash provided by financing activities wasprimarily due to no share repurchases in the first nine months of 2007 comparedwith 4,300,000 shares repurchased for $91.4 million in the first nine months of2006, partially offset by the repayment of the PortAuthority loan and reducedproceeds from the exercise of stock options compared with the first nine monthsof 2006.

We had operating lease and software licensecommitments of approximately $17.8 million as of September 30, 2007 (which doesnot include SurfControl commitments for operating leases and softwarelicenses). A majority of our operating lease commitments are related to ourcorporate headquarters lease, which extends through December 2013. Ourcorporate headquarters lease includes escalating rent payments from 2007 to2013. The rent expense related to our worldwide office space leases arerecorded monthly on a straight-line basis in accordance with generally acceptedaccounting principles. Future minimum annual payments under non-cancelableoperating leases and software license agreements at September 30, 2007 are asfollows (in thousands):

| **Years Ending December 31:** | ** ** | **Operating  Leases** | ** ** | **Software  License** | ** ** | **Total** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|-----------------------|------------|-----------|------------|
| 2007                                         |       | $                     | 1,353      |                  | $          | —    |       | $ | 1,353 |   |
| 2008                                         |       | 2,897                 |       | 307                   |       | 3,204     |       |
| 2009                                         |       | 2,717                 |       | 307                   |       | 3,024     |       |
| 2010                                         |       | 2,675                 |       | —                |       | 2,675     |       |
| 2011                                         |       | 2,597                 |       | —                |       | 2,597     |       |
| 2012                                         |       | 2,450                 |       | —                |       | 2,450     |       |
| 2013                                         |       | 2,539                 |       | —                |       | 2,539     |       |
|                                         |       | $                     | 17,228     |                  | $          | 614       |       | $ | 17,842 |   |

 

As of September 30, 2007 and 2006, we did not have anyrelationships with unconsolidated entities or financial partners, such as entitiesoften referred to as structured finance or special purpose entities, whichwould have been established for the purpose of facilitating off-balance sheetarrangements or other contractually narrow or limited purposes. As such, we arenot exposed to any financing, liquidity, market or credit risk that could ariseif we had engaged in such relationships.

 

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In April 2003, we announced that our Board ofDirectors authorized a stock repurchase program of up to 4 million shares ofour common stock.  In August 2005, 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 8 million shares. In July 2006, 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 12 million shares.Repurchases may be made from time to time on the open market at prevailing marketprices or in privately negotiated transactions. Depending on market conditionsand other factors, purchases under this program may be commenced or suspendedat any time, or from time to time, without prior notice. As of September 30,2007, we had repurchased 8,170,060 shares of our common stock under thisprogram, for an aggregate of $170.4 million at an average price of $20.86 pershare. Under the terms of our new senior credit facility, we are restrictedfrom repurchasing our common stock for an aggregate purchase price that exceedsthe sum of $25 million plus 50% of aggregate amount of our consolidated netincome during the period from the effective date of the facility through themost recent quarter end for which we have filed quarterly financial statements.  We do not intend to repurchase shares for theremainder of 2007.

On April 26, 2007, weentered into a Senior Credit Agreement for a $300 million senior creditfacility and an interim credit facility in connection with the funds certainrequirements for the acquisition of SurfControl that was announced on April 26,2007. We completed the acquisition of SurfControl on October 3, 2007. In orderto finance a portion of the purchase price, on October 11, 2007, we amended andrestated the Senior Credit Agreement. The $225 million senior credit facilitydescribed in our amended and restated Senior Credit Agreement consists of afive year $210 million term loan and a $15 million revolving credit facility.The term loan was fully funded on October 11, 2007, and the revolving line ofcredit remains unused. The senior credit facility is secured by substantiallyall of our assets, including pledges of stock of some of our subsidiaries(subject to limitations in the case of foreign subsidiaries) and by securedguarantees by our domestic subsidiaries. The term loan amortizes at a rate of2.5%, 10%, 12.5%, and 15%, respectively, during the first four years of theterm and 60% during the fifth year. The initial interest rate is LIBOR plus 250basis points (7.62% for the first month), and is subject to step downs in thespread over LIBOR based upon  potentialfuture improvements in our total leverage ratio.  We are required to use 50% of excess cashflow for fiscal year 2007 and then 25% after fiscal year 2007, as defined inthe senior credit agreement, to make mandatory prepayments of principal, whichare not subject to any prepayment penalties. The amended and restated Senior Credit Agreement contains financialcovenants, including a consolidated leverage ratio and a consolidated interestcoverage ratio. The amended and restated Senior Credit Agreement also containsaffirmative and negative covenants. We did not borrow any amounts under theoriginal interim credit facility, which was terminated by its terms when theSenior Credit Agreement was amended and restated.

** **

We believe that our unrestricted cash and cash equivalents balances, investments in marketable securities and our ongoing cash flow from operations will be sufficient to satisfy our cash requirements, including our one-time restructuring costs and capital expenditures, for at least the next 12 months.  Our cash requirements may increase for reasons we do not currently foresee or we may make acquisitions as part of our growth strategy that increase our cash requirements.  We may elect to raise funds for these purposes through capital markets transactions or debt or private equity transactions as appropriate, including drawdowns on our revolving line of credit, subject to the restrictions on incurring additional debt in our senior credit facility and our obligation to use all of the proceeds of any equity offering to make mandatory prepayments of principal under our senior credit facility.  We intend to continue to invest our cash in excess of current operating requirements in interest-bearing, investment-grade securities.

**Off-BalanceSheet Arrangements**

As of September 30, 2007, 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,cash equivalents and investments in marketable securities. We invest our excesscash in highly liquid short-term investments, municipal securities, commercialpaper and corporate bonds. These investments are not held for trading or otherspeculative purposes. Changes in interest rates affect the investment income weearn on our investments and therefore impact our cash flows and results ofoperations.

Our interest income is exposed to changes in interestrates primarily from our short-term available-for-sale investments. Ahypothetical 100 basis point adverse move in interest rates along the entireinterest rate yield curve would not materially affect the fair value of ourinterest sensitive financial instruments at September 30, 2007. Changes ininterest rates over time will, however, affect our interest income. As ofSeptember 30, 2007, we did not use interest rate derivative instruments to

 

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manage exposure to interest rate changes.

After our acquisition of SurfControl, which closed onOctober 3, 2007, our interest expense will be subject to changes in interestrates for our borrowings under our variable rate senior credit facility.  Our senior credit agreement provides that wemust maintain hedge agreements so that at least 50% of the aggregate principalamount of the term loan is subject to either a fixed interest rate or interestrate protection for a period of not less than 2.5 years.

We utilize foreign currency forward contracts,zero-cost collar contracts and option contracts to hedge foreign currencymarket exposures of underlying assets and liabilities.  In addition, working funds necessary tofacilitate the short-term operations of our subsidiaries are kept 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 tradingpurposes.

Notional and fair values of our Euro and British Pound hedging positions at September 30, 2007 and 2006 are presented in the table below (in thousands):
| ** **    | ** ** | **September 30, 2007**               | ** ** | **September 30, 2006** | ** ** |
|---------------|------------|--------------------------------------|------------|-----------------------------|------------|
| ** **    | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD**    | ** ** | **Fair Value  USD** | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD** | ** ** | **Fair Value  USD** | ** ** |
| Euro          |       | €                               | —     |                        | $          | — |   | $ | — |   | € | 2,200 |   | $ | 2,818 |   | $ | 2,841 |   |
| British Pound |       | £                               | —     |                        | —     |   | — |   | £ | 1,000 |   | 1,871 |   | 1,858 |   |
| Total         |       |                                 |       | $                           | —     |   | $ | — |   |   | ** ** | $ | 4,689 | ** ** | $ | 4,699 | ** ** |

 

The $2.8 million notional decrease in our Eurohedged position at September 30, 2007 compared to September 30, 2006 isprimarily due to the need for funds required for the SurfControl acquisition.There were no Euro contacts outstanding as of September 30, 2007.  For both the three and nine months endedSeptember 30, 2007, less than 15% of our total billings were denominated in theEuro. We do not expect Euro billings to represent more than 15% of our totalbillings during 2007.

The $1.9 million notionaldecrease in our British Pound hedged position at September 30, 2007 compared toSeptember 30, 2006 is primarily due to the natural hedge againstour British Pound expenditures by billings in the British Pound which began inMay 2007. As of September 30, 2007 noBritish Pound contracts were outstanding.** **We do not expect to hedge theBritish Pound as we continue billing in the British Pound which creates anatural hedge against our British Pound expenditures.

At September 30, 2007, we utilized a £200 millionoption contract, with a strike price of $2.10 or $420.0 million, and a £25million ($51.2 million) forward, expiring on October 11, 2007 at a rate of$2.048 per British Pound, to hedge the purchase price for SurfControl. Therewere no such contracts related to the SurfControl acquisition outstanding as ofSeptember 30, 2006.  We subsequently soldthe £200 million option and entered into GBP forward contracts expiring onOctober 11, 2007. After the funding for the SurfControl acquisition was fullydisbursed, we do not expect to enter into any additional foreign currencyhedges related to the acquisition of SurfControl.

**Item 4. Controls and Procedures**

**Disclosure Controls andProcedures**

**Wemaintain disclosure controls and procedures (as defined in Rules 13a — 15(e)and 15d — 15(e) of the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) designed to ensure that we are able to collect the information we arerequired to disclose in the reports we file under the Exchange Act, and torecord, process, summarize and report this information within the time periodsspecified in the rules of the Securities and Exchange Commission.**Our Chief Executive Officer and ChiefFinancial Officer evaluated our disclosure controls and procedures as of theend of the period covered by this report. Based on their evaluation, our ChiefExecutive Officer and Chief Financial Officer have concluded that thesecontrols and procedures are effective as of the end of the period covered bythis Quarterly Report.

**Changes In Internal ControlOver Financial Reporting**

There havebeen no significant changes in our internal control over financial reporting orin other factors that could significantly affect our internal control overfinancial reporting, including any corrective actions with regard tosignificant deficiencies and material weaknesses, during the period covered bythis Quarterly Report.

 

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**Part II -Other Information**

 

**Item1. Legal Proceedings**

 

On September 29,2006, Jason Tauber filed a putative class action against us and otherunidentified individuals in California Superior Court for the County of SanDiego, captioned Tauber v. Websense. The complaint alleges that the plaintiffand a putative class of certain software engineers and computer professionalswho worked for us as exempt employees during the period from September 15,2002 through the present should have been classified as non-exempt employeesunder California law and should have been paid for overtime. The complaint alsoalleges related wage and hour violations of the California Labor Code arisingfrom the alleged misclassification and that the failure to pay overtimeconstitutes an unfair business practice under California Business andProfessions Code §17200. The complaint seeks unspecified damages for unpaidovertime, prejudgment interest, attorneys’ fees and other costs, statutorypenalties for alleged violations, and other proper relief. The parties to theaction have been granted preliminary court approval to settle all claims madein the putative class action, and the claims administrator has deliverednotices to the alleged class members. During the second quarter of 2007, the Company charged the $3.2 millionof the pending settlement amount between the operating expense categories andcost of revenue on the consolidated statement of income, apportioned based uponthe Company’s estimate of amounts payable to eligible individuals in thesettlement. As of September 30, 2007, $3.2 million remains as a reserve withinother accrued expenses on the consolidated balance sheet relating to thissettlement.

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 positions, 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.

**Item 1A.Risk Factors**

 

You shouldcarefully consider the following information in addition to other informationin 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.

 

We have markedwith an asterisk (*) those risk factors that reflect material changes from therisk factors included in our Quarterly Report on Form 10-Q filed with theSecurities and Exchange Commission on August 8, 2007.

 

 

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*We have experienced declining growth rates,particularly for Web filtering sales to large enterprises in North America andWestern Europe, and therefore need to increase our sales to small and mediumsized business customers.**

Ourgrowth plans for new sales in North America and Western Europe are largelydependent on our ability to increase sales in the SMB segment and maintain oursubscription base in the large enterprise market through subscription renewals.We released our first product targeted at the SMB segment, Websense Express, inJuly 2007, and we cannot assure that we will have success in increasingsales to the SMB segment. We will also need to increase sales through ourtwo-tier distribution channel in North America and our two-tier distributionarrangements in Western Europe that target SMB customers. Numerous competitorstarget the SMB segment for Web filtering and security sales, many of whom aredifferent competitors from our primary competitors in the large enterprisespace. If Websense Express does not meet our customers’ expectations in the SMBsegment or if we fail to compete effectively for volume business through ourtwo-tier distribution model, our financial results will be negatively affected.

*We have moved toward a two-tier distribution channelin North America which is intended to increase the quantity of our indirectsales.**

As we continue to move toward a two-tier indirectsales model in North America, our revenue will be derived almost entirely fromsales through indirect channels, including value-added resellers, distributorsthat sell our products to end-users, providers of managed Internet services andother resellers. Ingram Micro and All Tech are our only broad-line distributorsin North America, so the success of our North American sales efforts is relianton their success in selling our products to their reseller network. Ourindirect sales model involves a number of additional risks, including:

•       ourresellers and distributors, including Ingram Micro and All Tech, are notsubject to minimum sales requirements or any obligation to market our productsto 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 new productofferings such as our security-oriented offerings and our new ILP offerings;

•       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 ourcompetitors.

Ourability to meaningfully increase the amount of our products sold through oursales channels also depends on our ability to adequately and efficientlysupport these 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. Additionally, we are continually evaluating thechanges to our internal ordering and partner management systems in order toeffectively execute our two-tier distribution strategy. Any failure to properlyand efficiently support our sales channels will result in lost salesopportunities.

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

In January 2007, weacquired PortAuthority Technologies Inc., and on October 3, 2007 we acquiredSurfControl.  We may acquire additionalcompanies, services and technologies in the future as part of our efforts to expandand diversify our business. Although we review the records of companies orbusinesses 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 of ourbusiness.

Inthe case of the SurfControl acquisition, we expect to achieve cost synergiesfrom restructuring of the combined businesses following the closing.  As previously disclosed, we expect that thecombination with SurfControl will be dilutive to our earnings during the fourthquarter of 2007.  We expect to incurrestructuring and other related expenses that will negatively affect ourresults of operations under generally accepted accounting principles.  The size and scope of the acquisition ofSurfControl increase both the scope and consequence of ongoing integrationrisks. We may not successfully address the integration challenges in a timelymanner, or at all, and we may not fully realize all of the anticipated benefitsor

 

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synergiesof the SurfControl acquisition (which are principally associated withrestructurings, including workforce reductions and other operationalefficiencies).  The timing of theachievement of synergies may also deviate from our estimates depending upon thesuccess of the integration process.

Acquisitionsinvolve 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;

•       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 and cost savings to offset acquisition costs.

Acquisitionsmay 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 and restructuring and other relatedexpenses;

•       becomesubject to intellectual property or other litigation; and

•       creategoodwill or other intangible assets that could result in significant impairmentcharges and/or amortization expense.

As a result, if we failto properly evaluate, execute and integrate acquisitions such as PortAuthorityand SurfControl, our business and prospects may be seriously harmed.

***The covenants in our new seniorcredit facility restrict our financial and operational flexibility, includingour ability to complete additional acquisitions and invest in new businessopportunities.****

**Inconnection with our acquisition of SurfControl, on October 11, 2007 we enteredinto an amended and restated senior credit facility to provide financing for asubstantial portion of the acquisition purchase price.  Our senior credit facility contains covenantsthat restrict, among other things, our ability to borrow money, make particulartypes of investments, including investments in our subsidiaries, make otherrestricted payments, pay down subordinated debt, swap or sell assets, merge orconsolidate or make acquisitions.  Anevent of default under our senior credit facility could allow the lenders todeclare all amounts outstanding with respect to the senior credit facility tobe immediately due and payable.  Ascollateral for the loan, we pledged substantially all of our consolidatedassets and the stock of some of our subsidiaries (subject to limitations withrespect to foreign subsidiaries) to secure the debt under our senior creditfacility.  If the amounts outstandingunder the senior credit facility were accelerated, the lenders could proceedagainst those consolidated assets and the stock of our subsidiaries.  Any event of default, therefore, could have amaterial adverse effect on our business. Our senior credit**

** **

** **

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** **

**facility also requires us tomaintain specified financial ratios.  Ourability to meet these financial ratios can be affected by events beyond ourcontrol, and we cannot assure that we will meet those ratios.**

** **

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

On October 11,2007, we borrowed $210 million under the senior credit agreement.  As a result, we are incurring interestexpense for the amounts we borrowed under the senior credit facility, and weexpect our income from our cash, cash equivalents and marketable securities todecline as we used a significant portion of our cash to fund a portion of theacquisition cost.   This debt and thelimitations our senior credit facility impose on us could have importantconsequences, including:

•                  it may be difficult for us to satisfy ourobligations under the senior credit facility;

•                  we will have to use much of our cash flowfor scheduled debt service rather than for potential investments;

•                  we may be less able to obtain other debtfinancing in the future;

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

•                  our vulnerability to general adverseeconomic and industry conditions could be increased; and

•                  we could be at a competitive disadvantageto competitors with less debt.

*Ourfuture success depends on our ability to sell new, renewal and upgraded Webfiltering and Web security subscriptions.**

Substantiallyall of our revenue in the first nine months of 2007 was derived from new andrenewal subscriptions to our Web filtering and Web security products, and weexpect that a significant majority of our sales for the fourth quarter of 2007will continue to be derived from our Web filtering and security products aswell as from sales of SurfControl’s products. We expect sales of our ILPproducts and other products under development to comprise only a very smallportion of our overall sales in the fourth quarter of 2007. If our Webfiltering and security products fail to meet the needs of our existing andtarget customers, or if they do not compare favorably in price, features andperformance to competing products, our operating results and our business willbe significantly impaired.  If we cannotsufficiently increase our customer base with the addition of new customers,particularly in the SMB segment, increase seats under subscriptions fromexisting customers or renew a sufficient number of SurfControl’s Web filteringcustomers or migrate them to our Web filtering product, we will not be able togrow our business to meet expectations.

Subscriptionsfor our Web filtering and security products typically have durations of 12, 24or 36 months. Our customers have no obligation to renew their subscriptionsupon expiration. Our revenue also depends upon maintaining a high rate of salesof renewal subscriptions and in selling further subscriptions to existingcustomers in order to add additional seats or product offerings within theirrespective organizations. This may require increasingly costly sales effortstargeting senior management and other management personnel associated with ourcustomers’ Internet and security infrastructure. We may not be able to maintainor continue to generate increasing revenue from existing customers*.*

*Failure of our security products, including our ILP productsand on-demand security solutions to achieve more widespread market acceptancewill seriously harm our business.**

Our future financialperformance depends on our ability to diversify our offerings by successfullydeveloping, introducing and gaining customer acceptance of our new products andservices, particularly our security offerings. On January 8, 2007, weacquired PortAuthority Technologies, Inc., and as a result of thatacquisition, we now sell Websense Content Protection Suite, our ILP offeringfor the content security market.   Inaddition, on October 3, 2007, we acquired SurfControl, and as a result of thatacquisition, we now sell on-demand security solutions based upon SurfContol’sBlackSpider technology.  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 andILP products as well as the integration of SurfControl could distract us fromsales of our core Web filtering and Web security offerings, negativelyimpacting our overall sales. Any failure or delay in diversifying our existingofferings, or diversification at the detriment to our core Web filtering andWeb security offerings, could harm our business, results of operations andfinancial condition.

 

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*We face increasing competition from much largersoftware and hardware companies, which places pressure on our pricing and whichcould prevent us from increasing revenue or maintaining profitability. Inaddition, as we increase our emphasis on our security-oriented products, weface competition from better-established security companies that havesignificantly 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 profitability could be negatively impacted. Even ifour products provide greater functionality and are more effective than certainother competitive products, potential customers might accept this limitedfunctionality in lieu of purchasing our products. In addition, our own indirectsales channels may decide to develop or sell competing products instead of ourproducts. Pricing pressures and increased competition generally could result inreduced sales, reduced margins or the failure of our products to achieve ormaintain more widespread market acceptance, any of which could have a materialadverse effect on our business, results of operations and financial condition.

Ourcurrent principal competitors include:

•       companiesoffering Web filtering and Web security solutions, such as Microsoft, Symantec,McAfee, Cisco Systems, Juniper Networks, Message Labs, Trend Micro, Google,ScanSafe, Blue Coat Systems, Secure Computing, Alladin, Finjan, FaceTime, Mi5Networks, St. Bernard Software, 8e6 Technologies, Marshal, Clearswift, Sophos,Barracuda, Digital Arts and Computer Associates;

•       companiesintegrating Web filtering into specialized security appliances, such as 8e6Technologies, Blue Coat Systems, Cisco Systems, McAfee, WatchGuard andSonicWALL;

•       companiesoffering information leak prevention solutions, such as Vontu (recentlyannounced to be acquired by Symantec), Verdasys, Vericept, Tablus, Symantec,Secure Computing, IBM, Reconnex, Provilla, Proofpoint, Palisade Systems,Orchestria, Oakley Networks, McAfee, Intrusion, Fidelis, Checkpoint and CodeGreen Networks;

•       companiesoffering messaging security, such as McAfee, Symantec, Google, Barracuda,Secure Computing, Sonicwall, Tumbleweed, Messagelabs, MXlogic, Microsoft,Proofpoint and Borderware

•       companiesoffering on-demand e-mail and web security services, such as Google,Messagelabs, McAfee, Symantec, MXLogic, and Scansafe;

•       companiesoffering desktop security solutions such as Check Point Software, CiscoSystems, McAfee, Microsoft, Symantec, Computer Associates, Internet SecuritySystems (IBM) and Trend Micro; and

•       companiesoffering proxy based solutions such as Microsoft, BlueCoat Systems, CiscoSystems and Juniper.

As wedevelop and market our products with an increasing security-oriented emphasis,we also face increasing competition from security solutions providers. Many ofour competitors within the Web security market, such as Symantec,McAfee, Trend Micro, Cisco Systems and Microsoft enjoy substantialcompetitive 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 beunable to gain sufficient traction as a provider of Web security solutions, andour competitors may be able to respond more quickly and effectively than we canto new or emerging technologies and changes in customer requirements, or devotegreater resources to the development, marketing, promotion and sale of theirproducts than we can.

 

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Current and potentialcompetitors have established or may establish cooperative relationships amongthemselves or with third parties to increase the functionality and marketacceptance of their products. In addition, our competitors may be able toreplicate our products, make more attractive offers to existing and potentialemployees and strategic partners, develop new products or enhance existingproducts and services more quickly. Accordingly, new competitors or alliancesamong competitors may emerge and rapidly acquire significant market share. Inaddition, we also expect that competition will increase as a result of industryconsolidation. For all of the foregoing reasons, we may not be able to competesuccessfully against our current and future competitors.

*Our international operations involve risks that couldincrease our expenses, adversely affect our operating results, and requireincreased 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 engineering operations inBeijing, China, and acquired PortAuthority Technologies, Inc., whoseengineering efforts are based in Israel. We intend to maintain our principalengineering efforts for our ILP products in Israel.  SurfControl also has substantial engineeringoperations outside the United States, including in the United Kingdom,Australia and China.

Weplan to continue to expand our international operations, but such expansion iscontingent upon the financial performance of our existing internationaloperations as well as our identification of growth opportunities.  Our international operations are subject torisks in addition to those faced 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;

•       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; and

•       costsand delays associated with developing software in multiple languages.

Allof our foreign subsidiaries’ operating expenses are incurred in foreigncurrencies. As a result, should the dollar weaken, our foreign operatingexpenses would increase. Should foreign currency exchange rates fluctuate, ourearnings and net cash flows from international operations may be adverselyaffected, especially if the trend continues of international sales growing as apercentage of our total sales.

*Salesto customers outside the United States have accounted for a significant portionof our revenue, which exposes us to risks inherent in international sales.**

We market and sell our products outside the UnitedStates through value-added resellers, distributors and other resellers.International sales represented 41% of our total revenue generated during thequarter ended September 30, 2007 compared with 37% of our total revenue duringthe quarter ended September 30, 2006. As a key component of our businessstrategy to generate new business sales, we intend to expand our internationalsales, but success cannot be assured. In addition to the risks associated withour domestic sales, our international sales are subject to the following risks:

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

 

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•       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.

Thesefactors could have a material adverse effect on our international sales. Anyreduction in international sales, or our failure to further develop ourinternational distribution channels, could have a material adverse effect onour business, results of operations and financial condition.

Our international revenueis currently primarily denominated in U.S. dollars. As a result, fluctuationsin the value of the U.S. dollar and foreign currencies may make our productsmore expensive for international customers, which could harm our business. Wecurrently bill certain international customers in Euros and British Pounds.SurfControl has historically billed certain international customers in Euros,British Pounds, Australian Dollars, China Yuan Renminbi, Singapore Dollars,Japanese Yen and Israel New Shekels. This may increase our risks associatedwith fluctuations in foreign currency exchange rates since we cannot be assuredof receiving the same U.S. dollar equivalent as when we bill exclusively inU.S. dollars. We engage in currency hedging activities with the intent oflimiting the risk of exchange rate fluctuation. Our hedging activities alsoinvolve inherent risks that could result in an unforeseen loss. If we fail toproperly forecast rate fluctuations these activities could have a negativeimpact.

*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 designed tooperate with a variety of network hardware and software platforms, we will needto continuously modify and enhance our products to keep pace with changes inInternet-related hardware, software, communication, browser and databasetechnologies. We may not be successful in either developing such products orintroducing them to the market in a timely fashion. In addition, uncertaintiesabout the timing and nature of new network platforms or technologies, ormodifications to existing platforms or technology could increase our researchand development expenses. The failure of our products to operate effectivelywith the existing and future network platforms and technologies will limit orreduce the market for our products, result in customer dissatisfaction andseriously harm our business, results of operations and financial condition.

We may spend significanttime and money on research and development to design and develop our ILPproducts. If these products fail to achieve broad market acceptance in ourtarget markets, we may be unable to generate significant revenue from ourresearch and development efforts. Moreover, even if we are able to developinformation leak prevention products, they may not be accepted in our targetmarkets. As a result, our business, results of operations and financialcondition would be adversely impacted.

*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 software applications included inour databases, 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.

We rely upon acombination of automated filtering technology and human review to categorizeURLs and software applications in our proprietary databases. Our customers maynot agree with our determinations that particular URLs and softwareapplications should be included or not included in specific categories of ourdatabases. In addition, it is possible that

 

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our filtering processesmay place objectionable or security risk material in categories that aregenerally unrestricted by our users’ Internet and computer access policies,which could result in such material not being blocked from the network. Anymiscategorization could result in customer dissatisfaction and harm ourreputation. Any failure to effectively categorize and filter URLs and softwareapplications according to our customers’ expectations will impair the growth ofour business. Our databases and database technologies may not be able to keeppace with the growth in the number of URLs and software applications,especially the growing amount of content utilizing foreign languages and theincreasing sophistication of malicious code and the delivery mechanismsassociated with spyware, phishing and other hazards associated with theInternet.

*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 complexand are deployed in a wide variety of complex network environments. Ourproducts may have errors or defects that users identify after deployment, whichcould harm our reputation and our business. In addition, products as complex asours frequently contain undetected errors when first introduced or when newversions or enhancements are released. We have from time to time found errorsin versions of our products, and we expect to find such errors in the future.Because customers rely on our products to manage employee behavior to protectagainst security risks and prevent the loss of sensitive data, any significantdefects or errors in our products may result in negative publicity or legalclaims. For example, an actual or perceived breach of network or computersecurity at one of our customers, regardless of whether the breach isattributable to our products, could adversely affect the market’s perception ofour security products. Moreover, parties whose Web sites or softwareapplications are placed in security-risk categories or other categories withnegative connotations may seek redress against us for falsely labeling them orfor interfering with their business. The occurrence of errors could adverselyaffect sales of our products, divert the attention of engineering personnelfrom our product development efforts and cause significant customer relationsor legal problems.

Our products may also bemisused or abused by customers or non-customer third parties who obtain accessand use of our products. These situations may arise where an organization usesour products 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.

*We face risksrelated 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 systemintegrators. Significant product displacements could impact our revenue andhave a material adverse 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. If networksecurity functions become standard features of computer hardware or ofoperating system software or other software, our products may become obsoleteand unmarketable, particularly if the quality of these network securityfeatures is comparable to that of our products. Furthermore, even if thenetwork security and/or management functions provided as standard features byhardware providers or operating systems or other software is more limited thanthat of our products, our customers might accept this limited functionality inlieu of purchasing additional software. Sales of our products would suffermaterially if we were then unable to develop new Web filtering, security andILP products to further enhance operating systems or other software and toreplace 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 isrequired in determining our worldwide provision for income taxes and for ouraccruals for other state, federal and international taxes such as sales and VATtaxes. In the ordinary course of a global business, there are many transactionsfor which the ultimate tax outcome is uncertain. Some of these uncertaintiesarise as a consequence of intercompany arrangements to share revenue and costs.In such arrangements there are uncertainties about the amount and manner ofsuch sharing, which could ultimately result in changes once the arrangementsare reviewed by taxing authorities.

 

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Although we believe thatour approach to determining the amount of such arrangements is reasonable, noassurance can be given that the final tax authority review of these matterswill not be materially different than that which is reflected in our historicalincome tax provisions and other tax accruals. Such differences could have amaterial effect on our income tax provisions or benefits, or other taxaccruals, in the period in which such determination is made, and consequently,on our results of operations for such period.

From time to time, we arealso audited by various state, federal and international authorities relatingto tax matters. We fully cooperate with all audits. Our audits are in variousstages of completion; however, no outcome for a particular audit can bedetermined with certainty prior to the conclusion of the audit and appealsprocess. As each audit is concluded, adjustments, if any, are appropriatelyrecorded in our financial statements in the period determined. To provide forpotential tax exposures, we maintain allowances for tax contingencies based onreasonable estimates of our potential exposure with respect to the taxliabilities that may result from such audits. However, if the reserves areinsufficient upon completion of any audits, there could be an adverse impact onour financial position and results of operations.

*Any failure toprotect our proprietary technology would negatively impact our business.**

Intellectual property iscritical to our success, and we rely upon trademark, copyright and trade secretlaws in the United States and other jurisdictions as well as confidentialityprocedures and contractual provisions to protect our proprietary technology andour Websense and SurfControl brands. We rely on trade secrets to protecttechnology where we believe patent protection is not appropriate or obtainable.However, trade secrets are difficult to protect. While we require employees,collaborators and consultants to enter into confidentiality agreements, wecannot assure that these agreements will not be breached or that we will haveadequate remedies for any breach. We may not be able to adequately protect ourtrade secrets or other proprietary information in the event of any unauthorizeduse or disclosure or the lawful development by others of such information.

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

Wecurrently have only nine issued patents in the United States and six patentsissued internationally, and we may be unable to obtain further patentprotection in the future. We have other pending patent applications in theUnited States and in other countries. We cannot ensure that:

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

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

•       anyof our pending patent applications are not obvious or anticipated such thatthey will not result in issued patents;

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

•       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, legalstandards relating to the validity, enforceability and scope of protection ofintellectual property rights are uncertain. Effective patent, trademark,copyright and trade secret protection may not be available to us in everycountry in which our products are available. The laws of some foreign countriesmay not be as protective of intellectual property rights as U.S. laws, andmechanisms for enforcement of intellectual property rights may be inadequate.As a result our means of protecting our proprietary technology and brands maynot be adequate. Furthermore, despite our efforts, we may be unable to preventthird parties from infringing upon or misappropriating our intellectualproperty, including the misappropriation or misuse of the content of ourproprietary databases of universal resource locators (“URLs”) and softwareapplications. Any such infringement or misappropriation could have a materialadverse effect on our business, results of operations and financial condition.

 

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*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 Internetindustries are characterized by the existence of a large number of patents,trademarks and copyrights and by frequent litigation based on allegations ofpatent infringement or other violations of intellectual property rights. As weexpand our product offerings in the data leakage and security area where largercompanies with large patent portfolios compete, the possibility of anintellectual property claim against us grows. We could receive claims that wehave infringed the intellectual property rights of others, including claimsregarding patents, copyrights, and trademarks. Any such claim, with or withoutmerit, could result in costly litigation and distract management fromday-to-day operations. If we are not successful in defending such claims, wecould be required to stop selling our products, pay monetary amounts as damages,enter into royalty or licensing arrangements, or satisfy indemnificationobligations 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.*

We expect that nearly allof our revenue for the foreseeable future will come from subscriptions toWebsense Enterprise and our add-on products. Upon execution of a subscriptionagreement, we invoice our customers for the full term of the subscriptionagreement. We then recognize revenue from customers daily over the terms oftheir subscription agreements, which typically have durations of 12, 24 or 36months. As a result, a majority of the revenue we report in each quarter isderived from deferred revenue from subscription agreements entered into andpaid for during previous quarters. Because of this financial model, the revenuewe report in any quarter or series of quarters may mask significant downturns insales and the market acceptance of our products, before these downturns resultin declining revenues.

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

Our quarterly operatingresults have varied significantly in the past, and will likely vary in thefuture primarily as the result of fluctuations in our billings, revenues,operating expenses and tax provisions. Although a significant portion of ourrevenue in any quarter comes from previously deferred revenue, a meaningfulportion of our revenue in any quarter depends on the number, size and length ofsubscriptions to our products that are sold in that quarter. The risk ofquarterly fluctuations is increased by the fact that a significant portion ofour quarterly sales have historically been generated during the last month ofeach fiscal quarter, with many of the largest enterprise customers purchasingsubscriptions to our products nearer to the end of the last month of eachquarter. Due to the unpredictability of these end-of-period buying patterns,forecasts may not be achieved.

Weexpect that our operating expenses will increase substantially in the future aswe expand our selling and marketing activities, increase our research and developmentefforts and hire additional personnel which could impact our gross margins. Inaddition, our operating expenses historically have fluctuated, and may continueto fluctuate in the future, as the result of the factors described below andelsewhere in this quarterly report:

•       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; and

•       timingof expenses associated with commissions paid on sales of subscriptions to ourproducts.

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

 

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*The market priceof our common stock is likely to be highly volatile and subject to widefluctuations.*

Themarket price of our common stock has been and likely will continue to be highlyvolatile and could be subject to wide fluctuations in response to a number offactors that are beyond our control, including:

•       announcements of technological innovations ornew products or services by our competitors;

•       demand for our products, including fluctuationsin subscription renewals;

•       changes in the pricing policies of ourcompetitors; and

•       changes in government regulations.

Inaddition, the market price of our common stock could be subject to widefluctuations in response to:

•       announcements of technological innovations ornew products or services by us;

•       changes in our pricing policies; and

•       quarterly variations in our revenues andoperating expenses.

Further, the stock markethas experienced significant price and volume fluctuations that haveparticularly affected the market price of the stock of many Internet-relatedcompanies, and that often have been unrelated or disproportionate to theoperating performance of these companies. A number of publicly tradedInternet-related companies have current market prices below their initialpublic offering prices. Market fluctuations such as these may seriously harmthe market price of our common stock. In the past, securities class actionsuits have been filed following periods of market volatility in the price of acompany’s securities. If such an action were instituted, we would incursubstantial costs and a diversion of management attention and resources, whichwould seriously harm our business, results of operations and financialcondition.

*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 dependslargely upon the continued services of our executive officers and other keymanagement personnel and our ability to recruit new personnel to executive andkey management positions.  We are alsosubstantially dependent on the continued service of our existing engineeringpersonnel because of the complexity of our products and technologies. We do nothave employment agreements with a majority of our executive officers, keymanagement or development personnel and, therefore, they could terminate theiremployment with us at any time without penalty. We do not maintain key personlife insurance policies on any of our employees. The loss of one or more of ourkey employees could 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 growthplan, we must attract and retain highly qualified personnel. We need to hireadditional personnel in virtually all operational areas, including selling andmarketing, research and development, operations and technical support, customerservice and administration. Competition for these personnel is intense,especially for engineers with high levels of experience in designing anddeveloping software and Internet-related products. We may not be successful inattracting and retaining qualified personnel. We have from time to time in thepast experienced, and we expect to continue to experience in the future,difficulty in hiring and retaining highly skilled employees with appropriatequalifications. In order to attract and retain personnel in a competitivemarketplace, we believe that we must provide a competitive compensationpackage, including cash and equity based compensation. The volatility of ourstock price may from time to time adversely affect our ability to recruit orretain employees. Many of the companies with which we compete for experiencedpersonnel have greater resources than we have. If we fail to attract newpersonnel or retain and motivate our current personnel, our business and futuregrowth prospects could be severely harmed.

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*Compliance with changing regulation of corporategovernance, accounting principles and public disclosure may result inadditional expenses.*

Changing laws,regulations and standards relating to corporate governance, accountingprinciples and public disclosure, including the Sarbanes-Oxley Act of 2002, newSEC regulations and NASDAQ Global Select Market rules, are creating uncertaintyfor companies such as ours. These new or changed 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 andthe related regulations regarding our required assessment of our internalcontrols over financial reporting and our external auditors’ audit of thatassessment has required the commitment of significant financial and managerialresources. If our efforts to comply with new or changed laws, regulations andstandards differ from the activities intended by regulatory or governing bodiesdue to ambiguities related to practice, our reputation may be harmed.

***If wecannot effectively manage our internal growth and the integration of acquiredbusinesses, our business revenues, profit margins and prospects may suffer.****

** **

If we fail to manage ourinternal growth and the integration of acquired businesses in a manner thatminimizes strains on our resources, we could experience disruptions in ouroperations that could negatively affect our revenue, billings or profitability.  We are pursuing a strategy of organic growththrough implementation of two-tier distribution, international expansion,introduction of new products and expansion of our product sales to the smalland medium sized businesses. We also completed two strategic acquisitions, andare continuing the process of integrating PortAuthority and SurfControl.  Finally, we have opened or acquiredengineering centers in China, Israel, the United Kingdom and Australia.  Each of these initiatives requires aninvestment of our financial and employee resources and involves risks that mayresult in a lower return on our investments than we expect. These initiativesalso may limit the opportunities we pursue or investments we would otherwisemake, which may in turn impact our prospects.

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

Some provisions of 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 attempted change of control. Delaware lawalso could make it more difficult for a third party to acquire us.Section 203 of the Delaware General Corporation Law has an anti-takeovereffect with respect to transactions not approved in advance by our board,including discouraging attempts that might result in a premium over the marketprice of the shares of common stock held by our stockholders.

Our senior 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.

 

*We do not intendto pay dividends.*

We have not declared or paid any cash dividends on ourcommon stock since we have been a publicly traded company. We currently intendto retain any future cash flows from operations to fund growth and, do notexpect to pay any cash dividends in the foreseeable future.  Moreover, we are not permitted to pay cashdividends under the terms of our senior credit facility.

 

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**Item2.    Unregistered Sales of EquitySecurities and Use of Proceeds**

 

**None.**

** **

**Item 3.    Defaults upon Senior Securities**

** **

**None.**

** **

**Item 4.  Submission of Matters to a Vote of SecurityHolders**

** **

**None.**

** **

** **

**Item 5.    Other Information**

** **

**None.**

** **

**40**

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**Item 6.    Exhibits**

** **

**Exhibits**

** **
| 2.1(1)  |   | Transaction Agreement by and among Websense, Inc.,  Websense SC Operations Limited and SurfControl plc, dated April 26, 2007.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|---------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.2(1)  |   | Rule 2.5 Announcement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.1(2)  |   | Amended and Restated Certificate of Incorporation.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 3.2(3)  |   | Amended and Restated Bylaws.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.1(2)  |   | Specimen Stock Certificate of Websense, Inc.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.1(4) |   | $225,000,000 Amended and Restated Senior Credit  Agreement, among Websense, Inc. as borrower, the lenders from time to time  parties thereto, Morgan Stanley Senior Funding, Inc. as sole lead arranger  and sole bookrunner, Morgan Stanley Senior Funding, Inc. as senior  administrative agent, Bank of America, N.A., as syndication agent, Key Bank  National Association, JP Morgan Chase Bank and Citibank, N.A., as  co-documentation agents, Morgan Stanley Senior Funding, Inc. as senior  administrative agent, and Morgan Stanley & Co. Incorporated, as senior  collateral agent for the benefit of the secured parties. |
| 10.2(4) |   | Amended and Restated 2000 Stock Incentive Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 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 Current Report on Form 8-K (No 000-30093) filed on May 2,2007.

(2)             Filedas an Exhibit to our Registration Statement on Form S-1/A (No 333-95619) filedon March 3, 2000.

(3)             Filedas an Exhibit to our Current Report on Form 8-K (No 000-30093) filed on April19, 2007.

(4)             Filedas an Exhibit to our Current Report on Form 8-K (No 000-30093) filed on October17, 2007.

 

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##### **SIGNATURES**

#####  

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
|                   |   | **WEBSENSE, INC.** |
|------------------------|--------|--------------------|
|                   |   |               |   |   |
| Date: November 8, 2007 |   |               | By: | /s/ GENE HODGES |
|                   |   |               |   | Gene Hodges |
|                   |   |               |   | *Chief Executive Officer* |
|                   |   |               |   |   |
| Date: November 8, 2007 |   |               | By: | /s/ DUDLEY MENDENHALL |
|                   |   |               |   | Dudley Mendenhall |
|                   |   |               |   | *Chief Financial Officer* |

 

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**EXHIBIT INDEX**
| 2.1(1)  |   | Transaction Agreement by and among Websense, Inc.,  Websense SC Operations Limited and SurfControl plc, dated April 26, 2007.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|---------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.2(1)  |   | Rule 2.5 Announcement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.1(2)  |   | Amended and Restated Certificate of Incorporation.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 3.2(3)  |   | Amended and Restated Bylaws.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.1(2)  |   | Specimen Stock Certificate of Websense, Inc.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.1(4) |   | $225,000,000 Amended and Restated Senior Credit  Agreement, among Websense, Inc. as borrower, the lenders from time to time  parties thereto, Morgan Stanley Senior Funding, Inc. as sole lead arranger  and sole bookrunner, Morgan Stanley Senior Funding, Inc. as senior  administrative agent, Bank of America, N.A., as syndication agent, Key Bank  National Association, JP Morgan Chase Bank and Citibank, N.A., as  co-documentation agents, Morgan Stanley Senior Funding, Inc. as senior  administrative agent, and Morgan Stanley & Co. Incorporated, as senior  collateral agent for the benefit of the secured parties. |
| 10.2(4) |   | Amended and Restated 2000 Stock Incentive Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 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).                                                                                                                                                                                                                                                                                                                                                                                                                                          |

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(1)    Filed asan Exhibit to our Current Report on Form 8-K (No 000-30093) filed on May 2,2007.

(2)             Filedas an Exhibit to our Registration Statement on Form S-1/A (No 333-95619) filedon March 3, 2000.

(3)             Filedas an Exhibit to our Current Report on Form 8-K (No 000-30093) filed on April19, 2007.

(4)             Filedas an Exhibit to our Current Report on Form 8-K (No 000-30093) filed on October17, 2007.

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