**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 June 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**

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**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)

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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 July 31, 2007 was 45,146,816.

 

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**Websense, Inc.**

**Form 10-Q**

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

**TABLE OF CONTENTS**
|                               | ** ** | **Page**  |
|-------------------------------|------------|-----------|
| Part I. Financial Information |       |      |
|                          |       |      |   |   |   |   |
|                          |       | Item 1.   |   | Consolidated  Financial Statements (Unaudited) |   |   |
|                          |       |      |   | Consolidated  Balance Sheets as of June 30, 2007 and December 31, 2006 |   | 3 |
|                          |       |      |   | Consolidated  Statements of Income for the three and six months ended June 30, 2007 and  2006 |   | 4 |
|                          |       |      |   | Consolidated  Statement of Stockholders’ Equity for the six months ended June 30, 2007 |   | 5 |
|                          |       |      |   | Consolidated  Statements of Cash Flows for the six months ended June 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 |   | 39 |
|                          |       | Item 3.   |   | Defaults upon  Senior Securities |   | 39 |
|                          |       | 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 inthousands)**
| ** **                                       | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                       | ** ** | ** **              | ** ** | **(See Note 1)**  | ** ** |
| **Assets**                                       |       |                    |       |                        |       |
| Current assets:                                  |       |                    |       |                        |       |
| Cash and cash  equivalents                       |       | $                       | 28,513     |                        | $          | 83,523 |   |
| Cash and cash  equivalents-restricted            |       | 1,285                   |       | —                      |       |
| Marketable  securities                           |       | 16,380                  |       | 243,382                     |       |
| Marketable  securities-restricted                |       | 215,716                 |       | —                      |       |
| Accounts  receivable, net                        |       | 43,813                  |       | 52,740                      |       |
| Prepaid income  taxes                            |       | 1,875                   |       | —                      |       |
| Current portion  of deferred income taxes        |       | 18,092                  |       | 18,179                      |       |
| Other current  assets                            |       | 5,385                   |       | 3,943                       |       |
| Total current  assets                            |       | 331,059                 |       | 401,767                     |       |
|                                             |       |                    |       |                        |       |
| Property and equipment,  net                     |       | 7,679                   |       | 5,793                       |       |
| Intangible assets, net                           |       | 14,017                  |       | 1,067                       |       |
| Goodwill                                         |       | 73,467                  |       | —                      |       |
| Deferred income taxes,  less current portion     |       | 20,212                  |       | 13,806                      |       |
| Deposits and other  assets                       |       | 9,275                   |       | 1,824                       |       |
| Total assets                                     |       | $                       | 455,709    |                        | $          | 424,257 |   |
|                                             |       |                    |       |                        |       |
| **Liabilities and stockholders’  equity**   |       |                    |       |                        |       |
| Current liabilities:                             |       |                    |       |                        |       |
| Accounts payable                                 |       | $                       | 2,542      |                        | $          | 2,712 |   |
| Accrued payroll  and related benefits            |       | 11,341                  |       | 9,164                       |       |
| Other accrued  expenses                          |       | 12,529                  |       | 7,084                       |       |
| Current portion  of income taxes payable         |       | 216                     |       | 4,229                       |       |
| Current portion  of deferred revenue             |       | 145,362                 |       | 148,539                     |       |
| Total current  liabilities                       |       | 171,990                 |       | 171,728                     |       |
|                                             |       |                    |       |                        |       |
| Income taxes  payable, less current portion      |       | 10,242                  |       | —                      |       |
| Deferred  revenue, less current portion          |       | 72,171                  |       | 71,804                      |       |
|                                             |       |                    |       |                        |       |
| Stockholders’ equity:                       |       |                    |       |                        |       |
| Common stock                                     |       | 513                     |       | 509                         |       |
| Additional  paid-in capital                      |       | 252,261                 |       | 237,302                     |       |
| Treasury stock,  at cost                         |       | (139,779                | )          | (139,744                    | )          |
| Retained  earnings                               |       | 88,368                  |       | 82,748                      |       |
| Accumulated  other comprehensive loss            |       | (57                     | )          | (90                         | )          |
| Total  stockholders’ equity                 |       | 201,306                 |       | 180,725                     |       |
| Total liabilities and  stockholders’ equity |       | $                       | 455,709    |                        | $          | 424,257 |   |

 

See accompanying notes.

3

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**Websense, Inc.Consolidated Statements of Income**

**(Unaudited) (inthousands, except per share amounts)**
| ** **                                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                       | ** ** | **June 30,  2007**          | ** ** | **June 30,  2006**        | ** ** | **June 30,  2007** | ** ** | **June 30,  2006** | ** ** |
|                                             |       |                             |       |                           |       |   |   |   |   |
| Revenue                                          |       | $                                | 50,449     |                           | $          | 43,687 |   | $ | 100,196 |   | $ | 85,747 |   |
|                                             |       |                             |       |                           |       |   |   |   |   |
| Cost of revenues                                 |       |                             |       |                           |       |   |   |   |   |
| Cost of revenues                                 |       | 4,805                            |       | 3,704                          |       | 8,833 |   | 7,082 |   |
| Amortization of acquired technology              |       | 629                              |       | —                         |       | 1,258 |   | — |   |
| Total cost of  revenues                          |       | 5,434                            |       | 3,704                          |       | 10,091 |   | 7,082 |   |
| Gross margin                                     |       | 45,015                           |       | 39,983                         |       | 90,105 |   | 78,665 |   |
|                                             |       |                             |       |                           |       |   |   |   |   |
| Operating  expenses:                             |       |                             |       |                           |       |   |   |   |   |
| Selling and marketing                            |       | 25,127                           |       | 18,922                         |       | 50,040 |   | 36,936 |   |
| Research and development                         |       | 10,325                           |       | 5,535                          |       | 17,451 |   | 10,978 |   |
| General and administrative                       |       | 6,575                            |       | 5,225                          |       | 13,761 |   | 10,433 |   |
| Write off of in-process research and development |       | —                           |       | —                         |       | 1,270 |   | — |   |
| Total operating expenses                         |       | 42,027                           |       | 29,682                         |       | 82,522 |   | 58,347 |   |
|                                             |       |                             |       |                           |       |   |   |   |   |
| Income from  operations                          |       | 2,988                            |       | 10,301                         |       | 7,583 |   | 20,318 |   |
|                                             |       |                             |       |                           |       |   |   |   |   |
| Other income,  net                               |       | 1,475                            |       | 2,821                          |       | 3,915 |   | 5,456 |   |
|                                             |       |                             |       |                           |       |   |   |   |   |
| Income before  income taxes                      |       | 4,463                            |       | 13,122                         |       | 11,498 |   | 25,774 |   |
|                                             |       |                             |       |                           |       |   |   |   |   |
| Provision for  income taxes                      |       | 2,334                            |       | 5,055                          |       | 5,502 |   | 9,763 |   |
|                                             |       |                             |       |                           |       |   |   |   |   |
| Net income                                       |       | $                                | 2,129      |                           | $          | 8,067 |   | $ | 5,996 |   | $ | 16,011 |   |
|                                             |       |                             |       |                           |       |   |   |   |   |
| Net income per  share:                           |       |                             |       |                           |       |   |   |   |   |
|                                             |       |                             |       |                           |       |   |   |   |   |
| Basic net income per share                       |       | $                                | 0.05       |                           | $          | 0.17 |   | $ | 0.13 |   | $ | 0.34 |   |
| Diluted net income per share                     |       | $                                | 0.05       |                           | $          | 0.17 |   | $ | 0.13 |   | $ | 0.33 |   |
| Weighted average shares – basic             |       | 45,060                           |       | 47,586                         |       | 44,978 |   | 47,766 |   |
| Weighted average shares – diluted           |       | 45,561                           |       | 48,368                         |       | 45,499 |   | 48,710 |   |

 

See accompanyingnotes.

4

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**Websense, Inc.** Consolidated Statement of Stockholders’ Equity

**(Unaudited and inthousands)**
| ** **                                                                                                                | ** ** | **Common stock** | ** ** | **Additional** | ** ** | **Treasury**             | ** ** | **Retained** | ** ** | **Accumulated  other  comprehensive** | ** ** | **Total  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                                                                         |       | 225                   |       | 3              |       | 2,385                    |       | —       |       | —                                |       | —                        |       | 2,388 |   |
|                                                                                                                      |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Issuance of common stock for ESPP purchase                                                                                |       | 105                   |       | 1              |       | 2,211                    |       | —       |       | —                                |       | —                        |       | 2,212 |   |
|                                                                                                                      |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Issuance of common stock from restricted stock units,  net                                                                |       | 28                    |       | —         |       | —                   |       | (35          | )          | —                                |       | —                        |       | (35 | ) |
|                                                                                                                      |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Share-based compensation expense                                                                                          |       | —                |       | —         |       | 10,536                   |       | —       |       | —                                |       | —                        |       | 10,536 |   |
|                                                                                                                      |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Excess tax benefit of share-based compensation                                                                            |       | —                |       | —         |       | 685                      |       | —       |       | —                                |       | —                        |       | 685 |   |
|                                                                                                                      |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Net income                                                                                                                |       | —                |       | —         |       | —                   |       | —       |       | 5,996                                 |       | —                        |       | 5,996 |   |
|                                                                                                                      |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Net change in unrealized gain on marketable  securities, net of tax                                                       |       | —                |       | —         |       | —                   |       | —       |       | —                                |       | 14                            |       | 14 |   |
|                                                                                                                      |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Net change in unrealized gain on fair market  valuation of foreign currency contracts, net of tax                         |       | —                |       | —         |       | —                   |       | —       |       | —                                |       | 19                            |       | 19 |   |
|                                                                                                                      |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Comprehensive income                                                                                                      |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       | 6,029 |   |
| Balance at June 30, 2007                                                                                                  |       | 45,143                |       | $              | 513        |                     | $          | 252,261      |       | $                                     | (139,779   | )                             | $          | 88,368 |   | $ | (57 | ) | 201,306 |   |
|                                                                                                                           |            |                       |            |                |            |                          |            |              |            |                                       |            |                               |            |  |  |  |  |  |  |  |  |

 

See accompanying notes.

5

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**Websense, Inc.Consolidated Statements of Cash Flows**

**(Unaudited and in thousands)**
| ** **                                                                                   | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                   | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** |
| ** **                                                                                   | ** ** | **2007**                       | ** ** | **2006** | ** ** |
| **Operating  activities:**                                                                   | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Net income                                                                                   |       | $                              | 5,996      |   | $ | 16,011 |   |
|                                                                                         |       |                           |       |   |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:           |       |                           |       |   |   |
| Depreciation                                                                                 |       | 2,153                          |       | 1,571 |   |
| Write-off of in-process research and development                                             |       | 1,270                          |       | — |   |
| Amortization of intangible assets                                                            |       | 1,760                          |       | — |   |
| Share-based compensation                                                                     |       | 10,536                         |       | 9,710 |   |
| Deferred revenue                                                                             |       | (2,810                         | )          | 5,981 |   |
| Deferred income taxes                                                                        |       | (4,645                         | )          | (4,731 | ) |
| Unrealized gain on foreign exchange contracts                                                |       | 25                             |       | 116 |   |
| Excess tax benefit of share-based compensation                                               |       | (685                           | )          | (2,593 | ) |
| Unrealized loss on option hedge                                                              |       | 1,053                          |       | — |   |
| Changes in operating assets and liabilities, net of  effects from purchase of PortAuthority: |       |                           |       |   |   |
| Accounts receivable                                                                          |       | 9,632                          |       | 13,716 |   |
| Prepaid income taxes                                                                         |       | (1,875                         | )          | 1,218 |   |
| Other current assets                                                                         |       | (1,564                         | )          | (1,167 | ) |
| Deposits and other assets                                                                    |       | (3,662                         | )          | (14 | ) |
| Accounts payable                                                                             |       | (336                           | )          | (520 | ) |
| Accrued payroll and related benefits                                                         |       | (735                           | )          | (940 | ) |
| Other accrued expenses                                                                       |       | 4,542                          |       | 279 |   |
| Income taxes payable                                                                         |       | 3,104                          |       | 3,459 |   |
| Net cash  provided by operating activities                                                   |       | 23,759                         |       | 42,096 |   |
|                                                                                         |       |                           |       |   |   |
| **Investing  activities:**                                                                   | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Cash paid to  acquire PortAuthority, net of cash acquired                                    |       | (81,988                        | )          | — |   |
| Purchases of  property and equipment                                                         |       | (3,277                         | )          | (2,266 | ) |
| Change in restricted  cash and cash equivalents                                              |       | (1,285                         | )          | — |   |
| Purchases of  marketable securities                                                          |       | (227,811                       | )          | (355,839 | ) |
| Maturities of  marketable securities                                                         |       | 241,483                        |       | 297,016 |   |
| Purchases of  marketable securities- restricted                                              |       | (54,311                        | )          | — |   |
| Maturities of  marketable securities- restricted                                             |       | 51,939                         |       | — |   |
| Cash paid for  option contract on SurfControl acquisition                                    |       | (4,590                         | )          | — |   |
| Net cash used in  investing activities                                                       |       | (79,840                        | )          | (61,089 | ) |
|                                                                                         |       |                           |       |   |   |
| **Financing  activities:**                                                                   | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Proceeds from  exercise of stock options                                                     |       | 2,388                          |       | 6,430 |   |
| 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                                              |       | 685                            |       | 2,593 |   |
| Purchases of  treasury stock                                                                 |       | —                         |       | (33,070 | ) |
| Net cash  provided by (used in) financing activities                                         |       | 1,071                          |       | (22,059 | ) |
|                                                                                         |       |                           |       |   |   |
| Decrease in cash  and cash equivalents                                                       |       | (55,010                        | )          | (41,052 | ) |
|                                                                                         |       |                           |       |   |   |
| Cash and cash  equivalents at beginning of period                                            |       | 83,523                         |       | 61,629 |   |
|                                                                                         |       |                           |       |   |   |
| Cash and cash  equivalents at end of period                                                  |       | $                              | 28,513     |   | $ | 20,577 |   |
| ** **                                                                                   | ** ** | ** **                     | ** ** | ** ** | ** ** |
| **Supplemental  cash flow information:**                                                     | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Income taxes  paid                                                                           |       | $                              | 7,983      |   | $ | 6,334 |   |
| Unrealized gain  on marketable securities                                                    |       | $                              | 14         |   | $ | 202 |   |

 

See accompanying notes.

6

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**Websense,Inc.**

**Notes ToConsolidated Financial Statements (Unaudited)**

1. *Basis of Presentation*

The accompanyingunaudited consolidated financial statements have been prepared in conformitywith United States generally accepted accounting principles for interimfinancial statements and with the instructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, certain information or footnote disclosuresnormally included in complete financial statements prepared in accordance with UnitedStates generally accepted accounting principles have been condensed or omittedpursuant to the rules and regulations of the Securities and ExchangeCommission. In the opinion of management, the statements include all adjustmentsnecessary, which are of a normal and recurring nature, for the fair presentationof our financial position and of the results for the interim periods presented.

These financialstatements should be read in conjunction with the audited consolidated financialstatements and notes thereto for the year ended December 31, 2006, included inWebsense, Inc.’s (Websense or the Company) Annual Report on Form 10-K filedwith the Securities and Exchange Commission. Operating results for the threeand six months ended June 30, 2007 are not necessarily indicative of theresults that may be expected for any other interim period or for the yearending December 31, 2007. The balance sheet at December 31, 2006 has beenderived from the audited financial statements at that date but does not includeall of the information and footnotes required by United States generallyaccepted accounting principles for complete financial statements.

2. *Net Income PerShare*

Websense computes net income per share as permitted by the FinancialAccounting Standards Board (FASB) with Statement of Financial AccountingStandards (SFAS) No. 128, *Earnings Per Share*(EPS) (SFAS No. 128). Under the provisions of SFAS No. 128, basic netincome per share is computed by dividing the net income for the period by theweighted average number of common shares outstanding during the period. Dilutednet income per share is computed by dividing the net income for the period bythe weighted average number of common and common equivalent shares outstandingduring the period. Common equivalent shares consist of dilutive stock optionsand restricted stock units. Dilutive securities include both dilutive stockoptions and dilutive restricted stock units and are calculated based on theaverage share price for each fiscal period using the treasury stock method.

During the three monthsended June 30, 2007 and 2006, the difference between the weighted averageshares used in determining basic EPS versus diluted EPS related to dilutivesecurities totaled 501,000 and 782,000 shares, respectively. Potentiallydilutive securities totaling 6,342,000 and 4,369,000 shares for the threemonths ended June 30, 2007 and 2006, respectively, were excluded fromhistorical basic and diluted earnings per share because of their anti-dilutiveeffect.

During the six monthsended June 30, 2007 and 2006, the difference between the weighted averageshares used in determining basic EPS versus diluted EPS related to dilutivesecurities totaled 521,000 and 944,000 shares, respectively. Potentiallydilutive securities totaling 5,809,000 and 3,834,000 shares for the six monthsended June 30, 2007 and 2006, respectively, were excluded from historical basicand diluted earnings per share because of their anti-dilutive effect.

7

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The following is areconciliation of the numerator and denominator used in calculating basic EPSto the numerator and denominator used in calculating diluted EPS for allperiods presented:
| ** **                       | ** ** | **Net Income**                                                   | ** ** | **Shares**        | ** ** | **Per Share** | ** ** |
|----------------------------------|------------|-----------------------------------------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                       | ** ** | **(Numerator)**                                                       | ** ** | **(Denominator)** | ** ** | **Amount**         | ** ** |
| ** **                       | ** ** | **(In thousands, except per share amounts)** | ** ** |
| **For the  Three Months Ended:** | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| **June  30, 2007:**              | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| Basic EPS                        |       | $                                                                     | 2,129      |              | 45,060     |               | $          | 0.05 |   |
| Effect of options                |       | —                                                                |       | 501               |       | (0.00              | )          |
| Diluted EPS                      |       | $                                                                     | 2,129      |              | 45,561     |               | $          | 0.05 |   |
| ** **                       | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| **June  30****, 2006:**          | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| Basic EPS                        |       | $                                                                     | 8,067      |              | 47,586     |               | $          | 0.17 |   |
| Effect of options                |       | —                                                                |       | 782               |       | (0.00              | )          |
| Diluted EPS                      |       | $                                                                     | 8,067      |              | 48,368     |               | $          | 0.17 |   |
| ** **                       | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| **For the  Six Months Ended:**   | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| **June  30, 2007:**              | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| Basic EPS                        |       | $                                                                     | 5,996      |              | 44,978     |               | $          | 0.13 |   |
| Effect of options                |       | —                                                                |       | 521               | ** ** | (0.00              | )          |
| Diluted EPS                      |       | $                                                                     | 5,996      |              | 45,499     |               | $          | 0.13 |   |
| ** **                       | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| **June  30****, 2006:**          | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| Basic EPS                        |       | $                                                                     | 16,011     |              | 47,766     |               | $          | 0.34 |   |
| Effect of options                |       | —                                                                |       | 944               | ** ** | (0.01              | )          |
| Diluted EPS                      |       | $                                                                     | 16,011     |              | 48,710     |               | $          | 0.33 |   |

 

3. *Comprehensive Income*

The components ofcomprehensive income, as required to be reported by SFAS No. 130, *Reporting Comprehensive Income*, were as follows (inthousands):
|                                                                                                    | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                         | ** ** | **June 30, 2007**      | ** ** | **June 30, 2006**    | ** ** | **June 30, 2007** | ** ** | **June 30, 2006** | ** ** |
| Net income                                                                                         |       | $                                | 2,129      |                           | $          | 8,067 |   | $ | 5,996 |   | $ | 16,011 |   |
| Net change in  unrealized gain on marketable securities, net of tax                                |       | (22                              | )          | 23                             |       | 14 |   | 202 |   |
| Net change in  unrealized gain on fair market valuation of foreign currency contracts, net  of tax |       | 13                               |       | 57                             |       | 19 |   | 116 |   |
| Comprehensive income                                                                               |       | $                                | 2,120      |                           | $          | 8,147 |   | $ | 6,029 |   | $ | 16,329 |   |

 

8

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4.*Stockholders’ Equity*

**Share-Based Compensation**

*Employee Stock PurchasePlan*

Shares available forissuance under the Company’s Employee 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 six months ended June 30, 2007                                       |       | (105,321                         | )          |
| Shares reserved for issuance  at June 30, 2007                                             |       | 1,825,765                        |       |

 

The Company used the following assumptions to estimatethe fair value of the semi-annual employee stock purchase plan share grantsduring the six months ended June 30, 2007 and 2006:
|                                     | ** ** | **Six Months  Ended**  | ** ** | **Six Months  Ended**  | ** ** |
|-------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                          | ** ** | **June 30, 2007** | ** ** | **June 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 OptionPlans*

The Amended and Restated2000 Stock Incentive Plan (the 2000 Plan) provides for the grant of stockoptions to the Company’s directors, officers, employees and consultants. The2000 Plan provides for the grant of incentive and non-statutory stock options,restricted stock units and rights to purchase stock to employees, directors orconsultants of the Company. The 2000 Plan provides that incentive stock optionswill be granted only to employees and are subject to certain limitations as tofair value during a calendar year.  Todate, only non-statutory stock options and restricted stock units have beengranted under the 2000 Plan. Through June 30, 2007, the Company has granted120,000 restricted stock units. The unvested restricted stock units have aweighted average grant date fair value of $29.37 and an aggregate intrinsicvalue (the amount by which the fair value exceeds the award price) of $1.9million as of June 30, 2007.

In addition, the 2000 Plan provides for automatic annual increases inthe number of shares authorized and reserved for issuance thereunder equal tothe lesser of (i) 4% of the Company’s outstanding shares on the last businessday in December of the calendar year immediately preceding or (ii) 3,000,000shares. At June 30, 2007, a total of 21,349,542 shares have been authorized forissuance under the 2000 Plan, of which 808,308 remain available for grant.

On January 8, 2007, the Compensation Committee of Websense’sBoard of Directors adopted the Websense, Inc. 2007 Stock Incentive AssumptionPlan (the 2007 Plan).  In connection withthe acquisition of PortAuthority Technologies, Inc. (PortAuthority), theCompany agreed to substitute unvested stock options to purchase PortAuthoritycommon stock that were granted under PortAuthority’s 2004 Global Share OptionPlan (the PortAuthority Option Plan) and outstanding immediately prior to theeffective time of the acquisition with options to purchase an aggregate of74,891 shares of Websense common stock (the Substitute Options).  The Substitute Options have the samecontractual lives and vesting periods as they did under the PortAuthorityOption Plan.  The number of shares andexercise prices of the Substitute Options were determined based on the conversionratio as defined by the merger agreement with PortAuthority.

9

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The following table summarizes the Company’s stock optionactivity since December 31, 2006:
|                               | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|-------------------------------|------------|----------------------------|------------|--------------------------------------------|------------|
| Balance at  December 31, 2006 |       | 7,038,259                  |       | $                                          | 22.61      |   |
| Granted                       |       | 2,134,259                  |       | 22.58                                      |       |
| Exercised                     |       | (224,838                   | )          | 10.62                                      |       |
| Cancelled                     |       | (466,906                   | )          | 23.34                                      |       |
| Balance at June 30,  2007     |       | 8,480,774                  |       | 22.88                                      |       |
|                               |            |                            |            |                                            |            |  |

 

The results for the threeand six months ended June 30, 2007 include share-based compensation expense of$5.3 million (excluding tax effects) and $10.5 million (excluding tax effects),respectively, in the following expense categories of the consolidated statementof income (in thousands).
|                                                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                            | ** ** | **June 30,  2007**          | ** ** | **June 30,  2006**        | ** ** | **June 30,  2007** | ** ** | **June 30,  2006** | ** ** |
| Share-based  compensation in:                         |       |                             |       |                           |       |   |   |   |   |
| Cost of revenues                                      |       | $                                | 388        |                           | $          | 368 |   | $ | 717 |   | $ | 694 |   |
| Total  share-based compensation in cost of revenues   |       | 388                              |       | 368                            |       | 717 |   | 694 |   |
|                                                  |       |                             |       |                           |       |   |   |   |   |
| Selling and  marketing                                |       | 2,192                            |       | 2,054                          |       | 4,205 |   | 4,005 |   |
| Research and  development                             |       | 954                              |       | 890                            |       | 1,886 |   | 1,731 |   |
| General and  administrative                           |       | 1,780                            |       | 1,658                          |       | 3,728 |   | 3,280 |   |
| Total  share-based compensation in operating expenses |       | 4,926                            |       | 4,602                          |       | 9,819 |   | 9,016 |   |
| Total share-based  compensation                       |       | $                                | 5,314      |                           | $          | 4,970 |   | $ | 10,536 |   | $ | 9,710 |   |

 

TheCompany used the following assumptions to estimate the fair value of stockoptions granted under the 2000 plan for the three and six months endedJune 30, 2007 and 2006:
|                                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                          | ** ** | **June 30,  2007**          | ** ** | **June 30,  2006**        | ** ** | **June 30,  2007** | ** ** | **June 30,  2006** | ** ** |
| Average expected  life (years)      |       | 3.0                              |       | 3.9                            |       | 3.1 |   | 4.3 |   |
| Average expected  volatility factor |       | 34.1                             | %          | 51.1                           | %          | 35.5 | % | 55.4 | % |
| Average  risk-free interest rate    |       | 4.7                              | %          | 5.0                            | %          | 4.7 | % | 4.8 | % |
| Average expected  dividend yield    |       | —                           |       | —                         |       | — |   | — |   |

 

TheCompany used the following assumptions to estimate the fair value of theoptions granted under the 2007 Plan for the six months ended June 30, 2007:average expected life – 5.5 years; average expected volatility factor – 55.7%;average risk free interest rate – 4.7% and average expected dividend yield –zero.  No options were granted under the2007 Plan during the second quarter of 2007.

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**Treasury Stock**

As of June 30, 2007, the Company had repurchased8,170,060 shares of its common stock since April 2003 under the Board ofDirectors’ authorized stock repurchase program, for an aggregate of $170.4million at an average price of $20.86 per share.  The Company did not repurchase any shares ofits common stock during the quarter ended June 30, 2007, and does not intend torepurchase additional shares for the remainder of 2007.  Remaining shares authorized for repurchaseunder the Company’s stock repurchase program as of June 30, 2007 are asfollows:
|                                             | ** ** | **June 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, the Company acquired all of the outstanding stock of PortAuthorityTechnologies Inc. (PortAuthority), a provider of information leak preventiontechnology.  The Company acquiredPortAuthority to combine the two companies’ technologies to help customersprevent unauthorized use or disclosure of confidential data whilesimultaneously protecting users and data from external malicious threats.  The Company expects to benefit from the acquisitionby expanding its current product offerings and increasing its revenues. These are among the factors that contributed to a purchase price for thePortAuthority acquisition that resulted in the recognition of goodwill of $73.5million. PortAuthority’s operations were assumed as of the date of theacquisition and are included in the Company’s results of operations beginningon January 9, 2007 and, as a result, are not reflected in the Company’s resultsof operations for the three and six months ended June 30, 2006.

Pursuant to the termsof the agreement, signed on December 20, 2006, the Company acquired all ofPortAuthority’s outstanding capital stock, for $88.2 million in cash, fundedwith existing cash resources. The purchase price includes $5.0 million which isheld in an escrow account and will be available to satisfy any Company claimsfor indemnification from the former stockholders of PortAuthority until theescrow is released. The total purchase price, including transaction expenses ofapproximately $1.9 million, has been allocated to tangible and intangibleassets acquired based on estimated fair values, with the remainder classifiedas goodwill.

The total purchase priceof the acquisition was as follows (in thousands):
| Cash paid for PortAuthority  business |   | $     | 88,170 |   |
|---------------------------------------|--------|-------|--------|--------|
| Transaction  costs                    |   | 1,897 |   |
| Total purchase price                  |   | $     | 90,067 |   |

 

The transaction costsincurred by the Company primarily consist of fees for attorneys, financialadvisors, accountants, debt prepayment penalty and other advisors directlyrelated to the transaction.

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The total purchase pricehas been allocated as follows based on the assets and liabilities acquired asof January 8, 2007 (in thousands):
| Fair value of net tangible  assets acquired and liabilities assumed: |   |   |   |   |   |
|----------------------------------------------------------------------|--------|--------|--------|--------|--------|
| Cash and cash equivalents                                            |   | $      | 8,078  |   |   |   |
| Other assets                                                         |   | 2,676  |   |   |   |
| Other liabilities                                                    |   | (5,920 | )      |   |   |
| Long-term loan                                                       |   | (4,214 | )      |   |   |
|                                                                 |   |   |   | 620    |   |
| 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                                                             |   |   |   | 73,467 |   |
| Total purchase price                                                 |   |   |   | $      | 90,067 |   |
|                                                                      |        |        |        |        |        |  |  |

 

The $4.2 million ofPortAuthority indebtedness assumed in the transaction was repaid in the firstquarter of 2007.

The amountallocated to in-process technology represents the fair value of an acquired,to-be-completed research project. The estimated value of approximately $1.3million of the research project was determined by estimating the costs todevelop the acquired technology into a commercially viable product, estimatingthe future net cash flows from the project once commercially viable, anddiscounting the net cash flows to their present value. As of the acquisitiondate, this project was not expected to have reached technological feasibilityand will have no alternative future use. Accordingly, the amount allocated toin-process technology was charged to Websense’s statement of income for the sixmonths ended June 30, 2007.

The accompanyingconsolidated statements of income reflect the operating results of thePortAuthority business since January 8, 2007.  Assuming the acquisition ofPortAuthority had occurred on January 1, 2006, the pro forma unaudited resultsof operations would have been as follows (in thousands):
|                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **            | ** ** | **June 30,  2007**          | ** ** | **June 30,  2006**        | ** ** | **June 30,  2007** | ** ** | **June 30,  2006** | ** ** |
| Revenue               |       | $                                | 50,449     |                           | $          | 43,943 |   | $ | 100,196 |   | $ | 86,079 |   |
| Net Income            |       | 2,129                            |       | 5,542                          |       | 5,890 |   | 11,083 |   |
| Net income per share: |       |                             |       |                           |       |   |   |   |   |
| Basic                 |       | $                                | 0.05       |                           | $          | 0.12 |   | $ | 0.13 |   | $ | 0.23 |   |
| Diluted               |       | $                                | 0.05       |                           | $          | 0.11 |   | $ | 0.13 |   | $ | 0.23 |   |

 

The above proforma unaudited results of operations do not include pro forma adjustmentsrelating to costs of integration or post-integration cost reductions that maybe incurred or realized by the Company in excess of actual amounts incurred orrealized through June 30, 2007.

**Offerto Purchase Surf Control**

OnApril 26, 2007, the Company announced that it has made a pre-conditional cashoffer to acquire all of the issued and to-be-issued ordinary shares, excludingtreasury shares, of SurfControl plc, a U.K. based provider of on-demand andsoftware-based Web and email security solutions.  Under the terms of the offer, SurfControlshareholders will receive 700 pence (approximately $14) in cash for eachSurfControl share.  The offer valuesSurfControl’s existing issued share capital at approximately £201 million(approximately $403 million based upon the exchange rate at June 30, 2007).  The Company is obligated to pay the purchaseprice in British Pounds and has purchased an option contract to hedge against£244.1 million at a foreign exchange rate of $2.10 or $512.6 million. TheCompany paid a $4.6 million premium to purchase the option on April 30, 2007and wrote down the fair value of the option at June 30, 2007 by $1.1 million,which is reflected in other income, net on the consolidated statement of 

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income.  At June 30, 2007, the fair value of thepremium of $3.5 million is included within deposits and other assets on theconsolidated balance sheet.  The Companysubsequently sold the option and acquired three new option contracts to hedgeagainst a total of £244.1 million that expire on November 1, 2007.  See Subsequent Event.

Thetransaction is expected to close on or about October 3rd, 2007 and is expected to befinanced through a combination of the Company’s cash resources and the newsenior credit facility.  The offer wascleared by the United States Department of Justice and the Federal Trade Commissionon June 4, 2007 and by the U.K. Office of Fair Trading on July 6, 2007.  The offer is being effected by a scheme ofarrangement under Section 425 of the U.K. Companies Act 1985.  SurfControl made the scheme documentavailable to SurfControl shareholders on July 20, 2007.  The SurfControl shareholders must approve theScheme, at a meeting scheduled for August 16, 2007, by a majority of holders ofSurfControl shares, representing not less than three-quarters of sharesoutstanding.* *Asof June 30, 2007, the Company has incurred approximately $5.1 million oftransaction costs in connection with this offer, which are reflected on theCompany’s consolidated balance sheet in deposits and other assets, accountspayable and other accrued expenses.

**Inconnection with the SurfControl announcement, the Company entered into anagreement with Morgan Stanley Senior Funding Inc. and Bank of America, NationalAssociation, for a $300 million senior credit facility.  The senior facility will consist of up to a$285 million six-year term loan and a $15 million revolving creditfacility.  The Company currentlyexpects  to borrow approximately $180million to $200 million from the available senior credit facility at theclosing of the acquisition.  The seniorcredit facility is only available for funding the acquisition and relatedtransaction costs.  At funding, thesenior credit facility will be secured by substantially all of the Company’sassets, including pledges of the Company’s first tier subsidiaries’ stock(except for limits on the stock pledges of foreign subsidiaries) and will beguaranteed by the Company’s domestic subsidiaries.  Loans made under the term loan amortize at1.0% per year for years one through five, with the remaining 95% due in thesixth year of the agreement.  The Companyis required to use 50% of excess cash flow for fiscal year 2007 and then 25%after fiscal year 2007, as defined in the senior credit agreement, to makemandatory prepayments of principal, which are not subject to any prepayment penalties.  The Company will have the option to borrow atprime rate or at a Eurodollar base rate plus, in each case, an applicablemargin based on the Company’s corporate credit rating at the time offunding.  The senior credit facilitycontains financial covenants, as defined per the senior credit agreement,comprised of a consolidated leverage ratio and a consolidated interest coverageratio.  The senior credit agreement alsocontains affirmative and negative covenants. In addition, the Company has entered into an interim credit facilitywith the same lenders that is collateralized by approximately $217 million ofthe Company’s cash, cash equivalents and marketable securities that aredeposited in restricted accounts and not available to the Company for any otheruses while the acquisition of SurfControl is pending.  The Company expects to use the restrictedfunds to pay for a portion of the purchase price of SurfControl.  The interim credit facility was entered intoas part of a funds certain process for cash acquisitions of UK public companiesthat are subject to the City Code.  Underthe City Code, Morgan Stanley as financial adviser has indicated that it issatisfied that sufficient financial resources will be made available to theCompany to satisfy the maximum cash consideration that would be payable underthe terms of the offer.  The Company doesnot expect to borrow any amounts under the interim credit agreement.  Morgan Stanley Senior Funding, Inc. and Bankof America expect to syndicate the senior credit facility after the closing ofthe SurfControl acquisition.  It ispossible that the Company will be required to amend the senior credit facilityto enable the syndication of the facility as required under the market flexprovisions of the senior credit facility.**

6. *Goodwill and  Intangible Assets*

As of June 30,2007, the Company’s goodwill balance of $73.5 million solely relates to theCompany’s acquisition of PortAuthority on January 8, 2007.  The Company did not have any goodwill orintangible assets at June 30, 2006.

The Companyrecords goodwill when the purchase price of net tangible and intangible assetsacquired exceeds 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 impairment.

The Companyreviews for impairment by 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. TheCompany measures fair value under SFAS No. 144, which is generally based on thepresent value of estimated future cash flows. The Company’s 

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analysis is based onavailable information and on assumptions and projections it considers to bereasonable and supportable. The discounted cash flow analysis considers thelikelihood of possible outcomes and is based on the Company’s best estimate ofprojected future cash flows. If necessary, the Company performs subsequentcalculations to measure the amount of the impairment loss based on the excessof the carrying value over the fair value of the impaired assets.

Intangible assets,subject to amortization, were as follows as of June 30, 2007 (in thousands):
|                         | ** ** | **Weighted  Average Life  (years)** | ** ** | **Cost** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|-------------------------|------------|------------------------------------------|------------|----------|------------|-------------------------------|------------|---------|------------|
|                    |       |                                     |       |     |       |                          |       |    |       |
| Technology              |       | 5.7                                      |       | $        | 13,900     |                          | $          | (1,392  | )          | $ | 12,508 |   |
| Non-compete  agreements |       | 1                                        |       | 800      |       | (400                          | )          | 400     |       |
| Customer  relationships |       | 7                                        |       | 700      |       | (50                           | )          | 650     |       |
| Trade name              |       | 5                                        |       | 510      |       | (51                           | )          | 459     |       |
| Total                   |       |                                     |       | $        | 15,910     |                          | $          | (1,893  | )          | $ | 14,017 |   |

 

Remainingamortization expense, as of June 30, 2007, is expected to be as follows (inthousands):
| Years Ending December 31: | ** ** | ** ** | ** ** |
|------------------------------------------|------------|------------|------------|
| 2007 (July to  December)                 |       | $          | 1,759      |   |
| 2008                                     |       | 2,719      |       |
| 2009                                     |       | 2,585      |       |
| 2010                                     |       | 2,319      |       |
| 2011                                     |       | 2,319      |       |
| Thereafter                               |       | 2,316      |       |
| Total expected  amortization expense     |       | $          | 14,017     |   |

 

7.*Foreign Currency Hedges*

TheCompany uses derivatives to manage foreign currency risk and not forspeculative or trading purposes. The Company’s objective is to reduce the riskto earnings and cash flows associated with changes in foreign currency exchangerates. Gains and losses resulting from changes in the fair values of thosederivative instruments will be recorded to earnings or other comprehensiveincome depending on the use of the derivative instrument and whether itqualifies for hedge accounting.

During the three and six months ended June 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 $64,000 and $84,000 for the three months ended June 30, 2007,and 2006, respectively and $148,000 and $131,000 for the six months ended June 30, 2007 and 2006, respectively.

During the three and six months ended June 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 losses related to the contracts designated as cash flow hedges settled during the six months ended June 30, 2007 and 2006 are included in the respective operating categories the Company hedges its British Pound expenditures against. These net realized gains (losses) amounted to approximately $9,000 and $70,000 for the three months ended June 30, 2007 and 2006, respectively and ($14,000) and $50,000 for the six months ended June 30, 2007 and 2006, respectively.

Duringthe three and six months ended June 30, 2007, the Company utilized a £244.1million option contract with a strike price of $2.10 or $512.6 million to hedgethe anticipated purchase price for SurfControl. This contract doesnot qualify for hedge accounting as it relates to a forecasted businesscombination.  The Company paid a$4.6 million premium to 

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purchase the optionon April 30, 2007 and wrote down the fair value of the option at June 30, 2007by $1.1 million, which is reflected in other income, net on the consolidatedstatement of income.  At June 30, 2007,the fair value of the option of $3.5 million is included within deposits andother assets on the consolidated balance sheet. The Company subsequently sold this option and acquired three new optioncontracts expiring on November 1, 2007. See Subsequent Event.

Notional and fair values of the Company’s Euro and British Pound hedging positions at June 30, 2007 and 2006 are presented in the table below (in thousands):
|               | ** ** | **June 30, 2007**          | ** ** | **June 30, 2006** | ** ** |
|---------------|------------|--------------------------------------|------------|-----------------------------|------------|
| ** **    | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value**         | ** ** | **Fair Value** | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value** | ** ** | **Fair Value** | ** ** |
| ** **    | ** ** | ** **                           | ** ** | **USD**                     | ** ** | **USD** | ** ** | ** ** | ** ** | **USD** | ** ** | **USD** | ** ** |
| Euro          |       | €                               | 2,000      |                        | $          | 2,660 |   | $ | 2,610 |   | € | 785 |   | $ | 1,004 |   | $ | 1,003 |   |
| British Pound |       | £                               | 950        |                        | 1,886      |   | 1,900 |   | £ | 900 |   | 1,581 |   | 1,626 |   |
| Total         |       |                                 |       | $                           | 4,546      |   | $ | 4,510 |   |   |   | $ | 2,585 |   | $ | 2,629 |   |

 

Euroforward contracts at June 30, 2007 and 2006 were designated as fair valuehedges and were not required to be tested for effectiveness as hedge accountingwas not selected. All Euro contracts will be settled before September 30, 2007.Realized gains or losses related to the settlements, if any, will be recordedin other income, net at the time of settlement.

BritishPound zero-cost collar contracts were designated as cash flow hedges and weredetermined effective as of June 30, 2007 and 2006. All British Pound contractswill be settled before July 31, 2007. Realized gains and losses related to thesettlements, if any, will be recorded in the respective operating categoriesthe Company hedges its British Pound expenditures against.

8. *Tax Matters*

The Company adopted FASBInterpretation 48, *Accounting forUncertainty in Income Taxes* (FIN 48), at the beginning of fiscalyear 2007. As a result of the implementation the Company recognized a $1.2million increase to reserves for uncertain tax positions. This increase wasaccounted for as an adjustment to the January 1, 2007 balance of additionalpaid in capital and retained earnings on the consolidated balance sheet.Including the cumulative effect increase, at the beginning of 2007, the Companyhad approximately $9.2 million of total gross unrecognized tax benefits. Ofthis total, $5.8 million (net of federal, state and foreign tax benefits)represents the amount of unrecognized tax benefits that, if recognized, woulddecrease the effective income tax rate in future periods. In addition, consistentwith the provisions of FIN 48, the Company determines the classification ofuncertain tax liabilities as current or non-current based on anticipatedpayment date. Accordingly, the Company has reflected $10.2 million asnon-current income taxes payable as of June 30, 2007.

Estimated interest andpenalties related to the underpayment of income taxes are classified as acomponent of provision for income taxes in the consolidated statements ofincome and totaled $49,000 during the three months ended June 30, 2007 and$100,000 during the six months ended June 30, 2007. Accrued interest andpenalties were $434,000 as of January 1, 2007.

TheCompany and its subsidiaries are subject to U.S. federal income tax as well asincome tax of multiple state and foreign jurisdictions. The Company hassubstantially concluded all U.S. federal and state income tax audits for yearsthrough 2002. Substantially all material foreign income tax audits have beenconcluded for years through 2002. California income tax returns for 2003 and2004 are currently under examination. The Company does not anticipate thattotal unrecognized tax benefits will significantly change due to the settlementof audits and the expiration of statute of limitations prior to June 30, 2008.  At June 30, 2007, the Company had deferredtax assets of $38.3 million.

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TheCompany has requested a ruling regarding unrecognized state income taxbenefits. It is reasonably possible within 12 months of June 30, 2007 that theuncertain tax position established for the 2006 tax year could be decided inthe Company’s favor resulting in the reduction of the gross uncertain taxliability in an amount up to $1.7 million.

*9.Litigation*

OnSeptember 29, 2006, Jason Tauber filed a putative class action against theCompany and other unidentified individuals in California Superior Court for theCounty of San Diego, captioned Tauber v. Websense. The complaint alleges thatthe plaintiff and a putative class of certain software engineers and computerprofessionals who worked for the Company as exempt employees during the periodfrom September 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 executed a stipulation of settlement tosettle all claims made in the putative class action.  The stipulation of settlement is stillsubject to court approval.  During thesecond quarter of 2007, the Company included $3.2 million, including $0.2million of payroll tax, as a reserve within other accrued expenses on theconsolidated balance sheet, and the Company charged $3.2 million of the pendingsettlement amount between the operating expense categories and cost of revenueon the consolidated statement of income for the quarter, apportioned based uponthe Company’s estimate of amounts payable to eligible individuals in thesettlement.

TheCompany is involved in various legal actions in the normal course of business.Based on current information, including consultation with the Company’slawyers, the Company believes that it has adequately reserved for any ultimateliability that may result from these actions such that any liability would notmaterially affect the Company’s consolidated financial positions, results ofoperation or cash flows. The Company’s evaluation of the likely impact of theseactions could change in the future and unfavorable outcomes and/or defensecosts, depending upon the amount and timing, could have a material adverseeffect on the Company’s results of operations or cash flows in a future period.

10. *Recently Issued Accounting Standards*

In February 2007, the FASB issued SFASNo. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities—Including an Amendment of FASBStatement No. 115 (SFAS No. 159).* This standard permits anentity to choose to measure many financial instruments and certain other itemsat fair value. Most of the provisions in SFAS No. 159 are elective;however, the amendment to SFAS No. 115, *Accountingfor Certain Investments in Debt and Equity Securities,* applies toall entities with available-for-sale and trading securities. The fair valueoption established by SFAS No. 159 permits all entities to choose tomeasure eligible items at fair value at specified election dates. A businessentity will report unrealized gains and losses on items for which the fairvalue option has been elected in earnings at each subsequent reporting date.The fair value option: (a) may be applied instrument by instrument, with afew exceptions, 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 Event*

On July 31, 2007, the Company sold its rights to the £244.1million option contract for $5.1 million, recording a realized gain ofapproximately $0.5 million. Simultaneous to this sale, the Company paid a totalpremium of approximately $1.2 million for three option contracts, all with anexpiration of November 1, 2007, totaling £244.1 million with a weighted averagestrike price of $2.109. This subsequent event did not impact the write-down ofthe fair value of the option contract that occurred during the second quarterof 2007.

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**Item 2. Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

**Thefollowing discussion and analysis should be read in conjunction with thefinancial statements and related notes contained elsewhere in this report. See “RiskFactors” under Part II, Item 1A below regarding certain factors known to usthat could cause reported financial information not to be necessarilyindicative of future results.**

**Forward Looking Statements**

**Thisreport on Form 10-Q may contain “forward-looking statements” within the meaningof the federal securities laws made pursuant to the safe harbor provisions ofthe Private Securities Litigation Reform Act of 1995. These statements, whichrepresent our expectations or beliefs concerning various future events, maycontain words such as “may,” “will,” “expects,” “anticipates,” “intends,” “plans,”“believes,” “estimates,” or other words indicating future results. Suchstatements may include but are not limited to statements concerning thefollowing:**

·                  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

·                  anticipatedproduct enhancements or releases.

**Theseforward-looking statements are subject to risks and uncertainties, includingthose risks and uncertainties described herein under Part II, Item 1A “RiskFactors,” that could cause actual results to differ materially from thoseanticipated as of the date of this report. We assume no obligation to updateany forward-looking statements to reflect events or circumstances arising afterthe date of this report.**

**Overview**

Our products help organizations manage their networksand computing resources to provide a secure and productive computingenvironment. We provide Web filtering and Web security software products thatenable organizations to protect employees and confidential information fromexternal Web-based attacks such as spyware, and phishing, as well as analyze,report and manage how employees use computing resources and the Internet. InJanuary 2007, we acquired our technology development partner forinformation leak prevention solutions, PortAuthority Technologies Inc.(PortAuthority). As a result, in addition to our Web filtering and Web securitysoftware products, we offer information leak prevention software that helpsprevent the loss of confidential information from internal threats, such asineffective business process controls, employee error and malfeasance.

At the foundation of our Web filtering and Websecurity product offering is the Websense Enterprise® software application,which serves as a central policy engine and management and reporting platformfor our Web filtering and related add-on Web security products. WebsenseEnterprise gives organizations the ability to enhance network security, improveemployee productivity, mitigate potential legal liability and conserve networkbandwidth by allowing organizations to identify potential risk areas andimplement and automate Web access and application usage policies that reducethese risks. When combined with our Web security products that utilize ourThreatSeekerTM technology including Security Filtering, Remote Filtering andClient Policy ManagerTM, Websense Enterprise allows organizations to enhancenetwork and content security by blocking access to malicious Web sites andpreventing the transmission of data to known spyware destination sites. Tosimplify the purchase process for our value-added resellers and customers, wehave included Websense Enterprise and our most popular add-on security productsand services, within Websense® Web Security SuiteTM. In July 2007, we launchedWebsense® Express to provide similar Web filtering and Web securityfunctionality targeted for small and mid-sized organizations of under 1,000users (SMB). We currently derive a significant percentage of our revenue fromsubscriptions to our Web filtering and Web security solutions and expect thisto continue in the future.

The Websense Content Protection Suite is an integratedinformation leak prevention solution that protects organizations frominformation leaks and data loss by discovering the location of sensitive datainside the network, monitoring the data as it attempts to travel inside oroutside the organization, and  protectingthe data, with policy-based controls that align to business 

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processes.  TheContent Protection Suite provides protection for data at rest, data in use, anddata in motion, and is available with two modules: the Content Auditor and theContent Enforcer.  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 information leakprevention products and other products under development will comprise only avery small portion of our overall sales in 2007.

We also have been developing Web content filtering andsecurity solutions to protect Internet users from receiving and accessingunwanted or illegal content on their mobile phones and personal digitalassistants (PDAs). We have engaged in discussions regarding mobile filteringsolutions with several third parties, and we expect a market for our solutionsto develop once the wireless carriers determine that there is a sufficientmarket need for security protection on wireless mobile devices.  We cannot predict with certainty when we willbegin to generate revenue from this business.

During the six months ended June 30, 2007, we derivedapproximately 40% of revenue from international sales, compared with 36% forthe six months ended June 30, 2006, with the United Kingdom comprisingapproximately 10% of our total revenue in both periods. We believeinternational markets continue to represent a significant growth opportunityand we are continuing to expand our international operations, particularly inselected countries in the European, Asia/Pacific and Latin American markets.

We sell our products through both indirect channelsand directly. Sales through indirect channels currently account for more than90% of our revenue, and we plan to increase the percentage of our revenueobtained through indirect channels. Our strategy is to increase new and renewalcustomer sales through independent software distributors and resellers andincrease the focus of our internal sales and marketing force on supporting ourchannel strategy. In August 2006, we announced a new two-tier distributionstrategy in North America and entered into a relationship with Ingram Micro todistribute, market and support our Web security and Web filtering software inNorth America. Through joint marketing programs with Websense, Ingram Microwill focus its efforts on recruiting new resellers, especially resellersfocused on selling to SMBs, and on building awareness and demand within ourexisting North America channel partner base. We also plan to increase sales to SMB customers through our new WebsenseExpress software which is targeted for organizations with under 1,000 users.

On April 26, 2007, we announced that we are acquiringSurfControl plc (a London stock exchange listed company) through apre-conditional cash offer to acquire all of the ordinary shares of SurfControlfor 700 pence per share (or an aggregate of approximately $403 million basedupon the exchange rate at June 30, 2007) through a scheme of arrangement.  SurfControl has substantial internationaloperations, including in the United Kingdom, Australia, China and Israel and weexpect the acquisition to accelerate our growth. The transaction is expected toclose on or about October 3, 2007.

**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 

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**re-subscribe typically must do soat the then current rates to continue using our products. Our revenue issignificantly influenced by new and renewal subscriptions, and a decrease insubscription amounts could negatively impact our future revenue.**

We record channel marketing payments and channelrebates as an offset to revenue. We recognize channel marketing payments as anoffset to revenue as the marketing service is provided. We recognize channelrebates as an offset to revenue on a straight-line basis over the term of thesubscription 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,” we review goodwill that has anindefinite useful life for impairment at least annually in our fourth fiscalquarter, or more frequently if an event occurs indicating the potential forimpairment. Intangible assets are carried at cost, less accumulatedamortization. We amortize the cost of identified intangible assets on astraight-line basis over their expected economic lives. In accordance with SFASNo. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” wereview intangible assets that have finite useful lives when an event occursindicating the potential 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 projectedfuture cash flows. If necessary, we perform subsequent calculations to measurethe amount of the impairment loss based on the excess of the carrying valueover the fair value of the impaired assets.**

*Share-BasedCompensation.***OnJanuary 1, 2006, we adopted the provisions of Statement No. 123R and SAB No.107 requiring the measurement and recognition of all share-based compensationunder the fair value method.  Share-basedcompensation expense related to stock options is recorded based on the fairvalue of the award on its grant date which we estimate using the Black-Scholesvaluation model based on the provisions prescribed under Statement No. 123R andSAB No. 107.  Share-based compensationexpense related to restricted stock unit awards is calculated based on themarket price of our common 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 June 30, 2007, we had deferred tax assets of $38.3 million. We believe thatit 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 andUncertain Tax Positions.*   Significant judgment isrequired in determining our consolidated income tax provision and evaluatingour U.S. and foreign tax positions. In July 2006, the FASB issuedInterpretation 48, *Accounting forUncertainty in Income Taxes* (FIN 48), which became effective for usbeginning in 2007. FIN 48 addressed the determination of how tax benefitsclaimed or expected to be claimed on a tax return should be recorded in thefinancial statements. Under FIN 48, we must recognize the tax benefit from anuncertain tax position only if it is more likely than not that the tax positionwill be sustained on examination by the taxing authorities, based on thetechnical merits of the position. The tax benefits recognized in the financialstatements from such a position are measured based on the largest benefit thathas a greater than fifty percent likelihood of being realized upon ultimateresolution. 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.

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# **Results of Operations**

***Three months ended June 30, 2007 comparedwith the three months ended June 30, 2006***

The following table summarizes our operating resultsas a percentage of total revenue for each of the periods shown.
|                                     | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|
| ** **                          | ** ** | **June 30, 2007**      | ** ** | **June 30, 2006** | ** ** |
| ** **                          | ** ** | **(Unaudited)**                  | ** ** |
| ** **                          | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Revenue                             |       | 100                              | %          | 100 | % |
|                                |       |                             |       |   |   |
| Cost of revenues:                   |       |                             |       |   |   |
| Cost of revenues                    |       | 10                               |       | 8 |   |
| Amortization of acquired technology |       | 1                                |       | — |   |
| Total cost of revenues              |       | 11                               |       | 8 |   |
|                                |       |                             |       |   |   |
| Gross margin                        |       | 89                               |       | 92 |   |
|                                |       |                             |       |   |   |
| Operating  expenses:                |       |                             |       |   |   |
| Selling and marketing               |       | 50                               |       | 43 |   |
| Research and development            |       | 20                               |       | 13 |   |
| General and administrative          |       | 13                               |       | 12 |   |
| Total operating expenses            |       | 83                               |       | 68 |   |
|                                |       |                             |       |   |   |
| Income from  operations             |       | 6                                |       | 24 |   |
|                                |       |                             |       |   |   |
| Other income,  net                  |       | 3                                |       | 6 |   |
|                                |       |                             |       |   |   |
| Income before  income taxes         |       | 9                                |       | 30 |   |
|                                |       |                             |       |   |   |
| Provision for  income taxes         |       | 5                                |       | 11 |   |
|                                |       |                             |       |   |   |
| Net income                          |       | 4                                | %          | 19 | % |

 

# **Revenue**

Revenueincreased to $50.4 million in the second quarter of 2007 from $43.7 million inthe second quarter of 2006. The increase was primarily a result of the additionof new, renewed and upgraded subscriptions from our customers that resulted ina 1.7 million increase in the number of seats under subscription from 24.1million at June 30, 2006 to 25.8 million at June 30, 2007. As a percentage ofsubscription revenue, new business increased to 37% in the second quarter of2007 from 35% in the second quarter of 2006. We expect revenue to increase inthe future as a result of our deferred revenue under existing subscriptions,our renewal business, our recently-acquired information leak preventionbusiness, expected growth in SMB business and expected growth in internationalsales, partially offset by increased channel marketing payments and channelrebates which are recorded as reductions to revenue.

# **Cost of Revenues**

*Cost of revenues.* Cost ofrevenues consist of the costs of content review, technical support andinfrastructure costs associated with maintaining our databases. Cost ofrevenues increased to $4.8 million in the second quarter of 2007 from $3.7million in the second quarter of 2006. The increase of $1.1 million wasprimarily due to additional personnel in our technical support group andallocated costs. We allocate the total costs for human resources, employeebenefits, payroll taxes, information technology, facilities, fixed assetdepreciation and legal costs to each of our functional areas based on salariesand headcount data. As a percentage of revenue, cost of revenues increased to10% from 8% during the second quarters of 2007 and 2006.  We expect cost of revenues to increase in thefuture to maintain the technical support needs of our growing customer base.

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*Amortization of acquired technology.*Amortization of acquired technology primarily relates to the developedtechnology acquired from the PortAuthority acquisition in January 2007.  The acquired technology is being amortized ona straight-line basis over its estimated weighted average economic life of 5.7years.

# **Gross Margin**

Gross margin increased to $45.0 million in the secondquarter of 2007 from $40.0 million in the second quarter of 2006. The increasewas primarily due to increased revenue. As a percentage of revenue, grossmargin decreased to 89% in the second quarter of 2007 from 92% in the secondquarter of 2006 due to the increased costs as described in the Costs ofRevenues section above.

# **Operating Expenses**

*Selling and marketing*.Selling and marketing expenses consist primarily of salaries, commissions andbenefits related to personnel engaged in selling, marketing and customersupport functions, including costs related to public relations, advertising,promotions and travel as well as allocated costs. Selling and marketingexpenses do not include payments to channel partners for marketing services andrebates.  Selling and marketing expensesincreased to $25.1 million, or 50% of revenue, in the second quarter of 2007,from $18.9 million, or 43% of revenue, in the second quarter of 2006. Theincrease in selling and marketing expenses of $6.2 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. We expect selling andmarketing expenses to increase in absolute dollars in the future as morepersonnel are added to support our expanding selling and marketing effortsworldwide, including for our recently acquired information leak preventionproducts from PortAuthority, and as increased sales result in higher overallsales commission expenses.

*Researchand development.* Researchand development expenses consist primarily of salaries and benefits forsoftware developers and allocated costs. Research and development expensesincreased to $10.3 million, or 20% of revenue, in the second quarter of 2007from $5.5 million, or 13% of revenue, in the second quarter of 2006. Theincrease of $4.8 million in research and development expenses was primarily dueto the litigation settlement expense for the putative class action entitledTauber vs. Websense, increased personnel, including new personnel added fromthe PortAuthority acquisition in January 2007, needed to support our expandinglist of technology partners, the enhancements of Websense Enterprise, thedevelopment of Websense Express and enhancements to our new information leakprevention products and allocated costs. We expect research and developmentexpenses to increase in absolute dollars in the future as more personnel areadded to support our continued enhancements of our existing products and newproducts.

*General and administrative*.General and administrative expenses consist primarily of salaries, benefits andrelated expenses for our executive, finance, administrative personnel, thirdparty professional service fees, and allocated costs. General andadministrative expenses increased to $6.6 million, or 13% of revenue, in thesecond quarter of 2007 from $5.2 million, or 12% of revenue, in the secondquarter of 2006. The $1.4 million increase in general and administrativeexpense was primarily due to additional personnel needed to support our growingoperations, including the acquisition of PortAuthority in January 2007, andallocated costs. We expect general and administrative expenses to increase inabsolute dollars in the future periods due to our growth in operations andexpansion of our international operations.

# **Other Income, Net**

Other income, net decreased to $1.5 million in thesecond quarter of 2007 from $2.8 million in the second quarter of 2006. Thedecrease was primarily due to the mark to market write-down of $1.1 million forthe foreign exchange option contract purchased to hedge against the SurfControlacquisition purchase price in British Pounds and lower cash, cash equivalentsand marketable securities balances during the second quarter of 2007 comparedto the second quarter of 2006, principally related to the acquisition ofPortAuthority for approximately $90 million in January 2007, partially offsetby higher interest rates during the second quarter of 2007 compared to thesecond quarter of 2006. The majority of our investments of cash and cashequivalents and marketable securities are tax-exempt.

In connection with our recently announced acquisitionof SurfControl, we entered into two new credit facilities with Morgan StanleySenior Funding and Bank of America, NA, including a $207 million interim creditfacility that was required 

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to beentered into in order to satisfy the funds certain requirement for cashtakeovers of UK public companies.  Theinterim credit facility is collateralized with approximately $217 million ofour cash equivalents and marketable securities in restricted accounts, and weexpect to use these restricted funds to fund a portion of the purchase price ofSurfControl.  We will continue to earnincome on the restricted funds until the closing of the SurfControlacquisition, which is expected in October 2007. We expect that the majority of our cash, cash equivalents and marketablesecurities, including cash we continue to generate through operations, willcontinue to be held in tax-exempt investments during the foreseeable future.

# **Provision for Income Taxes**

In the second quarter of 2007, United States andforeign income tax expense was $2.3 million, compared to $5.1 million for thesecond quarter of 2006.  The effectiveincome tax rate increased to 52% in the second quarter of 2007 from 39% in thesecond quarter of 2006. The increase in the tax rate is primarily related tothe treatment of the unrealized loss on the foreign currency option purchasedfor the anticipated SurfControl acquisition, less tax exempt interest income,higher foreign taxes and higher effective state income tax rates. Our effectivetax rate may change in future periods due to the composition of taxable incomebetween domestic and international operations along with potential changes orinterpretations in tax rules and legislation, or corresponding accountingrules.

***Six months ended June 30, 2007 compared with the six monthsended June 30, 2006***

Thefollowing table summarizes our operating results as a percentage of totalrevenue for each of the periods shown.
|                                                   | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------|------------|--------------------------------|------------|
| ** **                                        | ** ** | **June 30, 2007**    | ** ** | **June 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                             |       | 43 |   |
| Research and  development                         |       | 17                             |       | 13 |   |
| General and  administrative                       |       | 14                             |       | 12 |   |
| Write off of  in-process research and development |       | 1                              |       | — |   |
| Total operating  expenses                         |       | 82                             |       | 68 |   |
|                                              |       |                           |       |   |   |
| Income from operations                            |       | 8                              |       | 24 |   |
|                                              |       |                           |       |   |   |
| Other income, net                                 |       | 3                              |       | 6 |   |
|                                              |       |                           |       |   |   |
| Income before income  taxes                       |       | 11                             |       | 30 |   |
|                                              |       |                           |       |   |   |
| Provision for income  taxes                       |       | 5                              |       | 11 |   |
|                                              |       |                           |       |   |   |
| Net income                                        |       | 6                              | %          | 19 | % |

 

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# **Revenue**

Revenueincreased to $100.2 million in the first six months of 2007 from $85.7 millionin the first six months of 2006. The increase was primarily due to the additionof new, renewed and upgraded subscriptions from our customers that resulted ina 1.7 million increase in the number of seats under subscription from 24.1million at June 30, 2006 to 25.8 million at June 30, 2007. As a percentage ofsubscription revenue, new business increased to 38% in the first six months of2007 from 34% in the first six months of 2006.

# **Cost of Revenue**

# *Costof revenues.* Cost ofrevenue increased to $8.8 million in the first six months of 2007 from $7.1million in the first six months of 2006. The increase of $1.7 million wasprimarily due to additional personnel in our technical support group andallocated costs. We allocate the total costs for human resources, employeebenefits, payroll taxes, 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 six months of 2007 from 8% in 2006.

*Amortization of acquired technology.*Amortization of acquired technology primarily relates to the developedtechnology acquired from the PortAuthority acquisition in January 2007.  The acquired technology is being amortized ona straight-line basis over its estimated weighted average economic life of 5.7 years.

# **Gross Margin**

# Gross margin increased to $90.1 million in the first six months of 2007from $78.7 million in the first six months of 2006. The increase was primarilydue to increased revenue. As a percentage of revenue, gross margin decreased to90% in the first six months of 2007 from 92% in the first six months of 2006 dueto the increased costs as described in the Costs of Revenue section above.

# **Operating Expenses**

*Sellingand marketing*.Selling and marketing expenses increased to $50.0 million in the first sixmonths of 2007 from $36.9 million in the first six months of 2006. The increasein selling and marketing expenses of $13.1 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. We expect selling andmarketing expenses to increase in absolute dollars in the future as morepersonnel are added to support our expanding selling and marketing effortsworldwide, including for our recently acquired information leak preventionproducts from PortAuthority, and as increased sales result in higher overallsales commission expenses.

*Researchand development.* Researchand development expenses increased to $17.5 million in the first six months of2007 from $11.0 million in the first six months of 2006. The increase of $6.5million in research and development expenses was primarily due to thelitigation settlement expense for the putative class action entitled Tauber vs.Websense, increased personnel, including new personnel added from thePortAuthority acquisition in January 2007, needed to support our expanding listof technology partners, the enhancements of Websense Enterprise and WebsenseExpress and enhancements to our new information leak prevention products andallocated costs.

*General and administrative*.General and administrative expenses increased to $13.8 million in the first sixmonths of 2007 from $10.4 million in the first six months of 2006. The $3.4million increase in general and administrative expense was primarily due toadditional personnel needed to support our growing operations, including theacquisition of PortAuthority in January 2007, and allocated costs. We expectgeneral and administrative expenses to increase in absolute dollars in thefuture periods due to our growth in operations and expansion of ourinternational operations.

*Write off of in-process research and development.*Write off of in-process research and development**representsthe fair value of an acquired, to be completed research project obtained fromthe PortAuthority acquisition that had not reached technological feasibility atthe acquisition date 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 six months of 2007.

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# **Other Income, Net**

# Other income, net decreased to $3.9 million in the first six months of2007 from $5.5 million in the first six months of 2006. The decrease wasprimarily due to the mark to market write-down of $1.1 million for theforeign exchange option contract purchased to hedge against the SurfControlacquisition purchase price in British Pounds and lower cash, cash equivalentsand marketable securities balances during the first six months of 2007 comparedto the first six months of 2006, principally related to the acquisition ofPortAuthority for approximately $90 million in January 2007, partially offsetby higher interest rates during the first six months of 2007 compared to thefirst six months of 2006.

# **Provision for Income Taxes**

In the first six months of 2007, United States and foreign income taxexpense decreased to $5.5 million compared to $9.8 million in 2006. Theeffective income tax rate increased to 48% in the first six months of 2007 from38% in the first six months of 2006. The increase in the tax rate was primarilydriven by the write off of non deductible in process research and development acquiredin the PortAuthority acquisition, the tax treatment of the unrealizedloss on the foreign currency option contract purchased for the anticipatedSurfControl acquisition, less taxexempt interest income, higher foreign taxes, and higher effective state incometax rate.

**Liquidity and Capital Resources**

As of June 30, 2007, we had restricted andnon-restricted cash and cash equivalents of $29.8 million, restricted andnon-restricted investments in marketable securities of $232.1 million andretained earnings of $88.4 million. As of December 31, 2006, we had cash andcash equivalents of $83.5 million, investments in marketable securities of$243.4 million and retained earnings of $82.7 million.  Cash, cash equivalents and marketablesecurities became restricted in the second quarter of 2007 pursuant to theterms of the new credit facilities described below.

**Net cashprovided by operating activities was $23.8 million in the first six months of2007 compared with $42.1 million in the first six months of 2006. The $18.3million decrease in cash provided by operating activities was primarily due todecreased net income of $10.0 million, decreased growth in deferred revenue asa result of higher growth in recognized revenue than growth in subscriptionamounts compared to the first six months of 2006 and a $4.1 million decrease inthe change in accounts receivable between the two six month periods. Ouroperating cash flow is significantly influenced by subscription renewals and accountsreceivable collections, and deferred revenue. A future decrease in subscription renewals or accounts receivablecollections, or a lower deferred revenue balance, would negatively impact ouroperating cash flow.**

Net cash used in investing activities was $79.8million in the first six****months of 2007 compared with netcash used in investing activities of $61.1 million in the first six****monthsof 2006. The $18.7 million increase of net cash used in investing activitieswas primarily due to cash used of $82.0 million to purchase PortAuthority inJanuary 2007 and cash used of $4.6 million to purchase an option contract tohedge against the British Pound purchase price for the SurfControl acquisition,partially offset by the change in cash provided of $72.5 million by the net ofpurchases and maturities of marketable securities.

Net cash provided by financing activities was $1.1 millionin the first six****months of 2007 compared with netcash used in financing activities of $22.1 million in the first six****monthsof 2006. The $23.0 million increase of net cash provided by financingactivities was primarily due to no share repurchases in the first six months of2007 compared with 1,300,000 shares repurchased for $33.1 million in the firstsix months of 2006, partially offset by the repayment of the PortAuthority loanand reduced proceeds from the exercise of stock options compared with the firstsix months of 2006.

Wehave operating lease and software license commitments of approximately $17.4million as of June 30, 2007. A majority of our operating lease commitments arerelated to our corporate headquarters lease, which extends throughDecember 2013.  Our corporateheadquarters lease includes escalating rent payments from 2007 to 2013. Therent expense related to our worldwide office space leases are recorded monthlyon a straight-line basis in accordance with generally accepted accountingprinciples. Future minimum annual payments under non-cancelable operatingleases and software license agreements at June 30, 2007 are as follows (inthousands):

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| Years Ending December 31: | ** ** | **Operating  Leases** | ** ** | **Software  License** | ** ** | **Total** | ** ** |
|------------------------------------------|------------|-----------------------|------------|-----------------------|------------|-----------|------------|
| 2007                                     |       | $                     | 2,497      |                  | $          | —    |       | $ | 2,497 |   |
| 2008                                     |       | 2,409                 |       | 307                   |       | 2,716     |       |
| 2009                                     |       | 2,209                 |       | 307                   |       | 2,516     |       |
| 2010                                     |       | 2,285                 |       | —                |       | 2,285     |       |
| 2011                                     |       | 2,361                 |       | —                |       | 2,361     |       |
| 2012                                     |       | 2,450                 |       | —                |       | 2,450     |       |
| 2013                                     |       | 2,539                 |       | —                |       | 2,539     |       |
|                                     |       | $                     | 16,750     |                  | $          | 614       |       | $ | 17,364 |   |

 

Asof June 30, 2007 and 2006, we did not have any relationships withunconsolidated entities or financial partners, such as entities often referredto as structured finance or special purpose entities, which would have beenestablished for the purpose of facilitating off-balance sheet arrangements orother contractually narrow or limited purposes. As such, we are not exposed toany financing, liquidity, market or credit risk that could arise if we hadengaged in such relationships.

On April 3, 2003, we announced that our Board ofDirectors authorized a stock repurchase program of up to 4 million shares ofour common stock.  On August 15, 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. On July 25, 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 prevailingmarket prices 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 June 30, 2007,we had repurchased 8,170,060 shares of our common stock under this program, foran aggregate of $170.4 million at an average price of $20.86 per share. Underthe terms of our new senior credit facility, we are restricted fromrepurchasing our stock for a purchase price that exceeds 50% of ourconsolidated net income during the period from the effective date of thefacility through the most recent quarter end for which we have filed quarterlyfinancial statements. We do not intend to repurchase shares for the remainderof 2007.

**On April26, 2007, we entered into an agreement with Morgan Stanley Senior Funding Inc.and Bank of America, National Association for a $300 million senior creditfacility.  Our senior facility consistsof up to a $285 million six-year term loan and a $15 million revolving credit facility.  We intend to use the proceeds of the loan tofund, in part, the acquisition of SurfControl that we announced on April 26,2007.  We currently expect to borrowapproximately $180 to $200 million from the available senior credit facility atthe closing of the acquisition.  Thesenior credit facility is not available for borrowing for any otherpurpose.  At funding, the senior creditfacility will be secured by substantially all of our assets, including pledgesof our first tier subsidiaries’ stock (except for limits on the stock pledgesof foreign subsidiaries) and is guaranteed by our domestic subsidiaries.  Loans made under the term loan amortize at1.0% per year for years one through five, with the remaining 95% due in thesixth year of the agreement.  We arerequired to use up to 50% of excess cash flow to make mandatory prepayments ofprincipal, which are not subject to any prepayment penalties.  We will have the option to borrow at primerate or at a Eurodollar base rate plus, in each case, an applicable marginbased on our corporate credit rating at the time of funding  The senior credit facility contains financialcovenants, as defined per the senior credit agreement, comprised of aconsolidated leverage ratio and a consolidated interest coverage ratio.  In addition, we have entered into an interimcredit facility with the same lenders that is collateralized by approximately$217 million of our cash, cash equivalents and marketable securities that aredeposited in restricted accounts and not available to us for any other useswhile the acquisition of SurfControl is pending.  We expect to use our restricted funds to payfor a portion of the purchase price of SurfControl.  In connection with the financing for theacquisition, we purchased an option against**£244.1 million for the 15month period until the long stop date under the transaction agreement withSurfControl.  On July 31, 2007, we soldthe 15 month option and acquired three new options against a total of £244.1million that expire on November 1, 2007. We expect the acquisition of SurfControl to close on or about October 3,2007.

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 capital expenditures and stock repurchases, if any, exclusive of the purchase price of SurfControl, for at least the next 12 months.  We expect to fund the purchase of SurfControl from our approximately $217 million in restricted cash equivalents and marketable securities, non-restricted cash and cash equivalents and marketable securities and proceeds from our senior credit facility.  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, subject to the restrictions on incurring additional debt in our 

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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 June 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, cashequivalents and investments in marketable securities. We invest our excess cashin highly liquid short-term investments, municipal securities, commercial paperand 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.**

**We are exposed to changes in interest rates primarily fromour short-term available-for-sale investments. If our acquisition ofSurfControl closes, we will be subject to changes in interest rates for ourborrowings under our variable rate senior credit facility.  Under our current policies, we do not useinterest rate derivative instruments to manage exposure to interest ratechanges. A hypothetical 100 basis point adverse move in interest rates alongthe entire interest rate yield curve would not materially affect the fair valueof our interest sensitive financial instruments at June 30, 2007. Changes ininterest rates over time will, however, affect our interest income.**

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 June 30, 2007 and 2006 are presented in the table below (in thousands):
|               | ** ** | **June 30, 2007**          | ** ** | **June 30, 2006** | ** ** |
|---------------|------------|--------------------------------------|------------|-----------------------------|------------|
| ** **    | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value**         | ** ** | **Fair Value** | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value** | ** ** | **Fair Value** | ** ** |
| ** **    | ** ** | ** **                           | ** ** | **USD**                     | ** ** | **USD** | ** ** | ** ** | ** ** | **USD** | ** ** | **USD** | ** ** |
| Euro          |       | €                               | 2,000      |                        | $          | 2,660 |   | $ | 2,610 |   | € | 785 |   | $ | 1,004 |   | $ | 1,003 |   |
| British Pound |       | £                               | 950        |                        | 1,886      |   | 1,900 |   | £ | 900 |   | 1,581 |   | 1,626 |   |
| Total         |       |                                 |       | $                           | 4,546      |   | $ | 4,510 |   |   | ** ** | $ | 2,585 | ** ** | $ | 2,629 | ** ** |

 

The $1.7 million notional increase in our Euro hedgedposition at June 30, 2007 compared to June 30, 2006 is primarily due to thelengthening of the period hedged and increased Euro-based billings of customersin Euro-denominated countries. All of the Euro hedging contracts will besettled before September 30, 2007.  Forboth the three and six months ended June 30, 2007, less than 15% of our totalbillings were denominated in the Euro. We do not expect Euro billings torepresent more than 15% of our total billings during 2007.

The $0.3 million notionalincrease in our British Pound hedged position at June 30, 2007 compared to June30, 2006 is primarily due to the shortening of the period hedged becausewe have created a natural hedge against our British Pound expenditures bybilling in the British Pound beginning in May 2007. All of the British Pound hedging contracts will be settled before August31, 2007.** **We expect our British Pound hedge commitments toreduce as we continue billing in the British Pound and create a natural hedgeagainst our British Pound expenditures.

During the six months ended June 30, 2007, the Companyutilized a £244.1 million option contract with a strike price of $2.10 or$512.6 million to hedge the anticipated purchase price for SurfControl.  The Company paid a $4.6 million premium topurchase the option on April 30, 2007 and the option has a $3.5 million fairvalue at June 30, 2007. OnJuly 31, 2007, we sold the option contract and acquired three new optionsagainst a total of £244.1 million that expire on November 1, 2007. Weexpect the acquisition of SurfControl to close on or about October 3, 2007.

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**Item 4. Controls and Procedures**

**Disclosure Controls and Procedures**

**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 Control Over FinancialReporting**

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**

**Item 1. Legal Proceedings**

OnSeptember 29, 2006, Jason Tauber filed a putative class action against usand other unidentified individuals in California Superior Court for the Countyof San Diego, captioned Tauber v. Websense. The complaint alleges that theplaintiff and a putative class of certain software engineers and computerprofessionals who 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 arising fromthe alleged misclassification and that the failure to pay overtime constitutesan unfair business practice under California Business and Professions Code §17200. The complaint seeks unspecified damages for unpaid overtime, prejudgmentinterest, attorneys’ fees and other costs, statutory penalties for allegedviolations, and other proper relief. The parties to the action executed astipulation of settlement to settle all claims made in the putative classaction.  The stipulation of settlement isstill subject to court approval.  Duringthe second quarter of 2007, the Company included $3.2 million, including $0.2million of payroll tax, as a reserve within other accrued expenses on theconsolidated balance sheet, and the Company charged $3.2 million of the pendingsettlement amount between the operating expense categories and cost of revenueon the consolidated statement of income for the quarter, apportioned based uponthe Company’s estimate of amounts payable to eligible individuals in thesettlement.

Weare involved in various legal actions in the normal course of business. Basedon current information, including consultation with our lawyers, we believe wehave adequately 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 should carefully consider the followinginformation in addition to other information in this report in evaluating ourbusiness and our prospects.  The risksand uncertainties described below are those that we currently deem to bematerial and that we believe are specific to our company and our industry.  In addition to these risks, our business maybe subject to risks currently unknown to us. If any of these or other risks actually occur, our business may beadversely affected, the trading price of our common stock could decline, andyou may lose all or part of your investment in Websense.

We have marked with an asterisk (*) those risk factorsthat reflect material changes from the risk factors included in our QuarterlyReport on Form 10-Q filed with the Securities and Exchange Commission on May 2,2007.

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

During the first half of 2006, we were unable tosustain our growth rates for sales of Web filtering products to largeenterprises, particularly for new sales to this market segment. During thesecond half of 2006, we expanded our focus on increasing sales to small andmedium sized business (SMB) customers in North America and Western Europe whilesales growth rates in the large enterprise market segment slowed down. Ourgrowth plans for new sales in North America and Western Europe in 2007 arelargely dependent on our ability to increase sales in the SMB segment andrenewal of our subscription base in the large enterprise market. We releasedour first product targeted at the SMB segment, Websense Express, inJuly 2007, and we cannot assure commercial success of this product. Wewill also need to increase sales through our two-tier distribution channel inNorth America and establish similar two-tier distribution arrangements inWestern Europe that target SMB customers. Numerous competitors target the SMBsegment for Web filtering and security sales, many of whom are differentcompetitors from our primary competitors in the large enterprise space. IfWebsense Express does not meet our customers’ expectations in the SMB segmentor if we fail to compete effectively for volume business through our two-tierdistribution model, our financial results will be negatively affected.

*We have moved toward atwo-tier distribution channel in North America which is intended to increasethe quantity of our indirect sales.**

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, 

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providers of managed Internet services and otherresellers. Currently, Ingram Micro is our only broad-line distributor in NorthAmerica, so the success of our North American sales efforts is reliant onIngram Micro’s success in selling our products to their reseller network. Ourindirect sales model involves a number of additional risks, including:

·       our resellers anddistributors, including Ingram Micro, are not subject to minimum salesrequirements or any obligation to market our products to their customers;

·       we cannot control the levelof effort our resellers and distributors expend or the extent to which any ofthem will be successful in marketing and selling our products;

·       we cannot assure that ourchannel partners will market and sell our new product offerings such as oursecurity-oriented offerings and our new information leak prevention offerings;

·       our reseller anddistributor agreements are generally nonexclusive and may be terminated at anytime without cause; and

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

Ourability to meaningfully increase the amount of our products sold through oursales channels also depends on our ability to adequately and efficiently supportthese channel partners with, among other things, appropriate financialincentives to encourage pre-sales investment and sales tools, such as salestraining, technical training and product collateral needed to support theircustomers and prospects. 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 ortechnologies can be difficult to integrate, disrupt our business, dilutestockholder value and adversely affect our operating results.**

InJanuary 2007, we acquired PortAuthority Technologies Inc., and on April 26,2007 we announced that we are acquiring SurfControl.  The SurfControl acquisition is expected toclose on or about October 3rd, 2007.  We mayacquire additional companies, services and technologies in the future as partof our efforts to expand and diversify our business. Although we review therecords of companies or businesses we are interested in acquiring, even anin-depth review may not reveal existing or potential problems or permit us tobecome familiar enough with a business to assess fully its capabilities anddeficiencies. Integration of acquired companies may disrupt or slow themomentum of the activities of our business.

In the case of the SurfControl acquisition, we expectto achieve cost synergies from restructuring of the combined businessesfollowing the closing.   As previouslydisclosed, we expect the combination with SurfControl, expected to occur in thefourth quarter of 2007, will be dilutive to our earnings during the firstquarter following the completion of the acquisition because our plannedrestructuring cannot be implemented until after the closing and our expectedcost synergies will not be immediately achieved.  We expect to incur restructuring and otherrelated expenses that will negatively affect our results of operations undergenerally accepted accounting principles. In addition, we will begin incurring interest expense for the amounts weborrow under our senior credit facility to fund a portion of the acquisitioncost and we expect our income from our cash, cash equivalents and marketablesecurities to decline as we use our restricted funds to fund a portion of theacquisition cost.   Our estimates of costsynergies and our estimates of the timing of achieving cost synergies are basedupon our review of SurfControl’s business and our familiarity with the industryand markets.  Our estimates are basedupon numerous assumptions that are subject to risks and uncertainties and theactual amount of cost synergies achieved and/or the timing of achieving thosesynergies could deviate materially from our estimates.  The timing of the achievement of synergiesmay also deviate from our estimates depending upon the success of theintegration process.  Also, while weexpect the shareholders of SurfControl to approve the scheme of arrangement bythe requisite vote, we have not obtained irrevocable undertakings from theshareholders of SurfControl, other than the members of SurfControl’s board ofdirectors, to support the proposed acquisition. It is possible that SurfControlcould receive a competing offer or the SurfControl shareholders could declineto support the transaction.

Acquisitions involve numerous risks, including:

·       difficulties in integratingoperations, technologies, services and personnel of the acquired company;

·       diversion of financial andmanagement resources from existing operations;

·       risk of entering newmarkets;

·       potential loss of keyemployees of the acquired company;

·       potential loss of customersand original equipment manufacturing relationships of the acquired company;

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·       integrating personnel withdiverse business and cultural backgrounds;

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

·       assumption of liabilitiesof the acquired company, including debt and litigation; and

·       inability to generatesufficient revenue and cost savings to offset acquisition costs.

Acquisitions may also cause us to:

·       issue equity securitiesthat would dilute our current stockholders’ percentage ownership;

·       assume certain liabilities;

·       incur additional debt;

·       make large and immediateone-time write-offs and restructuring and other related expenses;

·       become subject tointellectual property or other litigation; and

·       create goodwill or otherintangible assets that could result in significant impairment charges and/oramortization expense.

As aresult, if we fail to properly evaluate, execute and integrate acquisitionssuch as PortAuthority and SurfControl, our business and prospects may beseriously 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.****

** In connection with our planned acquisition of SurfControl,in April 2007 we entered into new credit facilities to provide financing for asubstantial portion of the acquisition purchase price. Our senior creditfacility contains covenants that restrict, among other things, our ability toborrow money, make particular types of investments, including investments inour subsidiaries, make other restricted payments, pay down subordinated debt,swap or sell assets, merge or consolidate or make acquisitions other than thepending acquisition of SurfControl.  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.  A majorevent of default under the senior credit facility occurring between signing andthe closing of the SurfControl acquisition, could allow the lenders not to fundthe loan needed to close the acquisition of SurfControl.  At funding of the loan, we will pledgesubstantially all of our consolidated assets and the stock of our subsidiaries(subject to limitations with respect to foreign subsidiaries) to secure thedebt under our senior credit facility. If the amounts outstanding under the senior credit facility wereaccelerated, the lenders could proceed against those consolidated assets andthe stock of our subsidiaries.  Any eventof default, therefore, could have a material adverse effect on ourbusiness.  Our senior credit facilityalso requires us to maintain specified financial ratios.  Our ability to meet these financial ratioscan be affected by events beyond our control, and we cannot assure that we willmeet those ratios.**

**MorganStanley Senior Funding, Inc. and Bank of America expect to syndicate the seniorfacility after the closing of the SurfControl acquisition.  It is possible that we will be required toamend the senior credit facility to enable the syndication of the facility asrequired under the market flex provisions of the senior credit facility.**

***The amount of our debt expectedto be outstanding as of the closing of the SurfControl acquisition may preventus from taking actions we would otherwise consider in our best interest.***

The Company currently has no debt. However, our debt expected to beoutstanding as of the closing of the SurfControl acquisition,  the limitations our senior credit facilityimpose on us and the restrictions on approximately $217 million of our cashresources pending the acquisition of SurfControl could have importantconsequences, including:

·                  itmay be difficult for us to satisfy our obligations under the senior creditfacility;

·                  wewill have to use much of our cash flow for scheduled debt service rather thanfor potential investments;

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·                  wemay be less able to obtain other debt financing in the future;

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

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

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

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

Substantiallyall of our revenue in 2006 and the first six months of 2007 was derived fromnew and renewal subscriptions to our Web filtering and Web security products.We expect that a significant majority of our sales for the remainder of 2007will continue to be derived from our Web filtering and security products andthat sales of our newly acquired information leak prevention products and otherproducts under development will comprise only a very small portion of ouroverall sales in 2007. If our Web filtering and security products fail to meetthe needs of our existing and target customers, or if they do not comparefavorably in price, features and performance to competing products, ouroperating results and our business will be significantly impaired. If we cannotsufficiently increase our customer base with the addition of new customers,particularly in the SMB segment, and increase seats under subscriptions fromexisting customers, we will not be able to grow our business to meetexpectations.

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 securityproducts, including our information leak prevention products, to achieve morewidespread market acceptance will seriously harm our business. **

Ourfuture financial performance depends on our ability to diversify our offeringsby successfully developing, introducing and gaining customer acceptance of ournew products and services, particularly our security offerings. OnJanuary 8, 2007, we acquired PortAuthority Technologies, Inc., and asa result of that acquisition, we now sell Websense Content Protection Suite,our information leak prevention products for the content security market. Wemay not be successful in achieving market acceptance of these or any newproducts that we develop.  In the secondquarter, sales of our information leak prevention products were slightly belowexpectations, and we can not assure that we will meet expectations in the future.   Moreover, our recent increased emphasis onthe development, marketing and sale of our security offerings and informationleak prevention products could distract us from sales of our core Web filteringand Web security offerings, negatively impacting our overall sales. Any failureor delay in diversifying our existing offerings, or diversification at thedetriment to our core Web filtering and Web security offerings, could harm ourbusiness, results of operations and financial condition.

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

Themarket for our products is intensely competitive and is likely to become evenmore so in the future.  Our currentprincipal Web filtering competitors frequently offer their products at asignificantly lower price than our products, which has resulted in pricingpressures on sales of our product and potentially could result in thecommoditization of products in our space. We also face current and potentialcompetition from vendors of Internet servers, operating systems and networkinghardware, many of which now, or may in the future, develop and/or bundle Webfiltering or other competitive products with their products. Increasedcompetition may cause price reductions or a loss of market share, either ofwhich could have a material adverse effect on our business, results ofoperations and financial condition. If we are unable to maintain the currentpricing on sales of our products or increase our pricing in the future, ourprofitability could be negatively impacted. Even if our products providegreater functionality and are more effective than certain other competitiveproducts, potential customers might accept this limited functionality in lieuof purchasing our products. In addition, our own indirect sales channels maydecide to develop or sell competing products instead of our products. Pricingpressures and increased competition generally could result in reduced sales,reduced margins or the failure of our products to achieve or maintain morewidespread market acceptance, any of which could have a material adverse effecton our business, results of operations and financial condition.

Our current principal competitors include:

·       companies offering Webfiltering and Web security solutions, such as Microsoft, Symantec, McAfee,Cisco Systems, SurfControl, Juniper Networks, Message Labs, Trend Micro,Postini (recently announced to be acquired by Google), ScanSafe, Blue CoatSystems, Secure Computing, Alladin, Finjan, FaceTime, Mi5 Networks, St. BernardSoftware, 8e6 Technologies, Marshal, Clearswift, Sophos, Barracuda, DigitalArts and Computer Associates;

·       companies integrating Webfiltering into specialized security appliances, such as 8e6 Technologies, BlueCoat Systems, Cisco Systems, McAfee, WatchGuard and SonicWALL;

·       companies offeringinformation leak protection solutions, such as Vontu, Verdasys, Vericept,Tablus, Symantec, Secure Computing, Reconnex, Provilla, Proofpoint, PalisadeSystems, Orchestria, Oakley Networks, McAfee, Intrusion, Fidelis, Checkpointand Code Green Networks;

·       companies offering desktopsecurity solutions such as Check Point Software, Cisco Systems, McAfee,Microsoft, Symantec, Computer Associates, Internet Security Systems (IBM) andTrend Micro; and

·       companies offering proxybased solutions such as Microsoft, BlueCoat Systems, Cisco Systems and Juniper.

As we develop and market our products with anincreasing security-oriented emphasis, we also face increasing competition fromsecurity solutions providers. Many of our competitors within the Web securitymarket, such as Symantec Corporation, McAfee, Trend Micro, Cisco Systems andMicrosoft enjoy substantial competitive advantages, including:

·       greater name recognitionand larger marketing budgets and resources;

·       established marketingrelationships and access to larger customer bases; and

·       substantially greaterfinancial, technical and other resources.

As aresult, we may be unable to gain sufficient traction as a provider of Websecurity solutions, and our competitors may be able to respond more quickly andeffectively than we can to new or emerging technologies and changes in customerrequirements, or devote greater resources to the development, marketing,promotion and sale of their products than we can. 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 

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increaseas a result of industry consolidation. For all of the foregoing reasons, we maynot be able to compete successfully against our current and future competitors.

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

Wehave significant operations outside of the United States, including researchand development, sales and customer support. We recently establishedengineering operations in Beijing, China, and acquired PortAuthorityTechnologies, Inc., whose engineering efforts are based in Israel. Weintend to maintain our principal engineering efforts for our information leakprevention products in Israel.  On April26, 2007, we announced that we are acquiring SurfControl, which also hassubstantial operations outside the United States, including in the UnitedKingdom, Australia, China and Israel.

We plan to continue to expand our internationaloperations, but such expansion is contingent upon the financial performance ofour existing international operations as well as our identification of growthopportunities.  Our acquisition ofSurfControl will also expand our international operations.  Our international operations are subject torisks in addition to those faced by our domestic operations, including:

·       difficulties associatedwith managing a distributed organization located on multiple continents ingreatly varying time zones;

·       potential loss ofproprietary information due to misappropriation or laws that may be lessprotective of our intellectual property rights;

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

·       political unrest, war orterrorism, particularly in areas in which we have facilities;

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

·       difficulties incoordinating the activities of our geographically dispersed and culturallydiverse operations;

·       seasonal reductions inbusiness activity in the summer months in Europe and in other periods in othercountries;

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

·       costs and delays associatedwith 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.

*Sales to customersoutside the United States have accounted for a significant portion of ourrevenue, 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 approximately 40% of our total revenuegenerated during the quarter ended June 30, 2007 compared with 36% of our totalrevenue during the quarter ended June 30, 2006. As a key component of ourbusiness strategy to generate new business sales, we intend to expand ourinternational sales, but success cannot be assured. In addition to the risksassociated with our domestic sales, our international sales are subject to thefollowing risks:

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

·       our ability to successfullylocalize software products for a significant number of international markets;

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

·       laws and business practicesfavoring local competitors;

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·       dependence on foreigndistributors and their sales channels;

·       longer payment cycles forsales in foreign countries and difficulties in collecting accounts receivable;

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

·       regional economic andpolitical 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.

Ourinternational revenue is currently primarily denominated in U.S. dollars. As aresult, fluctuations in the value of the U.S. dollar and foreign currencies maymake our products more expensive for international customers, which could harmour business. We currently bill certain international customers in Euros andBritish Pounds. This may increase our risks associated with fluctuations inforeign currency exchange rates since we cannot be assured of receiving thesame U.S. dollar equivalent as when we bill exclusively in U.S. dollars. Weengage in currency hedging activities with the intent of limiting the risk ofexchange rate fluctuation. Our hedging activities also involve inherent risksthat could result in an unforeseen loss. If we fail to properly forecast ratefluctuations these activities could have a negative impact.

*We may not be able todevelop acceptable new products or enhancements to our existing products at arate required by our rapidly changing market.*

Ourfuture success depends on our ability to develop new products or enhancementsto our existing products that keep pace with rapid technological developmentsand that address the changing needs of our customers. Although our products aredesigned to operate with a variety of network hardware and software platforms,we will need to continuously modify and enhance our products to keep pace withchanges in Internet-related hardware, software, communication, browser anddatabase technologies. We may not be successful in either developing suchproducts or introducing them to the market in a timely fashion. In addition,uncertainties about the timing and nature of new network platforms ortechnologies, or modifications to existing platforms or technology couldincrease our research and development expenses. The failure of our products tooperate effectively with the existing and future network platforms andtechnologies will limit or reduce the market for our products, result incustomer dissatisfaction and seriously harm our business, results of operationsand financial condition.

Wemay spend significant time and money on research and development to design anddevelop our information leak prevention products. If these products fail toachieve broad market acceptance in our target markets, we may be unable togenerate significant revenue from our research and development efforts.Moreover, even if we are able to develop information prevention products, theymay not be accepted in our target markets. As a result, our business, resultsof operations and financial condition would be adversely impacted.

*Our products may fail tokeep pace with the rapid growth and technological change of the Internet inaccordance with our customers’ expectations.*

Theongoing evolution of the Internet and computing environments will require us tocontinually improve the functionality, features and reliability of ourdatabases. Because our products primarily manage access to URLs and softwareapplications included in our databases, if our databases do not contain ameaningful portion of relevant content, the effectiveness of our Web filteringproducts will be significantly diminished. Any failure of our databases to keeppace with the rapid growth and technological change of the Internet, such asthe increasing amount of multimedia content on the Internet that is not easilyclassified, will impair the market acceptance of our products.

Werely upon a combination of automated filtering technology and human review tocategorize URLs and software applications in our proprietary databases. Ourcustomers may not agree with our determinations that particular URLs andsoftware applications should be included or not included in specific categoriesof our databases. In addition, it is possible that our filtering processes mayplace objectionable or security risk material in categories that are generallyunrestricted by our users’ Internet and computer access policies, which couldresult in such material not being blocked from the network. Any miscategorizationcould result in customer dissatisfaction and harm our reputation. Any failureto effectively categorize and filter URLs and software applications accordingto our customers’ expectations will impair the growth of our business. Ourdatabases and database technologies may not be able to keep pace with thegrowth in the number of URLs and software applications, especially the growingamount of content utilizing foreign languages and the increasing sophisticationof malicious code and the delivery mechanisms associated with spyware, phishingand other hazards associated with the Internet.

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

Ourproducts are complex and are deployed in a wide variety of complex networkenvironments. Our products may have errors or defects that users identify afterdeployment, which could harm our reputation and our business. In addition,products as complex as ours frequently contain undetected errors when firstintroduced or when new versions or enhancements are released. We have from timeto time found errors in versions of our products, and we may find such errorsin the future. 

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Becausecustomers rely on our products to manage employee behavior to protect againstsecurity risks and prevent the loss of sensitive data, any significant defectsor errors in our products may result in negative publicity or legal claims. Forexample, an actual or perceived breach of network or computer security at oneof our customers, regardless of whether the breach is attributable to ourproducts, could adversely affect the market’s perception of our securityproducts. Moreover, parties whose Web sites or software applications are placedin security-risk categories or other categories with negative connotations mayseek redress against us for falsely labeling them or for interfering with theirbusiness. The occurrence of errors could adversely affect sales of our products,divert the attention of engineering personnel from our product developmentefforts and cause significant customer relations or legal problems.

Ourproducts may also be misused or abused by customers or non-customer thirdparties who obtain access and use of our products. These situations may arisewhere an organization uses our products in a manner that impacts their endusers’ or employees’ privacy or where our products are misappropriated tocensor private access to the Internet. Any of these situations could result innegative press coverage and negatively affect our reputation.

*We face risks related to customer outsourcing tosystem integrators.*

Someof our customers have outsourced the management of their information technologydepartments to large system integrators. If this trend continues, ourestablished customer relationships could be disrupted and our products could bedisplaced by alternative system and network protection solutions offered bysystem integrators. Significant product displacements could impact our revenueand have a material adverse effect on our business.

*Other vendors may includeproducts similar to ours in their hardware or software and render our productsobsolete.*

Inthe future, vendors of hardware and of operating system software or othersoftware may continue to enhance their products or bundle separate products toinclude functions that are currently provided primarily by network securitysoftware. If network security functions become standard features of computerhardware or of operating system software or other software, our products maybecome obsolete and unmarketable, particularly if the quality of these networksecurity features is comparable to that of our products. Furthermore, even ifthe network security and/or management functions provided as standard featuresby hardware providers or operating systems or other software is more limitedthan that of our products, our customers might accept this limitedfunctionality in lieu of purchasing additional software. Sales of our productswould suffer materially if we were then unable to develop new Web filtering,security and information leak prevention products to further enhance operatingsystems or other software and to replace any obsolete products.

*Our worldwide income taxprovisions and other tax accruals may be insufficient if any taxing authoritiesassume taxing positions that are contrary to our positions.*

Significantjudgment is required in determining our worldwide provision for income taxesand for our accruals for other state, federal and international taxes such assales and VAT taxes. In the ordinary course of a global business, there aremany transactions for which the ultimate tax outcome is uncertain. Some ofthese uncertainties arise as a consequence of intercompany arrangements toshare revenue and costs. In such arrangements there are uncertainties about theamount and manner of such sharing, which could ultimately result in changesonce the arrangements are reviewed by taxing authorities. Although we believethat our approach to determining the amount of such arrangements is reasonable,no assurance 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.

Fromtime to time, we are also audited by various state, federal and internationalauthorities relating to tax matters. We fully cooperate with all audits. Ouraudits are in various stages of completion; however, no outcome for aparticular audit can be determined with certainty prior to the conclusion ofthe audit and appeals process. As each audit is concluded, adjustments, if any,are appropriately recorded in our financial statements in the perioddetermined. To provide for potential tax exposures, we maintain allowances fortax contingencies based on reasonable estimates of our potential exposure withrespect to the tax liabilities that may result from such audits. However, ifthe reserves are insufficient upon completion of any audits, there could be anadverse impact on our financial position and results of operations.

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*Any failure to protect our proprietary technologywould negatively impact our business.**

Intellectualproperty is critical to our success, and we rely upon trademark, copyright andtrade secret laws in the United States and other jurisdictions as well asconfidentiality procedures and contractual provisions to protect ourproprietary technology and our Websense brand. We rely on trade secrets toprotect technology where we believe patent protection is not appropriate orobtainable. However, trade secrets are difficult to protect. While we requireemployees, collaborators and consultants to enter into confidentialityagreements, we cannot assure that these agreements will not be breached or thatwe will have adequate remedies for any breach. We may not be able to adequatelyprotect our trade secrets or other proprietary information in the event of anyunauthorized use or disclosure or the lawful development by others of suchinformation.

Wehave registered our Websense and Websense Enterprise trademarks in severalcountries and have registrations for the Websense trademark pending in severalother countries. Effective trademark protection may not be available in everycountry where our products are available. Furthermore, any of our trademarksmay be challenged by others or invalidated through administrative process orlitigation.

We currently have only six issued patents in theUnited States and two patents issued internationally, and we may be unable toobtain further patent protection in the future. We have several pending patentapplications in the United States and in other countries. We cannot ensurethat:

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

·       we were the first to filepatent applications for these inventions;

·       any of our pending patentapplications are not obvious or anticipated such that they will not result inissued patents;

·       others will notindependently develop similar or alternative technologies or duplicate any ofour technologies;

·       any patents issued to uswill provide us with any competitive advantages or will not be challenged bythird parties;

·       we will develop additionalproprietary technologies that are patentable; or

·       the patents of others willnot have a negative effect on our ability to do business.

Furthermore,legal standards relating to the validity, enforceability and scope ofprotection of intellectual 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.

*Third parties claimingthat we infringe their proprietary rights could cause us to incur significantlegal expenses and prevent us from selling our products.*

Thesoftware and Internet industries are characterized by the existence of a largenumber of patents, trademarks and copyrights and by frequent litigation basedon allegations of patent infringement or other violations of intellectualproperty rights. As we expand our product offerings in the data leakage andsecurity area where larger companies with large patent portfolios compete, thepossibility of an intellectual property claim against us grows. We couldreceive claims that we have infringed the intellectual property rights ofothers, including claims regarding patents, copyrights, and trademarks. Anysuch claim, with or without merit, could result in costly litigation anddistract management from day-to-day operations. If we are not successful indefending such claims, we could be required to stop selling our products, paymonetary amounts as damages, enter into royalty or licensing arrangements, orsatisfy indemnification obligations that we have with some of our customers.

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*Because we recognizerevenue from subscriptions for our products ratably over the term of thesubscription, downturns in sales may not be immediately reflected in ourrevenue.*

Weexpect that nearly all of our revenue for the foreseeable future will come fromsubscriptions to Websense Enterprise and our add-on products. Upon execution ofa subscription agreement, we invoice our customers for the full term of thesubscription agreement. We then recognize revenue from customers daily over theterms of their subscription agreements, which typically have durations of 12,24 or 36 months. As a result, a majority of the revenue we report in eachquarter is derived from deferred revenue from subscription agreements enteredinto and paid for during previous quarters. Because of this financial model,the revenue we report in any quarter or series of quarters may mask significantdownturns in sales and the market acceptance of our products, before thesedownturns result in declining revenues.

*Our quarterly operatingresults may fluctuate significantly, and these fluctuations may cause our stockprice to fall.*

Ourquarterly operating results have varied significantly in the past, and willlikely vary in the future primarily as the result of fluctuations in ourbillings, revenues, operating expenses and tax provisions. Although asignificant portion of our revenue in any quarter comes from previouslydeferred revenue, a meaningful portion of our revenue in any quarter depends onthe number, size and length of subscriptions to our products that are sold inthat quarter. The risk of quarterly fluctuations is increased by the fact thata significant portion of our quarterly sales have historically been generatedduring the last month of each fiscal quarter, with many of the largestenterprise customers purchasing subscriptions to our products nearer to the endof the last month of each quarter. Due to the unpredictability of theseend-of-period buying patterns, forecasts may not be achieved.

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

·       timing of marketingexpenses for activities such as trade shows and advertising campaigns;

·       quarterly variations ingeneral and administrative expenses, such as recruiting expenses andprofessional services fees;

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

·       timing of expensesassociated with commissions paid on sales of subscriptions to our products.

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

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

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

·       announcements oftechnological innovations or new products or services by our competitors;

·       demand for our products,including fluctuations in subscription renewals;

·       changes in the pricingpolicies of our competitors; and

·       changes in government regulations.

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

·       announcements oftechnological innovations or new products or services by us;

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·       changes in our pricingpolicies; and

·       quarterly variations in ourrevenues and operating expenses.

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

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

Oursuccess depends largely upon the continued services of our executive officersand other key management personnel and our ability to recruit new personnel toexecutive and key management positions. As we have publicly announced, we are in the process of recruiting a newchief financial officer who would assume those duties from our currentPresident and Chief Financial Officer, Douglas C. Wride.  Mr. Wride will remain President and focus onthe integration of SurfControl.  We arealso substantially dependent on the continued service of our existingengineering personnel because of the complexity of our products andtechnologies. We do not have employment agreements with a majority of ourexecutive officers, key management or development personnel and, therefore,they could terminate their employment with us at any time without penalty. Wedo not maintain key person life insurance policies on any of our employees. Theloss of one or more of our key employees could seriously harm our business,results of operations and financial condition. In such an event we may beunable to recruit personnel to replace these individuals in a timely manner, orat all, on acceptable terms.

*Because competition forour target employees is intense, we may not be able to attract and retain thehighly skilled employees we need to support our planned growth.*

Toexecute our growth plan, we must attract and retain highly qualified personnel.We need to hire additional personnel in virtually all operational areas,including selling and marketing, research and development, operations andtechnical support, customer service and administration. Competition for thesepersonnel is intense, especially for engineers with high levels of experiencein designing and developing software and Internet-related products. We may notbe successful in attracting and retaining qualified personnel. We have fromtime to time in the past experienced, and we expect to continue to experiencein the future, difficulty in hiring and retaining highly skilled employees withappropriate qualifications. In order to attract and retain personnel in acompetitive marketplace, we believe that we must provide a competitivecompensation package, including cash and equity based compensation. The volatilityof our stock price may from time to time adversely affect our ability torecruit or retain employees. Many of the companies with which we compete forexperienced personnel have greater resources than we have. If we fail toattract new personnel or retain and motivate our current personnel, ourbusiness and future growth prospects could be severely harmed.

*Compliance with changingregulation of corporate governance, accounting principles and public disclosuremay result in additional expenses.*

Changinglaws, 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.

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

If we fail tomanage our internal growth and the integration of acquired businesses in amanner that minimizes strains on our resources, we could experience disruptionsin our operations that could negatively affect our revenue, billings orprofitability.  We are pursuing astrategy of organic growth through implementation of two-tier distribution, internationalexpansion, introduction of new products and expansion of our product sales tothe small and medium sized businesses. We also have pursued two strategicacquisitions, and are in the process of integrating PortAuthority and awaitstockholder approval and satisfaction of other conditions to complete ouracquisition of SurfControl.  Finally, wehave opened or acquired engineering centers in China and Israel.  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 athird party to acquire us, even if doing so would be beneficial to ourstockholders.*

Some provisions ofour certificate of incorporation and bylaws, as well as some provisions ofDelaware law, may discourage, delay or prevent third parties from acquiring us,even if doing so would be beneficial to our stockholders. For example, ourcertificate of incorporation provides for a classified board, with each boardmember serving a staggered three-year term. It also provides that stockholdersmay not fill board vacancies, call stockholder meetings or act by writtenconsent. Our bylaws further provide that advance written notice is requiredprior to stockholder proposals. Each of these provisions makes it moredifficult for stockholders to obtain control of our board or initiate actionsthat are opposed by the then current board. Additionally, we have authorizedpreferred stock that is undesignated, making it possible for the board to issueup to 5,000,000 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.

Oursenior credit facility also accelerates and becomes payable in full upon ourchange of control, which is defined generally as a person or group acquiring35% of our voting securities or a proxy contest that results in changing amajority of our board of directors. These consequences may discourage third parties from attempting toacquire us.

*We do not intend to pay dividends.*

We have notdeclared or paid any cash dividends on our common stock since we have been apublicly traded company. We currently intend to retain any future cash flowsfrom operations to fund growth and, do not expect to pay any cash dividends inthe foreseeable future.  Moreover, we arenot permitted to pay cash dividends under the terms of our senior creditfacility.

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

**None.**

**Item 3.**           Defaults upon SeniorSecurities

**None.**

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

**The Annual Meeting ofStockholders was held on Tuesday, June 5, 2007. The following matters were voted upon at the meeting and were adopted bythe margins indicated:**

**1.**                                       The stockholders elected two directors to hold officefor a term expiring upon the 2010 Annual Meeting of Stockholders.
| ** **                                   | ** ** | **Number of Shares** | ** ** |
|----------------------------------------------|------------|--------------------------------|------------|
| **Name of Directors Elected** | ** ** | **For**                        | ** ** | **Withheld** | ** ** |
|                                         |       |                           |       |   |   |
| John B. Carrington                           |       | 41,348,268                     |       | 458,010 |   |
| Gary  E. Sutton                              |       | 38,733,773                     |       | 3,072,505 |   |

 

**The following individuals arecontinuing directors with terms expiring upon the 2008 Annual Meeting ofStockholders:  Mark S. St.Clare and PeterC. Waller.**

**The following individuals arecontinuing directors with terms expiring upon the 2009 Annual Meeting ofStockholders:  Bruce T. Coleman, GeneHodges and John F. Schaefer.**

**2.**                                    The stockholders ratified the appointment of Ernst& Young LLP as our independent registered public accounting firm for thefiscal year ending December 31, 2007.
| For     |   | 41,793,011 |   |
|---------|--------|------------|--------|
| Against |   | 6,353      |   |
| Abstain |   | 6,914      |   |

 

**Item 5.**           Other Information

**None.**

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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(1) |   | $300,000,000 Senior Credit Agreement among Websense,  Inc., as borrower, the several lenders from time to time parties thereto,  Morgan Stanley Senior Funding, Inc., as syndication agent, Bank of America,  N.A., as documentation agent, and Morgan Stanley Senior Funding, Inc., as  senior administrative agent and senior collateral agent, dated as of April  26, 2007.                         |
|   | 10.2(1) |   | $207,000,000 Interim Credit and Guarantee Agreement  among Websense, Inc. and Websense International Limited, as borrowers, the  several lenders from time to time parties thereto, Morgan Stanley Senior  Funding, Inc., as syndication agent, Bank of America, N.A., as documentation  agent, and Morgan Stanley Senior Funding, Inc., as interim administrative  agent, dated as of April 26, 2007. |
|   | 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)             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)             Filed as an Exhibitto our Current Report on Form 8-K (No 000-30093) filed on April 19, 2007.

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##### **SIGNATURES**

Pursuant to the requirements of the Securities Exchange Actof 1934, the registrant has duly caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.
|                       | **WEBSENSE, INC.** |
|-----------------------|--------------------|
|                  |               |   |   |   |
| Date: August 8,  2007 |               | By: |   | /s/ GENE HODGES |   |
|                  |               |   |   |   Gene Hodges |
|                  | * *           | * * | * * | *  Chief Executive Officer* |
|                  |               |   |   |   |
| Date: August 8,  2007 |               | By: |   | /s/ DOUGLAS C. WRIDE |   |
| ** **            |               |   |   |   Douglas C. Wride |
| ** **            | * *           | * * | * * | *  President and* |
| ** **            | * *           | * * | * * | *  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(1) |   | $300,000,000 Senior Credit Agreement among Websense,  Inc., as borrower, the several lenders from time to time parties thereto,  Morgan Stanley Senior Funding, Inc., as syndication agent, Bank of America,  N.A., as documentation agent, and Morgan Stanley Senior Funding, Inc., as  senior administrative agent and senior collateral agent, dated as of April  26, 2007.                         |
| 10.2(1) |   | $207,000,000 Interim Credit and Guarantee Agreement  among Websense, Inc. and Websense International Limited, as borrowers, the  several lenders from time to time parties thereto, Morgan Stanley Senior  Funding, Inc., as syndication agent, Bank of America, N.A., as documentation  agent, and Morgan Stanley Senior Funding, Inc., as interim administrative  agent, dated as of April 26, 2007. |
| 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)             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)             Filed as an Exhibitto our Current Report on Form 8-K (No 000-30093) filed on April 19, 2007.

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