** **

**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 March 31, 2008**

 

**OR**

 

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

** **

**For the Transition Period from          to         **

 

**Commission File Number 000-30093**

 

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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, a non-accelerated filer or a smaller reporting company.  See the definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

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

 

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

 

The number of shares outstanding of the registrant’s Common Stock, $.01 par value, as of April 30, 2008 was 45,132,875.

 

** **

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** **

**Websense, Inc.**

**Form 10-Q**

**For the Period Ended March 31, 2008**

 

**TABLE OFCONTENTS**

 
|                                     | ** ** | **Page** |
|-------------------------------------|------------|----------|
| Part I.  Financial Information |       |     |
|                                |       |     |   |   |   |   |
|                                |       | Item 1.  |   | Consolidated  Financial Statements (Unaudited) |   |   |
|                                |       |     |   | Consolidated Balance  Sheets as of March 31, 2008 and December 31, 2007 |   | 3 |
|                                |       |     |   | Consolidated  Statements of Operations for the three months ended March 31, 2008 and  2007 |   | 4 |
|                                |       |     |   | Consolidated  Statement of Stockholders’ Equity for the three months ended March 31,  2008 |   | 5 |
|                                |       |     |   | Consolidated  Statements of Cash Flows for the three months ended March 31, 2008 and  2007 |   | 6 |
|                                |       |     |   | Notes to  Consolidated Financial Statements |   | 7 |
|                                |       | Item 2.  |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   | 15 |
|                                |       | Item 3.  |   | Quantitative  and Qualitative Disclosures About Market Risk |   | 24 |
|                                |       | Item 4.  |   | Controls and Procedures |   | 25 |
|                                |       |     |   |   |   |   |
| Part II. Other  Information    |       |     |
|                                |       |     |   |   |   |   |
|                                |       | Item 1.  |   | Legal Proceedings |   | 25 |
|                                |       | Item 1A. |   | Risk Factors |   | 26 |
|                                |       | Item 2.  |   | Unregistered  Sales of Equity Securities and Use of Proceeds |   | 37 |
|                                |       | Item 3.  |   | Defaults  upon Senior Securities |   | 37 |
|                                |       | Item 4.  |   | Submission  of Matters to a Vote of Security Holders |   | 37 |
|                                |       | Item 5.  |   | Other Information |   | 37 |
|                                |       | Item 6.  |   | Exhibits |   | 38 |
|                                |       |     |   |   |   |   |
| Signatures                          |       | 39       |

 

2

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**Part I– Financial Information**

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

** **

**Websense, Inc.**

**Consolidated Balance Sheets**

**(Unaudited and in thousands)**

 
| ** **                                       | ** ** | **March 31,  2008** | ** ** | **December 31,  2007** | ** ** |
|--------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                       | ** ** | ** **               | ** ** | **(See Note 1)**  | ** ** |
| **Assets**                                       |       |                     |       |                        |       |
| Current assets:                                  |       |                     |       |                        |       |
| Cash and cash  equivalents                       |       | $                        | 71,037     |                        | $          | 66,383 |   |
| Marketable  securities                           |       | 632                      |       | 19,781                      |       |
| Accounts  receivable, net                        |       | 47,044                   |       | 76,328                      |       |
| Prepaid income  taxes                            |       | 2,161                    |       | 3,734                       |       |
| Current portion  of deferred income taxes        |       | 29,203                   |       | 22,870                      |       |
| Other current  assets                            |       | 11,325                   |       | 10,109                      |       |
| Total current  assets                            |       | 161,402                  |       | 199,205                     |       |
|                                             |       |                     |       |                        |       |
| Property and  equipment, net                     |       | 17,288                   |       | 17,657                      |       |
| Intangible  assets, net                          |       | 140,875                  |       | 152,906                     |       |
| Goodwill                                         |       | 377,726                  |       | 385,916                     |       |
| Deferred income  taxes, less current portion     |       | 28,940                   |       | 19,048                      |       |
| Deposits and  other assets                       |       | 5,076                    |       | 5,798                       |       |
| Total assets                                     |       | $                        | 731,307    |                        | $          | 780,530 |   |
|                                             |       |                     |       |                        |       |
| **Liabilities  and stockholders’ equity**   |       |                     |       |                        |       |
| Current  liabilities:                            |       |                     |       |                        |       |
| Accounts payable                                 |       | $                        | 256        |                        | $          | 3,255 |   |
| Accrued payroll  and related benefits            |       | 19,958                   |       | 28,960                      |       |
| Other accrued  expenses                          |       | 31,132                   |       | 30,463                      |       |
| Current portion  of income taxes payable         |       | 7,677                    |       | 1,531                       |       |
| Current portion  of deferred tax liability       |       | 7,984                    |       | 10,399                      |       |
| Current portion  of deferred revenue             |       | 194,570                  |       | 190,569                     |       |
| Total current  liabilities                       |       | 261,577                  |       | 265,177                     |       |
| Income taxes  payable, less current portion      |       | 9,322                    |       | 12,264                      |       |
| Senior secured  credit facility                  |       | 160,000                  |       | 190,000                     |       |
| Deferred  revenue, less current portion          |       | 93,058                   |       | 96,116                      |       |
| Deferred tax  liability, less current portion    |       | 15,959                   |       | 20,964                      |       |
| Other long term  liabilities                     |       | 3,426                    |       | 1,634                       |       |
| Total  liabilities                               |       | 543,342                  |       | 586,155                     |       |
|                                             |       |                     |       |                        |       |
| Stockholders’  equity:                      |       |                     |       |                        |       |
| Common stock                                     |       | 516                      |       | 515                         |       |
| Additional  paid-in capital                      |       | 273,555                  |       | 267,164                     |       |
| Treasury stock,  at cost                         |       | (144,797                 | )          | (139,792                    | )          |
| Retained  earnings                               |       | 61,571                   |       | 67,808                      |       |
| Accumulated  other comprehensive loss            |       | (2,880                   | )          | (1,320                      | )          |
| Total  stockholders’ equity                 |       | 187,965                  |       | 194,375                     |       |
| Total  liabilities and stockholders’ equity |       | $                        | 731,307    |                        | $          | 780,530 |   |

 

See accompanying notes.

 

3

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**Websense, Inc.**

**Consolidated Statements of Operations**

**(Unaudited) (in thousands, except per share amounts)**

 
| ** **                              | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|
| ** **                              | ** ** | **March 31,  2008**         | ** ** | **March 31,  2007** | ** ** |
|                                    |       |                             |       |   |   |
| Revenue                                 |       | $                                | 66,984     |   | $ | 49,747 |   |
|                                    |       |                             |       |   |   |
| Cost of revenues:                       |       |                             |       |   |   |
| Cost of revenues                        |       | 8,867                            |       | 4,028 |   |
| Amortization of  acquired technology    |       | 3,072                            |       | 629 |   |
| Total cost of  revenues                 |       | 11,939                           |       | 4,657 |   |
| Gross margin                            |       | 55,045                           |       | 45,090 |   |
|                                    |       |                             |       |   |   |
| Operating  expenses:                    |       |                             |       |   |   |
| Selling and  marketing                  |       | 42,821                           |       | 24,913 |   |
| Research and  development               |       | 13,460                           |       | 8,396 |   |
| General and  administrative             |       | 12,853                           |       | 7,186 |   |
| Total operating  expenses               |       | 69,134                           |       | 40,495 |   |
|                                    |       |                             |       |   |   |
| (Loss) income  from operations          |       | (14,089                          | )          | 4,595 |   |
|                                    |       |                             |       |   |   |
| Interest expense                        |       | (4,432                           | )          | — |   |
| Other (expense)  income, net            |       | (109                             | )          | 2,440 |   |
|                                    |       |                             |       |   |   |
| (Loss) income  before income taxes      |       | (18,630                          | )          | 7,035 |   |
|                                    |       |                             |       |   |   |
| (Benefit)  provision for income taxes   |       | (12,393                          | )          | 3,168 |   |
|                                    |       |                             |       |   |   |
| Net (loss)  income                      |       | $                                | (6,237     | ) | $ | 3,867 |   |
|                                    |       |                             |       |   |   |
| Net (loss)  income per share:           |       |                             |       |   |   |
|                                    |       |                             |       |   |   |
| Basic net (loss)  income per share      |       | $                                | (0.14      | ) | $ | 0.09 |   |
| Diluted net  (loss) income per share    |       | $                                | (0.14      | ) | $ | 0.09 |   |
| Weighted average  shares – basic   |       | 45,395                           |       | 44,830 |   |
| Weighted average  shares – diluted |       | 45,395                           |       | 45,485 |   |

 

See accompanyingnotes.

 

4

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**Websense, Inc.**

**Consolidated Statement of Stockholders’ Equity**

**(Unaudited and in thousands)**

 
| ** **                                                               | ** ** | **Common stock** | ** ** | **Additional** | ** ** | **Treasury**        | ** ** | **Retained** | ** ** | **Accumulated  other  comprehensive** | ** ** | **Total  stockholders’** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|---------------------|------------|--------------|------------|---------------------------------------|------------|-------------------------------|------------|
| ** **                                                               | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **paid-in capital** | ** ** | **stock**    | ** ** | **earnings**                          | ** ** | **loss**                      | ** ** | **equity** | ** ** |
| Balance at  December 31, 2007                                       |       | 45,394                |       | $              | 515        |                | $          | 267,164      |       | $                                     | (139,792   | )                             | $          | 67,808 |   | $ | (1,320 | ) | $ | 194,375 |   |
|                                                                     |       |                  |       |           |       |                |       |         |       |                                  |       |                          |       |   |   |
| Issuance of  common stock upon exercise of options                       |       | 24                    |       | 1              |       | 223                 |       | —       |       | —                                |       | —                        |       | 224 |   |
|                                                                     |       |                  |       |           |       |                |       |         |       |                                  |       |                          |       |   |   |
| Issuance of  common stock from restricted stock units, net               |       | 24                    |       | —         |       | —              |       | (7           | )          | —                                |       | —                        |       | (7 | ) |
|                                                                     |       |                  |       |           |       |                |       |         |       |                                  |       |                          |       |   |   |
| Share-based  compensation expense                                        |       | —                |       | —         |       | 6,168               |       | —       |       | —                                |       | —                        |       | 6,168 |   |
|                                                                     |       |                  |       |           |       |                |       |         |       |                                  |       |                          |       |   |   |
| Purchase of treasury  stock                                              |       | (264                  | )          | —         |       | —              |       | (4,998       | )          | —                                |       | —                        |       | (4,998 | ) |
|                                                                     |       |                  |       |           |       |                |       |         |       |                                  |       |                          |       |   |   |
| Net loss                                                                 |       | —                |       | —         |       | —              |       | —       |       | (6,237                                | )          | —                        |       | (6,237 | ) |
|                                                                     |       |                  |       |           |       |                |       |         |       |                                  |       |                          |       |   |   |
| Net change in  unrealized loss on interest rate swap and cap, net of tax |       | —                |       | —         |       | —              |       | —       |       | —                                |       | (1,084                        | )          | (1,084 | ) |
|                                                                     |       |                  |       |           |       |                |       |         |       |                                  |       |                          |       |   |   |
| Cumulative  translation adjustments                                      |       | —                |       | —         |       | —              |       | —       |       | —                                |       | (476                          | )          | (476 | ) |
|                                                                     |       |                  |       |           |       |                |       |         |       |                                  |       |                          |       |   |   |
| Comprehensive  loss                                                      |       |                  |       |           |       |                |       |         |       |                                  |       |                          |       | (7,797 | ) |
| Balance at  March 31, 2008                                          |       | 45,178                |       | $              | 516        |                | $          | 273,555      |       | $                                     | (144,797   | )                             | $          | 61,571 |   | $ | (2,880 | ) | 187,965 |   |
|                                                                          |            |                       |            |                |            |                     |            |              |            |                                       |            |                               |            |  |  |  |  |  |  |  |  |

 

See accompanyingnotes.

 

5

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**Websense, Inc.**

**Consolidated Statements of Cash Flows**

**(Unauditedand in thousands)**

 
| ** **                                                                                                     | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                     | ** ** | **March 31,**               | ** ** | **March 31,** | ** ** |
| ** **                                                                                                     | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| **Operating  activities:**                                                                                     |       |                             |       |   |   |
| Net (loss)  income                                                                                             |       | $                                | (6,237     | ) | $ | 3,867 |   |
| Adjustments to  reconcile net (loss) income to net cash provided by operating activities:                      |       |                             |       |   |   |
| Depreciation and  amortization                                                                                 |       | 16,064                           |       | 1,962 |   |
| In-process  research and development                                                                           |       | —                           |       | 1,270 |   |
| Share-based  compensation                                                                                      |       | 6,168                            |       | 5,222 |   |
| Deferred income  taxes                                                                                         |       | (18,241                          | )          | (1,119 | ) |
| Unrealized loss  on foreign exchange contracts                                                                 |       | 380                              |       | 6 |   |
| Unrealized  foreign exchange loss on re-measurement                                                            |       | 290                              |       | — |   |
| Excess tax  benefit from share-based compensation                                                              |       | —                           |       | (224 | ) |
| Changes in  operating assets and liabilities, net of effects from purchases of  PortAuthority and SurfControl: |       |                             |       |   |   |
| Accounts  receivable                                                                                           |       | 28,916                           |       | 16,609 |   |
| Other assets                                                                                                   |       | 112                              |       | (2,492 | ) |
| Accounts payable                                                                                               |       | (3,073                           | )          | (935 | ) |
| Accrued payroll  and related benefits                                                                          |       | (7,826                           | )          | (1,687 | ) |
| Other  liabilities                                                                                             |       | (2,462                           | )          | 2,023 |   |
| Deferred revenue                                                                                               |       | 1,691                            |       | (6,899 | ) |
| Income taxes  payable                                                                                          |       | 3,127                            |       | 3,665 |   |
| Net cash  provided by operating activities                                                                     |       | 18,909                           |       | 21,268 |   |
|                                                                                                           |       |                             |       |   |   |
| **Investing  activities:**                                                                                     |       |                             |       |   |   |
| Purchases of  property and equipment                                                                           |       | (2,388                           | )          | (1,753 | ) |
| Cash paid for  purchased technology (intangible asset)                                                         |       | (375                             | )          | — |   |
| Cash refunded  (paid) for acquisition of PortAuthority, net of cash acquired                                   |       | 147                              |       | (81,967 | ) |
| Cash received  from sale of CyberPatrol assets (Note 4)                                                        |       | 1,400                            |       | — |   |
| Purchases of  marketable securities                                                                            |       | (20,160                          | )          | (168,417 | ) |
| Maturities of  marketable securities                                                                           |       | 39,323                           |       | 177,712 |   |
| Net cash  provided by (used in) investing activities                                                           |       | 17,947                           |       | (74,425 | ) |
|                                                                                                           |       |                             |       |   |   |
| **Financing  activities:**                                                                                     |       |                             |       |   |   |
| Principal  payments on senior secured credit facility                                                          |       | (30,000                          | )          | — |   |
| Repayment of  PortAuthority loan                                                                               |       | —                           |       | (4,214 | ) |
| Proceeds from  exercise of stock options                                                                       |       | 224                              |       | 862 |   |
| Excess tax  benefit of share-based compensation                                                                |       | —                           |       | 224 |   |
| Purchase of  treasury stock                                                                                    |       | (2,797                           | )          | — |   |
| Net cash used in  financing activities                                                                         |       | (32,573                          | )          | (3,128 | ) |
| Effect of  exchange rate changes on cash and cash equivalents                                                  |       | 371                              |       | — |   |
| Increase  (decrease) in cash and cash equivalents                                                              |       | 4,654                            |       | (56,285 | ) |
| Cash and cash  equivalents at beginning of period                                                              |       | 66,383                           |       | 83,523 |   |
| Cash and cash  equivalents at end of period                                                                    |       | $                                | 71,037     |   | $ | 27,238 |   |
|                                                                                                           |       |                             |       |   |   |
| **Supplemental  cash flow information:**                                                                       |       |                             |       |   |   |
| Income taxes  paid                                                                                             |       | $                                | 773        |   | $ | 192 |   |
| Unrealized gain  on marketable securities                                                                      |       | $                                | —     |   | $ | 36 |   |
| Increase in  other accrued expenses for purchase of treasury stock                                             |       | $                                | 2,201      |   | $ | — |   |

 

See accompanying notes.

 

6

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**Websense, Inc.**

 

**Notes To Consolidated FinancialStatements (Unaudited)**

 

1. *Basis of Presentation*

 

Theaccompanying unaudited consolidated financial statements have been prepared inconformity with United States generally accepted accounting principles (“GAAP”)for interim financial statements and with the instructions to Form 10-Qand Article 10 of Regulation S-X. Accordingly, certain information orfootnote disclosures normally included in complete financial statementsprepared in accordance with GAAP have been condensed or omitted pursuant to therules and regulations of the Securities and Exchange Commission. In theopinion of management, the statements include all adjustments necessary, whichare of a normal and recurring nature, for the fair presentation of ourfinancial position and results of operations for the interim periods presented.

 

Thesefinancial statements should be read in conjunction with the auditedconsolidated financial statements and notes for the fiscal year ended December 31,2007, included in Websense, Inc.’s (“Websense” or the “Company”) AnnualReport on Form 10-K filed with the Securities and Exchange Commission.Operating results for the three months ended March 31, 2008 are notnecessarily indicative of the results that may be expected for any otherinterim period or for the fiscal year ending December 31, 2008. Thebalance sheet at December 31, 2007 has been derived from the audited financialstatements at that date but does not include all of the information andfootnotes required by GAAP for complete financial statements. Certain priorperiod amounts have been reclassified to conform to the current periodpresentation.

 

2. *Net (Loss) Income Per Share*

 

Websense computes net (loss)income per share (“EPS”) as permitted by the Financial Accounting StandardsBoard (“FASB”) with Statement of Financial Accounting Standards (“SFAS”) No. 128,*Earnings Per Share* (“SFAS 128”).Under the provisions of SFAS 128, basic EPS is computed by dividing the net(loss) income for the period by the weighted average number of common sharesoutstanding during the period. Diluted EPS is computed by dividing the netincome for the period by the weighted average number of common and commonequivalent shares outstanding during the period. Common equivalent sharesconsist of dilutive stock options and restricted stock units. Dilutive stockoptions and dilutive restricted stock units are calculated based on the averageshare price for each fiscal period using the treasury stock method. Inaccordance with SFAS 128, if, however, the Company reports a net loss, thediluted EPS is computed in the same manner as the basic EPS.

 

As theCompany reported a net loss for the three months ended March 31, 2008,basic and diluted EPS were the same. During the three months ended March 31,2008 and March 31, 2007, the difference between the weighted averageshares used in determining basic EPS versus diluted EPS related to dilutivesecurities which totaled zero and 655,000 shares, respectively. Potentiallydilutive securities totaling 8,272,000 and 5,378,000 shares for the threemonths ended March 31, 2008 and 2007, respectively, were excluded from thediluted EPS calculation because of their anti-dilutive effect.

 

Thefollowing is a reconciliation of the numerator and denominator used incalculating basic EPS to the numerator and denominator used in calculatingdiluted EPS for all periods presented:

 
| ** **                       | ** ** | **Net (Loss)  Income**                                           | ** ** | **Shares**        | ** ** | **Per Share** | ** ** |
|----------------------------------|------------|-----------------------------------------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                       | ** ** | **(Numerator)**                                                       | ** ** | **(Denominator)** | ** ** | **Amount**         | ** ** |
| ** **                       | ** ** | **(In thousands, except per share amounts)** | ** ** |
| **For the  Three Months Ended:** | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| **March 31,  2008:**        | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| Basic EPS                        |       | $                                                                     | (6,237     | )                 | 45,395     |               | $          | (0.14 | ) |
| Effect of  dilutive securities   |       | —                                                                |       | —            |       | —             |       |
| Diluted EPS                      |       | $                                                                     | (6,237     | )                 | 45,395     |               | $          | (0.14 | ) |
| ** **                       | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| **March 31,  2007:**        | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| Basic EPS                        |       | $                                                                     | 3,867      |              | 44,830     |               | $          | 0.09 |   |
| Effect of  dilutive securities   |       | —                                                                |       | 655               |       | (0.00              | )          |
| Diluted EPS                      |       | $                                                                     | 3,867      |              | 45,485     |               | $          | 0.09 |   |

 

7

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3. *Comprehensive (Loss) Income*

 

Thecomponents of comprehensive (loss) income, as required to be reported by SFAS130, *Reporting Comprehensive Income*, were asfollows (in thousands):

 
| ** **                                                                             | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                             | ** ** | **March 31,  2008**         | ** ** | **March 31,  2007** | ** ** |
| Net (loss)  income                                                                     |       | $                                | (6,237     | ) | $ | 3,867 |   |
| Net change in  unrealized gain on marketable securities, net of tax                    |       | —                           |       | 36 |   |
| Net change in  unrealized gain on fair value of foreign currency contracts, net of tax |       | —                           |       | 6 |   |
| Net change in  unrealized loss on interest rate swap and cap, net of tax               |       | (1,084                           | )          | — |   |
| Cumulative  translation adjustment                                                     |       | (476                             | )          | — |   |
| Comprehensive  (loss) income                                                           |       | $                                | (7,797     | ) | $ | 3,909 |   |

 

4. *Acquisitions*

 

**SurfControl**

 

In October 2007,the Company completed the acquisition of SurfControl plc (“SurfControl”), aU.K.-based provider of Web and e-mail security solutions.  The total purchase price of the acquisitionwas as follows (in thousands):

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

 

The purchase price allocation is preliminary andsubject to revision as more detailed analyses are completed and additionalinformation on the fair value of assets and liabilities becomes available.  Any change in the fair value of the netassets acquired will change the amount of the purchase price allocable togoodwill.  The Company expects tofinalize the purchase price by September 2008.  The preliminary allocation of the purchaseprice as of March 31, 2008 is as follows (in thousands):

 
| Fair value of net  tangible assets acquired and liabilities assumed: |   |    |   |    |    |
|----------------------------------------------------------------------|--------|---------|--------|---------|---------|
| Cash and cash  equivalents                                           |   | $       | 65,995 |    |    |   |
| Accounts receivable                                                  |   | 16,586  |   |    |    |
| Other current assets                                                 |   | 3,515   |   |    |    |
| Property and equipment                                               |   | 10,641  |   |    |    |
| Deferred income taxes                                                |   | (33,051 | )      |    |    |
| Accounts payable and  accrued expenses                               |   | (46,588 | )      |    |    |
| Deferred revenue                                                     |   | (19,707 | )      |    |    |
|                                                                 |   |    |   | (2,609  | )  |
| Fair value of  identifiable intangible assets acquired:              |   |    |   |    |    |
| Technology                                                           |   | 29,265  |   |    |    |
| Customer relationships                                               |   | 128,500 |   |    |    |
|                                                                 |   |    |   | 157,765 |    |
| Goodwill                                                             |   |    |   | 305,718 |    |
| Total estimated  purchase price                                      |   |    |   | $       | 460,874 |   |
|                                                                      |        |         |        |         |         |  |  |

 

In connection with the acquisition, the Company’smanagement approved plans to restructure the operations of the acquired companyby terminating 320 of SurfControl’s employees and exiting certain SurfControlfacilities. As of March 31, 2008, of the 320 employees originallyidentified for termination, 280 have been terminated, 20 

 

8

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no longer qualify for severance payments and theremaining 20 are expected to be terminated by September 2008. Theseworkforce reductions are across all functions and geographies and affectedemployees were, or will be, provided cash severance packages.  Additionally, the Company has consolidatedfacilities and has exited, or will be exiting, leases in certain locations aswell as reducing the square footage required to operate some locations.  The Company will finalize its facility exitplans by September 2008 which could further result in adjustments to thefair value of the associated acquired liabilities. The Company has accrued theestimated costs associated with the employee severance and facility exitobligations as liabilities assumed in the acquisition of SurfControl andaccordingly, these estimated costs are included as part of the purchase priceof SurfControl. Changes to the estimates of these costs after September 2008will be recorded as a reduction to goodwill or as an expense to the results ofoperations, as appropriate.  As of March 31,2008, $11.7 million of severance and facility exit obligations remain accruedfor payments in future periods as follows (in thousands):

 

| ** **           | ** ** | **Balance at  December 31,  2007** | ** ** | **Cash  Payments** | ** ** | **Adjustments** | ** ** | **Foreign Exchange  Adjustments** | ** ** | **Balance at March 31, 2008** | ** ** |
|----------------------|------------|----------------------------------------------|------------|--------------------|------------|-----------------|------------|----------------------------------------|------------|----------------------------------------------|------------|
|                 |       |                                         |       |               |       |            |       |                                   |       |                                         |       |
| Severance costs      |       | $                                            | 6,761      |               | $          | (3,011          | )          | $                                      | (1,366     | )                                            | $          | 10 |   | $ | 2,394 |   |
| Facility exit  costs |       | 9,379                                        |       | (126               | )          | (2              | )          | 29                                     |       | 9,280                                        |       |
| Total                |       | $                                            | 16,140     |               | $          | (3,137          | )          | $                                      | (1,368     | )                                            | $          | 39 |   | $ | 11,674 |   |

 

The accruals for severance costs at March 31, 2008primarily represent the amounts to be paid to employees that have beenterminated or identified for termination as a result of the restructuring plandescribed above.  These amounts areexpected to be paid within fiscal year 2008.

 

The accruals for facility exit costs at March 31,2008 represent the remaining fair value of lease obligations for exitinglocations, as determined at the expected cease-use dates of those facilities,and will be paid out over the remaining lease terms, the last of which ends infiscal year 2013.  As of March 31,2008, the facility exit accrual has not been reduced for any estimated subleaseincome nor have any adjustments been made due to favorable or unfavorablecurrent lease terms as the Company has not yet obtained the information neededto make such an estimate.  The Company anticipatessuch information will be obtained by September 2008 and will adjust thefacility exit accrual accordingly.

 

In connection with the acquisition of SurfControl,Websense acquired SurfControl’s consumer internet safety software businessknown as CyberPatrol.  During the threemonths ended March 31, 2008, the Company entered into an Asset PurchaseAgreement for the sale of certain assets relating to CyberPatrol for $1.4million in cash.  The sale closed on March 31,2008.  The assets sold were primarilyintellectual property for the technology and existing customer contracts.  As the Company has not completed its purchaseprice allocation for the purchase of SurfControl and the best indication offair value is a third party sale between a willing buyer and a willing seller,the Company recorded the sale as follows: increase to cash of $1.4 million, decrease to deferred revenue of $0.7million and a reduction to goodwill of $2.1 million with no gain or lossrecorded from the sale.

 

5. *Intangible Assets andGoodwill*

 

Intangible assets subject to amortization consisted ofthe following as of March 31, 2008 (in thousands):

 

| ** **              | ** ** | **Weighted Average Life  (years)** | ** ** | **Cost** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|-------------------------|------------|----------------------------------------------|------------|----------|------------|-------------------------------|------------|---------|------------|
|                    |       |                                         |       |     |       |                          |       |    |       |
| Technology              |       | 3.0                                          |       | $        | 42,175     |                          | $          | (8,425  | )          | $ | 33,750 |   |
| Customer  relationships |       | 6.3                                          |       | 129,200  |       | (22,458                       | )          | 106,742 |       |
| Trade name              |       | 3.8                                          |       | 510      |       | (127                          | )          | 383     |       |
| Total                   |       |                                         |       | $        | 171,885    |                          | $          | (31,010 | )          | $ | 140,875 |   |

 

9

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As of March 31, 2008, remaining amortizationexpense is expected to be as follows (in thousands):

 
| **Years Ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2008                                         |       | $          | 37,282     |   |
| 2009                                         |       | 38,470     |       |
| 2010                                         |       | 25,678     |       |
| 2011                                         |       | 14,818     |       |
| 2012                                         |       | 8,163      |       |
| Thereafter                                   |       | 16,464     |       |
| Total                                        |       | $          | 140,875    |   |

 

The following table summarizes the activity related tothe carrying value of the Company’s goodwill during the three months ended March 31,2008 (in thousands):

 
| ** **                                         | ** ** | **Three Months Ended  March 31, 2008** | ** ** |
|----------------------------------------------------|------------|------------------------------------------------------------|------------|
| Balance at  December 31, 2007                 |       | $                                                          | 385,916    |   |
| Reduction from sale  of CyberPatrol assets         |       | (2,148                                                     | )          |
| Refund from  escrow from PortAuthority acquisition |       | (147                                                       | )          |
| SurfControl  deferred income tax adjustment        |       | (4,681                                                     | )          |
| Other  SurfControl purchase accounting adjustments |       | (1,214                                                     | )          |
| Balance at  March 31, 2008                    |       | $                                                          | 377,726    |   |

 

**6*. Senior Secured CreditFacility***

** **

In connection with the acquisition of SurfControl in October 2007,the Company entered into an amended and restated senior credit agreement (the“Senior Credit Agreement”).  The $225million senior secured credit facility consists of a five year $210 millionsenior secured credit facility and a $15 million revolving credit facility. Thesenior secured credit facility was fully funded on October 11, 2007, andthe revolving line of credit remains unused. At March 31, 2008, the outstanding balance under the senior securedcredit facility was $160 million as a result of the Company making optionalprepayments totaling $30 million in the quarter ended March 31, 2008 andoptional prepayments totaling $20 million in the quarter ended December 31,2007.  The senior secured credit facilityis secured by substantially all of the assets of the Company, including pledgesof stock of some of its subsidiaries (subject to limitations in the case offoreign subsidiaries) and by secured guarantees by the Company’s domesticsubsidiaries. The senior secured credit facility initially amortized at aminimum rate of 2.5%, 10%, 12.5%, and 15%, respectively, during the first fouryears of the term and 60% during the fifth year. In conjunction with theCompany’s optional $20 million prepayment on December 31, 2007, theCompany amended its Senior Credit Agreement to eliminate any additionalmandatory payments until September 30, 2009.  The initial interest rate on the creditfacility was LIBOR plus 250 basis points (5.2% at March 30, 2008), and wassubject to step downs in the spread over LIBOR based upon potential futureimprovements in the Company’s total leverage ratio. The unused portion of therevolving credit facility required a 50 basis points fee per annum, alsosubject to step downs based upon potential future improvements in the Company’stotal leverage ratio. As of March 31, 2008, the Company qualified for areduction in the applicable margin on the senior secured credit facility andrevolving credit facility fee. Effective March 31, 2008, the interest rateon the senior secured credit facility became LIBOR plus 225 basis points (4.95%at March 31, 2008) and the revolving credit facility fee became 25 basispoints (0.25%) per annum. The Senior Credit Agreement contains financialcovenants, including a consolidated leverage ratio and a consolidated interestcoverage ratio, as well as affirmative and negative covenants.

 

As of March 31, 2008, future remaining minimumprincipal payments under the senior secured credit facility will be as follows(in thousands):

 
| **Years Ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2008                                         |       | $          | —     |   |
| 2009                                         |       | 5,263      |       |
| 2010                                         |       | 22,105     |       |
| 2011                                         |       | 26,527     |       |
| 2012                                         |       | 106,105    |       |
| Total                                        |       | $          | 160,000    |   |

 

10

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The Senior Credit Agreement provides that the Companymust maintain hedge agreements so that at least 50% of the aggregate principalamount of the senior secured credit facility is subject to fixed interest rateprotection for a period of not less than 2.5 years. On October 11, 2007 inconjunction with the funding of the senior secured credit facility, the Companyentered into an interest rate swap agreement to pay a fixed rate of interest(4.85% per annum) and receive a floating rate interest payment (based on threemonth LIBOR) on an equivalent amount. The initial principal amount of theagreement was $105 million on October 11, 2007. In addition, on October 11,2007 the Company entered into an interest rate cap agreement to limit themaximum interest rate on a portion of its senior secured credit facility to6.5% per annum. The amount of principal protected by this agreement increasesfrom $5 million at December 31, 2007 to $74.3 million on June 30,2010. Both the interest rate swap and cap expire on September 30, 2010.

 

7. *Foreign Currency Hedges*

 

The Company uses derivatives to manage foreign currency risk and notfor speculative or trading purposes. The Company’s objective is to reduce therisk to earnings and cash flows associated with changes in foreign currency exchangerates. Gains and losses resulting from changes in the fair values of thosederivative instruments are recorded to earnings or other comprehensive (loss)income depending on the use of the derivative instrument and whether itqualifies for hedge accounting.

 

During the three months ended March 31, 2008 and 2007, the Companyutilized Euro foreign currency forward contracts to hedge anticipated Eurodenominated accounts receivable. All such contracts entered into weredesignated as fair value hedges and were not required to be tested foreffectiveness as hedge accounting was not elected. None of the contracts wereterminated prior to settlement. Net realized losses and gains related to thecontracts designated as fair value hedges settled during the three months endedMarch 31, 2008 and 2007 are included in other (expense) income, net, inthe accompanying consolidated statements of operations and amounted toapproximately ($277,000) and $85,000 for the three months ended March 31,2008 and 2007, respectively.

 

Notional and fair values of the Company’s Euro and British Pound hedging positions at March 31, 2008 and 2007 are presented in the table below (in thousands):

 
| ** **    | ** ** | **March 31, 2008**         | ** ** | **March 31, 2007** | ** ** |
|---------------|------------|--------------------------------------|------------|------------------------------|------------|
| ** **    | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD**     | ** ** | **Fair Value  USD** | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD** | ** ** | **Fair Value  USD** | ** ** |
| Euro          |       | €                               | 5,200      |                         | $          | 7,800 |   | $ | 7,420 |   | € | 2,000 |   | $ | 2,627 |   | $ | 2,577 |   |
| British Pound |       | £                               | —     |                         | —     |   | — |   | £ | 1,200 |   | 2,356 |   | 2,351 |   |
| Total         |       |                                 |       | $                            | 7,800      |   | $ | 7,420 |   |   |   | $ | 4,983 |   | $ | 4,928 |   |

 

*8. Fair Value Measurements*

 

*SFAS 157*

 

SFAS No. 157,*Fair Value Measurements* (“SFAS157”) defines fair value, establishes a framework for measuring fair value andestablishes a hierarchy that categorizes and prioritizes the sources to be usedto estimate fair value. SFAS 157 also expands financial statement disclosuresabout fair value measurements. On February 12, 2008, the FASB issued FASBStaff Position 157-2 (“FSP 157-2”), which delays the effective date of SFAS 157for one year for all nonfinancial assets and nonfinancial liabilities, except thosethat are recognized or disclosed at fair value in the financial statements on arecurring basis.  The Company elected apartial deferral of SFAS 157 under the provisions of FSP 157-2 related tothe measurement of fair value used when evaluating nonfinancial assets andliabilities. The Company is currently evaluating the impact of FSP 157-2 on itsfinancial statements. The impact of partially adopting SFAS 157 effective January 1,2008 was not material to our financial statements.

 

*Fair Value Measurements on aRecurring Basis*

 

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

 

The followingtable presents the balances of assets and liabilities measured at fair value ona recurring basis as of March 31, 2008 (in thousands):

 
| ** **                          | ** ** | **Level 1****(1)** | ** ** | **Level 2****(2)** | ** ** | **Level 3****(3)** | ** ** | **Total** | ** ** |
|-------------------------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------|------------|-----------|------------|
| Assets:                             |       |                    |       |                    |       |                    |       |      |       |
| Marketable  securities              |       | $                       | 632        |                    | $          | —                  |       | $         | —     |   | $ | 632 |   |
| Interest rate  cap                  |       | —                  |       | 15                      |       | —                  |       | 15        |       |
|                                |       |                    |       |                    |       |                    |       |      |       |
| Liabilities:                        |       |                    |       |                    |       |                    |       |      |       |
| Interest rate  swaps                |       | $                       | —     |                    | $          | 3,419                   |       | $         | —     |   | $ | 3,419 |   |
| Foreign currency  forward contracts |       | —                  |       | 380                     |       | —                  |       | 380       |       |

 

----

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

 

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

 

(3) – noobservable pricing inputs in the market

 

11

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Marketable securities represent an investment in amunicipal bond which is measured using quoted prices in active markets and isclassified as Level 1.  Included in Otherassets and in Other accrued expenses are derivative contracts, comprised ofinterest rate swaps and cap as well as foreign currency forward contracts, thatare valued using models based on readily observable market parameters for allsubstantial terms of the Company’s derivative contracts and thus are classifiedwithin Level 2.

 

*Fair Value Measurements on aNonrecurring Basis*

 

As permitted by FSP157-2, the Company electedto defer the fair value measurement disclosure of its nonfinancial assets andliabilities.

 

*SFAS No. 159*

 

SFAS No. 159, *The Fair Value Option for Financial Assets andFinancial Liabilities—Including an Amendment of SFAS 115* (“SFAS 159”),permits but does not require companies to measure financial instruments andcertain other items at fair value. Unrealized gains and losses on items forwhich the fair value option has been elected are reported in earnings. As the Company did not electto fair value any of its financial instruments under the provisions of SFAS159, the adoption of this statement effective January 1, 2008 did not havean impact on the Company’s financial statements.

 

9.*Stockholders’ Equity*

 

**Share-Based Compensation**

 

*Employee Stock Purchase Plan*

 

Shares available for issuance under the Company’sEmployee Stock Purchase Plan are as follows:

 
| ** **                                                                                 | ** ** | **Number of   Shares** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| Shares reserved  for issuance at December 31, 2007                                    |       | 1,691,165                        |       |
| Shares reserved  for issuance during 2008 based on automatic increase in shares authorized |       | 453,936                          |       |
| Shares reserved  for issuance at March 31, 2008                                       |       | 2,145,101                        |       |

 

*Employee Stock Option Plans*

 

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

 
| ** **                                       | ** ** | **Number of   Shares** | ** ** | **Weighted  Average  Exercise Price** | ** **  |
|--------------------------------------------------|------------|----------------------------------|------------|--------------------------------------------|-------------|
| Balance at December 31, 2007 |       | 9,086,786                        |       | $                                          |  22.62 | ** ** |
| Granted                                          |       | 757,125                          |       | 18.29                                      |        |
| Exercised                                        |       | (23,829                          | )          | 9.40                                       |        |
| Cancelled                                        |       | (356,362                         | )          | 22.90                                      |        |
| Balance at  March 31, 2008                  |       | 9,463,720                        |       | 22.29                                      |        |
|                                                  |            |                                  |            |                                            |             |  |

 

Sharesreserved for future grants under the Company’s stock option plans are asfollows:

 
| ** **                                                                                           | ** ** | **Number of    Shares** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| Shares reserved  for future grants at December 31, 2007                                         |       | 222,629                                |       |
| Shares reserved  for future grants during 2008 based on the automatic increase in shares  authorized |       | 1,815,746                              |       |
| Shares granted  during quarter ended March 31, 2008                                             |       | (757,125                               | )          |
| Shares cancelled  during quarter ended March 31, 2008                                           |       | 356,362                                |       |
| Shares reserved  for future grants at March 31, 2008                                            |       | 1,637,612                              |       |

 

Theresults for the three months ended March 31, 2008 and 2007 includeshare-based compensation expense of $6.2 million and $5.2 million (excludingtax effects), respectively, in the following expense categories of theconsolidated statements of operations (in thousands).

 

12

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| ** **                                            | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                            | ** ** | **March 31,  2008**         | ** ** | **March 31,  2007** | ** ** |
| Share-based compensation  in:                         |       |                             |       |   |   |
| Cost of revenues                                      |       | $                                | 361        |   | $ | 329 |   |
| Total  share-based compensation in cost of revenues   |       | 361                              |       | 329 |   |
|                                                  |       |                             |       |   |   |
| Selling and  marketing                                |       | 2,317                            |       | 2,013 |   |
| Research and  development                             |       | 1,124                            |       | 932 |   |
| General and  administrative                           |       | 2,366                            |       | 1,948 |   |
| Total  share-based compensation in operating expenses |       | 5,807                            |       | 4,893 |   |
| Total  share-based compensation                       |       | $                                | 6,168      |   | $ | 5,222 |   |

 

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

 
| ** **                          | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|
| ** **                          | ** ** | **March 31,   2008**   | ** ** | **March 31,   2007** | ** ** |
|                                |       |                             |       |   |   |
| Average expected  life (years)      |       | 3.1                              |       | 3.0 |   |
| Average expected  volatility factor |       | 34.8                             | %          | 35.9 | % |
| Average  risk-free interest rate    |       | 2.3                              | %          | 4.7 | % |
| Average expected  dividend yield    |       | —                           |       | — |   |

 

**Treasury Stock**

 

The Companyresumed repurchasing shares of its common stock during the first three monthsof 2008 as follows.

 
| ** **                                                   | ** ** | **Shares** | ** ** | **Average Price  Per Share** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|----------------------------------------|------------|
| Shares  repurchased through December 31, 2007           |       | 8,170,060  |       | $                                      | 20.86      |   |
| Shares  repurchased during quarter ended March 31, 2008 |       | 264,400    |       | $                                      | 18.90      |   |
| Shares  repurchased through March 31, 2008              |       | 8,434,460  |       | $                                      | 20.80      |   |

 

Under the terms ofthe Company’s Senior Credit Agreement, the Company is restricted fromrepurchasing its common stock for an aggregate purchase price that exceeds thesum of $25 million plus 50% of the aggregate amount of its consolidated netincome, as defined in the Senior Credit Agreement, during the period from theeffective date of the facility through the most recent quarter end for whichquarterly financial statements have been filed. The remaining shares authorized for repurchase under the Company’s stockrepurchase program as of March 31, 2008 was 3,565,540 shares.  As of March 31, 2008, $31.9 million remainedauthorized for repurchase under the Company’s Senior Credit Agreement.

 

10. *Tax Matters*

 

The Company adopted FASB Interpretation 48, *Accounting for Uncertainty in Income Taxes*(“FIN 48”), at the beginning of fiscal year 2007.  At March 31, 2008, the Company hadapproximately $8.5 million of total gross unrecognized tax benefits. Includedin this balance are $5.3 million of unrecognized tax benefits that, ifrecognized, would reduce the Company’s annual effective tax rate. Estimatedinterest and penalties related to the underpayment of income taxes areclassified as a component of provision for income taxes in the consolidatedstatements of operations.  The Companyaccrued potential penalties and interest of $0.1 million related to theseunrecognized tax benefits during the quarter ended March, 31, 2008, and in total,as of March 31, 2008, the Company has recorded a liability for potentialpenalties and interest of $0.8 million.

 

13

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The Company and itssubsidiaries are subject to U.S. federal income tax as well as income tax ofmultiple state and foreign jurisdictions. The Company has substantiallyconcluded all U.S. federal and state income tax audits for years through 2003.Substantially all material foreign income tax audits have been concluded foryears through 2002. The federal income tax return for 2005 and Californiaincome tax returns for 2003 and 2004 are currently under examination. At March 31,2008, the Company had net deferred tax assets of $34.2 million.

 

During the quarter, theCompany received a favorable ruling regarding unrecognized state income taxbenefits, resulting in the reduction of the gross uncertain tax liability of$4.2 million.  This favorable rulingresulted in approximately $2.7 million of net tax benefit being recognized inthe statement of operations in the quarter ended March 31, 2008 with theremaining $1.5 million being recorded as a reduction to the related deferredtax asset. In addition, due to the potential resolution of federal, state andforeign tax examinations, and the expiration of various statutes oflimitations, it is reasonably possible that the Company’s gross unrecognizedtax benefits balance may change within the next twelve months by a range ofzero to $0.9 million.

 

11*. Litigation*

 

The Company is involvedin various legal actions in the normal course of business. Based on currentinformation, including consultation with the Company’s lawyers, the Companybelieves that it has adequately reserved, under GAAP, for any ultimateliability that may result from these actions such that any liability would notmaterially affect the Company’s consolidated financial position, results ofoperations or cash flows. The Company’s evaluation of the likely impact ofthese actions 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.

 

12. *RecentlyIssued Accounting Standards*

 

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

 

In December 2007 theFASB issued SFAS No. 141R, *BusinessCombinations* (“SFAS 141R”). SFAS 141R establishes principlesand requirements for how the acquirer of a business recognizes and measures inits financial statements the identifiable assets acquired, the liabilitiesassumed, and any noncontrolling interest in the acquiree. The statement alsoprovides guidance for recognizing and measuring the goodwill acquired in thebusiness combination and establishes what information to disclose to enableusers of the financial statements to evaluate the nature and financial effectsof the business combination. SFAS 141R is effective for financialstatements issued for fiscal years beginning after December 15, 2008.Accordingly, any business combinations the Company engages in will be recordedand disclosed following existing GAAP until January 1, 2009. The Companyexpects SFAS 141R may have an impact on its consolidated financialstatements when effective, but the nature and magnitude of the specific effectswill depend upon the nature, terms and size of the acquisitions, if any,consummated after the effective date. The Company is currently assessing thepotential impact that adoption of SFAS 141R may have on its financial statements.

 

14

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**Item 2. Management’s Discussion and Analysis ofFinancial 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“Risk Factors” under Part II, Item 1A below regarding certain factorsknown to us that could cause reported financial information not to benecessarily indicative of future results.**

** **

**Forward-Looking Statements**

** **

**Thisreport on Form 10-Q may contain “forward-looking statements” within themeaning of the federal securities laws made pursuant to the safe harborprovisions of the Private Securities Litigation Reform Act of 1995. Thesestatements, which represent our expectations or beliefs concerning variousfuture events, may contain words such as “may,” “will,” “expects,”“anticipates,” “intends,” “plans,” “believes,” “estimates,” or other wordsindicating future results. Such statements may include but are not limited tostatements concerning the following:**

** **

·                  anticipatedtrends in revenue;

 

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

 

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

 

·                  growthopportunities in domestic and international markets;

 

·                  new and enhancedchannels of distribution;

 

·                  customeracceptance and satisfaction with our products;

 

·                  expected trendsin operating and other expenses;

 

·                  anticipated cashand intentions regarding usage of cash;

 

·                  changes ineffective 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“Risk Factors,” 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**

 

Since we commencedoperations in 1994 as a reseller of computer security products, Websense hasevolved into a leading provider of content security software solutions,including Web security, email and messaging security and data loss prevention(“DLP”) solutions.  In today’s Web/enterprisehybrid computing environment, customers must deploy integrated Web, email anddata security products to achieve effective protection against blended Web andemail attacks, as well as from inadvertent data leaks due to faulty businessprocesses.  To expand our productoffering to meet the changing demands of the security software industry, in January 2007,we entered the emerging market for DLP and acquired PortAuthority Technologies, Inc.(“PortAuthority”), our technology development partner for DLP solutions.Additionally, in October 2007, we acquired SurfControl plc(“SurfControl”), a leading provider of Web and email security softwaresolutions, which expanded our product portfolio to include email securitysoftware and hosted Web and email security solutions.

 

Today, we offercomprehensive Web, email and data security products, available as layeredsoftware or on-demand solutions. We have focused on integrating theintelligence from each of these product areas to protect organizations’employees and critical business data from external Web-based and email-basedattacks, and from internal employee-generated threats such as an employee errorand malfeasance.  Our customers use oursoftware products to provide a secure and productive computing environment foremployees, business partners and customers. Our products allow organizations to:

 

15

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·              prevent access to undesirable anddangerous elements on the Web, such as Web sites that contain inappropriatecontent or sites that download viruses, spyware, keyloggers, phishing andpharming exploits and an ever-increasing variety of malicious code;

 

·              filter “spam” out of incoming emailtraffic;

 

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

 

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

 

·              restrict the unauthorized use and loss ofsensitive data, such as customer or employee information; and

 

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

 

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

 

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

 

·              dynamic classification of uncategorized,high-risk content based on our knowledge of the Web, email attack vectors, andmalicious code characteristics; and

 

·              policy enforcement software thatautomates enforcement of pre-defined business policies regarding acceptableusers and uses of various content categories.

 

During the three monthsended March 31, 2008, we derived approximately 41% of our revenue frominternational sales, compared with approximately 39% for the three months endedMarch 31, 2007, with the United Kingdom comprising approximately 12% and10% of our total revenue for the three months ended March 31, 2008 and2007, respectively. We believe international markets continue to represent asignificant growth opportunity and we are continuing to expand ourinternational operations, particularly in selected countries in the European,Asia/Pacific, Latin American and Australian markets.

 

We sell our productsprimarily through indirect channels.  In2006, we transitioned our Web security products to a two-tier system of distributorsand value-added resellers in North America, in order to increase the number ofvalue-added resellers selling our products and further extend our reach intothe small and medium-sized business (“SMB”) market segments.  We have historically relied on a two-tier distributionstrategy outside North America.  Onoccasion, we do sell products directly to value-added resellers or tocustomers, but sales through indirect channels currently account for more than90% of our revenue.

 

As described elsewhere inthis report, we recognize revenue from subscriptions to our products, includingadd-on modules, on a daily straight-line basis commencing on the day the termof the subscription begins, over the term of the subscription agreement. Werecognize the operating expenses related to these sales as they are incurred.These operating expenses include sales commissions, which are based on thetotal amount of the subscription contract and are fully expensed in the periodthe product is first delivered. Operating expenses have continued to increaseas compared with prior periods due to expanded selling and marketing efforts,continued product research and development and investments in administrativeinfrastructure to support subscription sales that we will recognize as revenuein subsequent periods.

 

In October 2007, weclosed our acquisition of SurfControl and as a result we have incurredoperating losses under U.S. generally accepted accounting principles (“GAAP”)since the acquisition closed. Similar to Websense, SurfControl sold productsprimarily under subscriptions whereby revenues were recorded ratably over theterm of the agreement. Under GAAP purchase accounting, we wrote off $97.4million of the deferred revenue of SurfControl, leaving a balance of $19.7million as of the closing. This adjustment reflects the fair value of thepost-contract technical support services that will be recognized daily inaccordance with our revenue recognition policy. We do not expect to generatesignificant revenue from the installed SurfControl customer base until thesesubscriptions are up for renewal. In connection with the acquisition, we haveincurred restructuring costs primarily in connection with reducing SurfControlheadcount and eliminating redundant facilities. We also immediately started to incur the expenses of operating theSurfControl operations as well as recording the amortization of the acquiredintangibles.  As a result, we expect tocontinue to operate at a loss under GAAP until we generate sufficient revenuefrom the subsequent renewal of subscriptions from the installed SurfControlcustomer base to offset these expenses. Given the average remaining term of the SurfControl subscriptions, wecurrently do not expect to 

 

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operate at a profit under GAAP in fiscal year 2008.  Our ability to retain SurfControl customersand maintain our overall pricing levels for our products will impact ourresults of operations and the timing of our return to profitability.

 

We allocate the totalcosts for human resources, employee benefits, payroll taxes, informationtechnology, facilities, fixed asset depreciation and legal costs to each of ourfunctional areas based on salaries and headcount data.  Our overall costs to be allocated haveincreased as a result of the growth in our headcount and increased personnelcosts, the growth of our facilities costs, and increased legal costs attributableto the increased complexity and maturity of our business and overall growth,and we expect this trend to continue.

 

In connection with theacquisition of SurfControl, we approved plans to restructure the operations ofthe acquired company by terminating 320 of SurfControl’s employees and exitingcertain SurfControl facilities. As of March 31, 2008, of the 320 employeesthat we identified as being subject to the involuntarily termination 280 havebeen terminated, 20 no longer qualify for severance payments and the remaining20 are expected to be phased out during fiscal year 2008.  These workforce reductions are across allfunctions and geographies and affected employees were, or will be, providedcash severance packages. Additionally, we have consolidated facilities and haveexited, or will be exiting, leases in certain locations as well as reducing thesquare footage required to operate some locations. We will finalize ourfacility exit plans by September 2008. We have accrued the estimated costs associatedwith the employee severance and facility exit obligations as liabilitiesassumed in the acquisition of SurfControl and, accordingly, included as part ofthe purchase price of SurfControl. Changes to the estimates of these costs afterSeptember 2008 will be recorded either as a reduction to goodwill or as anexpense to the results of operations.

 

**Critical Accounting Policies and Estimates**

** **

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

 

*Revenue Recognition.*When a purchase decision is made for our products, customers enter into asubscription agreement, which is generally 12, 24 or 36 months in duration andfor a fixed number of users. Other services such as upgrades/enhancements andstandard post-contract technical support services are sold together with ourproduct subscription and provided throughout the subscription term.  We recognize revenue on a daily straight-linebasis commencing on the date the term of the subscription begins, andcontinuing over the term of the subscription agreement, provided the fee isfixed or determinable, persuasive evidence of an arrangement exists andcollectability is reasonably assured. Upon entering into a subscriptionarrangement for a fixed or determinable fee, we electronically deliver accesscodes to users and then promptly invoice customers for the full amount of theirsubscriptions. Payment is due for the full term of the subscription, generallywithin 30 to 60 days of the invoice. We record amounts billed to customers inexcess of recognizable revenue as deferred revenue on our balance sheet.

 

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

 

*Acquisitions, Goodwill and Other Intangible Assets.* We account for acquired businesses using thepurchase method of accounting in accordance with SFAS No. 141, *Business Combinations* (“SFAS 141”), which requires that theassets acquired and liabilities assumed be recorded at the date of acquisitionat their respective fair values.  Anyexcess of the purchase price over the estimated fair values of net assetsacquired is recorded as goodwill.  Thefair value of intangible assets, including acquired technology and customerrelationships, is based on significant judgments made by management andaccordingly we obtain the assistance from third party valuation specialists. The valuations and useful life assumptions are based on informationavailable near the acquisition date and are based on expectations andassumptions that are considered reasonable by management.  The judgments made in determining estimatedfair values assigned to assets acquired and liabilities assumed, as well asasset lives, can materially impact our results of operations.

 

In accordance with SFAS No. 142,*Goodwill and Other Intangible Assets*(“SFAS 142”), we review goodwill that has an indefinite useful life forimpairment at least annually in our fourth fiscal quarter, or more frequentlyif an event occurs indicating the potential for impairment.  We amortize the cost of identified intangibleassets using amortization methods that reflect the pattern in which the economic benefits of the intangibleassets are consumed or otherwise used up. In accordance with SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets* (“SFAS 144”), wereview intangible assets that have finite useful lives when an event occursindicating the potential for impairment. We review for impairment 

 

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by facts or circumstances, either external or internal, indicating thatwe may not recover the carrying value of the asset.  We measure impairment losses related tolong-lived assets based on the amount by which the carrying amounts of theseassets exceed their fair values.  Wemeasure fair value under SFAS 144, which is generally based on the estimatedfuture cash flows. Our analysis is based on available information and onassumptions and projections that we consider to be reasonable and supportable.  If necessary, we perform subsequentcalculations to measure the amount of the impairment loss based on the excessof the carrying value over the fair value of the impaired assets.

 

*Share-Based Compensation.***Effective January 1, 2006, we adoptedthe provisions of SFAS No. 123(R), *Share-BasedPayment* (“SFAS 123R”) andStaff Accounting Bulletin No. 107 (“SAB 107”) requiring the measurementand recognition of all share-based compensation under the fair valuemethod.  Share-based compensation expenserelated to stock options is recorded based on the fair value of the award onits grant date which we estimate using the Black-Scholes valuation modelbased on the provisions prescribed under SFAS 123R and SAB 107.  Share-based compensation expense related torestricted stock unit awards is calculated based on the market price of ourcommon stock on the date of grant.

 

*Income Tax Provision andUncertain Tax Positions.* Significant judgment isrequired in determining our consolidated income tax provision and evaluatingour U.S. and foreign tax positions. We adopted FASB Interpretation 48, *Accounting for Uncertainty in Income Taxes*(“FIN 48”) beginning in 2007. FIN 48 addresses the determination of how taxbenefits claimed or expected to be claimed on a tax return should be recordedin the financial statements. Under FIN 48, we must recognize the tax benefitfrom an uncertain tax position only if it is more likely than not that the taxposition will be sustained on examination by the taxing authorities, based onthe technical merits of the position. The tax benefits recognized in thefinancial statements from such a position are measured based on the largestbenefit that has a greater than fifty percent likelihood of being realized uponresolution. We consider many factors when evaluating and estimating our taxpositions and tax benefits, which may require periodic adjustments and whichmay not accurately anticipate actual outcomes.

 

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#  

# **Results of Operations**

#  

***Three months ended March 31, 2008 compared with thethree months ended March 31, 2007***

 

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

 
| ** **                            | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|
| ** **                            | ** ** | **March 31,   2008**   | ** ** | **March 31,   2007** | ** ** |
| ** **                            | ** ** | **(Unaudited)**                  | ** ** |
| ** **                            | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Revenue                               |       | 100                              | %          | 100 | % |
|                                  |       |                             |       |   |   |
| Cost of revenues:                     |       |                             |       |   |   |
| Cost of revenues                      |       | 13                               |       | 8 |   |
| Amortization of  acquired technology  |       | 5                                |       | 1 |   |
| Total cost of  revenues               |       | 18                               |       | 9 |   |
|                                  |       |                             |       |   |   |
| Gross margin                          |       | 82                               |       | 91 |   |
|                                  |       |                             |       |   |   |
| Operating  expenses:                  |       |                             |       |   |   |
| Selling and  marketing                |       | 64                               |       | 50 |   |
| Research and  development             |       | 20                               |       | 17 |   |
| General and  administrative           |       | 19                               |       | 15 |   |
| Total operating  expenses             |       | 103                              |       | 82 |   |
|                                  |       |                             |       |   |   |
| (Loss) income  from operations        |       | (21                              | )          | 9 |   |
|                                  |       |                             |       |   |   |
| Interest expense                      |       | (7                               | )          | — |   |
| Other (expense)  income, net          |       | —                           |       | 5 |   |
|                                  |       |                             |       |   |   |
| (Loss) income  before income taxes    |       | (28                              | )          | 14 |   |
|                                  |       |                             |       |   |   |
| (Benefit)  provision for income taxes |       | (19                              | )          | 6 |   |
|                                  |       |                             |       |   |   |
| Net (loss)  income                    |       | (9                               | )%         | 8 | % |

 

# **Revenue**

#  

Revenue increased to$67.0 million in the first quarter of 2008 from $49.7 million in the firstquarter of 2007. The increase was a result of the addition of new, renewed andupgraded subscriptions (including $14.0 million from new or renewal SurfControlseat subscriptions and revenue recognized from the deferred revenue acquiredfrom SurfControl). Our first quarter 2008 revenue reflects a full quarter ofrevenue from our acquisition of SurfControl in October 2007. For theremainder of 2008, we also expect our revenue to increase over 2007 due to theaddition of our recently acquired SurfControl business, our deferred revenueunder existing subscriptions, our renewal business, planned growth in SMBbusiness and international sales, and planned growth of our DLP business,partially offset by increased channel marketing payments and channel rebates,which are recorded as reductions to revenue. Until sufficient existing subscriptions for the installed SurfControlcustomer base are subsequently renewed, revenue contributed by the SurfControlproducts will be minimal as compared to SurfControl’s historic stand-alonerevenue as we wrote down SurfControl’s deferred revenue by $97.4 million to itsestimated fair value of $19.7 million at the date of acquisition as requiredunder GAAP.

 

# **Cost ofRevenues**

#  

*Cost ofrevenues.* Cost of revenues consists of the costs of contentreview, technical support and infrastructure costs associated with maintainingour databases and costs associated with providing our hosted security services.Cost of revenues increased to $8.9 million in the first quarter of 2008 from$4.0 million in the first quarter of 2007. The increase of $4.9 million wasprimarily due to additional personnel in our technical support and databasegroups, including the increased headcount attributable to the acquisition ofSurfControl, and the addition of DLP products and allocated costs. Ourheadcount 

 

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in cost of revenue departments increased from 155 at March 31,2007 to 201 at March 31, 2008. We allocate the total costs for humanresources, employee benefits, payroll taxes, information technology,facilities, fixed asset depreciation and legal costs to each of our functionalareas based on salaries and headcount data. As a percentage of revenue, cost ofrevenues increased to 13% from 8% during the first quarter of 2008 compared to2007.  We expect cost of revenue toremain higher for the remainder of 2008 as compared to 2007, both in absolutedollars and as a percentage of revenue, in order to support the growth andmaintenance of our databases and due to costs associated with providing ourhosted security services as well as the technical support needs of ourcustomers.

 

*Amortizationof acquired technology.* Amortization of acquired technologyprimarily relates to the developed technology acquired from the PortAuthorityacquisition in January 2007 and SurfControl acquisition in October 2007.The increase of $2.4 million in amortization of acquired technology from thefirst quarter of 2007 to the first quarter of 2008 was primarily due to theacquisition of SurfControl in October 2007. The acquired technology isbeing amortized over a weighted average period of 3.0 years. We expect to incur$9.1 million in amortization expense of acquired technology during theremainder of 2008.

 

# **GrossMargin**

#  

Gross margin increased to$55.0 million in the first quarter of 2008 from $45.1 million in the firstquarter of 2007. As a percentage of revenue, gross margin decreased to 82% inthe first quarter of 2008 from 91% in the first quarter of 2007 due to theincreased costs described in the preceding Cost of Revenues section. We expectthat gross margin as a percentage of revenue will remain in excess of 80% ofrevenue for the remainder of 2008.

 

# **OperatingExpenses**

#  

*Sellingand marketing*. Selling and marketing expenses consistprimarily of salaries, commissions and benefits related to personnel engaged inselling, marketing and customer support functions, including costs related topublic relations, advertising, promotions and travel, amortization of acquiredcustomer relationships as well as allocated costs. Selling and marketingexpenses do not include payments to channel partners for marketing services andrebates.  Selling and marketing expensesincreased to $42.8 million, or 64% of revenue, in the first quarter of 2008,from $24.9 million, or 50% of revenue, in the first quarter of 2007.Approximately $9.3 million of the increase was due to the amortization ofacquired intangibles (primarily customer relationships) which resulted from theacquisition of SurfControl in October 2007. The acquired customerrelationships intangible assets are being amortized over a weighted averageperiod of approximately 6.3 years. In addition to the amortization of acquiredintangible assets, the increase in selling and marketing expenses was primarilydue to increased personnel costs and related travel, including new personneladded from the SurfControl acquisition in October 2007 and allocatedcosts. Our headcount in sales and marketing increased from 375 employees at March 31,2007 to 516 employees at March 31, 2008. We expect selling and marketingexpenses to increase in absolute dollars and as a percentage of revenue for theremainder of 2008 as compared to 2007 due to having a full year of amortizationof acquired intangibles, having a full year of additional sales and marketingpersonnel from SurfControl to support our expanding selling and marketingefforts worldwide, and increased sales resulting in higher overall salescommission expenses. We expect amortization of acquired intangibles of $28.1million for the remainder of 2008 as a result of the amortization of acquiredintangibles from the SurfControl and Port Authority acquisitions. We alsoexpect to achieve cost savings as compared to the historical SurfControlselling and marketing expense primarily as a result of the integration of thesales personnel that was completed in the first quarter of 2008 and a reductionin headcount from the levels as of the closing of the acquisition.

 

*Research and development.* Research and development expensesconsist primarily of salaries and benefits for software developers andallocated costs. Research and development expenses increased to $13.5 million,or 20% of revenue, in the first quarter of 2008 from $8.4 million, or 17% ofrevenue, in the first quarter of 2007. The increase of $5.1 million in researchand development expenses was primarily due to increased personnel cost,including adding new full time employees due to the SurfControl acquisition in October 2007,and increased hiring to support our expanding list of technology partners,enhancements to Websense Enterprise, and enhancements to additional productsand allocated costs. Our headcount increased in research and development from168 employees at March 31, 2007 to 332 employees at March 31, 2008.Included in research and development for the quarter ended March 31, 2007was $1.3 million of in-process research and development related to ourPortAuthority acquisition in January 2007. We expect future research and developmentexpenses to increase in absolute dollars and as a percentage of revenue for theremainder of 2008 as compared to 2007 due to having a full year of additionalengineering personnel from SurfControl and the hiring of personnel to supportour continued enhancements of our existing and new products.  We are managing the increase in our absoluteresearch and development expense by operating research and developmentfacilities in multiple international locations, including Beijing, China, thathave lower costs than our operations in the United States.

 

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*Generaland administrative*. General and administrative expensesconsist primarily of salaries, benefits and related expenses for our executive,finance and administrative personnel, third party professional service fees andallocated costs. General and administrative expenses increased to $12.9million, or 19% of revenue, in the first quarter of 2008 from $7.2 million, or15% of revenue, in the first quarter of 2007. The $5.7 million increase ingeneral and administrative expense was primarily due to additional personnelneeded to support our growing operations, including the acquisition ofSurfControl in October 2007 and allocated costs.  Our headcount increased in general andadministrative departments from 66 at March 31, 2007 to 102 at March 31,2008.  We expect general andadministrative expenses to increase in absolute dollars and as a percentage ofrevenue for the remainder of 2008 as compared to 2007 due to having a full yearof additional personnel from SurfControl and to support growth in operationsand expansion of our international operations. We do not expect to incur the historical SurfControl general andadministrative expense levels due to the termination of the executive officersof SurfControl and other personnel, elimination of certain facilities andelimination of expenses relating to SurfControl being a public UK companylisted on the London Stock Exchange.

 

**Interest Expense**

** **

Interest expense represents the interest incurred onour senior secured credit facility that we utilized to pay for a portion of theSurfControl purchase price in October 2007.  Also included in the interest expense is$1,040,000 of amortization of deferred financing fees that were capitalized aspart of the senior secured credit facility. Interest expense will increase for the remainder of 2008 as compared to2007 due to having the senior secured credit facility outstanding for the fullyear of 2008.  The amount of interestexpense will fluctuate due to changes in the outstanding principal balance anddue to changes in LIBOR and potential changes in our applicable spread to LIBORbased upon improvements in our leverage ratio in accordance with our seniorsecured credit facility. Interest expense should decline in the remainingquarters of fiscal 2008 as compared to the first quarter of 2008 due to thelower outstanding principal amount and lower marginal interest rate.

 

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

#  

Other (expense) income,net decreased to a $109,000 net other expense in the first quarter of 2008 froma $2.4 million net other income in the first quarter of 2007. The decrease wasdue primarily to reduced interest income of approximately $1.8 million in thefirst quarter of 2008 compared to the first quarter of 2007 as a result of ouruse of approximately $191 million in cash, cash equivalents and marketablesecurities to fund the acquisition of SurfControl in October 2007.  In addition, we had increased losses of$192,000 on foreign exchange forward contracts and $580,000 on foreign exchangere-measurement losses due to unfavorable movements in the foreign exchangerates during the first quarter of 2008 compared to the first quarter of2007.  Due to the reduced cash, cash equivalentsand marketable securities as a result of the acquisition of SurfControl as wellas the prepayments on our senior secured credit facility and stock repurchases,we expect other (expense) income, net to decrease in absolute dollars duringthe remainder of 2008 as compared to 2007.

 

# **Provisionfor Income Taxes**

#  

We recognized an incometax benefit of $12.4 million and an income tax expense of$3.2 million for the three months ended March 31, 2008 and 2007,respectively. Our effective tax rates were a tax benefit of 66.5% and a taxprovision of 45% for the three months ended March 31, 2008 and March 31,2007, respectively. The significant changes in our effective tax rate reflectthe favorable impact of a ruling regarding unrecognized state income taxes andthe release of a valuation allowance plus the unfavorable impact of less taxexempt interest income and a higher effective state income tax rate. Oureffective tax rate may change in future periods due to the composition oftaxable income between domestic and international operations along with thepotential changes or interpretations in tax rules and legislation, orcorresponding accounting rules. We expect the effective income tax rate to beless favorable in the second quarter of 2008 compared to the first quarter of2008 due to the discrete events related to the favorable ruling and valuationallowance release.

 

In accordance with theprovisions of SFAS 109, we assess, on a quarterly basis, the realizability ofour deferred income tax assets. A valuation allowance must be established when,based upon the evaluation of all available evidence, it is more likely than notthat all or a portion of the deferred income tax asset will not be realized.During fiscal year 2007, a $4.7 million valuation allowance was recordedagainst the deferred tax assets of SurfControl at acquisition and an additional$4.3 million was recorded related to the increase of deferred tax assetsarising from the operations of SurfControl reflected in our fiscal year 2007statement of operations.

 

Realization of deferredincome tax assets is dependent upon taxable income in prior carryback years,estimates of future taxable income, tax planning strategies and reversals ofexisting taxable temporary differences. Based on our 

 

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assessment of these items during the first quarter of 2008, it is morelikely than not that we will be able to fully utilize our deferred tax assets.Accordingly, we released the valuation allowance and recorded a credit togoodwill of $4.7 million and a credit to income tax provision of approximately$4.3 million.

 

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

#  

As of March 31,2008, we had cash and cash equivalents of $71.0 million, investments inmarketable securities of $632,000 and retained earnings of $61.6 million.  During the first quarter of 2008, we used ourcash, cash equivalents and marketable securities primarily to pay down $30million on our senior secured credit facility as optional prepayments andapproximately $2.8 million for stock repurchases (of the $5 million stockrepurchases recorded during the quarter, $2.8 million was paid during thequarter and the remaining $2.2 million was paid in April 2008, but allpurchases were made by March 31, 2008).

 

Net cash provided byoperating activities was $18.9 million in the first three months of 2008compared with $21.3 million in the first three months of 2007. The $2.4 milliondecrease in cash provided by operating activities was primarily due to the netloss with lower non-cash items recorded in the first quarter of 2008 offset by thenet increase in the change in operating assets and liabilities compared to thefirst quarter of 2007. The first quarter of 2008 cash flows from operations wasnegatively impacted by cash payments for restructuring related items as well aspayment for litigation that was settled in the second quarter of 2007. Ouroperating cash flow is significantly influenced by new and renewedsubscriptions, accounts receivable collections and changes in deferredrevenue.  A future decrease insubscription renewals or accounts receivable collections, or a lower deferredrevenue balance, would negatively impact our operating cash flow.

 

Net cash provided byinvesting activities was $17.9 million in the first three months of 2008 compared with net cash used in investingactivities of $74.4 million in the first three months of 2007. The $92.3 million increase of net cashprovided by investing activities was primarily due to cash used of $82.0million to purchase PortAuthority in January 2007 and a $9.9 million netincrease in maturities over purchases of marketable securities during the firstquarter of 2008 compared to the first quarter of 2007.

 

Net cash used infinancing activities was $32.6 million in the first three months of 2008 compared with $3.1 million in the first three months of 2007. The $29.5million increase of net cash used in financing activities was primarily due tooptional principal prepayments of $30 million on our senior secured credit facilityin the first quarter of 2008, and share repurchases of $2.8 million in thefirst three months of 2008 compared to none in the first three months of 2007,partially offset by the repayment of $4.2 million of the PortAuthority loan inthe first three months of 2007.

 

In connection with the acquisition of SurfControl in October 2007,we entered into an amended and restated senior credit agreement (the “SeniorCredit Agreement”).  The $225 millionsenior secured credit facility consists of a five year $210 million seniorsecured credit facility and a $15 million revolving credit facility. The seniorsecured credit facility was fully funded on October 11, 2007, and therevolving line of credit remains unused. Through March 31, 2008, we havemade optional prepayments totaling $50 million on our senior secured creditfacility, reducing the outstanding balance to $160 million.  The senior secured credit facility is securedby substantially all of our assets, including pledges of stock of some of oursubsidiaries (subject to limitations in the case of foreign subsidiaries) andby secured guarantees by our domestic subsidiaries. The senior secured creditfacility initially amortized at a minimum rate of 2.5%, 10%, 12.5%, and 15%,respectively, during the first four years of the term and 60% during the fifthyear. In conjunction with our optional $20 million prepayment on December 31,2007, we amended our Senior Credit Agreement to eliminate any additionalmandatory payments until September 30, 2009.  The initial interest rate on the creditfacility was LIBOR plus 250 basis points (5.2% at March 30, 2008), and wassubject to step downs in the spread over LIBOR based upon potential futureimprovements in our total leverage ratio. The unused portion of the revolving creditfacility required a 50 basis points fee per annum, also subject to step downsbased upon potential future improvements in our total leverage ratio. As of March 31,2008, we qualified for a reduction in the applicable margin on the seniorsecured credit facility and revolving credit facility fee. Effective March 31,2008, the interest rate on the senior secured credit facility became LIBOR plus225 basis points (4.95% at March 31, 2008) and the revolving seniorsecured credit facility fee became 25 basis points (0.25%) per annum. TheSenior Credit Agreement contains financial covenants, including a consolidatedleverage ratio and a consolidated interest coverage ratio, as well asaffirmative and negative covenants.

 

The Senior Credit Agreement provides that we mustmaintain hedge agreements so that at least 50% of the aggregate principalamount of the senior secured credit facility is subject to fixed interest rateprotection for a period of not less than 2.5 years. On October 11, 2007 inconjunction with the funding of the senior secured credit facility, we enteredinto an interest rate swap agreement to pay a fixed rate of interest (4.85% perannum) and receive a floating rate interest payment (based on three monthLIBOR) on an equivalent amount. The initial principal amount of the swapagreement was $105 

 

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million on October 11, 2007. In addition, on October 11, 2007we entered into an interest rate cap agreement to limit the maximum interestrate on a portion of our senior secured credit facility to 6.5% per annum. Theamount of principal protected by this agreement increases from $5 million at December 31,2007 to $74.3 million on June 30, 2010. Both the interest rate swap andcap expire on September 30, 2010.

 

*Obligations and commitments.*  The following table summarizes ourcontractual payment obligations and commitments as of March 31, 2008 (inthousands):

 
| ** **                      | ** ** | **Payment Obligation by Year** | ** ** |
|---------------------------------|------------|-----------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                      | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **2012** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| Senior secured  credit facility |       | $                                             | —     |   | $ | 5,263 |   | $ | 22,105 |   | $ | 26,527 |   | $ | 106,105 |   | $ | — |   | $ | 160,000 |   |
| Operating leases                |       | 5,061                                         |       | 4,421 |   | 4,026 |   | 3,405 |   | 3,212 |   | 4,602 |   | 24,727 |   |
| Facility exit  obligations      |       | 1,272                                         |       | 2,017 |   | 2,106 |   | 1,813 |   | 1,106 |   | 966 |   | 9,280 |   |
| Severance  obligations          |       | 2,394                                         |       | — |   | — |   | — |   | — |   | — |   | 2,394 |   |
| Software license                |       | 439                                           |       | 585 |   | 97 |   | — |   | — |   | — |   | 1,121 |   |
| Total                           |       | $                                             | 9,166      |   | $ | 12,286 |   | $ | 28,334 |   | $ | 31,745 |   | $ | 110,423 |   | $ | 5,568 |   | $ | 197,522 |   |

 

Obligations under ourSenior Credit Agreement represent the future minimum principal debt paymentsdue under the senior secured credit facility. In addition to the amounts listed in the above table, we also haveinterest payment and fee obligations related to the senior secured creditfacility (see Note 6 to the Financial Statements).

 

We lease our facilitiesunder operating lease agreements that expire at various dates through2015.  Approximately one-half of ouroperating lease commitments are related to our corporate headquarters lease,which extends through December 2013. Our corporate headquarters lease includes escalating rent payments from2008 to 2013.

 

Facility exit obligationsrepresent estimated future lease and operating costs from facilities acquiredfrom SurfControl that are being exited. These costs will be paid over the respective lease terms through2013.  These amounts are included in ourconsolidated balance sheet.

 

Severance obligationsrepresent the estimated future severance payments in connection with theSurfControl employees who were or will be terminated.

 

Software licenseobligations represent purchase commitments for software licenses made in theordinary course of business.

 

In addition, due to theuncertainty with respect to the timing of future cash flows associated with ourunrecognized tax benefits at March 31, 2008, we are unable to makereasonably reliable estimates of the period of cash settlement with therespective taxing authorities. Therefore, $8.5 million of unrecognized taxbenefits have been excluded from the contractual payment obligations tableabove.

 

As of March 31, 2008 and 2007, we did not haveany relationships with unconsolidated entities or financial partners, such asentities often referred to as structured finance or special purpose entities,which would have been established for the purpose of facilitating off-balancesheet arrangements or other contractually narrow or limited purposes. As such,we are not exposed to any financing, liquidity, market or credit risk thatcould arise if we had engaged in such relationships.

 

In 2003, we announcedthat our Board of Directors authorized a stock repurchase program of up to 4million shares of our common stock.  In2005, we announced that our Board of Directors increased the size of the stockrepurchase program by an additional 4 million shares, for a total program sizeof up to 8 million shares. In 2006, we announced that our Board of Directorsincreased the size of the stock repurchase program by an additional 4 millionshares, for a total program size of up to 12 million shares. Repurchases may bemade from time to time on the open market at prevailing market prices or inprivately negotiated transactions. Depending on market conditions and otherfactors, purchases under this program may be commenced or suspended at anytime, or from time to time, without prior notice. During the quarter ended March 31,2008, we repurchased 264,400 shares of our common stock for an aggregate ofapproximately $5.0 million at an average price of $18.90 per share. As of March 31,2008, we have repurchased a total of 8,434,460 shares of our common stock underthis program, for an aggregate of $175.4 million at an average price of $20.80per share. Under the terms of the Senior Credit Agreement, we are restrictedfrom repurchasing our common stock for an aggregate purchase price that exceedsthe sum of 

 

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$25 million plus 50% of the aggregate amount of our consolidated netincome, as defined in our Senior Credit Agreement, during the period from theeffective date of the facility through the most recent quarter end for which wehave filed quarterly financial statements. As of March 31, 2008, we canrepurchase up to $31.9 million of our common stock under our Senior CreditAgreement. We intend to repurchase shares during the remainder of 2008.

 

We believe that our cash and cash equivalents balances, investments in marketable securities, revolving credit balances and our ongoing cash flow from operations will be sufficient to satisfy our cash requirements, including our capital expenditures, debt repayment obligations and stock repurchases, if any, for at least the next 12 months. During the first quarter of 2008, we made voluntary prepayments on our senior secured credit facility of $30 million and repurchased approximately $5 million of our common stock. Our cash requirements may increase for reasons we do not currently foresee or we may make acquisitions as part of our growth strategy that increase our cash requirements. We may elect to raise funds for these purposes or to reduce our cost of capital through capital markets transactions or debt or private equity transactions as appropriate. We intend to continue to invest our cash in excess of current operating and capital requirements in interest-bearing, investment-grade securities.

 

**Off-Balance Sheet Arrangements**

 

As of March 31, 2008, we did not have any material off-balance sheet arrangements as defined in Regulation S-K Item 303(a)(4).

 

**Item 3.Quantitative and Qualitative Disclosures About Market Risk**

 

Ourmarket risk exposures are related to our cash, cash equivalents, investments inmarketable securities and senior secured credit facility. We invest our excesscash in highly liquid short-term investments such as municipal bonds,government agency bonds and corporate bonds. These investments are not held fortrading or other speculative purposes. Changes in interest rates affect theinvestment income we earn on our investments and the interest expense incurredon our senior secured credit facility and therefore impact our cash flows andresults of operations.

 

We areexposed to changes in interest rates primarily from our short-termavailable-for-sale investments and from our borrowings under our variable ratesenior secured credit facility used in connection with the acquisition ofSurfControl in October 2007.  OurSenior Credit Agreement provides that we must maintain hedge agreements so thatat least 50% of the aggregate principal amount of the senior secured creditfacility is subject to fixed interest rate protection for a period of not lessthan 2.5 years from the date of the initial funding of the loan.

 

Ahypothetical 100 basis point adverse move in interest rates along the entireinterest rate yield curve would materially affect our interest expense. Basedon our outstanding senior secured credit facility balance at March 31,2008 and taking into consideration our interest rate swap and cap, our interestexpense would increase by approximately $550,000 during the next 12 months ifthere were a 100 basis point adverse move in the interest rate yield curve.

 

Ahypothetical 100 basis point adverse move in interest rates along the entireinterest rate yield curve would not materially affect the fair value of ourinterest sensitive investments at March 31, 2008. Changes in interestrates over time will, however, affect our interest income.

 

We utilize foreigncurrency forward contracts to hedge foreign currency market exposures ofunderlying assets and liabilities.  Webill certain international customers in Euros, British Pounds, AustralianDollars, Chinese Yuan Renminbi and Japanese Yen.  We also keep working funds necessary tofacilitate the short-term operations of our subsidiaries in the local currenciesin which they do business. Our objective is to reduce the risk to earnings andcash flows associated with changes in foreign currency exchange rates. We donot use foreign currency contracts for speculative or trading purposes.

 

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Notional and fair valuesof our Euro and British Pound hedging positions at March 31, 2008 and 2007are presented in the table below (in thousands):

 
| ** **    | ** ** | **March 31, 2008**         | ** ** | **March 31, 2007** | ** ** |
|---------------|------------|--------------------------------------|------------|------------------------------|------------|
| ** **    | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD**     | ** ** | **Fair Value  USD** | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD** | ** ** | **Fair Value  USD** | ** ** |
| Euro          |       | €                               | 5,200      |                         | $          | 7,800 |   | $ | 7,420 |   | € | 2,000 |   | $ | 2,627 |   | $ | 2,577 |   |
| British Pound |       | £                               | —     |                         | —     |   | — |   | £ | 1,200 |   | 2,356 |   | 2,351 |   |
| Total         |       |                                 |       | $                            | 7,800      |   | $ | 7,420 |   |   |   | $ | 4,983 |   | $ | 4,928 | ** ** |

 

The $5.2 million notionalincrease in our Euro hedged position at March 31, 2008 compared to March 31,2007 is primarily due to the increase in Euro billings in 2008 compared to2007. For the three months ended March 31, 2008, less than 15% of ourtotal billings were denominated in the Euro. We do not expect Euro billings torepresent more than 20% of our total billings during 2008.

 

Theapproximate $2.4 million notional decrease in our British Pound hedged positionat March 31, 2008 compared to March 31, 2007 is primarily due tothe natural hedge against our British Pound expenditures by billings in theBritish Pound which began in May 2007. As of March 31, 2008 no British Pound contracts were outstanding.** **Wedo not expect to hedge the British Pound as we continue billing in the BritishPound which, because we have substantial operations in the United Kingdom andexpenses in British Pounds, creates a natural hedge against our billings inBritish Pounds.

 

Given our foreignexchange position at March 31, 2008, a 10% change in foreign exchangerates upon which these foreign exchange contracts are based would result inexchange gains and losses.  In allmaterial aspects, these exchange gains and losses would be fully offset byexchange gains and losses on the underlying net monetary exposures for whichthe contracts are designated as hedges. We do not expect material exchange rate gains and losses from unhedgedforeign currency exposures.

 

**Item 4.Controls and Procedures**

 

**Disclosure Controls and Procedures**

** **

**Wemaintain disclosure controls and procedures (as defined in Rules 13a — 15(e) and15d — 15(e) of the Securities Exchange Act of 1934, as amended (the“Exchange Act”)) designed to ensure that we are able to collect the informationwe are required to disclose in the reports we file under the Exchange Act, andto record, process, summarize and report this information within the timeperiods specified 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.

 

**Part II- Other Information**

 

**Item1. Legal Proceedings**

 

We are involved invarious legal actions in the normal course of business. Based on current information,including consultation with our lawyers, we believe we have adequately reservedfor any ultimate liability that may result from these actions such that anyliability would not materially affect our consolidated financial position,results of operations or cash flows. Our evaluation of the likely impact ofthese actions could change in the future and unfavorable outcomes and/ordefense costs, depending upon the amount and timing, could have a materialadverse effect on our results of operations or cash flows in a future period.

 

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**Item 1A.Risk Factors**

 

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

 

Wehave marked with an asterisk (*) those risk factors that reflect materialchanges from the risk factors included in our Annual Report on Form 10-Kfiled with the Securities and Exchange Commission on February 28, 2008.

 

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

* *

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

 

*Our revenue is derived almost entirely from salesthrough indirect channels and we depend upon these channels to create demandfor our products.**

* *

As we have moved toward atwo-tier indirect sales model in North America, our revenue has been derived almostentirely from sales through indirect channels, including value-added resellers,distributors that sell our products to end-users, providers of managed Internetservices and other resellers. Ingram Micro and All Tech are our only broad-linedistributors in North America, so the success of our North American salesefforts is reliant on their success in selling our products to their resellernetwork. Ingram Micro accounted for approximately 22% of our revenue during thequarter ended March 31, 2008.  ShouldIngram Micro experience financial difficulties or otherwise delay or preventour collection of accounts receivable from them, our revenue and cash flowwould be significantly adversely affected. Our indirect sales model involves a number of additional risks,including:

 

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

 

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

 

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

 

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

 

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

 

Our ability to meaningfully increase the amount of ourproducts sold through our sales channels also depends on our ability toadequately and efficiently support these channel partners with, among otherthings, appropriate financial incentives to encourage pre-sales investment andsales tools, such as sales training, technical training and product collateralneeded to support their customers and prospects. Additionally, we arecontinually evaluating the changes to our internal ordering and partnermanagement systems in order to effectively execute our two-tier distributionstrategy. Any failure to properly and efficiently support our sales channelswill result in lost sales opportunities.

 

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* *

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

* *

In January 2007, we acquired PortAuthorityTechnologies, Inc. (“PortAuthority”), and in October 2007 we acquiredSurfControl plc (“SurfControl”).  With respect to SurfControl, we expectto continue to incur restructuring and other related expenses that willnegatively affect our results of operations under U.S. generally acceptedaccounting principles (“GAAP”). As a result of the SurfControl acquisition,Websense became an unprofitable operating business under GAAP after more thanfive years as a profitable operating business under GAAP.  Given our subscription model, we expect tocontinue to operate at a loss under GAAP until we generate sufficient revenuefrom the subsequent renewal of subscriptions from the installed SurfControlcustomer base to offset the expenses we began to incur as of the close of theSurfControl acquisition to operate the SurfControl business.  Although we expect to continue to competeeffectively for subscription renewals from the SurfControl customers, we facesubstantial competition and we may not retain as high a percentage of the SurfControlcustomer base as we expect.

 

The size and scope of the acquisition of SurfControlalso increase both the scope and consequence of ongoing integration risks thatwould be associated with any acquired business. We may not successfully addressthe integration challenges in a timely manner, or at all, and we may not fullyrealize all of the anticipated benefits or synergies of the SurfControlacquisition (which are principally associated with restructurings, includingworkforce reductions and other operational efficiencies).  The timing of the achievement of synergiesmay also deviate from our estimates depending upon the success of theintegration process.

 

Acquisitions involve numerous risks, including:

 

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

 

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

 

·      diversionof financial and management resources from existing operations and core businesses;

 

·      riskof entering new markets;

 

·      potentialloss of key employees of the acquired company;

 

·      integratingpersonnel with diverse business and cultural backgrounds;

 

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

 

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

 

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

 

Acquisitionsmay also cause us to:

 

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

 

·      assumecertain liabilities;

 

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

 

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

 

·      becomesubject to intellectual property or other litigation; and

 

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

 

We may acquire additional companies, services andtechnologies in the future as part of our efforts to expand and diversify ourbusiness. Although we review the records of companies or businesses we areinterested in acquiring, even an in-depth review may not reveal existing orpotential problems or permit us to become familiar enough with a business toassess fully its capabilities and deficiencies. Integration of acquired companiesmay disrupt or slow the momentum of the activities of our business. As aresult, if we fail to properly evaluate, execute and integrate acquisitionssuch as our PortAuthority and SurfControl acquisitions, our business andprospects may be seriously harmed.

 

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** **

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

** **

**In connection with our acquisition of SurfControl inOctober 2007, we entered into an amended and restated senior securedcredit facility to provide financing for a substantial portion of theacquisition purchase price.  Our seniorsecured credit facility contains covenants that restrict, among other things,our ability to borrow money, make particular types of investments, includinginvestments in our subsidiaries, make other restricted payments, pay downsubordinated debt, swap or sell assets, merge or consolidate or makeacquisitions.  An event of default underour senior secured credit facility could allow the lenders to declare allamounts outstanding with respect to the senior secured credit facility to beimmediately due and payable.  Ascollateral for the loan, we pledged substantially all of our consolidatedassets and the stock of some of our subsidiaries (subject to limitations withrespect to foreign subsidiaries) to secure the debt under our senior securedcredit facility.  If the amountsoutstanding under the senior secured credit facility were accelerated, thelenders could proceed against those consolidated assets and the stock of oursubsidiaries.  Any event of default,therefore, could have a material adverse effect on our business.  Our senior secured credit facility alsorequires us to maintain specified financial ratios.  Our ability to meet these financial ratioscan be affected by events beyond our control, and we cannot assure that we willmeet those ratios.**

** **

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

** **

In October 2007, weborrowed $210 million under the senior credit agreement and $160 millionremained outstanding as of March 31, 2008. As a result, we are incurring interest expense for the amounts weborrowed under the senior secured credit facility, and our income from ourcash, cash equivalents and marketable securities has declined as we used asignificant portion of our cash and marketable securities to fund a portion ofthe acquisition cost.  This debt and thelimitations our senior secured credit facility impose on us could haveimportant consequences, including:

 

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

 

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

 

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

 

·                  we could be less able to takeadvantage of significant business opportunities, including acquisitions ordivestitures, as a result of debt covenants;

 

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

 

·                  we could be at a competitivedisadvantage to competitors with less debt.

 

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

* *

Substantially all of ourrevenue for the first quarter ended March 31, 2008 was derived from newand renewal subscriptions to our Web filtering and Web security products, andwe expect that a significant majority of our sales for the remainder of 2008will continue to be derived from our Web filtering and Web security products.We expect sales of our DLP products, hosted security services and otherproducts under development to comprise a relatively small portion of ouroverall sales in 2008. If our Web filtering and Web security products fail tomeet the needs of our existing and target customers, or if they do not comparefavorably in price, features and performance to competing products, ouroperating results and our business will be significantly impaired.  If we cannot sufficiently increase ourcustomer base with the addition of new customers, particularly in the SMB segment,increase seats under subscriptions from existing customers or renew asufficient number of SurfControl’s Web filtering customers or migrate them toour Web filtering product, we will not be able to grow our business to meetexpectations.

 

Subscriptions for our Webfiltering and security products typically have durations of 12, 24 or 36months. Our customers have no obligation to renew their subscriptions uponexpiration. Our revenue also depends upon maintaining a high rate of sales ofrenewal 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*.*

 

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* *

*Failure of our security products, including our DLPproducts and hosted security solutions, to achieve more widespread marketacceptance will seriously harm our business.**

* *

Our future financial performance depends on ourability to diversify our offerings by successfully developing, introducing andgaining customer acceptance of our new products and services, particularly oursecurity offerings. We now sell the Websense Data Protection Suite, our DLPoffering for the data security market, Websense Hosted Web Security and WebsenseHosted Email Security, our hosted security services, and Websense EmailSecurity, our email filtering solution. We may not be successful in achievingmarket acceptance of these or any new products that we develop.  Moreover, our recent increased emphasis onthe development, marketing and sale of our security offerings and DLP productsas well as the integration of SurfControl could distract us from sales of ourcore Web filtering and Web security offerings, negatively impacting our overallsales. Any failure or delay in diversifying our existing offerings, ordiversification at the detriment to our core Web filtering and Web securityofferings, could harm our business, results of operations and financialcondition and our growth.

 

*We face increasing competition from much largersoftware and hardware companies, which places pressure on our pricing and whichcould prevent us from increasing revenue or returning to profitability. Inaddition, as we increase our emphasis on our security-oriented products, weface competition from better-established security companies that havesignificantly greater resources.**

* *

The market for our products is intensely competitiveand is likely to become even more so in the future.  Our current principal Web filtering competitorsfrequently offer their products at a significantly lower price than ourproducts, which has resulted in pricing pressures on sales of our product andpotentially could result in the commoditization of products in our space. Wealso face current and potential competition from vendors of Internet servers,operating systems and networking hardware, many of which now, or may in thefuture, develop and/or bundle Web filtering or other competitive products withtheir products. Increased competition may cause price reductions or a loss ofmarket share, either of which could have a material adverse effect on ourbusiness, results of operations and financial condition. If we are unable tomaintain the current pricing on sales of our products or increase our pricingin the future, our results of operations could be negatively impacted. Even ifour products provide greater functionality and are more effective than certainother competitive products, potential customers might accept this limitedfunctionality in lieu of purchasing our products. In addition, our own indirectsales channels may decide to develop or sell competing products instead of ourproducts. Pricing pressures and increased competition generally could result inreduced sales, reduced margins or the failure of our products to achieve ormaintain more widespread market acceptance, any of which could have a materialadverse effect on our business, results of operations and financial condition.

 

Our current principal competitors include:

 

·              companies offering Web filtering and Web securitysolutions, such as Microsoft, Symantec/Vontu, McAfee, Cisco Systems, JuniperNetworks, MessageLabs, Trend Micro, Google/Postini, ScanSafe, Blue CoatSystems, Secure Computing, Alladin, Finjan, FaceTime, Mi5 Networks, St. BernardSoftware, 8e6 Technologies, Marshal, Clearswift, Sophos, Barracuda, DigitalArts and Computer Associates;

 

·              companies integrating Web filtering into specializedsecurity appliances, such as Blue Coat Systems, Cisco Systems, McAfee,WatchGuard, Secure Computing, Check Point Software, St. Bernard Software,Barracuda, Juniper Networks, Trend Micro, Mi5 Networks, SonicWALL, Sophos and8e6 Technologies;

 

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

 

·              companies offering messaging security, such as McAfee,Symantec/Vontu, Google/Postini, Cisco/Ironport, Barracuda, Secure Computing,SonicWALL, Tumbleweed, MessageLabs, MX Logic, Microsoft, Proofpoint, Clearswiftand Borderware;

 

·              companies offering on-demand e-mail and web securityservices, such as Google/Postini, MessageLabs, McAfee, Symantec/Vontu, MXLogic, Email Systems/Webroot, St. Bernard Software,  Trend Micro andScansafe;

 

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

 

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·              companies offering proxy-based solutions such asMicrosoft, Blue Coat 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, McAfee, Trend Micro, Cisco Systems and Microsoftenjoy substantial competitive advantages, including:

 

·                    greatername recognition and larger marketing budgets and resources;

 

·                    establishedmarketing relationships and access to larger customer bases; and

 

·                    substantiallygreater financial, technical and other resources.

 

As a result, we may be unable to gain sufficienttraction as a provider of Web security solutions, and our competitors may beable to respond more quickly and effectively than we can to new or emergingtechnologies and changes in customer requirements, or devote greater resourcesto the development, marketing, promotion and sale of their products than wecan. Current and potential competitors have established or may establishcooperative relationships among themselves or with third parties to increasethe functionality and market acceptance of their products. In addition, our competitorsmay be able to replicate our products, make more attractive offers to existingand potential employees and strategic partners, develop new products or enhanceexisting products and services more quickly. Accordingly, new competitors oralliances among competitors may emerge and rapidly acquire significant marketshare. In addition, we also expect that competition will increase as a resultof industry consolidation. For all of the foregoing reasons, we may not be ableto compete successfully against our current and future competitors.

 

*Our international operations involve risks that couldincrease our expenses, adversely affect our operating results, and requireincreased time and attention of our management.*

* *

We have significant operations outside of the UnitedStates, including research and development, sales and customer support. We haveestablished or acquired engineering operations in Reading, England; Beijing,China; Sydney, Australia and Ra’anana, 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 internationaloperations are subject to risks in addition to those faced by our domesticoperations, including:

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

·                    costsand delays associated with developing software in multiple languages.

 

All of our foreign subsidiaries’ operating expensesare incurred in foreign currencies so if the dollar weakens, our consolidatedoperating expenses would increase. Should foreign currency exchange ratesfluctuate, our results of operations 

 

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

* *

We market and sell ourproducts outside the United States through value-added resellers, distributorsand other resellers. International sales represented 41% of our total revenuegenerated during the quarter ended March 31, 2008 compared with 39% of ourtotal revenue during the quarter ended March 31, 2007. As a key componentof our business strategy to generate new business sales, we intend to continueto expand our international sales, but success cannot be assured. In additionto the risks associated with our domestic sales, our international sales aresubject to the following risks:

 

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

 

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

 

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

 

·       lawsand business practices favoring local competitors;

 

·       dependenceon foreign distributors and their sales channels;

 

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

 

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

 

·       regionaleconomic and political conditions.

 

These factors could have a material adverse effect onour international sales. Any reduction in international sales, or our failureto further develop our international distribution channels, could have amaterial adverse effect on our business, results of operations and financialcondition.

 

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

 

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

* *

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

 

We may spend significanttime and money on research and development to design and develop our DLPproducts and our hosted security services. If these products fail to achievebroad market acceptance in our target markets, we may be unable to generatesignificant revenue from our research and development efforts. Moreover, evenif we are able to develop DLP products, they may not be accepted in our targetmarkets. As a result, our business, results of operations and financial conditionwould be adversely impacted.

 

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* *

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

* *

The ongoing evolution of the Internet and computingenvironments will require us to continually improve the functionality, featuresand reliability of our databases. Because our products primarily manage accessto URLs and executable files included in our databases, if our databases do notcontain a meaningful portion of relevant content, the effectiveness of our Webfiltering products will be significantly diminished. Any failure of ourdatabases to keep pace with the rapid growth and technological change of theInternet, such as the increasing amount of multimedia content on the Internetthat is not easily classified, will impair the market acceptance of ourproducts.

 

We rely upon a combination of automated filteringtechnology and human review to categorize URLs and executable files in ourproprietary databases. Our customers may not agree with our determinations thatparticular URLs and executable files should be included or not included inspecific categories of our databases. In addition, it is possible that ourfiltering processes may place objectionable or security risk material incategories that are generally unrestricted by our users’ Internet and computeraccess policies, which could result in such material not being blocked from thenetwork. Any miscategorization could result in customer dissatisfaction andharm our reputation. Any failure to effectively categorize and filter URLs andexecutable files according to our customers’ expectations could impair thegrowth of our business. Our databases and database technologies may not be ableto keep pace with the growth in the number of URLs and executable files,especially the growing amount of content utilizing foreign languages and theincreasing sophistication of malicious code and the delivery mechanismsassociated with spyware, phishing and other hazards associated with theInternet.

 

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

* *

Our products are complex and are deployed in a widevariety of complex network environments. Our products may have errors ordefects that users identify after deployment, which could harm our reputationand our business. In addition, products as complex as ours frequently containundetected errors when first introduced or when new versions or enhancementsare released. We have from time to time found errors in versions of ourproducts, and we expect to find such errors in the future. Because customersrely on our products to manage employee behavior to protect against securityrisks and prevent the loss of sensitive data, any significant defects or errorsin our products may result in negative publicity or legal claims. For example,an actual or perceived breach of network or computer security at one of ourcustomers, regardless of whether the breach is attributable to our products,could adversely affect the market’s perception of our security products.Moreover, parties whose Web sites or executable files are placed insecurity-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 ourproducts, divert the attention of engineering personnel from our productdevelopment efforts and cause significant customer relations or legal problems.

 

Our products may also be misused or abused bycustomers or non-customer third parties who obtain access to our products.These situations may arise where an organization uses our products in a mannerthat impacts their end users’ or employees’ privacy or where our products aremisappropriated to censor private access to the Internet. Any of thesesituations could result in negative press coverage and negatively affect ourreputation.

 

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

* *

Some of our customers have outsourced the managementof their information technology departments to large system integrators. If thistrend continues, our established customer relationships could be disrupted andour products could be displaced by alternative system and network protectionsolutions offered by system integrators. Significant product displacementscould impact our revenue and have a material adverse effect on our business.

 

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

* *

In the future, vendors of hardware and of operatingsystem software or other software may continue to enhance their products orbundle separate products to include functions that are currently providedprimarily by network security software. If network security functions becomestandard features of computer hardware or of operating system software or othersoftware, our products may become obsolete and unmarketable, particularly ifthe quality of these network security features is comparable to that of ourproducts. Furthermore, even if the network security and/or management functionsprovided as standard features by hardware providers or operating systems orother software is more limited than that of our products, our 

 

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customers might accept this limited functionality in lieu of purchasingadditional software. Sales of our products would suffer materially if we werethen unable to develop new Web filtering, security and DLP products to furtherenhance operating systems or other software and to replace any obsoleteproducts.

 

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

* *

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

 

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

 

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

* *

Intellectual property is critical to our success, andwe rely upon patent, trademark, copyright and trade secret laws in the UnitedStates and other jurisdictions as well as confidentiality procedures andcontractual provisions to protect our proprietary technology and our Websensebrands. We rely on trade secrets to protect technology where we believe patentprotection is not appropriate or obtainable. However, trade secrets aredifficult to protect. While we require employees, collaborators and consultantsto enter into confidentiality agreements, we cannot assure that theseagreements will not be breached or that we will have adequate remedies for anybreach. We may not be able to adequately protect our trade secrets or otherproprietary information in the event of any unauthorized use or disclosure orthe lawful development by others of such information.

 

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

 

We currently have ten issued patents in the UnitedStates and five patents issued internationally, and we may be unable to obtainfurther patent protection in the future. We have other pending patentapplications in the United States and in other countries. We cannot ensurethat:

 

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

 

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

 

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

 

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

 

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

 

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·       wewill develop additional proprietary technologies that are patentable; or

 

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

 

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

 

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

* *

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

 

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

* *

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

 

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

* *

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

 

We expect that our operating expenses will increasesubstantially in the future as we expand our selling and marketing activities,increase our research and development efforts and hire additional personnelwhich could impact our margins. Our operating expenses have increased as aresult of the acquisition of SurfControl. The cost synergies we expect to 

 

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achieve through the acquisition will be phased in through ourintegration process. In addition, our operating expenses historically havefluctuated, and may continue to fluctuate in the future, as the result of thefactors described below and elsewhere in this quarterly report:

 

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

 

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

 

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

 

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

 

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

 

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

 

*The market price of our common stock is likely to behighly volatile 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:

 

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

 

·       demandfor our products, including fluctuations in subscription renewals;

 

·       changesin the pricing policies of our competitors; and

 

·       changesin government regulations.

 

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

 

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

 

·       changesin our pricing policies; and

 

·       quarterlyvariations in our revenues and operating expenses.

 

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

 

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

* *

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

 

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

 

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

* *

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

 

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

* *

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

 

***If wecannot effectively manage our internal growth and the integration of acquiredbusinesses, our business revenues, results of operations and prospects maysuffer.***

** **

**If we fail to manage our internal growth and theintegration of acquired businesses in a manner that minimizes strains on ourresources, we could experience disruptions in our operations that couldnegatively affect our revenue, billings and results of operations.  We are pursuing a strategy of organic growththrough implementation of two-tier distribution, international expansion,introduction of new products and expansion of our product sales to the smalland medium sized businesses. In 2007, we also completed two strategicacquisitions, and are continuing the process of integrating PortAuthority andSurfControl.  Finally, we have opened oracquired engineering centers in China, Israel, the United Kingdom andAustralia.  Each of these initiativesrequires an investment of our financial and employee resources and involvesrisks that may result in a lower return on our investments than we expect.These initiatives also may limit the opportunities we pursue or investments wewould otherwise make, which may in turn impact our prospects.**

** **

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

** **

**Some provisions of our certificate of incorporationand bylaws, as well as some provisions of Delaware law, may discourage, delayor prevent third parties from acquiring us, even if doing so would bebeneficial to our stockholders. For example, our certificate of incorporation providesfor a classified board, with each board member serving a staggered three-yearterm. It also provides that stockholders may not fill board vacancies, callstockholder meetings or act by written consent. Our bylaws further provide thatadvance written notice is required prior to stockholder proposals. Each ofthese provisions**

** **

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** **

makes it more difficult for stockholders to obtain control of our boardor initiate actions that are opposed by the then current board. Additionally,we have authorized preferred stock that is undesignated, making it possible forthe board to issue up to 5,000,000 shares of preferred stock with voting orother rights and preferences that could impede the success of any attemptedchange of control. Delaware law also could make it more difficult for a thirdparty to acquire us. Section 203 of the Delaware General Corporation Lawhas an anti-takeover effect with respect to transactions not approved inadvance by our board, including discouraging attempts that might result in apremium over the market price of the shares of common stock held by ourstockholders.

** **

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

 

*We do not intend to pay dividends.*

* *

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

 

**Item2.****           UnregisteredSales of Equity Securities and Use of Proceeds**

 

**None.**

** **

**Item 3.**           Defaults upon SeniorSecurities

** **

**None.**

** **

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

** **

**None.**

** **

**Item 5.**           Other Information

** **

**None.**

** **

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** **

**Item 6.**           Exhibits

** **

**Exhibits**

** **
| 3.1(1) |   | Amended and  Restated Certificate of Incorporation.                                                                                                                                                              |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2(2) |   | Amended and  Restated Bylaws.                                                                                                                                                                                    |
| 4.1(3) |   | Specimen Stock  Certificate of Websense, Inc.                                                                                                                                                               |
| 10.2   |   | Employment  Agreement by and between Websense, Inc. and John McCormack, dated July 5,  2006.                                                                                                           |
| 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 Registration Statement on Form S-1/A (No333-95619) filed on March 3, 2000.

(2)             Filedas an Exhibit to our Current Report on Form 8-K (No 000-30093) filedon April 19, 2007.

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

 

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#####  

##### **SIGNATURES**

#####  

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

 
|                        | **WEBSENSE,  INC.** |
|------------------------|---------------------|
|                   |                |   |   |
| Date: May 8, 2008 |                | By: |  /s/ GENE  HODGES |
|                   |                |   |   | Gene Hodges |
|                   | * *            | * * | * * | *Chief  Executive Officer* |
|                   |                |   |   |
| Date: May 8, 2008 |                | By: |  /s/ DUDLEY  MENDENHALL |
| ** **             |                |   |   | Dudley  Mendenhall |
| ** **             | * *            | * * | * * | *Chief  Financial Officer* |

 

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**EXHIBIT INDEX**

 
| 3.1(1) |   | Amended and  Restated Certificate of Incorporation.                                                                                                                                                              |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2(2) |   | Amended and  Restated Bylaws.                                                                                                                                                                                    |
| 4.1(3) |   | Specimen Stock  Certificate of Websense, Inc.                                                                                                                                                               |
| 10.2   |   | Employment  Agreement by and between Websense, Inc. and John McCormack, dated July 5,  2006.                                                                                                           |
| 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 Registration Statement on Form S-1/A (No333-95619) filed on March 3, 2000.

(2)             Filedas an Exhibit to our Current Report on Form 8-K (No 000-30093) filedon April 19, 2007.

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

 

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