Table of Contents

** **

 

** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**FORM 10-Q**

 

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

 

**For the quarterly period ended June 30, 2008**

 

**OR**

 

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

 

**For the Transition Period from            to**

 

**Commission File Number 000-30093**

 

----

 

**Websense, Inc.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                    | ** ** | **51-0380839**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State  or other jurisdiction of incorporation or organization) |       | (I.R.S.  Employer Identification No.) |

 

**10240 Sorrento Valley RoadSan Diego, California 92121858-320-8000**

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

 

----

 

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

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See definitions 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 o   | (Do not check if a smaller reporting company) | Smaller reporting company o |

 

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

 

The number of shares outstanding of the registrant’s Common Stock, $.01 par value, as of July 31, 2008 was 45,054,264.

 

 

 

----

Tableof Contents

 

**Websense, Inc.**

**Form 10-Q**

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

 

**TABLE OF CONTENTS**

 
|                                    | **Page** |
|------------------------------------|----------|
| Part I. Financial Information |     |
|                               |     |
|                               | Item 1.  | Consolidated Financial  Statements (Unaudited) |   |
|                               |     | Consolidated Balance Sheets  as of June 30, 2008 and December 31, 2007 | 3 |
|                               |     | Consolidated Statements of  Operations for the three and six months ended June 30, 2008 and 2007 | 4 |
|                               |     | Consolidated Statement of  Stockholders’ Equity for the six months ended June 30, 2008 | 5 |
|                               |     | Consolidated Statements of  Cash Flows for the six months ended June 30, 2008 and 2007 | 6 |
|                               |     | Notes to  Consolidated Financial Statements | 7 |
|                               | Item 2.  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 16 |
|                               | Item 3.  | Quantitative  and Qualitative Disclosures About Market Risk | 27 |
|                               | Item 4.  | Controls and  Procedures | 28 |
|                               |     |   |   |
| Part II. Other  Information   |     |
|                               |     |   |   |
|                               | Item 1.  | Legal Proceedings | 28 |
|                               | Item 1A. | Risk Factors | 29 |
|                               | Item 2.  | Unregistered  Sales of Equity Securities and Use of Proceeds | 40 |
|                               | Item 3.  | Defaults  upon Senior Securities | 40 |
|                               | Item 4.  | Submission  of Matters to a Vote of Security Holders | 40 |
|                               | Item 5.  | Other Information | 41 |
|                               | Item 6.  | Exhibits | 42 |
|                               |     |   |   |
| Signatures                         | 43       |

 

2

----

Tableof Contents

 

**Part I– Financial Information**

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

** **

**Websense, Inc.**Consolidated BalanceSheets

**(Unaudited and in thousands)**

 
| ** **                                       | ** ** | **June 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                       | ** ** | ** **              | ** ** | **(See Note 1)**  | ** ** |
| **Assets**                                       |       |                    |       |                        |       |
| Current assets:                                  |       |                    |       |                        |       |
| Cash and cash  equivalents                       |       | $                       | 65,074     |                        | $          | 66,383 |   |
| Marketable  securities                           |       | —                  |       | 19,781                      |       |
| Accounts  receivable, net                        |       | 61,588                  |       | 76,328                      |       |
| Prepaid income  taxes                            |       | 2,241                   |       | 3,734                       |       |
| Current portion  of deferred income taxes        |       | 30,279                  |       | 22,870                      |       |
| Other current  assets                            |       | 12,922                  |       | 10,109                      |       |
| Total current  assets                            |       | 172,104                 |       | 199,205                     |       |
|                                             |       |                    |       |                        |       |
| Property and  equipment, net                     |       | 16,304                  |       | 17,657                      |       |
| Intangible  assets, net                          |       | 129,496                 |       | 152,906                     |       |
| Goodwill                                         |       | 376,135                 |       | 385,916                     |       |
| Deferred income  taxes, less current portion     |       | 35,258                  |       | 19,048                      |       |
| Deposits and  other assets                       |       | 4,690                   |       | 5,798                       |       |
| Total assets                                     |       | $                       | 733,987    |                        | $          | 780,530 |   |
|                                             |       |                    |       |                        |       |
| **Liabilities  and stockholders’ equity**   |       |                    |       |                        |       |
| Current  liabilities:                            |       |                    |       |                        |       |
| Accounts payable                                 |       | $                       | 1,640      |                        | $          | 3,255 |   |
| Accrued  compensation and related benefits       |       | 18,527                  |       | 28,960                      |       |
| Other accrued  expenses                          |       | 26,936                  |       | 30,463                      |       |
| Current portion  of income taxes payable         |       | 15,934                  |       | 1,531                       |       |
| Current portion  of deferred tax liability       |       | 6,055                   |       | 10,399                      |       |
| Current portion  of deferred revenue             |       | 204,663                 |       | 190,569                     |       |
| Total current  liabilities                       |       | 273,755                 |       | 265,177                     |       |
| Income taxes  payable, less current portion      |       | 9,661                   |       | 12,264                      |       |
| Senior secured  term loan                        |       | 155,000                 |       | 190,000                     |       |
| Deferred revenue,  less current portion          |       | 97,878                  |       | 96,116                      |       |
| Deferred tax  liability, less current portion    |       | 11,582                  |       | 20,964                      |       |
| Other long term  liabilities                     |       | 1,796                   |       | 1,634                       |       |
| Total  liabilities                               |       | 549,672                 |       | 586,155                     |       |
|                                             |       |                    |       |                        |       |
| Stockholders’  equity:                      |       |                    |       |                        |       |
| Common stock                                     |       | 519                     |       | 515                         |       |
| Additional  paid-in capital                      |       | 282,281                 |       | 267,164                     |       |
| Treasury stock,  at cost                         |       | (149,829                | )          | (139,792                    | )          |
| Retained  earnings                               |       | 53,377                  |       | 67,808                      |       |
| Accumulated  other comprehensive loss            |       | (2,033                  | )          | (1,320                      | )          |
| Total  stockholders’ equity                 |       | 184,315                 |       | 194,375                     |       |
| Total  liabilities and stockholders’ equity |       | $                       | 733,987    |                        | $          | 780,530 |   |

 

See accompanyingnotes.

 

3

----

Tableof Contents

 

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

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

 
| ** **                              | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                              | ** ** | **June 30,  2008**          | ** ** | **June 30,  2007**        | ** ** | **June 30,  2008** | ** ** | **June 30,  2007** | ** ** |
|                                    |       |                             |       |                           |       |   |   |   |   |
| Revenue                                 |       | $                                | 72,958     |                           | $          | 50,449 |   | $ | 139,942 |   | $ | 100,196 |   |
|                                    |       |                             |       |                           |       |   |   |   |   |
| Cost of  revenues:                      |       |                             |       |                           |       |   |   |   |   |
| Cost of revenues                        |       | 8,587                            |       | 4,805                          |       | 17,454 |   | 8,833 |   |
| Amortization of  acquired technology    |       | 3,081                            |       | 629                            |       | 6,153 |   | 1,258 |   |
| Total cost of  revenues                 |       | 11,668                           |       | 5,434                          |       | 23,607 |   | 10,091 |   |
| Gross margin                            |       | 61,290                           |       | 45,015                         |       | 116,335 |   | 90,105 |   |
|                                    |       |                             |       |                           |       |   |   |   |   |
| Operating  expenses:                    |       |                             |       |                           |       |   |   |   |   |
| Selling and  marketing                  |       | 44,338                           |       | 25,127                         |       | 87,159 |   | 50,040 |   |
| Research and  development               |       | 13,198                           |       | 10,325                         |       | 26,658 |   | 18,721 |   |
| General and  administrative             |       | 11,836                           |       | 6,575                          |       | 24,689 |   | 13,761 |   |
| Total operating  expenses               |       | 69,372                           |       | 42,027                         |       | 138,506 |   | 82,522 |   |
|                                    |       |                             |       |                           |       |   |   |   |   |
| (Loss) income  from operations          |       | (8,082                           | )          | 2,988                          |       | (22,171 | ) | 7,583 |   |
|                                    |       |                             |       |                           |       |   |   |   |   |
| Interest expense                        |       | (2,941                           | )          | —                         |       | (7,373 | ) | — |   |
| Other income,  net                      |       | 1,113                            |       | 1,475                          |       | 1,004 |   | 3,915 |   |
|                                    |       |                             |       |                           |       |   |   |   |   |
| (Loss) income  before income taxes      |       | (9,910                           | )          | 4,463                          |       | (28,540 | ) | 11,498 |   |
|                                    |       |                             |       |                           |       |   |   |   |   |
| (Benefit)  provision for income taxes   |       | (1,716                           | )          | 2,334                          |       | (14,109 | ) | 5,502 |   |
|                                    |       |                             |       |                           |       |   |   |   |   |
| Net (loss)  income                      |       | $                                | (8,194     | )                              | $          | 2,129 |   | $ | (14,431 | ) | $ | 5,996 |   |
|                                    |       |                             |       |                           |       |   |   |   |   |
| Net (loss)  income per share:           |       |                             |       |                           |       |   |   |   |   |
|                                    |       |                             |       |                           |       |   |   |   |   |
| Basic net (loss)  income per share      |       | $                                | (0.18      | )                              | $          | 0.05 |   | $ | (0.32 | ) | $ | 0.13 |   |
| Diluted net  (loss) income per share    |       | $                                | (0.18      | )                              | $          | 0.05 |   | $ | (0. 32 | ) | $ | 0.13 |   |
| Weighted average  shares – basic   |       | 45,208                           |       | 45,060                         |       | 45,299 |   | 44,978 |   |
| Weighted average  shares – diluted |       | 45,208                           |       | 45,561                         |       | 45,299 |   | 45,499 |   |

 

See accompanyingnotes.

 

4

----

Table of Contents

 

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

**(Unaudited and in thousands)**

 
| ** **                                                               | ** ** | **Common stock** | ** ** | **Additional** | ** ** | **Treasury**             | ** ** | **Retained** | ** ** | **Accumulated  other  comprehensive** | ** ** | **Total  stockholders’** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|--------------------------|------------|--------------|------------|---------------------------------------|------------|-------------------------------|------------|
| ** **                                                               | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **paid-in capital** | ** ** | **stock**    | ** ** | **earnings**                          | ** ** | **loss**                      | ** ** | **equity** | ** ** |
| Balance at  December 31, 2007                                       |       | 45,394                |       | $              | 515        |                     | $          | 267,164      |       | $                                     | (139,792   | )                             | $          | 67,808 |   | $ | (1,320 | ) | $ | 194,375 |   |
|                                                                     |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Issuance of  common stock upon exercise of options                       |       | 76                    |       | 1              |       | 719                      |       | —       |       | —                                |       | —                        |       | 720 |   |
|                                                                     |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Issuance of  common stock for ESPP purchase                              |       | 190                   |       | 2              |       | 2,901                    |       | —       |       | —                                |       | —                        |       | 2,903 |   |
|                                                                     |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Issuance of  common stock from restricted stock units, net               |       | 28                    |       | 1              |       | —                   |       | (39          | )          | —                                |       | —                        |       | (38 | ) |
|                                                                     |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Share-based  compensation expense                                        |       | —                |       | —         |       | 12,175                   |       | —       |       | —                                |       | —                        |       | 12,175 |   |
|                                                                     |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Tax shortfall  from stock option exercises                               |       | —                |       | —         |       | (678                     | )          | —       |       | —                                |       | —                        |       | (678 | ) |
|                                                                     |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Purchase of  treasury stock                                              |       | (538                  | )          | —         |       | —                   |       | (9,998       | )          | —                                |       | —                        |       | (9,998 | ) |
|                                                                     |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Other  comprehensive income (loss):                                      |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
|                                                                     |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Net loss                                                                 |       | —                |       | —         |       | —                   |       | —       |       | (14,431                               | )          | —                        |       | (14,431 | ) |
|                                                                     |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Net change in  unrealized loss on interest rate swap and cap, net of tax |       | —                |       | —         |       | —                   |       | —       |       | —                                |       | (68                           | )          | (68 | ) |
|                                                                     |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Cumulative  translation adjustments                                      |       | —                |       | —         |       | —                   |       | —       |       | —                                |       | (645                          | )          | (645 | ) |
|                                                                     |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Comprehensive  loss                                                      |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       | (15,144 | ) |
|                                                                     |       |                  |       |           |       |                     |       |         |       |                                  |       |                          |       |   |   |
| Balance at  June 30, 2008                                           |       | 45,150                |       | $              | 519        |                     | $          | 282,281      |       | $                                     | (149,829   | )                             | $          | 53,377 |   | $ | (2,033 | ) | $ | 184,315 |   |

 

See accompanyingnotes.

 

5

----

Table of Contents

 

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

**(Unaudited and in thousands)**

 
| ** **                                                                                                     | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                     | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** |
| ** **                                                                                                     | ** ** | **2008**                       | ** ** | **2007** | ** ** |
| **Operating  activities:**                                                                                     |       |                           |       |   |   |
| Net (loss)  income                                                                                             |       | $                              | (14,431    | ) | $ | 5,996 |   |
| Adjustments to  reconcile net (loss) income to net cash provided by operating activities:                      |       |                           |       |   |   |
| Depreciation and  amortization                                                                                 |       | 31,490                         |       | 3,913 |   |
| In-process  research and development                                                                           |       | —                         |       | 1,270 |   |
| Share-based  compensation                                                                                      |       | 12,175                         |       | 10,536 |   |
| Deferred income  taxes                                                                                         |       | (30,964                        | )          | (4,645 | ) |
| Unrealized  (gain) loss on foreign exchange                                                                    |       | (71                            | )          | 1,078 |   |
| Tax shortfall /  windfall from stock option exercises                                                          |       | 678                            |       | (685 | ) |
| Changes in  operating assets and liabilities, net of effects from purchases of  PortAuthority and SurfControl: |       |                           |       |   |   |
| Accounts  receivable                                                                                           |       | 14,817                         |       | 9,632 |   |
| Other assets                                                                                                   |       | (1,761                         | )          | (7,101 | ) |
| Accounts payable                                                                                               |       | (1,660                         | )          | (336 | ) |
| Accrued  compensation and related benefits                                                                     |       | (8,772                         | )          | (735 | ) |
| Other  liabilities                                                                                             |       | (5,293                         | )          | 4,542 |   |
| Deferred revenue                                                                                               |       | 16,582                         |       | (2,810 | ) |
| Income taxes  payable                                                                                          |       | 11,119                         |       | 3,104 |   |
| Net cash provided  by operating activities                                                                     |       | 23,909                         |       | 23,759 |   |
|                                                                                                           |       |                           |       |   |   |
| **Investing  activities:**                                                                                     |       |                           |       |   |   |
| Purchases of  property and equipment                                                                           |       | (4,109                         | )          | (3,277 | ) |
| Cash paid for  purchased technology (intangible assets)                                                        |       | (940                           | )          | — |   |
| Cash refunded  (paid) for acquisition of PortAuthority, net of cash acquired                                   |       | 147                            |       | (81,988 | ) |
| Cash paid for  option contract on SurfControl acquisition                                                      |       | —                         |       | (4,590 | ) |
| Cash received  from sale of CyberPatrol assets                                                                 |       | 1,400                          |       | — |   |
| Purchases of  marketable securities                                                                            |       | (20,160                        | )          | (282,122 | ) |
| Maturities of  marketable securities                                                                           |       | 39,963                         |       | 293,422 |   |
| Net cash  provided by (used in) investing activities                                                           |       | 16,301                         |       | (78,555 | ) |
|                                                                                                           |       |                           |       |   |   |
| **Financing  activities:**                                                                                     |       |                           |       |   |   |
| Principal  payments on senior secured term loan                                                                |       | (35,000                        | )          | — |   |
| Repayment of  PortAuthority loan                                                                               |       | —                         |       | (4,214 | ) |
| Proceeds from  exercise of stock options                                                                       |       | 720                            |       | 2,388 |   |
| Proceeds from  issuance of common stock for stock purchase plan                                                |       | 2,903                          |       | 2,212 |   |
| Tax shortfall /  windfall from stock option exercises                                                          |       | (678                           | )          | 685 |   |
| Purchase of  treasury stock                                                                                    |       | (9,998                         | )          | — |   |
| Net cash (used  in) provided by financing activities                                                           |       | (42,053                        | )          | 1,071 |   |
| Effect of  exchange rate changes on cash and cash equivalents                                                  |       | 534                            |       | — |   |
| Decrease in cash  and cash equivalents                                                                         |       | (1,309                         | )          | (53,725 | ) |
| Cash and cash  equivalents at beginning of period                                                              |       | 66,383                         |       | 83,523 |   |
| Cash and cash  equivalents at end of period                                                                    |       | $                              | 65,074     |   | $ | 29,798 |   |
|                                                                                                           |       |                           |       |   |   |
| **Supplemental  cash flow information:**                                                                       |       |                           |       |   |   |
| Income taxes  paid                                                                                             |       | $                              | 3,945      |   | $ | 7,983 |   |
| Unrealized gain  on marketable securities                                                                      |       | $                              | —     |   | $ | 14 |   |

 

See accompanyingnotes.

 

6

----

Table of Contents

 

**Websense, Inc.**

 

**Notes To Consolidated FinancialStatements (Unaudited)**

 

1. *Basis of Presentation*

 

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

 

These financial statements should be read inconjunction with the audited consolidated financial statements and notes forthe fiscal year ended December 31, 2007, included in Websense, Inc.’s(“Websense” or the “Company”) Annual Report on Form 10-K filed with theSecurities and Exchange Commission. Operating results for the three and sixmonths ended June 30, 2008 are not necessarily indicative of the resultsthat may be expected for any other interim period or for the fiscal year endingDecember 31, 2008. The balance sheet at December 31, 2007 has beenderived from the audited financial statements at that date but does not includeall of the information and footnotes required by GAAP for complete financialstatements. Certain prior period amounts have been reclassified to conform tothe current period presentation.

 

2. *Net (Loss)Income Per Share*

 

Websensecomputes net (loss) income per share (“EPS”) as permitted by the FinancialAccounting Standards Board (“FASB”) with Statement of Financial AccountingStandards (“SFAS”) No. 128, *Earnings Per Share*(“SFAS 128”). Under the provisions of SFAS 128, basic EPS is computed bydividing the net (loss) income for the period by the weighted average number ofcommon shares outstanding during the period. Diluted EPS is computed bydividing the net income for the period by the weighted average number of commonand common equivalent shares outstanding during the period. Common equivalentshares consist of dilutive stock options and restricted stock units. Dilutivestock options and dilutive restricted stock units are calculated based on 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 the Company reported a net loss for the three andsix months ended June 30, 2008, basic and diluted EPS were the same.During the three and six months ended June 30, 2007, the differencebetween the weighted average shares used in determining basic EPS versusdiluted EPS related to dilutive securities which totaled 501,000 and 521,000shares, respectively. Potentially dilutive securities totaling 8,784,000 and6,342,000 shares for the three months ended June 30, 2008 and 2007,respectively, were excluded from the diluted EPS calculation because of theiranti-dilutive effect. Potentially dilutive securities totaling 8,529,000 and5,809,000 shares for the six months ended June 30, 2008 and 2007,respectively, were excluded from the diluted EPS calculation because of theiranti-dilutive effect.

 

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

 
| ** **                       | ** ** | **Net (Loss)  Income**                                           | ** ** | **Shares**        | ** ** | **Per Share** | ** ** |
|----------------------------------|------------|-----------------------------------------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                       | ** ** | **(Numerator)**                                                       | ** ** | **(Denominator)** | ** ** | **Amount**         | ** ** |
| ** **                       | ** ** | **(In thousands, except per share amounts)** | ** ** |
| **For the  Three Months Ended:** | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| **June 30,  2008:**         | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| Basic EPS                        |       | $                                                                     | (8,194     | )                 | 45,208     |               | $          | (0.18 | ) |
| Effect of  dilutive securities   |       | —                                                                |       | —            |       | —             |       |
| Diluted EPS                      |       | $                                                                     | (8,194     | )                 | 45,208     |               | $          | (0.18 | ) |
| ** **                       | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| **June 30,  2007:**         | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| Basic EPS                        |       | $                                                                     | 2,129      |              | 45,060     |               | $          | 0.05 |   |
| Effect of  dilutive securities   |       | —                                                                |       | 501               |       | —             |       |
| Diluted EPS                      |       | $                                                                     | 2,129      |              | 45,561     |               | $          | 0.05 |   |

 

7

----

Tableof Contents

 
| **For the  Six Months Ended:** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **June 30,  2008:**       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic EPS                      |       | $          | (14,431    | )          | 45,299     |       | $          | (0.32 | ) |
| Effect of  dilutive securities |       | —     |       | —     |       | —     |       |
| Diluted EPS                    |       | $          | (14,431    | )          | 45,299     |       | $          | (0.32 | ) |
| ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **June 30,  2007:**       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic EPS                      |       | $          | 5,996      |       | 44,978     |       | $          | 0.13 |   |
| Effect of  dilutive securities |       | —     |       | 521        |       | —     |       |
| Diluted EPS                    |       | $          | 5,996      |       | 45,499     |       | $          | 0.13 |   |

 

3. *Comprehensive (Loss) Income*

 

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

 
| ** **                                                                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                             | ** ** | **June 30,  2008**          | ** ** | **June 30,  2007**        | ** ** | **June 30,  2008** | ** ** | **June 30,  2007** | ** ** |
| Net (loss)  income                                                                     |       | $                                | (8,194     | )                              | $          | 2,129 |   | $ | (14,431 | ) | $ | 5,996 |   |
| Net change in  unrealized (loss) gain on marketable securities, net of tax             |       | —                           |       | (22                            | )          | — |   | 14 |   |
| Net change in  unrealized gain on fair value of foreign currency contracts, net of tax |       | —                           |       | 13                             |       | — |   | 19 |   |
| Net change in  unrealized gain (loss) on interest rate swap and cap, net of tax        |       | 1,016                            |       | —                         |       | (68 | ) | — |   |
| Cumulative  translation adjustment                                                     |       | (169                             | )          | —                         |       | (645 | ) | — |   |
| Comprehensive  (loss) income                                                           |       | $                                | (7,347     | )                              | $          | 2,120 |   | $ | (15,144 | ) | $ | 6,029 |   |

 

4. *Acquisitions*

 

**SurfControl**

 

In October 2007, the Company completed the acquisitionof SurfControl plc (“SurfControl”), a U.K.-based provider of Web and e-mailsecurity solutions.  The total purchaseprice of the acquisition was as follows (in thousands):

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

 

The purchase priceallocation is preliminary and subject to revision as more detailed analyses arecompleted. Any change in the fair value of the net assets acquired will changethe amount of the purchase price allocable to goodwill.  The Company expects to finalize the purchaseprice by September 2008.  Thepreliminary allocation of the purchase price as of June 30, 2008 is asfollows (in thousands):

 

8

----

Table of Contents

 
| Fair value of  net tangible assets acquired and liabilities assumed: |   |    |   |    |    |
|----------------------------------------------------------------------|--------|---------|--------|---------|---------|
| Cash and cash  equivalents                                           |   | $       | 65,995 |    |    |   |
| Accounts  receivable                                                 |   | 16,723  |   |    |    |
| Other current  assets                                                |   | 3,515   |   |    |    |
| Property and  equipment                                              |   | 10,676  |   |    |    |
| Deferred income  taxes                                               |   | (33,051 | )      |    |    |
| Accounts payable  and accrued expenses                               |   | (46,802 | )      |    |    |
| Deferred revenue                                                     |   | (19,729 | )      |    |    |
|                                                                 |   |    |   | (2,673  | )       |
| Fair value of  identifiable intangible assets acquired:              |   |    |   |    |    |
| Technology                                                           |   | 29,265  |   |    |    |
| Customer  relationships                                              |   | 128,500 |   |    |    |
|                                                                 |   |    |   | 157,765 |    |
| Goodwill                                                             |   |    |   | 305,782 |    |
| Total purchase  price                                                |   |    |   | $       | 460,874 |   |
|                                                                      |        |         |        |         |         |  |  |

 

In connection with theacquisition, the Company’s management approved plans to restructure theoperations of the acquired company by terminating 320 of SurfControl’semployees and exiting certain SurfControl facilities. As of June 30, 2008,of the 320 employees originally identified for termination, 319 have beenterminated and the one remaining employee is expected to be terminated by September 2008.These workforce reductions are across all functions and geographies andaffected employees 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 June 30,2008, $9.5 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 June 30, 2008** | ** ** |
|----------------------|------------|----------------------------------------------|------------|--------------------|------------|-----------------|------------|----------------------------------------|------------|--------------------------------------------------|------------|
|                 |       |                                         |       |               |       |            |       |                                   |       |                                             |       |
| Severance costs      |       | $                                            | 6,761      |               | $          | (4,379          | )          | $                                      | (1,894     | )                                                | $          | 10 |   | $ | 498 |   |
| Facility exit  costs |       | 9,379                                        |       | (397               | )          | (1              | )          | 30                                     |       | 9,011                                            |       |
| Total                |       | $                                            | 16,140     |               | $          | (4,776          | )          | $                                      | (1,895     | )                                                | $          | 40 |   | $ | 9,509 |   |

 

The accruals forseverance costs at June 30, 2008 primarily represent the amounts to bepaid to employees that have been terminated or identified for termination as aresult of the restructuring plan described above.  These amounts are expected to be paid withinfiscal year 2008.

 

The accruals for facilityexit costs at June 30, 2008 represent the remaining fair value of lease obligationsfor exiting locations, as determined at the expected cease-use dates of thosefacilities, and will be paid out over the remaining lease terms, the last ofwhich ends in fiscal year 2013.  As of June 30,2008, 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 Companyanticipates such information will be obtained by September 2008 and willadjust the facility exit accrual accordingly.

 

During the first quarterof 2008, the Company completed certain integration activities in connectionwith the acquisition of SurfControl. As a result of the completion of theintegration activities, the Company reassessed the functional currencydesignation of the SurfControl entities and determined that a change infunctional currency designation was appropriate for certain SurfControlentities. The change in functional currency designation was made prospectivelyeffective as of the beginning of the second quarter of 2008.

 

9

----

Table of Contents

 

5. *IntangibleAssets and Goodwill*

 

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

 
| ** **              | ** ** | **Weighted Average Life  (years)** | ** ** | **Cost** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|-------------------------|------------|----------------------------------------------|------------|----------|------------|-------------------------------|------------|---------|------------|
|                    |       |                                         |       |     |       |                          |       |    |       |
| Technology              |       | 2.9                                          |       | $        | 43,270     |                          | $          | (11,534 | )          | $ | 31,736 |   |
| Customer  relationships |       | 6.1                                          |       | 129,200  |       | (31,797                       | )          | 97,403  |       |
| Trade name              |       | 3.5                                          |       | 510      |       | (153                          | )          | 357     |       |
| Total                   |       |                                         |       | $        | 172,980    |                          | $          | (43,484 | )          | $ | 129,496 |   |

 

As of June 30, 2008,remaining amortization expense is expected to be as follows (in thousands):

 
| **Years Ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2008                                         |       | $          | 24,929     |   |
| 2009                                         |       | 38,640     |       |
| 2010                                         |       | 25,831     |       |
| 2011                                         |       | 14,956     |       |
| 2012                                         |       | 8,261      |       |
| Thereafter                                   |       | 16,879     |       |
| Total                                        |       | $          | 129,496    |   |

 

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

 
| ** **                                         | ** ** | **Six Months Ended  June 30, 2008** | ** ** |
|----------------------------------------------------|------------|---------------------------------------------------------|------------|
| Balance at  December 31, 2007                 |       | $                                                       | 385,916    |   |
| Reduction from  sale of CyberPatrol assets         |       | (2,148                                                  | )          |
| Refund related  to PortAuthority acquisition       |       | (147                                                    | )          |
| PortAuthority  deferred income tax adjustment      |       | (1,655                                                  | )          |
| SurfControl  deferred income tax adjustment        |       | (4,681                                                  | )          |
| Other  SurfControl purchase accounting adjustments |       | (1,150                                                  | )          |
| Balance at  June 30, 2008                     |       | $                                                       | 376,135    |   |

 

**6*. Senior Secured CreditFacility***

 

In connection with the acquisition of SurfControl in October 2007,the Company entered into an amended and restated senior credit agreement (the “SeniorCredit Agreement”).  The $225 millionsenior secured credit facility consists of a five year $210 million senior securedterm loan and a $15 million revolving credit facility. The senior secured termloan was fully funded on October 11, 2007, and the revolving line ofcredit remains unused. At June 30, 2008, the outstanding balance under thesenior secured term loan was $155 million as a result of the Company makingoptional prepayments totaling $5 million in the quarter ended June 30,2008 and $35 million in the six months ended June 30, 2008, as well as anoptional $20 million prepayment on December 31, 2007. The senior securedcredit facility is secured by substantially all of the assets of the Company,including pledges of stock of some of its subsidiaries (subject to limitationsin the case of foreign subsidiaries) and by secured guarantees by the Company’sdomestic subsidiaries. The senior secured term loan initially amortized at aminimum rate of 2.5%, 10%, 12.5%, and 15%, respectively, during the first fouryears of the term and 60% during the fifth year. In conjunction with theCompany’s optional $20 million prepayment on December 31, 2007, theCompany amended its Senior Credit Agreement to eliminate any additionalmandatory payments until September 30, 2009.  The senior secured term loan bears interestat a spread above LIBOR with the spread determined based upon the Company’stotal leverage ratio, as defined in the Senior Credit Agreement. During thesecond quarter 2008, the annual interest rate was LIBOR plus 250 basis points(5.28% at June 30, 2008), and was subject to a potential step down in thespread over LIBOR based upon potential future improvements in the Company’stotal leverage ratio. The unused portion of the revolving credit facilityrequired a 50 basis points fee per annum, also subject to a step down basedupon potential future improvements in the Company’s total leverage ratio. Basedon the total leverage ratio as of June 30, 2008, the spread on both thesenior secured term loan and revolving credit facility will be reduced for thethird quarter of 2008 to LIBOR plus 225 basis points (5.03% as of June 30,2008) per annum for the senior secured term loan and 25 basis points per annumfor the 

 

10

----

Table of Contents

 

unused portion of the revolving credit facility. TheSenior Credit Agreement contains financial covenants, including a consolidatedleverage ratio and a consolidated interest coverage ratio, as well asaffirmative and negative covenants.

 

As of June 30, 2008, future remaining minimumprincipal payments under the senior secured term loan will be as follows (inthousands):

 
| **Years Ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2008                                         |       | $          | —     |   |
| 2009                                         |       | 5,099      |       |
| 2010                                         |       | 21,414     |       |
| 2011                                         |       | 25,697     |       |
| 2012                                         |       | 102,790    |       |
| Total                                        |       | $          | 155,000    |   |

 

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

 

7. *Foreign Currency Hedges*

 

The Company uses derivative financial instruments tomanage foreign currency risk relating to foreign exchange rates, fluctuationsarising from the sale of products internationally in foreign currencies, andfrom expenses in foreign currencies to support those sales. The Company doesnot use these instruments for speculative or trading purposes. The Company’sobjective is to reduce the risk to earnings and cash flows associated withchanges in foreign currency exchange rates. Derivative instruments arerecognized as either assets or liabilities in the accompanying financialstatements and are measured at fair value. Gains and losses resulting fromchanges in the fair values of those derivative instruments are recorded toearnings or other comprehensive (loss) income depending on the use of thederivative instrument and whether it qualifies for hedge accounting.

 

During the three and six months ended June 30, 2008 and 2007, the Company utilized Euro foreign currency forward contracts to hedge anticipated Euro denominated accounts receivable. All such contracts entered into were designated as fair value hedges and were not required to be tested for effectiveness as hedge accounting was not elected. None of the contracts were terminated prior to settlement. Net realized losses related to the contracts designated as fair value hedges settled during the three and six months ended June 30, 2008 and 2007 are included in other income, net, in the accompanying consolidated statements of operations and amounted to approximately $221,000 and $64,000 for the three months ended June 30, 2008 and 2007, respectively and $498,000 and $148,000 for the six months ended June 30, 2008 and 2007, respectively.

 

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

 
| ** **    | ** ** | **June 30, 2008**          | ** ** | **June 30, 2007** | ** ** |
|---------------|------------|--------------------------------------|------------|-----------------------------|------------|
| ** **    | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD**    | ** ** | **Fair Value  USD** | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD** | ** ** | **Fair Value  USD** | ** ** |
| Euro          |       | €                               | 2,850      |                        | $          | 4,325 |   | $ | 4,171 |   | € | 2,000 |   | $ | 2,660 |   | $ | 2,610 |   |
| British Pound |       | £                               | —     |                        | —     |   | — |   | £ | 950 |   | 1,886 |   | 1,900 |   |
| Total         |       |                                 |       | $                           | 4,325      |   | $ | 4,171 |   |   |   | $ | 4,546 |   | $ | 4,510 |   |

 

11

----

Table of Contents

 

8.*Fair Value Measurements*

 

*SFAS No. 157*

 

SFAS No. 157, *FairValue Measurements* (“SFAS 157”) defines fair value, establishes aframework for measuring fair value and establishes a hierarchy that categorizesand prioritizes the sources to be used to estimate fair value. SFAS 157 alsoexpands financial statement disclosures about fair value measurements. On February 12,2008, the FASB issued FASB Staff Position 157-2 (“FSP 157-2”), which delays theeffective date of SFAS 157 for one year for all nonfinancial assets andnonfinancial liabilities, except those that are recognized or disclosed at fairvalue in the financial statements on a recurring basis.  The Company elected a partial deferral ofSFAS 157 under the provisions of FSP 157-2 related to the measurement of fairvalue used when evaluating nonfinancial assets and liabilities. The Company iscurrently evaluating the impact of FSP 157-2 on its financial statements. Theimpact of partially adopting SFAS 157 effective January 1, 2008 was notmaterial to the Company’s financial statements.

 

*Fair Value Measurements on aRecurring Basis*

 

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

 

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

 
| ** **                          | ** ** | **Level 1****(1)** | ** ** | **Level 2****(2)** | ** ** | **Level 3****(3)** | ** ** | **Total** | ** ** |
|-------------------------------------|------------|-------------------------|------------|-------------------------|------------|-------------------------|------------|-----------|------------|
| Assets:                             |       |                    |       |                    |       |                    |       |      |       |
| Interest rate  cap                  |       | $                       | —     |                    | $          | 72                      |       | $         | —     |   | $ | 72 |   |
|                                |       |                    |       |                    |       |                    |       |      |       |
| Liabilities:                        |       |                    |       |                    |       |                    |       |      |       |
| Interest rate  swaps                |       | $                       | —     |                    | $          | 1,790                   |       | $         | —     |   | $ | 1,790 |   |
| Foreign currency  forward contracts |       | —                  |       | 154                     |       | —                  |       | 154       |       |

 

----

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

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

(3) – noobservable pricing inputs in the market

 

Included in Other assets and in Other accrued expensesare derivative contracts, comprised of interest rate swaps and an interest ratecap as well as foreign currency forward contracts, that are valued using modelsbased on readily observable market parameters for all substantial terms of theCompany’s derivative contracts and thus are classified within Level 2.

 

*Fair Value Measurements on aNonrecurring Basis*

 

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

 

*SFAS No. 159*

 

SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities—Including an Amendment of SFAS 115*(“SFAS 159”), permits but does not require companies to measure financialinstruments and certain other items at fair value. Unrealized gains and losseson items for which the fair value option has been elected are reported inearnings. As the Company did not elect to fair value any of its financialinstruments under the provisions of SFAS 159, the adoption of this statementeffective January 1, 2008 did not have an impact on the Company’sfinancial statements.

 

9.*Stockholders’ Equity*

 

**Share-Based Compensation**

 

*Employee Stock Purchase Plan*

 

Shares available forissuance under the Company’s Employee Stock Purchase Plan are as follows:

 

12

----

Table of Contents

 
| ** **                                                                                 | ** ** | **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 issued  during six months ended June 30, 2008                                  |       | (190,250                   | )          |
| Shares reserved  for issuance at June 30, 2008                                        |       | 1,954,851                  |       |

 

*Employee Stock Option Plans*

 

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

 
| ** **                         | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|------------------------------------|------------|----------------------------|------------|--------------------------------------------|------------|
| Balance at  December 31, 2007 |       | 9,086,786                  |       | $                                          | 22.62      |   |
| Granted                            |       | 2,034,750                  |       | 18.41                                      |       |
| Exercised                          |       | (75,876                    | )          | 9.50                                       |       |
| Cancelled                          |       | (598,345                   | )          | 22.61                                      |       |
| Balance at  June 30, 2008     |       | 10,447,315                 |       | 21.89                                      |       |
|                                    |            |                            |            |                                            |            |  |

 

Shares reserved for future grants under the Company’sstock option plans are as follows:

 
| ** **                                                                                           | ** ** | **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 the six months ended June 30, 2008                                       |       | (2,070,750                       | )          |
| Shares cancelled  during the six months ended June 30, 2008                                     |       | 598,345                          |       |
| Shares reserved  for future grants at June 30, 2008                                             |       | 565,970                          |       |

 

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

 
| ** **                                            | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                            | ** ** | **June 30,  2008**          | ** ** | **June 30,  2007**        | ** ** | **June 30,  2008** | ** ** | **June 30,  2007** | ** ** |
| Share-based  compensation in:                         |       |                             |       |                           |       |   |   |   |   |
| Cost of revenues                                      |       | $                                | 316        |                           | $          | 388 |   | $ | 677 |   | $ | 717 |   |
| Total share-based  compensation in cost of revenues   |       | 316                              |       | 388                            |       | 677 |   | 717 |   |
|                                                  |       |                             |       |                           |       |   |   |   |   |
| Selling and  marketing                                |       | 2,249                            |       | 2,192                          |       | 4,566 |   | 4,205 |   |
| Research and  development                             |       | 1,199                            |       | 954                            |       | 2,323 |   | 1,886 |   |
| General and  administrative                           |       | 2,241                            |       | 1,780                          |       | 4,609 |   | 3,728 |   |
| Total  share-based compensation in operating expenses |       | 5,689                            |       | 4,926                          |       | 11,498 |   | 9,819 |   |
| Total  share-based compensation                       |       | $                                | 6,005      |                           | $          | 5,314 |   | $ | 12,175 |   | $ | 10,536 |   |

 

13

----

Table ofContents

 

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

 
| ** **                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                          | ** ** | **June 30,  2008**          | ** ** | **June 30,  2007**        | ** ** | **June 30,  2008** | ** ** | **June 30,  2007** | ** ** |
|                                |       |                             |       |                           |       |   |   |   |   |
| Average expected  life (years)      |       | 3.0                              |       | 3.0                            |       | 3.0 |   | 3.1 |   |
| Average expected  volatility factor |       | 34.8                             | %          | 34.1                           | %          | 34.8 | % | 35.5 | % |
| Average  risk-free interest rate    |       | 2.7                              | %          | 4.7                            | %          | 2.6 | % | 4.7 | % |
| Average expected  dividend yield    |       | —                           |       | —                         |       | — |   | — |   |

 

*Treasury Stock*

 

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

 
| ** **                                                            | ** ** | **Shares** | ** ** | **Average Price  Per Share** | ** ** |
|-----------------------------------------------------------------------|------------|------------|------------|----------------------------------------|------------|
| Shares repurchased through December 31, 2007 |       | 8,170,060  |       | $                                      | 20.86      |   |
| Shares  repurchased during the six months ended June 30, 2008    |       | 537,904    |       | $                                      | 18.57      |   |
| Total shares  repurchased through June 30, 2008                  |       | 8,707,964  |       | $                                      | 20.72      |   |

 

Under the terms of theCompany’s Senior Credit Agreement, the Company is restricted from repurchasingits common stock for an aggregate purchase price that exceeds the sum of $25million plus 50% of the aggregate amount of its consolidated net income, asdefined in the Senior Credit Agreement, during the period from the effectivedate of the facility through the most recent quarter end for which quarterlyfinancial statements have been filed. The remaining shares authorized for repurchase under the Company’s stockrepurchase program as of June 30, 2008 was 3,292,036 shares. As of June 30,2008, $33.4 million remained authorized for repurchase under the Company’sSenior 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 June 30, 2008, the Company hadapproximately $8.7 million of total gross unrecognized tax benefits. Includedin this balance are $5.5 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 $0.3 million related to theseunrecognized tax benefits during the six months ended June 30, 2008, andin total, as of June 30, 2008, the Company has recorded a liability forpotential penalties and interest of $0.9 million.

 

The Company and itssubsidiaries are subject to U.S. federal income tax as well as income tax ofmultiple state and foreign jurisdictions. The Company has substantiallyconcluded all U.S. federal and state income tax audits for years through 2003.Substantially all material foreign income tax audits have been concluded foryears through 2002. The federal income tax return for 2005 and Californiaincome tax returns for 2003 and 2004 are currently under examination. At June 30,2008, the Company had net deferred tax assets of $47.9 million.

 

During the quarter ended March 31,2008, the Company received a favorable ruling regarding unrecognized stateincome tax benefits, resulting in the reduction of the gross uncertain taxliability of $4.2 million.  Thisfavorable ruling resulted in approximately $2.7 million of net tax benefitbeing recognized in the consolidated statement of operations in the six monthsended June 30, 2008 with the remaining $1.5 million being recorded as areduction to the related deferred tax asset. In addition, due to the potentialresolution of federal, state and foreign tax examinations, and the expirationof various statutes of limitations, it is reasonably possible that the Company’sgross unrecognized tax benefits balance may change within the next twelvemonths by a range of zero to $0.8 million.

 

14

----

Table of Contents

 

11*. Litigation*

 

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

 

12. *RecentlyIssued Accounting Standards*

 

In March 2008 theFASB issued SFAS No. 161, *Disclosures aboutDerivative Instruments and Hedging Activities, an Amendment of FASB Statement No. 133*(“SFAS 161”), which requires additional disclosures about the objectives of thederivative instruments and hedging activities, the method of accounting forsuch instruments under SFAS No. 133 and its related interpretations, and atabular disclosure of the effects of such instruments and related hedged itemson the Company’s financial position, financial performance and cash flows. SFAS161 is effective 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 establishesprinciples and requirements for how the acquirer of a business recognizes andmeasures in its financial statements the identifiable assets acquired, theliabilities assumed and any noncontrolling interest in the acquiree. Thestatement also provides guidance for recognizing and measuring the goodwillacquired in the business combination and establishes what information todisclose to enable users of the financial statements to evaluate the nature andfinancial effects of the business combination. SFAS 141R is effective forfinancial statements issued for fiscal years beginning after December 15,2008. Accordingly, any business combinations the Company engages in will berecorded and disclosed following existing GAAP until January 1, 2009. TheCompany expects SFAS 141R may have an impact on its consolidated financialstatements when effective, but the nature and magnitude of the specific effectswill depend upon the nature, terms and size of the acquisitions, if any,consummated after the effective date. The Company is currently assessing thepotential impact that adoption of SFAS 141R may have on its financialstatements.

 

15

----

Tableof Contents

 

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

 

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

 

**Forward-LookingStatements**

 

**This report on Form 10-Q may contain “forward-lookingstatements” within the meaning of the federal securities laws made pursuant tothe safe harbor provisions of the Private Securities Litigation Reform Act of 1995.These statements, which represent our expectations or beliefs concerningvarious future events, may contain words such as “may,” “will,” “expects,” “anticipates,”“intends,” “plans,” “believes,” “estimates” or other words indicating futureresults. Such statements may include but are not limited to statementsconcerning the following:**

 

·      anticipated trends inrevenue;

 

·      plans, strategies andobjectives of management for future operations;

 

·      risks associated withintegrating acquired businesses and launching new product offerings;

 

·      growth opportunities indomestic and international markets;

 

·      new and enhanced channels ofdistribution;

 

·      customer acceptance andsatisfaction with our products;

 

·      expected trends in operatingand other expenses;

 

·      anticipated cash andintentions regarding usage of cash;

 

·      changes in effective taxrates; and

 

·      anticipated productenhancements or releases.

 

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

 

**Overview**

 

Since we commencedoperations in 1994 as a reseller of computer security products, Websense hasevolved 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 through our acquisition of PortAuthorityTechnologies, Inc. (“PortAuthority”), our technology development partnerfor DLP solutions. Additionally, in October 2007, we acquired SurfControlplc (“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 our software products to provide a secureand productive computing environment for employees, business partners andcustomers. Our products allow organizations to:

 

·             preventaccess to undesirable and dangerous elements on the Web, such as Web sites thatcontain inappropriate content or sites that download an ever-increasing varietyof malicious code;

 

·             filterunwanted emails or “spam” out of incoming email traffic;

 

16

----

Tableof Contents

 

·     filter viruses and other malicious attachmentsfrom email and instant messages;

 

·     manage the use of non-Web Internet traffic, suchas 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’s valuablecomputing resources, including unauthorized downloading of high-bandwidthcontent.

 

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

 

·      proactivediscovery of Web and internal content, which is classified into highly granulardatabase categories;

 

·      proactivediscovery and identification of Web-based threats, including spyware, hackingtools, keyloggers, phishing and pharming exploits;

 

·      dynamicclassification of uncategorized, high-risk Web content, includinguser-generated Web 2.0 content, based on our knowledge of the Web, email attackvectors, and malicious code characteristics; and

 

·      policysoftware that automates enforcement of pre-defined business policies regardingacceptable users and uses of various Web and internal content categories.

 

During the six monthsended June 30, 2008, we derived approximately 41% of our revenue frominternational sales, compared with approximately 39% for the six months ended June 30,2007, with the United Kingdom comprising approximately 11% and 10% of our totalrevenue for the six months ended June 30, 2008 and 2007, respectively. Webelieve international markets continue to represent a significant growthopportunity and we are continuing to expand our international operations,particularly in selected countries in the European, Asia/Pacific, LatinAmerican and Australian markets.

 

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

 

As described elsewhere inthis report, we recognize revenue from subscriptions to our products, includingadd-on modules, on a daily straight-line basis over the term of thesubscription agreement, commencing on the first day of the subscription term.We recognize the operating expenses related to these sales as they areincurred. These operating expenses include sales commissions, which are basedon the total amount of the subscription contract and are fully expensed in theperiod the subscription term begins. Operating expenses have continued toincrease as compared with prior periods due to expanded selling and marketingefforts, continued product research and development and investments inadministrative infrastructure to support subscription sales that we willrecognize as revenue in subsequent periods.

 

In October 2007, wecompleted 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 initially recorded asdeferred revenue and recognized ratably over the term of the agreement. UnderGAAP purchase accounting, we wrote off $97.4 million of the deferred revenue ofSurfControl, leaving a balance of $19.7 million as the fair value of theobligation. This adjustment reflects the fair value of the post-contracttechnical support services that will be recognized daily in accordance with ourrevenue recognition policy. We do not expect to generate significant revenuefrom the installed SurfControl customer base until existing subscriptions areup for renewal. In connection with the acquisition, we have incurredrestructuring costs primarily in connection with reducing SurfControl headcountand eliminating redundant facilities.  Wealso immediately started to incur the expenses of managing the SurfControloperations 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 of the installed SurfControlcustomer base to offset these expenses. Given the average remaining term of the SurfControl subscriptions, wecurrently do not expect to operate at a profit under GAAP in fiscal year2008.  Our ability to retain SurfControlcustomers and maintain our overall pricing levels for our products will impactour results of operations and the timing of our return to profitability.

 

We allocate the totalcosts for human resources, employee benefits, payroll taxes, informationtechnology, facilities and fixed asset depreciation to each of our functionalareas based on headcount data.  Ouroverall costs to be allocated have 

 

17

----

Tableof Contents

 

increased as a result of the growth in our headcount,increased personnel costs and the growth of our facilities costs and we expectthis 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 June 30, 2008, of the 320 employeesthat we identified as being subject to the involuntary termination, 319 havebeen terminated and the one remaining employee is expected to be terminated by September 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 our facilityexit plans by September 2008. We have accrued the estimated costsassociated with the employee severance and facility exit obligations asliabilities assumed in the acquisition of SurfControl and, accordingly,included the costs as part of the purchase price of SurfControl. Changes to theestimates of these costs after September 2008 will be recorded either as areduction to goodwill or as an expense 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 apurchase decision is made for our products, customers enter into a subscriptionagreement, which is generally 12, 24 or 36 months in duration and for a fixednumber of users. Other services such as upgrades/enhancements and standardpost-contract technical support services are sold together with our productsubscription 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* (“SFAS142”), we review goodwill that has an indefinite useful life for impairment atleast annually in our fourth fiscal quarter, or more frequently if an eventoccurs indicating the potential for impairment. We amortize the cost of identified intangible assets using amortizationmethods that reflect the pattern in which the economic benefits of the intangible assets are consumed orotherwise used up.  In accordance withSFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets* (“SFAS 144”), we reviewintangible assets that have finite useful lives when an event occurs indicatingthe potential for impairment.  We reviewfor impairment by facts or circumstances, either external or internal,indicating that we may not recover the carrying value of the asset.  We measure impairment losses related tolong-lived assets based on the amount by which the carrying amounts of theseassets exceed their fair values.  Wemeasure fair value under SFAS 144, which is generally based on the estimatedfuture cash flows. Our analysis is based on available information and on assumptionsand 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.

 

18

----

Tableof Contents

 

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

 

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

 

19

----

Tableof Contents

 

# **Results ofOperations**

#  

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

 

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

 
| ** **                            | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|
| ** **                            | ** ** | **June 30,  2008**          | ** ** | **June 30,  2007** | ** ** |
| ** **                            | ** ** | **(Unaudited)**                  | ** ** |
| ** **                            | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Revenue                               |       | 100                              | %          | 100 | % |
|                                  |       |                             |       |   |   |
| Cost of revenues:                     |       |                             |       |   |   |
| Cost of revenues                      |       | 12                               |       | 10 |   |
| Amortization of  acquired technology  |       | 4                                |       | 1 |   |
| Total cost of  revenues               |       | 16                               |       | 11 |   |
|                                  |       |                             |       |   |   |
| Gross margin                          |       | 84                               |       | 89 |   |
|                                  |       |                             |       |   |   |
| Operating  expenses:                  |       |                             |       |   |   |
| Selling and  marketing                |       | 61                               |       | 50 |   |
| Research and  development             |       | 18                               |       | 20 |   |
| General and  administrative           |       | 16                               |       | 13 |   |
| Total operating  expenses             |       | 95                               |       | 83 |   |
|                                  |       |                             |       |   |   |
| (Loss) income  from operations        |       | (11                              | )          | 6 |   |
|                                  |       |                             |       |   |   |
| Interest expense                      |       | (4                               | )          | — |   |
| Other income,  net                    |       | 2                                |       | 3 |   |
|                                  |       |                             |       |   |   |
| (Loss) income  before income taxes    |       | (13                              | )          | 9 |   |
|                                  |       |                             |       |   |   |
| (Benefit)  provision for income taxes |       | (2                               | )          | 5 |   |
|                                  |       |                             |       |   |   |
| Net (loss)  income                    |       | (11                              | )%         | 4 | % |

 

# **Revenue**

#  

Revenue increased to$73.0 million in the second quarter of 2008 from $50.4 million in the secondquarter of 2007. The increase was a result primarily of the addition of new,renewed and upgraded subscriptions (including $16.0 million from new or renewedSurfControl seat subscriptions and $3.0 million of revenue recognized from thedeferred revenue acquired from SurfControl in October 2007). For theremainder of 2008, we expect our revenue to increase over 2007 due to theaddition of our acquired SurfControl business, our deferred revenue underexisting subscriptions, our renewal business, planned growth in sales,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 of Revenues**

#  

*Cost ofrevenues.* Cost of revenues consists of the costs of contentreview, technical support and infrastructure costs associated with maintainingour databases and costs associated with providing our hosted security services.Cost of revenues increased to $8.6 million in the second quarter of 2008 from$4.8 million in the second quarter of 2007. The increase of $3.8 million wasprimarily due to additional personnel in our technical support and databasegroups, including the increased headcount attributable to the acquisition ofSurfControl, the addition of hosted services and allocated costs. Our headcountin cost of revenue departments increased from 163 employees at June 30,2007 to 217 employees at 

 

20

----

Tableof Contents

 

June 30, 2008. Weallocate the costs for human resources, employee benefits, payroll taxes, informationtechnology, facilities and fixed asset depreciation to each of our functionalareas based on headcount data. As a percentage of revenue, cost of revenuesincreased to 12% from 10% during the second quarter of 2008 compared to 2007.  We expect cost of revenue to remain higher inabsolute dollars for the remainder of 2008 as compared to 2007 in order tosupport the growth and maintenance of our databases and due to costs associatedwith providing our hosted security services as well as the technical supportneeds of our customers.

 

*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 $2.5 million in amortization of acquired technology from thesecond quarter of 2007 to the second quarter of 2008 was primarily due to theacquisition of SurfControl in October 2007. The acquired technology isbeing amortized over a weighted average period of 2.9 years. We expect to incur$6.2 million in amortization expense of acquired technology during theremainder of 2008.

 

# **Gross Margin**

#  

Grossmargin increased to $61.3 million in the second quarter of 2008 from $45.0million in the second quarter of 2007. As a percentage of revenue, gross margindecreased to 84% in the second quarter of 2008 from 89% in the second quarterof 2007 due to the increased costs described in the preceding Cost of Revenuessection. We expect that gross margin as a percentage of revenue will remain inexcess of 80% of revenue for the remainder of 2008.

 

# **Operating Expenses**

#  

*Selling and marketing*. Selling andmarketing expenses consist primarily of salaries, commissions and benefitsrelated to personnel engaged in selling, marketing and customer supportfunctions, including costs related to public relations, advertising, promotionsand travel, amortization of acquired customer relationships as well asallocated costs. Selling and marketing expenses do not include payments tochannel partners for marketing services and rebates.  Selling and marketing expenses increased to$44.3 million, or 61% of revenue, in the second quarter of 2008, from $25.1million, or 50% of revenue, in the second quarter of 2007. Approximately $9.3million of the increase was due to the amortization of acquired intangibles(customer relationships) which resulted from the acquisition of SurfControl in October 2007.The acquired customer relationships intangible assets are being amortized overa weighted average period of approximately 6.1 years. In addition to theamortization of acquired intangible assets, the increase in selling andmarketing expenses was primarily due to increased personnel costs and relatedtravel, including new personnel added from the SurfControl acquisition in October 2007and allocated costs. Our headcount in sales and marketing increased from 380employees at June 30, 2007 to 519 employees at June 30, 2008. Weexpect selling and marketing expenses to increase in absolute dollars 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 to support our expanding selling and marketing efforts worldwide, andincreased sales resulting in higher overall sales commission expenses. Weexpect amortization of acquired intangibles of $18.7 million for the remainderof 2008 as a result of the amortization of acquired intangibles from theSurfControl and PortAuthority acquisitions.

 

*Research and development.* Research and development expensesconsist primarily of salaries and benefits for software developers andallocated costs. Research and development expenses increased to $13.2 million,or 18% of revenue, in the second quarter of 2008 from $10.3 million, or 20% ofrevenue, in the second quarter of 2007. The increase of $2.9 million inresearch and development expenses was primarily due to increased personnelcost, including adding new full time employees due to the SurfControlacquisition in October 2007, and increased hiring to support our managedrelease of our Web content gateway, data loss prevention endpoint module andenhancements to our other products as well as to support our expanding list oftechnology partners and allocated costs. Our headcount increased in researchand development from 193 employees at June 30, 2007 to 351 employees at June 30,2008. We expect future research and development expenses to increase inabsolute dollars for the remainder of 2008 as compared to 2007 due to having afull year of additional engineering personnel and an expanded base of productofferings.  We are managing the increasein our absolute research and development expense by operating research anddevelopment facilities in multiple international locations, including Beijing,China, that have lower costs than our operations in the United States.

 

*General and administrative*. General andadministrative expenses consist primarily of salaries, benefits and relatedexpenses for our executive, finance and administrative personnel, third partyprofessional service fees and allocated costs. General and administrativeexpenses increased to $11.8 million, or 16% of revenue, in the second quarterof 2008 from $6.6 million, or 13% of revenue, in the second quarter of 2007.The $5.2 million increase in general and administrative expense was primarilydue to additional personnel needed to support our growing operations, includingthe acquisition of SurfControl 

 

21

----

Table of Contents

 

in October 2007 andallocated costs.  Our headcount increasedin general and administrative departments from 66 employees at June 30,2007 to 112 employees at June 30, 2008. We expect general and administrative expenses to increase in absolutedollars for the remainder of 2008 as compared to 2007 due to having a full yearof additional personnel due to the SurfControl acquisition and to supportgrowth in operations and expansion of our international operations.

 

**Interest Expense**

 

Interest expense represents the interest incurred on our senior securedterm loan that we utilized to pay for a portion of the SurfControl purchaseprice in October 2007.  Alsoincluded in the interest expense is $325,000 of amortization of deferredfinancing fees that were capitalized as part of the senior secured creditfacility.  Interest expense will increasefor the remainder of 2008 as compared to 2007 due to having the senior securedterm loan outstanding for the full year of 2008.  The amount of interest expense will fluctuatedue to changes in the outstanding principal balance and due to changes in LIBORand changes in our applicable spread to LIBOR based upon improvements in ourleverage ratio in accordance with our senior secured credit facility agreement.Interest expense should decline in the remaining quarters of fiscal 2008 ascompared to the second quarter of 2008 due to the lower outstanding principalamount and lower marginal interest rate.

 

# **Other Income, Net**

#  

Otherincome, net decreased to $1.1 million in the second quarter of 2008 from $1.5million in the second quarter of 2007. The decrease was due primarily toreduced interest income of approximately $1.0 million in the second quarter of2008 compared to the second quarter of 2007 as a result of our use ofapproximately $245 million in cash, cash equivalents and marketable securitiesto fund the acquisition of SurfControl in October 2007, offset by foreignexchange re-measurement gains of approximately $691,000 due to favorablemovements in the foreign exchange rates during the second quarter of 2008compared to the second quarter of 2007. Due to the reduced cash, cash equivalents and marketable securities as aresult of the acquisition of SurfControl as well as the prepayments on oursenior secured term loan and stock repurchases, we expect other income, net todecrease in absolute dollars during the remainder of 2008 as compared to 2007.

 

# **Provision for Income Taxes**

#  

Werecognized an income tax benefit of $1.7 million and an income tax expenseof $2.3 million for the three months ended June 30, 2008 and 2007,respectively. Our effective tax rates were a tax benefit of 17.3% and a taxprovision of 52.3% for the three months ended June 30, 2008 and June 30,2007, respectively.

 

Oureffective tax rate decreased from the second quarter of 2007 to the secondquarter of 2008 primarily due to significant book losses in foreignjurisdictions with lower statutory rates, an increase in foreign withholdingtaxes and the impact that non-deductible items, primarily share-basedcompensation had on the amount of tax benefit recorded on our losses fromoperations. In addition, the Company’s effective tax rate in the second quarterof 2007 was impacted by the unrealized loss on a foreign currency optioncontract purchased in connection with the SurfControl acquisition and taxexempt interest income that did not recur in 2008.

 

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

 

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

 

22

----

Tableof Contents

 

***Six months ended June 30, 2008 compared with the sixmonths ended June 30, 2007***

 

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

 
| ** **                            | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------|------------|--------------------------------|------------|
| ** **                            | ** ** | **June 30,  2008**        | ** ** | **June 30,  2007** | ** ** |
| ** **                            | ** ** | **(Unaudited)**                | ** ** |
| ** **                            | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Revenue                               |       | 100                            | %          | 100 | % |
|                                  |       |                           |       |   |   |
| Cost of revenues:                     |       |                           |       |   |   |
| Cost of revenues                      |       | 13                             |       | 9 |   |
| Amortization of  acquired technology  |       | 4                              |       | 1 |   |
| Total cost of  revenues               |       | 17                             |       | 10 |   |
|                                  |       |                           |       |   |   |
| Gross margin                          |       | 83                             |       | 90 |   |
|                                  |       |                           |       |   |   |
| Operating  expenses:                  |       |                           |       |   |   |
| Selling and  marketing                |       | 62                             |       | 50 |   |
| Research and  development             |       | 19                             |       | 18 |   |
| General and  administrative           |       | 18                             |       | 14 |   |
| Total operating  expenses             |       | 99                             |       | 82 |   |
|                                  |       |                           |       |   |   |
| (Loss) income  from operations        |       | (16                            | )          | 8 |   |
|                                  |       |                           |       |   |   |
| Interest expense                      |       | (5                             | )          | — |   |
| Other income,  net                    |       | 1                              |       | 3 |   |
|                                  |       |                           |       |   |   |
| (Loss) income  before income taxes    |       | (20                            | )          | 11 |   |
|                                  |       |                           |       |   |   |
| (Benefit)  provision for income taxes |       | (10                            | )          | 5 |   |
|                                  |       |                           |       |   |   |
| Net (loss)  income                    |       | (10                            | )%         | 6 | % |

 

# **Revenue**

#  

Revenue increased to$139.9 million in the first six months of 2008 from $100.2 million in the firstsix months of 2007. The increase was a result primarily of the addition of new,renewed and upgraded subscriptions (including $26.0 million from new or renewedSurfControl seat subscriptions and $7.0 million of revenue recognized from thedeferred revenue acquired from SurfControl in October 2007).

 

# **Cost of Revenues**

#  

*Cost ofrevenues.* Cost of revenues increased to $17.5 million in thefirst six months of 2008 from $8.8 million in the first six months of 2007. Theincrease of $8.7 million was primarily due to additional personnel in ourtechnical support and database groups, including the increased headcountattributable to the acquisition of SurfControl, and the addition of DLPproducts, hosted services and allocated costs. Our headcount in cost of revenuedepartments increased from 163 employees at June 30, 2007 to 217 employeesat June 30, 2008.

 

*Amortizationof acquired technology.* Amortization of acquired technologyprimarily relates to the developed technology acquired from the PortAuthorityacquisition in January 2007 and SurfControl acquisition in October 2007.The increase of $4.9 million in amortization of acquired technology from thefirst six months of 2007 to the first six months of 2008 was primarily due tothe acquisition of SurfControl in October 2007.

 

# **Gross Margin**

#  

Grossmargin increased to $116.3 million in the first six months of 2008 from $90.1million in the first six months of 2007. As a percentage of revenue, grossmargin decreased to 83% in the first six months of 2008 from 90% in the firstsix 

 

23

----

Tableof Contents

 

months of 2007 due to theincreased costs described in the preceding Cost of Revenues section.

 

# **Operating Expenses**

#  

*Selling and marketing*. Selling andmarketing expenses increased to $87.2 million, or 62% of revenue, in the firstsix months of 2008, from $50.0 million, or 50% of revenue, in the first sixmonths of 2007. Approximately $18.6 million of the increase was due to theamortization of acquired intangibles (customer relationships) which resultedfrom the acquisition of SurfControl in October 2007. In addition to theamortization of acquired intangible assets, the increase in selling andmarketing expenses was primarily due to increased personnel costs and relatedtravel, including new personnel added from the SurfControl acquisition in October 2007and allocated costs. Our headcount in sales and marketing increased from 380employees at June 30, 2007 to 519 employees at June 30, 2008.

 

*Research and development.* Research and development expensesincreased to $26.7 million, or 19% of revenue, in the first six months of 2008from $18.7 million, or 18% of revenue, in the first six months of 2007. Theincrease of $8.0 million in research and development expenses was primarily dueto increased personnel cost, including adding new full time employees due tothe SurfControl acquisition in October 2007, and increased hiring for ourmanaged release of our Web content gateway, data loss prevention endpointmodule and developing enhancements to our other products, as well as to supportour expanding list of technology partners and allocated costs. Included inresearch and development for the first six months of June 30, 2007 was$1.3 million of in-process research and development related to ourPortAuthority acquisition in January 2007. Our headcount increased inresearch and development from 193 employees at June 30, 2007 to 351employees at June 30, 2008.

 

*General and administrative*. General andadministrative expenses increased to $24.7 million, or 18% of revenue, in thefirst six months of 2008 from $13.8 million, or 14% of revenue, in the firstsix months of 2007. The $10.9 million increase in general and administrativeexpense was primarily due to additional personnel needed to support our growingoperations, including the acquisition of SurfControl in October 2007 andallocated costs.  Our headcount increasedin general and administrative departments from 66 employees at June 30,2007 to 112 employees at June 30, 2008.

 

**Interest Expense**

 

Interest expense represents the interest incurred on our senior securedterm loan that we utilized to pay for a portion of the SurfControl purchaseprice in October 2007.  Alsoincluded in the interest expense is $1.4 million of amortization of deferredfinancing fees that were capitalized as part of the senior secured creditfacility.

 

# **Other Income, Net**

#  

Otherincome, net decreased to $1.0 million in the first six months of 2008 from $3.9million in the first six months of 2007. The decrease was due primarily toreduced interest income of approximately $2.9 million in the first six monthsof 2008 compared to the first six months of 2007 as a result of our use ofapproximately $245 million in cash, cash equivalents and marketable securitiesto fund the acquisition of SurfControl in October 2007.

 

# **Provision for Income Taxes**

#  

Werecognized an income tax benefit of $14.1 million and an income taxexpense of $5.5 million for the six months ended June 30, 2008 and2007, respectively. Our effective tax rates were a tax benefit of 49.4% and atax provision of 47.9% for the six months ended June 30, 2008 and June 30,2007, respectively. The significant changes in our effective tax rate reflectthe favorable impact of a ruling regarding unrecognized state income taxes andthe release of a valuation allowance plus the unfavorable impact of less taxexempt interest income and a higher effective state income tax rate.

 

Inaccordance with the provisions of SFAS 109, we assess, on a quarterly basis,the realizability of our deferred income tax assets. A valuation allowance mustbe established when, based upon the evaluation of all available evidence, it ismore likely than not that all or a portion of the deferred income tax assetwill not be realized. During fiscal year 2007, a $4.7 million valuationallowance was recorded against the deferred tax assets of SurfControl atacquisition and an additional $4.3 million was recorded related to the increaseof deferred tax assets arising from the operations of SurfControl reflected inour fiscal year 2007 consolidated statement of operations. Realization ofdeferred income tax assets is dependent upon taxable income in prior carrybackyears, estimates of future taxable income, tax planning strategies andreversals of existing taxable temporary differences. Based on our assessment ofthese items during the first six months of 2008, it is more likely than notthat we will be able to fully utilize our deferred tax assets. Accordingly, wereleased the valuation allowance and recorded a 

 

24

----

Table of Contents

 

credit to goodwill of$4.7 million and a credit to income tax provision of approximately $4.3million.

 

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

#  

As of June 30,2008, we had cash and cash equivalents of $65.1 million and retained earningsof $53.4 million.  During the first sixmonths of 2008, we used our cash, cash equivalents and marketable securitiesprimarily to pay down $35 million on our senior secured term loan as optionalprepayments and approximately $10.0 million for stock repurchases.

 

Netcash provided by operating activities was $23.9 million in the first six monthsof 2008 compared with $23.8 million in the first six months of 2007. Theminimal change in cash provided by operating activities was primarily due tothe net loss with higher non-cash items recorded in the first six months of2008 offset by the net increase in the change in operating assets andliabilities compared to the first six months of 2007. The first six months of2008 cash flows from operations was negatively impacted by cash payments forrestructuring related items as well as payment for a class-action litigationthat was settled in the first quarter of 2008. Our operating cash flow issignificantly influenced by new and renewed subscriptions, accounts receivablecollections and changes in deferred revenue. A future decrease in subscription renewals or accounts receivablecollections, or a lower deferred revenue balance, would negatively impact ouroperating cash flow.

 

Netcash provided by investing activities was $16.3 million in the first six months of 2008 compared with netcash used in investing activities of $78.6 million in the first six months of 2007. The $94.9 millionincrease of net cash provided by investing activities was primarily due to cashused of $82.0 million to purchase PortAuthority in January 2007, a $4.6million payment for a currency option contract in connection with theSurfControl acquisition in the first six months of 2007 and an $8.5 million netincrease in maturities over purchases of marketable securities during the firstsix months of 2008 compared to the first six months of 2007.

 

Netcash used in financing activities was $42.1 million in the first six months of 2008 compared with $1.1million provided by financing activities in the first six months of 2007. The $43.2 million increase of net cash used infinancing activities was primarily due to optional principal prepayments of$35.0 million on our senior secured term loan and share repurchases of $10.0million in the first six months of 2008 compared to none in the first sixmonths of 2007, partially offset by the repayment of $4.2 million of thePortAuthority loan in the first six months of 2007.

 

In connection with the acquisition of SurfControl in October 2007,we entered into an amended and restated senior credit agreement (the “SeniorCredit Agreement”).  The $225 millionsenior secured credit facility consists of a five year $210 million seniorsecured term loan and a $15 million revolving credit facility. The seniorsecured term loan was fully funded on October 11, 2007, and the revolvingline of credit remains unused. Through June 30, 2008, we have madeoptional prepayments totaling $55 million on our senior secured term loan,reducing the outstanding balance to $155 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 termloan 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 senior secured term loan bears interestat a spread above LIBOR with the spread determined based upon our totalleverage ratio. During the second quarter 2008, the annual interest rate wasLIBOR plus 250 basis points (5.28% at June 30, 2008), and was subject to apotential step down in the spread over LIBOR based upon potential futureimprovements in our total leverage ratio. The unused portion of the revolvingcredit facility required a 50 basis points fee per annum, also subject to astep down based upon potential future improvements in our total leverage ratio.Based on the total leverage ratio as of June 30, 2008, the spread on boththe senior secured term loan and revolving credit facility will be reduced forthe third quarter of 2008 to LIBOR plus 225 basis points (5.03% as of June 30,2008) per annum for the senior secured term loan and 25 basis points per annumfor the unused portion of the revolving credit facility. The Senior CreditAgreement contains financial covenants, including a consolidated leverage ratioand a consolidated interest coverage ratio, as well as affirmative and negativecovenants.

 

The Senior CreditAgreement provides that we must maintain hedge agreements so that at least 50%of the aggregate principal amount of the senior secured credit facility issubject to fixed interest rate protection for a period of not less than 2.5years. On October 11, 2007 in conjunction with the funding of the seniorsecured term loan, we entered into an interest rate swap agreement to pay afixed rate of interest (4.85% per annum) and receive a floating rate interest payment(based on three month LIBOR) on an equivalent amount. The initial notionalamount of the swap agreement was $105 million on October 11, 2007 and itamortizes each quarter down to $11 million on June 30, 2010. In addition,on October 11, 2007 we entered into an interest rate cap agreement tolimit the maximum interest rate on a portion of our senior secured term loan to6.5% per 

 

25

----

Tableof Contents

 

annum. The amount of principal protected by thisagreement increases from $5 million at December 31, 2007 to $74.3 millionon June 30, 2010. Both the interest rate swap and cap expire on September 30,2010.

 

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

 

*Obligations and commitments.*  The following table summarizes ourcontractual payment obligations and commitments as of June 30, 2008 (inthousands):

 
| ** **                                               | ** ** | **Payment Obligation by Year** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                               | ** ** | **2008**                                      | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **2012** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| Senior secured term loan                                 |       | $                                             | —     |   | $ | 5,099 |   | $ | 21,414 |   | $ | 25,697 |   | $ | 102,790 |   | $ | — |   | $ | 155,000 |   |
| Estimated interest and fees on senior secured term  loan |       | 4,943                                         |       | 9,235 |   | 7,627 |   | 6,167 |   | 3,378 |   | — |   | 31,350 |   |
| Operating leases                                         |       | 3,308                                         |       | 4,398 |   | 3,997 |   | 3,379 |   | 3,188 |   | 4,537 |   | 22,807 |   |
| Facility exit obligations                                |       | 1,008                                         |       | 2,017 |   | 2,106 |   | 1,814 |   | 1,106 |   | 960 |   | 9,011 |   |
| Severance obligations                                    |       | 498                                           |       | — |   | — |   | — |   | — |   | — |   | 498 |   |
| Software licenses                                        |       | 292                                           |       | 585 |   | 97 |   | — |   | — |   | — |   | 974 |   |
| Total                                                    |       | $                                             | 10,049     |   | $ | 21,334 |   | $ | 35,241 |   | $ | 37,057 |   | $ | 110,462 |   | $ | 5,497 |   | $ | 219,640 |   |

 

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

 

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

 

Facilityexit obligations represent estimated future lease and operating costs fromfacilities acquired from SurfControl that are being exited.  These costs will be paid over the respectivelease terms through 2013.  These amountsare included in our consolidated balance sheet.

 

Severanceobligations represent the estimated future severance payments in connectionwith the SurfControl employees who were or will be terminated.

 

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

 

Inaddition, due to the uncertainty with respect to the timing of future cash flowsassociated with our unrecognized tax benefits at June 30, 2008, we areunable to make reasonably reliable estimates of the period of cash settlementwith the respective taxing authorities. Therefore, $8.7 million of unrecognizedtax benefits have been excluded from the contractual payment obligations tableabove.

 

In2003, we announced that our Board of Directors authorized a stock repurchaseprogram of up to 4 million shares of our common stock.  In 2005, we announced that our Board ofDirectors increased the size of the stock repurchase program by an additional 4million shares, for a total program size of up to 8 million shares. In 2006, weannounced that our Board of Directors increased the size of the stockrepurchase program by an additional 4 million shares, for a total program sizeof up to 12 million shares. Repurchases may be made from time to time on theopen market at prevailing market prices or in privately negotiatedtransactions. In January 2008, we adopted a 10b5-1 plan that provides for quarterlypurchases of up to $5 million in stock in open market transactions. Dependingon market conditions and other factors, purchases under this program may becommenced or suspended at any time, or from time to time, without prior notice.During the six months ended June 30, 2008, we repurchased 537,904 sharesof our common stock for an aggregate of approximately $10.0 million at anaverage price of $18.57 per share. As of June 30, 2008, we haverepurchased a total of 8,707,964 shares of our common stock under this program,for an aggregate of $180.4 million at an average price of $20.72 per share.Under the terms of the Senior Credit Agreement, we are restricted fromrepurchasing our common stock for an aggregate purchase price that 

 

26

----

Table of Contents

 

exceeds the sum of $25million plus 50% of the aggregate amount of our consolidated net income, asdefined in our Senior Credit Agreement, during the period from the effectivedate of the facility through the most recent quarter end for which we havefiled quarterly financial statements. As of June 30, 2008, we canrepurchase up to $33.4 million of our common stock under our Senior CreditAgreement. We intend to repurchase shares during the remainder of 2008.

 

We believe that our cash and cash equivalents balances, revolving credit balances and our ongoing cash flow from operations will be sufficient to satisfy our cash requirements, including our capital expenditures, debt repayment obligations and stock repurchases, if any, for at least the next 12 months. During the first six months of 2008, we made voluntary prepayments on our senior secured term loan of $35 million and repurchased approximately $10 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-BalanceSheet Arrangements**

 

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

 

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

 

Our market risk exposures are related to our cash,cash equivalents and senior secured term loan. We invest our excess cash inhighly liquid short-term investments such as municipal bonds, government agencybonds and corporate bonds. These investments are not held for trading or otherspeculative purposes. Changes in interest rates affect the investment income weearn on our investments and the interest expense incurred on our senior securedterm loan and therefore impact our cash flows and results of operations.

 

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

 

A hypothetical 100 basis point adverse move ininterest rates along the entire interest rate yield curve would materiallyaffect our interest expense. Based on our outstanding senior secured term loanbalance at June 30, 2008 and taking into consideration our interest rateswap and cap, our interest expense would increase by approximately $613,000during the next 12 months if there were a 100 basis point adverse move in theinterest rate yield curve.

 

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

 

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

 

27

----

Tableof Contents

 

Notional and fair valuesof our Euro and British Pound hedging positions at June 30, 2008 and 2007are presented in the table below (in thousands):

 
| ** **    | ** ** | **June 30, 2008**          | ** ** | **June 30, 2007** | ** ** |
|---------------|------------|--------------------------------------|------------|-----------------------------|------------|
| ** **    | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD**    | ** ** | **Fair Value  USD** | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD** | ** ** | **Fair Value  USD** | ** ** |
| Euro          |       | €                               | 2,850      |                        | $          | 4,325 |   | $ | 4,171 |   | € | 2,000 |   | $ | 2,660 |   | $ | 2,610 |   |
| British Pound |       | £                               | —     |                        | —     |   | — |   | £ | 950 |   | 1,886 |   | 1,900 |   |
| Total         |       |                                 |       | $                           | 4,325      |   | $ | 4,171 |   |   | ** ** | $ | 4,546 |   | $ | 4,510 | ** ** |

 

Theapproximate $1.7 million notional increase in our Euro hedged position at June 30,2008 compared to June 30, 2007 is primarily due to the increase in Eurobillings in 2008 compared to 2007. For the six months ended June 30, 2008,less than 15% of our total billings were denominated in the Euro. We do notexpect Euro billings to represent more than 15% of our total billings during2008.

 

The approximate $1.9 million notional decrease inour British Pound hedged position at June 30, 2008 compared to June 30,2007 is primarily due to the natural hedge against our British Poundexpenditures by billings in the British Pound which began in May 2007. As of June 30, 2008 no British Poundcontracts were outstanding.** **We do not expect to hedgethe British Pound as we continue billing in the British Pound, as the billings createa natural hedge against our British Pound expenses.

 

Givenour foreign exchange position at June 30, 2008, a 10% change in foreignexchange rates upon which these foreign exchange contracts are based wouldresult in exchange gains and losses.  Inall material 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 un-hedgedforeign currency exposures.

 

**Item 4. Controls and Procedures**

 

**Disclosure Controls andProcedures**

** **

**Wemaintain disclosure controls and procedures (as defined in Rules 13a — 15(e) and15d — 15(e) of the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) designed to ensure that we are able to collect the information we arerequired to disclose in the reports we file under the Exchange Act, and torecord, process, summarize and report this information within the time periodsspecified in the rules of the Securities and Exchange Commission.**Our Chief Executive Officer and ChiefFinancial Officer evaluated our disclosure controls and procedures as of theend of the period covered by this report. Based on their evaluation, our ChiefExecutive Officer and Chief Financial Officer have concluded that thesecontrols and procedures are effective as of the end of the period covered bythis Quarterly Report.

** **

**Changes In Internal ControlOver Financial Reporting**

** **

There have been no significant changes in our internalcontrol over financial reporting or in other factors that could significantlyaffect our internal control over financial reporting, including any correctiveactions with regard to significant deficiencies and material weaknesses, duringthe period covered by this Quarterly Report.

 

**Part II - Other Information**

 

**Item 1. Legal Proceedings**

 

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

 

28

----

Tableof Contents

 

**Item 1A. Risk Factors**

 

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

 

Wehave marked with an asterisk (*) those risk factors that reflect materialchanges from the risk factors included in our Quarterly Report on Form 10-Qfiled with the Securities and Exchange Commission on May 9, 2008.

 

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

* *

Our growth plansfor new sales in North America and Western Europe are largely dependent on ourability to increase sales in the small and medium sized business (“SMB”)segment and maintain our subscription base in the large enterprise marketthrough subscription renewals.  We sell aproduct specifically targeted at the SMB segment, Websense Express, though wecannot assure that this product will ultimately increase sales to the SMBsegment.  We also need to increase salesthrough our two-tier distribution channel in North America and our two-tierdistribution arrangements in Western Europe that target SMB customers. Inaddition, we sell Websense Hosted Security 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 derivedalmost entirely from sales through indirect channels and we depend upon thesechannels to create demand for our products.**

* *

Our revenue hasbeen derived almost entirely from sales through indirect channels, includingvalue-added resellers, distributors that sell our products to end-users,providers of managed Internet services and other resellers. Although we relyupon these indirect channels of distribution, we also depend upon our internalsales force to generate sales leads and sell products through the resellernetwork. Ingram Micro, one or our broad-line distributors in North America,accounted for approximately 22% of our revenue during the six months ended June 30,2008.  Should Ingram Micro experiencefinancial difficulties or otherwise delay or prevent our collection of accountsreceivable from them, our revenue and cash flow would be significantlyadversely affected.  Our indirect salesmodel 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 newer 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 our competitors.

 

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.

 

29

----

Tableof Contents

 

*Acquired companies ortechnologies can be difficult to integrate, disrupt our business, dilutestockholder value and adversely affect our operating results.*

* *

In October 2007 we acquired SurfControl plc (“SurfControl”)and we expect to continue to incur restructuring and other related expensesthat will negatively affect our results of operations under U.S. generallyaccepted accounting principles (“GAAP”). As a result of the SurfControlacquisition, Websense became an unprofitable operating business under GAAPafter more than five 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 theSurfControl customer 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 involvenumerous risks, including:

 

·              difficulties inintegrating operations, technologies, services and personnel of the acquiredcompany;

 

·              potential loss of customers and originalequipment manufacturing relationships of the acquired company;

 

·              diversion of financial and managementresources from existing operations and core businesses;

 

·              risk of entering new markets;

 

·              potential loss of key employees of theacquired company;

 

·              integrating personnel with diversebusiness and cultural backgrounds;

 

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

 

·              assumption of liabilities of the acquiredcompany, including debt and litigation; and

 

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

 

Acquisitions mayalso cause us to:

 

·              issue equity securities that would diluteour current stockholders’ percentage ownership;

 

·              assume certain liabilities;

 

·              incur additional debt, such as the debtwe incurred to partially fund the acquisition of SurfControl;

 

·              make large and immediate one-timewrite-offs for restructuring and other related expenses;

 

·              become subject to intellectual propertyor 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 SurfControl acquisition, our business and prospects may beseriously harmed.

 

30

----

Tableof Contents

 

***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 $155 millionremained outstanding as of June 30, 2008. As a result, we are incurring interest expense for the amounts weborrowed under the senior secured term loan, and our income from our cash, cashequivalents and marketable securities has declined as we used a significantportion of our cash and marketable securities to fund a portion of theacquisition 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 successdepends on our ability to sell new, renewal and upgraded Web filtering and Websecurity subscriptions.*

* *

Substantially all of ourrevenue for the second quarter ended June 30, 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 SMBsegment, increase seats under subscriptions from existing customers or renew asufficient number of SurfControl’s Web filtering customers or migrate them toour Web filtering product, we will not be able to grow our business to meetexpectations.

 

Subscriptions for our Webfiltering and security products typically have durations of 12, 24 or 36months. Our customers have no obligation to renew their subscriptions uponexpiration. 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*.*

 

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

* *

Our future financial performance depends on ourability to diversify our offerings by successfully developing, introducing andgaining customer acceptance of our new products and services, particularly oursecurity offerings. We now sell the Websense Data Protection Suite, our DLPoffering for the data security market, Websense Hosted Web Security and 

 

31

----

Tableof Contents

 

Websense Hosted Email Security, our hosted securityservices, and Websense Email Security, our email filtering solution. During thesecond quarter of 2008, we commenced a managed release of our next generationWeb content gateway and our new DLP endpoint module and we are continuing todevelop and release products in accordance with our announced product roadmap.We may not be successful in achieving market acceptance of these or any newproducts that we develop.  Moreover, ourrecent increased emphasis on the development, marketing and sale of oursecurity offerings and DLP products as well as the integration of SurfControlcould distract us from sales of our core Web filtering and Web securityofferings, negatively impacting our overall sales. Any failure or delay indiversifying our existing offerings, or diversification at the detriment to ourcore Web filtering and Web security offerings, could harm our business, resultsof operations and financial condition and our growth.

 

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

* *

The market for our products is intensely competitiveand is likely to become even more so in the future.  Our current principal Web filteringcompetitors frequently offer their products at a significantly lower price thanour products, which has resulted in pricing pressures on sales of our productand potentially could result in the commoditization of products in our space.We also face current and potential competition from vendors of Internetservers, operating systems and networking hardware, many of which now, or mayin the future, develop and/or bundle Web filtering or other competitiveproducts with their products. Increased competition may cause price reductionsor a loss of market share, either of which could have a material adverse effecton our business, results of operations and financial condition. If we areunable to maintain the current pricing on sales of our products or increase ourpricing in the future, our results of operations could be negatively impacted.Even if our products provide greater functionality and are more effective thancertain other competitive products, potential customers might accept thislimited functionality in lieu of purchasing our products. In addition, our ownindirect sales channels may decide to develop or sell competing productsinstead of our products. Pricing pressures and increased competition generallycould result in reduced sales, reduced margins or the failure of our productsto achieve or maintain more widespread market acceptance, any of which couldhave a material adverse effect on our business, results of operations andfinancial condition.

 

Our currentprincipal 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, Aladdin, 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 and Scansafe;

 

·         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

 

·              companies offering proxy-based solutions such asMicrosoft, Blue Coat Systems, Cisco Systems and Juniper Networks.

 

32

----

Tableof Contents

 

As we develop and marketour products with an increasing security-oriented emphasis, we also face growingcompetition from security solutions providers. Many of our competitors withinthe Web security market, such as Symantec, McAfee, Trend Micro, CiscoSystems and Microsoft enjoy substantial competitive advantages, including:

 

·                    greatername recognition and larger marketing budgets and resources;

 

·                    establishedmarketing relationships and access to larger customer bases; and

 

·                    substantiallygreater financial, technical and other resources.

 

As a result, we may be unable to gain sufficienttraction as a provider of Web security solutions, and our competitors may beable to respond more quickly and effectively than we can to new or emergingtechnologies and changes in customer requirements, or devote greater resourcesto the development, marketing, promotion and sale of their products than wecan. Current and potential competitors have established or may establishcooperative relationships among themselves or with third parties to increasethe functionality and market acceptance of their products. In addition, ourcompetitors may be able to replicate our products, make more attractive offersto existing and potential employees and strategic partners, develop newproducts or enhance existing products and services more quickly. Accordingly,new competitors or alliances among competitors may emerge and rapidly acquiresignificant market share. In addition, we also expect that competition willincrease as a result of industry consolidation. For all of the foregoingreasons, we may not be able to compete successfully against our current andfuture competitors.

 

*Our internationaloperations involve risks that could increase our expenses, adversely affect ouroperating results and require increased 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 toexpand our international operations, but such expansion is contingent upon thefinancial performance of our existing international operations as well as ouridentification of growth opportunities. Our international operations are subject to risks in addition to thosefaced by our domestic operations, including:

 

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

 

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

 

·                    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 and net cash flows from internationaloperations may be adversely affected, especially if the trend continues ofinternational sales growing as a percentage of our total sales.

 

*Sales to customersoutside the United States have accounted for a significant portion of ourrevenue, which exposes us to risks inherent in international sales.*

* *

We market and sellour products outside the United States through value-added resellers,distributors and other resellers. 

 

33

----

Tableof Contents

 

International salesrepresented 41% of our total revenue generated during the quarter ended June 30,2008 compared with 39% of our total revenue during the quarter ended June 30,2007. As a key component of our business strategy to generate new businesssales, we intend to continue to expand our international sales, but successcannot be assured. In addition to the risks associated with our domestic sales,our international sales are subject to the following risks:

 

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

 

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

 

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

 

·       lawsand business practices favoring local competitors;

 

·       dependenceon foreign distributors and their sales channels;

 

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

 

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

 

·       regionaleconomic and political conditions.

 

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

 

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

 

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

 

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

* *

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.

 

34

----

Tableof Contents

 

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 in categoriesthat are generally unrestricted by our users’ Internet and computer accesspolicies, 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 productsto work properly or misuse of our products could impact sales, increase costs,and create risks of potential negative publicity and legal liability.*

* *

Our products are complex, are deployed in a widevariety of network environments and manage content in a dramatically changingWeb 2.0 world. Our products may have errors or defects that users identifyafter deployment, which could harm our reputation and our business. Inaddition, products as complex as ours frequently contain undetected errors whenfirst introduced or when new versions or enhancements are released. We havefrom time to time found errors in versions of our products, and we expect tofind such errors in the future. Because customers rely on our products tomanage employee behavior to protect against security risks and prevent the lossof sensitive data, any significant defects or errors in our products may resultin negative publicity or legal claims. For example, an actual or perceivedbreach of network or computer security at one of our customers, regardless ofwhether the breach is attributable to our products, could adversely affect themarket’s perception of our security products. Moreover, parties whose Web sitesor executable files are placed in security-risk categories or other categorieswith negative connotations may seek redress against us for falsely labelingthem or for interfering with their business. The occurrence of errors couldadversely affect sales of our products, divert the attention of engineering personnelfrom our product development efforts and cause significant customer relationsor legal problems.

 

Our products may also 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. Ifthis trend continues, our established customer relationships could be disruptedand our products could be displaced by alternative system and networkprotection solutions offered by system integrators. Significant productdisplacements could impact our revenue and have a material adverse effect onour business.

 

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

* *

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 customers mightaccept this limited functionality in lieu of purchasing additional software.Sales of our products would suffer materially if we were then unable to developnew Web filtering, security and DLP products to further enhance operatingsystems or other software and to replace any obsolete products.

 

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

* *

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. 

 

35

----

Tableof Contents

 

Although we believe that our approach to determiningthe amount of such arrangements is reasonable, no assurance can be given thatthe final tax authority review of these matters will not be materiallydifferent than that which is reflected in our historical income tax provisionsand other tax accruals. Such differences could have a material effect on ourincome tax provisions or benefits, or other tax accruals, in the period inwhich such determination is made, and consequently, on our results ofoperations for such period.

 

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 financial statementsin the period determined. To provide for potential tax exposures, we accrue foruncertain tax positions according to our accounting policies based on judgmentand estimates including historical audit activity. We believe sufficientaccruals have been recorded for these tax exposures. However, if the reservesare insufficient upon completion of any audits, there could be an adverseimpact 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 the Websensetrademark pending in several other countries. Effective trademark protectionmay not be available in every country where our products are available.Furthermore, any of our trademarks may be challenged by others or invalidatedthrough administrative process or litigation.

 

We currently have elevenissued patents in the United States and seven patents issued internationally,and we may be unable to obtain further patent protection in the future. We haveother pending patent applications in the United States and in other countries.We cannot ensure that:

 

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

 

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

 

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

 

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

 

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

 

·       wewill develop additional proprietary technologies that are patentable; or

 

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

 

Furthermore, 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.

 

36

----

Tableof Contents

 

*Third parties claimingthat we infringe their proprietary rights could cause us to incur significantlegal expenses and prevent 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 costlylitigation and distract management from day-to-day operations. If we are notsuccessful in defending such claims, we could be required to stop selling ourproducts, pay monetary amounts as damages, enter into royalty or licensingarrangements, or satisfy indemnification obligations that we have with some ofour customers.

 

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

* *

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

 

*Our quarterly operatingresults may fluctuate significantly, and these fluctuations may cause our stockprice 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 ouroperating expenses will increase substantially in the future as we expand ourselling and marketing activities, increase our research and development effortsand hire additional personnel which could impact our margins. Our operatingexpenses have increased as a result of the acquisition of SurfControl. The costsynergies we expect to achieve through the acquisition will be phased inthrough our integration process. In addition, our operating expenseshistorically have fluctuated, and may continue to fluctuate in the future, asthe result of the factors described below and elsewhere in this quarterlyreport:

 

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

 

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

 

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

 

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

 

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

 

37

----

Tableof Contents

 

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 ourcommon stock has been and likely will continue to be highly volatile and couldbe subject to wide fluctuations in response to a number of factors that arebeyond 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, themarket price of our common stock could be subject to wide fluctuations inresponse 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 beenunrelated or disproportionate to the operating performance of these companies.A number of publicly traded Internet-related companies have current marketprices below their initial public offering prices. Market fluctuations such asthese may seriously harm the market price of our common stock. In the past,securities class action suits have been filed following periods of marketvolatility in the price of a company’s securities. If such an action wereinstituted, we would incur substantial costs and a diversion of managementattention and resources, which would seriously harm our business, results ofoperations and financial condition.

 

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

* *

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

 

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

 

38

----

Table of Contents

 

*Compliance withregulation of corporate governance, accounting principles and public disclosuremay 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 and administrativeexpenses 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 involves risksthat may result in a lower return on our investments than we expect. Theseinitiatives also may limit the opportunities we pursue or investments we wouldotherwise 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 incorporationprovides for a classified board, with each board member serving a staggeredthree-year term. It also provides that stockholders may not fill boardvacancies, call stockholder meetings or act by written consent. Our bylawsfurther provide that advance written notice is required prior to stockholderproposals. Each of these provisions makes it more difficult for stockholders toobtain control of our board or initiate actions that are opposed by the thencurrent board. Additionally, we have authorized preferred stock that isundesignated, making it possible for the board to issue up to 5,000,000 sharesof preferred stock with voting or other rights and preferences that couldimpede the success of any attempted change of control. Delaware law also couldmake it more difficult for a third party to acquire us. Section 203 of theDelaware General Corporation Law has an anti-takeover effect with respect totransactions not approved in advance by our board, including discouragingattempts that might result in a premium over the market price of the shares ofcommon stock held by our stockholders.**

** **

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 consequences maydiscourage third parties from attempting to acquire us.

 

*We do not intend to pay dividends.*

* *

We have not declared or paid any cash dividends on ourcommon stock since we have been a publicly traded company. We currently intendto retain any future cash flows from operations to fund growth, pay down oursenior secured term loan and repurchase shares of our common stock, andtherefore do not expect to pay any cash dividends in the foreseeablefuture.  Moreover, we are not permittedto pay cash dividends under the terms of our senior secured credit facility.

 

39

----

Tableof Contents

 

**Item 2.****    Unregistered Sales of EquitySecurities and Use of Proceeds**

 

(a) Notapplicable.

 

(b) Notapplicable.

 

(c) Issuer Purchases of Equity Securities

 
| **Month**          | ** ** | **Number of  Shares  Purchased  During Month** | ** ** | **Average Price  Paid Per Share** | ** ** | **Cumulative  Number of Shares  Purchased as Part  of Publicly  Announced Plan** | ** ** | **Maximum Number of  Shares that May Be  Purchased Under the  Plan** | ** ** |
|--------------------|------------|----------------------------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|------------|
| January 2008  |       | —                                                   |       | $                                                | —     |                                                                                                           | 8,170,060  |                                                                                                    | 3,829,940  |   |
| February 2008 |       | 23,300                                                   |       | $                                                | 19.57      |                                                                                                           | 8,193,360  |                                                                                                    | 3,806,640  |   |
| March 2008    |       | 241,100                                                  |       | $                                                | 18.82      |                                                                                                           | 8,434,460  |                                                                                                    | 3,565,540  |   |
| April 2008    |       | 47,100                                                   |       | $                                                | 19.30      |                                                                                                           | 8,481,560  |                                                                                                    | 3,518,440  |   |
| May 2008      |       | 110,300                                                  |       | $                                                | 18.26      |                                                                                                           | 8,591,860  |                                                                                                    | 3,408,140  |   |
| June 2008     |       | 116,104                                                  |       | $                                                | 17.84      |                                                                                                           | 8,707,964  |                                                                                                    | 3,292,036  |   |
|               |       |                                                     |       |                                             |       |                                                                                                           |       |                                                                                                    |       |
| Total              |       | 537,904                                                  |       | $                                                | 18.57      |                                                                                                           | 8,707,964  |                                                                                                    | 3,292,036  |   |

 

1.               The purchases were made in open-market transactions.

 

2.               On April 3, 2003, we announced that our Board ofDirectors authorized a stock repurchase program of up to 4 million sharesof our common stock. On August 15, 2005, we announced that our Board ofDirectors increased the size of the stock repurchase program by an additional4 million shares, for a total program size of up to 8 million shares.On July 25, 2006, we announced that our Board of Directors increased thesize of the stock repurchase program by an additional 4 million shares,for a total program size of up to 12 million shares. In January 2008,we adopted a 10b5-1 plan that provides for quarterly purchases of up to $5million in stock in open market transactions. The remaining shares authorized for repurchase under our stock repurchaseprogram as of June 30, 2008 was 3,292,036 shares.

 

**Item 3.**    Defaults upon SeniorSecurities

** **

**None.**

** **

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

** **

**The Annual Meeting of Stockholders was held on Wednesday, June 4,2008.  The following matters were votedupon at the meeting and were adopted as indicated:**

** **

**1.**             The stockholders elected two directors to hold officefor a term expiring upon the 2011 Annual Meeting of Stockholders.

** **
| ** **                                   | ** ** | **Number of Shares** | ** ** |
|----------------------------------------------|------------|--------------------------------|------------|
| **Name of Directors Elected** | ** ** | **For**                        | ** ** | **Withheld** | ** ** |
|                                         |       |                           |       |   |   |
| Mark S. St.Clare                             |       | 24,046,068                     |       | 18,264,603 |   |
| Peter C. Waller                              |       | 39,261,918                     |       | 3,048,753 |   |

** **

**The following individuals are continuing directors withterms expiring upon the 2009 Annual Meeting of Stockholders:  Bruce T. Coleman, Gene Hodges and John F.Schaefer.**

** **

**The following individuals are continuing directors withterms expiring upon the 2010 Annual Meeting of Stockholders:  John B. Carrington and Gary E. Sutton.**

 

40

----

Tableof Contents

 

**2.**             The stockholders ratified the appointment of Ernst &Young LLP as our independent registered public accounting firm for the fiscalyear ending December 31, 2008.

** **
| For     |   | 39,926,726 |   |
|---------|--------|------------|--------|
| Against |   | 2,377,871  |   |
| Abstain |   | 6,074      |   |

** **

**Item 5.**    Other Information

** **

**None.**

 

41

----

Tableof Contents

 

**Item 6.**    Exhibits

** **

**Exhibits**

** **
| 3.1(1) |   | Amended and Restated  Certificate of Incorporation.                                                                                                                                                              |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2(2) |   | Amended and Restated  Bylaws.                                                                                                                                                                                    |
| 4.1(3) |   | Specimen Stock  Certificate of Websense, Inc.                                                                                                                                                               |
| 31.1   |   | Certification of  Principal Executive Officer pursuant to Exchange Act  Rules 13a-14(a) or 15d-14(a).                                                                                                  |
| 31.2   |   | Certification of  Principal Financial Officer pursuant to Exchange Act  Rules 13a-14(a) or 15d-14(a).                                                                                                  |
| 32.1   |   | Certification of  Principal Executive Officer pursuant to Exchange Act  Rules 13a-14(b) or 15d-14(b) and Section 1350 of Chapter  63 of Title 18 of the United States Code (18 U.S.C. 1350). |
| 32.2   |   | Certification of  Principal Financial Officer pursuant to Exchange Act  Rules 13a-14(b) or 15d-14(b) and Section 1350 of Chapter  63 of Title 18 of the United States Code (18 U.S.C. 1350). |

 

----

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

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

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

 

42

----

Tableof Contents

 

##### **SIGNATURES**

#####  

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

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

 

43

----

Tableof Contents

 

**EXHIBIT INDEX**

 
| 3.1(1) |   | Amended and Restated  Certificate of Incorporation.                                                                                                                                                              |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2(2) |   | Amended and Restated  Bylaws.                                                                                                                                                                                    |
| 4.1(3) |   | Specimen Stock  Certificate of Websense, Inc.                                                                                                                                                               |
| 31.1   |   | Certification of  Principal Executive Officer pursuant to Exchange Act  Rules 13a-14(a) or 15d-14(a).                                                                                                  |
| 31.2   |   | Certification of  Principal Financial Officer pursuant to Exchange Act  Rules 13a-14(a) or 15d-14(a).                                                                                                  |
| 32.1   |   | Certification of  Principal Executive Officer pursuant to Exchange Act  Rules 13a-14(b) or 15d-14(b) and Section 1350 of Chapter  63 of Title 18 of the United States Code (18 U.S.C. 1350). |
| 32.2   |   | Certification of  Principal Financial Officer pursuant to Exchange Act  Rules 13a-14(b) or 15d-14(b) and Section 1350 of Chapter  63 of Title 18 of the United States Code (18 U.S.C. 1350). |

 

----

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

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

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

 

----