**FORM 10-Q**

** **

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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** **
| **(Mark One)**                                                                                                                        |
|---------------------------------------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                            |
| **ý****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                 |
| ** **                                                                                                                            |
| **For the quarterly period ended September 30, 2004**                                                                                 |
| ** **                                                                                                                            |
| **OR**                                                                                                                                |
| ** **                                                                                                                            |
| **o****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                     |
| ** **                                                                                                                            |
| **For the  Transition Period from        to        ** |

** **

**Commission File Number 000-30093**

 

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**Websense, Inc.**

(Exact name of registrant as specified in its charter)

 
| **Delaware**                                                                                 | ** ** | **51-0380839**                       |
|----------------------------------------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation or organization)                               |       | (I.R.S. Employer Identification No.) |
|                                                                                         |
| **10240 Sorrento Valley Road**                                                               |
| **San Diego, California 92121**                                                              |
| **858-320-8000**                                                                             |
| (Address of principal executive offices, zip code and telephone number, including area code) |

 

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

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12-b-2 of the Exchange Act): Yes ý  No o

 

The number of shares outstanding of the registrant’s Common Stock, $.01 par value, as of October 29, 2004 was 23,343,783.

 

 

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**Websense, Inc.**

**Form 10-Q**

**For thePeriod Ended September 30, 2004**

 

**TABLE OFCONTENTS**

 
|                           | **Page** |
|--------------------------------|----------|
| Part  I. Financial Information |     |
|                           |     |   |   |
|                           | Item 1.  | Consolidated Financial  Statements (Unaudited) |   |
|                           |     | Consolidated Balance Sheets  as of September 30, 2004 and December 31, 2003 | 1 |
|                           |     | Consolidated  Statements of Income for the three and nine months ended September 30, 2004  and 2003 | 2 |
|                           |     | Consolidated  Statement of Stockholders’ Equity for the nine months ended September 30,  2004 | 3 |
|                           |     | Consolidated  Statements of Cash Flows for the nine months ended September 30, 2004 and  2003 | 4 |
|                           |     | Notes to  Consolidated Financial Statements | 5 |
|                           | Item  2. | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 10 |
|                           | Item  3. | Quantitative  and Qualitative Disclosures About Market Risk | 19 |
|                           | Item  4. | Controls  and Procedures | 20 |
|                           |     |   |   |
| Part II.  Other Information    |     |
|                           |     |   |   |
|                           | Item 1.  | Legal  Proceedings | 21 |
|                           | Item  2. | Unregistered  Sales of Equity Securities and Use of Proceeds | 21 |
|                           | Item 3.  | Defaults upon Senior  Securities | 21 |
|                           | Item  4. | Submission  of Matters to a Vote of Security Holders | 21 |
|                           | Item 5.  | Other Information | 21 |
|                           | Item 6.  | Exhibits | 22 |
|                           |     |   |   |
| Signatures                     | 23       |
|                                |          |  |  |  |  |

 

i

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**Part I – Financial Information**

 

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

 

**Websense,Inc.**

**Consolidated Balance Sheets**

**(Unaudited and in thousands)**

 
| ** **                                                   | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                   | ** ** | ** **              | ** ** | **(See Note 1)**       | ** ** |
| **Assets**                                                   |       |                    |       |                   |       |
| Current assets:                                              |       |                    |       |                   |       |
| Cash and cash equivalents                                    |       | $                       | 33,143     |                   | $          | 35,324 |   |
| Marketable securities                                        |       | 192,791                 |       | 147,535                |       |
| Accounts receivable, net of allowance for  doubtful accounts |       | 27,647                  |       | 27,999                 |       |
| Deferred income taxes                                        |       | 8,733                   |       | 8,733                  |       |
| Other current assets                                         |       | 1,759                   |       | 1,271                  |       |
| Total current assets                                         |       | 264,073                 |       | 220,862                |       |
|                                                         |       |                    |       |                   |       |
| Property and equipment, net                                  |       | 3,655                   |       | 2,997                  |       |
| Deferred income taxes, less current portion                  |       | 8,672                   |       | 8,672                  |       |
| Deposits and other assets                                    |       | 457                     |       | 418                    |       |
|                                                         |       |                    |       |                   |       |
| Total assets                                                 |       | $                       | 276,857    |                   | $          | 232,949 |   |
|                                                         |       |                    |       |                   |       |
| **Liabilities and stockholders’ equity**                |       |                    |       |                   |       |
| Current liabilities:                                         |       |                    |       |                   |       |
| Accounts payable                                             |       | $                       | 963        |                   | $          | 743 |   |
| Accrued payroll and related benefits                         |       | 5,473                   |       | 5,241                  |       |
| Other accrued expenses                                       |       | 5,259                   |       | 3,835                  |       |
| Income taxes payable                                         |       | 7,272                   |       | 241                    |       |
| Current portion of deferred revenue                          |       | 78,572                  |       | 65,480                 |       |
| Total current liabilities                                    |       | 97,539                  |       | 75,540                 |       |
|                                                         |       |                    |       |                   |       |
| Deferred revenue, less current portion                       |       | 33,614                  |       | 28,480                 |       |
|                                                         |       |                    |       |                   |       |
| Stockholders’ equity:                                   |       |                    |       |                   |       |
| Common stock                                                 |       | 241                     |       | 228                    |       |
| Additional paid-in capital                                   |       | 137,236                 |       | 120,639                |       |
| Treasury stock                                               |       | (25,242                 | )          | (7,684                 | )          |
| Retained earnings                                            |       | 33,771                  |       | 15,731                 |       |
| Accumulated other comprehensive income  (loss)               |       | (302                    | )          | 15                     |       |
| Total stockholders’ equity                              |       | 145,704                 |       | 128,929                |       |
|                                                         |       |                    |       |                   |       |
| Total liabilities and stockholders’ equity              |       | $                       | 276,857    |                   | $          | 232,949 |   |

 

Seeaccompanying notes.

 

1

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**Websense, Inc.**

**Consolidated Statements of Income**

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

 
| ** **                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                               | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** | **September  30,** | ** ** | **September 30,** | ** ** |
| ** **                               | ** ** | **2004**               | ** ** | **2003**              | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                     |       |                   |       |                  |       |   |   |   |   |
| Revenue                                  |       | $                      | 28,917     |                  | $          | 21,006 |   | $ | 80,171 |   | $ | 59,034 |   |
|                                     |       |                   |       |                  |       |   |   |   |   |
| Cost of revenue                          |       | 2,003                  |       | 1,412                 |       | 5,468 |   | 4,007 |   |
|                                     |       |                   |       |                  |       |   |   |   |   |
| Gross margin                             |       | 26,914                 |       | 19,594                |       | 74,703 |   | 55,027 |   |
|                                     |       |                   |       |                  |       |   |   |   |   |
| Operating expenses:                      |       |                   |       |                  |       |   |   |   |   |
| Selling and marketing                    |       | 10,615                 |       | 8,236                 |       | 30,480 |   | 22,417 |   |
| Research and development                 |       | 3,576                  |       | 3,224                 |       | 10,677 |   | 9,548 |   |
| General and administrative               |       | 2,045                  |       | 1,770                 |       | 6,397 |   | 4,986 |   |
| Amortization of stock-based compensation |       | —                 |       | 11                    |       | — |   | 76 |   |
| Total operating expenses                 |       | 16,236                 |       | 13,241                |       | 47,554 |   | 37,027 |   |
|                                     |       |                   |       |                  |       |   |   |   |   |
| Income from operations                   |       | 10,678                 |       | 6,353                 |       | 27,149 |   | 18,000 |   |
|                                     |       |                   |       |                  |       |   |   |   |   |
| Other income, net                        |       | 598                    |       | 418                   |       | 1,467 |   | 1,873 |   |
|                                     |       |                   |       |                  |       |   |   |   |   |
| Income before income taxes               |       | 11,276                 |       | 6,771                 |       | 28,616 |   | 19,873 |   |
|                                     |       |                   |       |                  |       |   |   |   |   |
| Provision for income taxes               |       | 4,170                  |       | 2,539                 |       | 10,576 |   | 7,693 |   |
|                                     |       |                   |       |                  |       |   |   |   |   |
| Net income                               |       | $                      | 7,106      |                  | $          | 4,232 |   | $ | 18,040 |   | $ | 12,180 |   |
|                                     |       |                   |       |                  |       |   |   |   |   |
| Net income per share:                    |       |                   |       |                  |       |   |   |   |   |
|                                     |       |                   |       |                  |       |   |   |   |   |
| Basic net income per share               |       | $                      | 0.31       |                  | $          | 0.19 |   | $ | 0.79 |   | $ | 0.56 |   |
| Diluted net income per share             |       | $                      | 0.29       |                  | $          | 0.18 |   | $ | 0.75 |   | $ | 0.53 |   |
| Weighted average shares – basic     |       | 23,250                 |       | 22,072                |       | 22,967 |   | 21,917 |   |
| Weighted average shares – diluted   |       | 24,228                 |       | 23,035                |       | 23,960 |   | 22,805 |   |

 

Seeaccompanying notes.

 

2

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**Websense, Inc.**

**Consolidated Statement of Stockholders’ Equity**

**(Unaudited and in thousands)**

 
| ** **                                                                        | ** ** | ** ** | ** ** | ** ** | ** ** | **Additional  paid-in capital** | ** ** | **Treasury  stock** | ** ** | **Retained  earnings** | ** ** | **Accumulated  other  comprehensive  income (loss)** | ** ** | **Total  stockholders’**** **** equity** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------|------------|------------|------------|---------------------------------|------------|---------------------|------------|------------------------|------------|------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                        | ** ** | ** ** |
| **Common stock**                                                                  |
| **Shares**                                                                        | ** ** | **Amount** |
|                                                                              |       |       |       |       |       |                            |       |                |       |                   |       |                                                 |       |                                                    |       |
| Balance at December 31, 2003                                                      |       | 22,445     |       | $          | 228        |                            | $          | 120,639             |       | $                      | (7,684     | )                                                    | $          | 15,731                                                  |       | $ | 15 |   | $ | 128,929 |   |
| Issuance of common stock upon exercise of  options                                |       | 1,149      |       | 12         |       | 15,347                          |       | —              |       | —                 |       | —                                               |       | 15,359                                                  |       |
| Issuance of common stock for purchase plan                                        |       | 97         |       | 1          |       | 1,250                           |       | —              |       | —                 |       | —                                               |       | 1,251                                                   |       |
| Issuance of common stock upon exercise of  warrant                                |       | 27         |       | —     |       | —                          |       | —              |       | —                 |       | —                                               |       | —                                                  |       |
| Purchase of treasury stock                                                        |       | (502       | )          | —     |       | —                          |       | (17,558             | )          | —                 |       | —                                               |       | (17,558                                                 | )          |
| Comprehensive income:                                                             |       |       |       |       |       |                            |       |                |       |                   |       |                                                 |       |                                                    |       |
| Net income                                                                        |       | —     |       | —     |       | —                          |       | —              |       | 18,040                 |       | —                                               |       | 18,040                                                  |       |
| Change in unrealized loss on securities  available for sale                       |       | —     |       | —     |       | —                          |       | —              |       | —                 |       | (257                                                 | )          | (257                                                    | )          |
| Change in unrealized loss on fair market  valuation of foreign exchange contracts |       | —     |       | —     |       | —                          |       | —              |       | —                 |       | (60                                                  | )          | (60                                                     | )          |
| Comprehensive income                                                              |       |       |       |       |       |                            |       |                |       |                   |       |                                                 |       | 17,723                                                  |       |
| Balance at September 30, 2004                                                     |       | 23,216     |       | $          | 241        |                            | $          | 137,236             |       | $                      | (25,242    | )                                                    | $          | 33,771                                                  |       | $ | (302 | ) | $ | 145,704 |   |

 

See accompanying notes.

 

3

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**Websense, Inc.**

**Consolidated Statements of Cash Flows**

**(Unaudited and in thousands)**

 
| ** **                                                                         | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                         | ** ** | **September 30,**     | ** ** | **September 30,** | ** ** |
| ** **                                                                         | ** ** | **2004**              | ** ** | **2003** | ** ** |
| **Operating activities:**                                                          |       |                  |       |   |   |
| Net income.                                                                        |       | $                     | 18,040     |   | $ | 12,180 |   |
|                                                                               |       |                  |       |   |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                  |       |   |   |
| Depreciation                                                                       |       | 1,673                 |       | 1,500 |   |
| Amortization of deferred compensation                                              |       | —                |       | 76 |   |
| Deferred revenue                                                                   |       | 18,226                |       | 13,589 |   |
| Unrealized loss on foreign exchange  contracts                                     |       | (60                   | )          | — |   |
| Changes in operating assets and  liabilities:                                      |       |                  |       |   |   |
| Accounts receivable                                                                |       | 352                   |       | (1,761 | ) |
| Deposits and other assets                                                          |       | (527                  | )          | (230 | ) |
| Accounts payable                                                                   |       | 220                   |       | (210 | ) |
| Accrued payroll and related benefits                                               |       | 232                   |       | 1,525 |   |
| Other accrued expenses                                                             |       | 1,424                 |       | (87 | ) |
| Income taxes payable                                                               |       | 7,031                 |       | 3,436 |   |
| Net cash provided by operating activities                                          |       | 46,611                |       | 30,018 |   |
|                                                                               |       |                  |       |   |   |
| **Investing activities:**                                                          |       |                  |       |   |   |
| Purchases of property and equipment                                                |       | (2,331                | )          | (1,780 | ) |
| Purchases of marketable securities                                                 |       | (226,046              | )          | (163,491 | ) |
| Maturities of marketable securities                                                |       | 145,265               |       | 78,231 |   |
| Sales of marketable securities                                                     |       | 35,268                |       | 57,410 |   |
| Net cash used in investing activities                                              |       | (47,844               | )          | (29,630 | ) |
|                                                                               |       |                  |       |   |   |
| **Financing activities:**                                                          |       |                  |       |   |   |
| Proceeds from exercise of stock options                                            |       | 15,359                |       | 3,021 |   |
| Proceeds from issuance of common stock for  stock purchase plan                    |       | 1,251                 |       | 853 |   |
| Purchases of treasury stock                                                        |       | (17,558               | )          | (4,818 | ) |
| Net cash used in financing activities                                              |       | (948                  | )          | (944 | ) |
|                                                                               |       |                  |       |   |   |
| Decrease in cash and cash equivalents                                              |       | (2,181                | )          | (556 | ) |
|                                                                               |       |                  |       |   |   |
| Cash and cash equivalents at beginning of  period                                  |       | 35,324                |       | 29,263 |   |
|                                                                               |       |                  |       |   |   |
| Cash and cash equivalents at end of period                                         |       | $                     | 33,143     |   | $ | 28,707 |   |

 

See accompanying notes.

 

4

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**Websense, Inc.**

 

**Notes To Consolidated Financial Statements****(Unaudited)**

 

1.  *Basis of Presentation*

 

The accompanying unaudited consolidatedfinancial statements have been prepared in conformity with accountingprinciples generally accepted in the United States for interim financial statementsand with 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 accounting principlesgenerally accepted in the United States have been condensed or omitted pursuantto the rules and regulations of the Securities and Exchange Commission. In theopinion of management, the statements include all adjustments necessary, whichare of a normal and recurring nature, for the fair presentation of ourfinancial position and of the results for the interim periods presented.

 

These financial statements should be read inconjunction with the audited consolidated financial statements and notesthereto for the year ended December 31, 2003, included in Websense, Inc.’sAnnual Report on Form 10-K filed with the Securities and ExchangeCommission.  Operating results for thethree months ended September 30, 2004 are not necessarily indicative of theresults that may be expected for any other interim period or for the yearending December 31, 2004.  The balancesheet at December 31, 2003 has been derived from the audited financialstatements at that date but does not include all of the information andfootnotes required by accounting principles generally accepted in the UnitedStates for complete financial statements.

 

2.  *Net Income Per Share*

 

Websense computes net income per share inaccordance with Statement of Financial Accounting Standards (SFAS) No. 128,Earnings Per Share (“EPS”). Under the provisions of SFAS No. 128, basic netincome per share is computed by dividing the net income for the period by theweighted average number of common shares outstanding during the period. Dilutednet income per share is computed by dividing the net income for the period bythe weighted average number of common and common equivalent shares outstandingduring the period. Common equivalent shares for all periods presented consistof dilutive stock options.

 

Dilutive securities include stock options,warrants and restricted stock subject to vesting. During the quarters ended September30, 2004 and 2003, the difference between the weighted average shares used indetermining basic EPS versus diluted EPS related to dilutive stock options andwarrants totaled 978,000 and 963,000, respectively. Potentially dilutivesecurities totaling 268,000 and 1,283,000 for the quarters ended September 30,2004 and 2003, respectively, were excluded from historical basic and dilutedearnings per share because of their anti-dilutive effect as a result of stockoptions which have exercise prices greater than the average market price of thecommon shares.

 

During the first nine months of 2004 and2003, the difference between the weighted average shares used in determiningbasic EPS versus diluted EPS related to dilutive stock options and warrantstotaled 993,000 and 888,000, respectively. Potentially dilutive securitiestotaling 104,000 and 1,504,000 for the first nine months of 2004 and 2003,respectively, were excluded from historical basic and diluted earnings pershare because of their anti-dilutive effect as a result of stock options whichhave exercise prices greater than the average market price of the commonshares.

 

5

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

 
| ** **                      | ** ** | **Net Income**                               | ** ** | **Shares**        | ** ** | **Per Share** | ** ** |
|---------------------------------|------------|----------------------------------------------|------------|-------------------|------------|---------------|------------|
| ** **                      | ** ** | **(Numerator)**                              | ** ** | **(Denominator)** | ** ** | **Amount**    | ** ** |
| ** **                      | ** ** | **(In thousands, except per share amounts)** | ** ** |
| **For the Three Months Ended:** | ** ** | ** **                                   | ** ** | ** **        | ** ** | ** **    | ** ** |
| **September 30, 2004:**         | ** ** | ** **                                   | ** ** | ** **        | ** ** | ** **    | ** ** |
| Basic EPS                       |       | $                                            | 7,106      |              | 23,250     |          | $          | 0.31 |   |
| Effect of options               |       | —                                       |       | 978               |       | (0.02         | )          |
| Diluted EPS                     |       | $                                            | 7,106      |              | 24,228     |          | $          | 0.29 |   |
| ** **                      | ** ** | ** **                                   | ** ** | ** **        | ** ** | ** **    | ** ** |
| **September 30, 2003:**         | ** ** | ** **                                   | ** ** | ** **        | ** ** | ** **    | ** ** |
| Basic EPS                       |       | $                                            | 4,232      |              | 22,072     |          | $          | 0.19 |   |
| Effect of options               |       | —                                       |       | 963               |       | (0.01         | )          |
| Diluted EPS                     |       | $                                            | 4,232      |              | 23,035     |          | $          | 0.18 |   |
| ** **                      | ** ** | ** **                                   | ** ** | ** **        | ** ** | ** **    | ** ** |
| **For the Nine months ended:**  | ** ** | ** **                                   | ** ** | ** **        | ** ** | ** **    | ** ** |
| **September 30, 2004:**         | ** ** | ** **                                   | ** ** | ** **        | ** ** | ** **    | ** ** |
| Basic EPS                       |       | $                                            | 18,040     |              | 22,967     |          | $          | 0.79 |   |
| Effect of options               |       | —                                       |       | 993               |       | (0.04         | )          |
| Diluted EPS                     |       | $                                            | 18,040     |              | 23,960     |          | $          | 0.75 |   |
|                            |       |                                         |       |              |       |          |       |
| **September 30, 2003:**         |       |                                         |       |              |       |          |       |
| Basic EPS                       |       | $                                            | 12,180     |              | 21,917     |          | $          | 0.56 |   |
| Effect of options               |       | —                                       |       | 888               |       | (0.03         | )          |
| Diluted EPS                     |       | $                                            | 12,180     |              | 22,805     |          | $          | 0.53 |   |

 

3. *Amortization of Stock-BasedCompensation*

 

For the three and nine months ended September30, 2004, the Company recorded no amortization of stock-based compensationbecause the expense was completely amortized in 2003. The allocation of the expenseby operating expense category in the three and nine months ended in the prioryear is as follows (in thousands):

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|-------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                      | ** ** | **September 30, 2003** | ** ** | **September 30, 2003** | ** ** |
| Selling and marketing                           |       | $                      | 5          |                   | $          | 29 |   |
| Research and development                        |       | 3                      |       | 15                     |       |
| General and administrative                      |       | 3                      |       | 32                     |       |
| Total amortization of stock-based  compensation |       | $                      | 11         |                   | $          | 76 |   |

 

6

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4. *Comprehensive Income*

 

The components of comprehensive income, asrequired to be reported by SFAS No. 130, Reporting Comprehensive Income, wereas follows (in thousands):

 
| ** **                                                                               | ** ** | **Three Months Ended**  | ** ** | **Nine Months Ended**   | ** ** |
|------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                                               | ** ** | **September  30, 2004** | ** ** | **September  30, 2003** | ** ** | **September  30, 2004** | ** ** | **September  30, 2003** | ** ** |
| Net income                                                                               |       | $                       | 7,106      |                    | $          | 4,232 |   | $ | 18,040 |   | $ | 12,180 |   |
| Change in unrealized gain (loss) on  investments                                         |       | 88                      |       | (53                     | )          | (257 | ) | (463 | ) |
| Change in unrealized gain (loss) on fair  market valuation of foreign exchange contracts |       | 104                     |       | —                  |       | (60 | ) | — |   |
| Comprehensive income                                                                     |       | $                       | 7,298      |                    | $          | 4,179 |   | $ | 17,723 |   | $ | 11,717 |   |

 

Accumulated other comprehensive income (loss)totaled ($302,000) and $15,000 at September 30, 2004 and December 31, 2003,respectively.

 

5.* **Stock-Based Compensation*

 

Pro forma information regarding net income(loss) is required by SFAS No. 123, Accounting for Stock-Based Compensation, asamended by SFAS 148, Accounting for Stock-Based Compensation – Transition andDisclosure, and has been determined as if the Company has accounted for itsemployee stock options and shares purchased under the employee stock purchaseplan under the fair value method of SFAS 123, as amended by SFAS 148. The proforma effects of stock-based compensation on net income and net income pershare have been estimated at the date of grant using the Black-Scholes optionpricing model based on the following weighted average assumptions since theCompany’s initial public offering in March of 2000: risk free interest rates of2.36% to 6.0%, dividend yields of 0%, expected volatility of 49% to 132%, andlife of 5 years.

 

7

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The Company’s pro forma information is asfollows (in thousands, except per share amounts):

 
| ** **                                                                                 | ** ** | **Three Months Ended**  | ** ** | **Nine Months Ended**   | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                                                 | ** ** | **September  30, 2004** | ** ** | **September  30, 2003** | ** ** | **September  30, 2004** | ** ** | **September  30, 2003** | ** ** |
| Net income as reported                                                                     |       | $                       | 7,106      |                    | $          | 4,232 |   | $ | 18,040 |   | $ | 12,180 |   |
| Stock based employee compensation cost  included in net income as reported, net of tax (1) |       | —                  |       | 7                       |       | — |   | 47 |   |
| Compensation expense under FAS 123, net of  tax (2)                                        |       | (2,941                  | )          | (2,395                  | )          | (8,107 | ) | (6,596 | ) |
| Pro forma net income                                                                       |       | $                       | 4,165      |                    | $          | 1,844 |   | $ | 9,933 |   | $ | 5,631 |   |
|                                                                                       |       |                    |       |                    |       |   |   |   |   |
| Basic net income per share as reported                                                     |       | $                       | 0.31       |                    | $          | 0.19 |   | $ | 0.79 |   | $ | 0.56 |   |
| Pro forma basic net income per share                                                       |       | $                       | 0.18       |                    | $          | 0.08 |   | $ | 0.43 |   | $ | 0.26 |   |
|                                                                                       |       |                    |       |                    |       |   |   |   |   |
| Diluted net income per share as reported                                                   |       | $                       | 0.29       |                    | $          | 0.18 |   | $ | 0.75 |   | $ | 0.53 |   |
| Pro forma diluted net income per share                                                     |       | $                       | 0.17       |                    | $          | 0.08 |   | $ | 0.41 |   | $ | 0.25 |   |

 

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(1)          TheCompany was recognizing deferred stock-based compensation expense on the deemedfair value of options granted prior to the initial public offering in March2000.  This expense was amortized on anaccelerated basis, in accordance with FIN 28, over approximately a four-yearperiod, which began in March 2000 and ended in December 2003.

 

(2)          TheCompany had an effective tax rate of 37% and 38% in the three months ended September30, 2004 and 2003, respectively.  TheCompany had an effective tax rate of 37% and 39% in the nine months ended September30, 2004 and 2003, respectively.

 

For purposes of pro forma disclosures, the estimated fair value isamortized to expense over the options vesting period.  The effect of applying SFAS 123, as amendedby SFAS 148, for purposes of providing pro forma disclosures may not berepresentative of the effects on our operating results in future years.

 

6. *Tax Matters*

 

From time totime, the Company is audited by various state, federal and internationalauthorities relating to tax matters.  TheCompany fully cooperates with all audits, but defends its positions vigorously.  The Company’s audits are in various stages ofcompletion; however, no outcome for a particular audit can be determined withcertainty prior to the conclusion of the audit and appeals process.  As each audit is concluded, adjustments, ifany, are appropriately recorded in the Company’s financial statements in theperiod determined.  To provide forpotential tax exposures, the Company maintains allowances for tax contingenciesbased on reasonable estimates of the Company’s potential exposure with respectto the tax liabilities that may result from such audits.  However, if the reserves are insufficientupon completion of any audits, there could be an adverse impact on the Company’sfinancial position and results of operations.

 

8

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7. *New Accounting Pronouncements*

 

On October 13, 2004, the FASB concluded thatStatement 123R, Share-Based Payment, which would require all companies tomeasure compensation cost for all share-based payments (including employeestock options) at fair value, would be effective for interim or annual periodsbeginning after June 15, 2005.  Retroactive application of therequirements of Statement 123 (not Statement 123R) to the beginning of thefiscal year that includes the effective date would be permitted, but notrequired.  Early adoption of Statement 123R is encouraged.  TheCompany will therefore be required to apply Statement 123R beginning July 1,2005 and could choose to apply Statement 123 retroactively from January 1, 2005to June 30, 2005 or the Company could choose to early adopt the proposedStatement.  The FASB plans to issue a final Statement on or aroundDecember 15, 2004.  The Company is currently evaluating the impact thatthis statement will have on its financial statements and no decision has beenmade with respect to the early adoption of this Statement.

 

8. *Reclassifications*

 

Certain reclassifications have been made for consistent presentation.

 

9

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

 

The following discussion and analysis shouldbe read in conjunction with the financial statements and related notescontained elsewhere in this report. See “Risks and Uncertainties” regardingcertain factors known to us that could cause reported financial information notto be necessarily indicative of future results.

** **

**Forward Looking Statements**

** **

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

 

•                  anticipatedtrends in revenue;

•                  growthopportunities in domestic and international markets;

•                  customeracceptance and satisfaction with our products;

•                  expected trendsin operating and other expenses;

•                  anticipated cashand intentions regarding usage of cash;

•                  changes ineffective tax rates; and

•                  anticipatedproduct enhancements or releases.

 

**Theseforward-looking statements are subject to risks and uncertainties that couldcause actual results to differ materially from those anticipated as of the dateof this report. We assume no obligation to update any forward-lookingstatements to reflect events or circumstances arising after the date of thisreport.**

 

**Overview**

 

**We provide Employee InternetManagement, or EIM, solutions that enable organizations to analyze, report andmanage how their employees use computing resources at work, including Internetaccess, instant messaging, peer-to-peer file sharing, network bandwidth anddesktop applications. Our primary product, Websense Enterprise®, givesorganizations the ability to rapidly implement and configure Internet accesspolicies in support of their efforts to improve employee productivity, conservenetwork bandwidth, mitigate potential legal liability and enhance networksecurity. In 1996, we released our first software product, Websense Internet ScreeningSystem, and since that time, we have focused our business on developing andselling EIM solutions. In December 1999, we released Websense EnterpriseVersion 4, which was sold through March 2003. We launched the next generationof Websense software - Websense Enterprise Version 5 - in March 2003, includingenhanced EIM capabilities.  We have alsointroduced Premium GroupTM databases and add-on modules featuring new networkand application management technology such as Client Policy ManagerTM, BandwidthOptimizerTM and Instant Messaging Attachment ManagerTM. We currently derivenearly all of our revenue from subscriptions to the Websense Enterprisesolution and expect this trend to continue in the future as more offerings areadded to the Websense Enterprise platform.**

 

 

10

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**Duringthe nine months ended September 30, 2004, we derived 32% of revenue frominternational sales compared with 31% for the nine months ended September 30,2003. We believe international markets represent a significant growthopportunity and we are continuing to expand our international operations,particularly in selected countries in the European, Asia/Pacific and LatinAmerican markets.**

** **

**We sellWebsense Enterprise through both indirect and direct channels. Sales throughindirect channels currently account for more than 80% of our revenue, and ourstrategy is to continue to rely on indirect sales channels for a significantmajority of our sales.**

** **

**Asdescribed elsewhere in this report, we recognize revenue from subscriptions toWebsense Enterprise on a monthly straight-line basis over the term of thesubscription. We recognize the operating expenses related to these sales asthey are incurred. These operating expenses include sales commissions, whichare based on the total amount of the subscription contract and are fullyexpensed in the period the product is delivered. Operating expenses havecontinued to increase as compared with prior periods due to expanded sellingand marketing efforts, continued product research and development andinvestments in administrative infrastructure to support subscription sales thatwe will recognize as revenue in subsequent periods.**

 

**Critical Accounting Policies**

** **

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

*** ***

***Revenue Recognition.***When apurchase decision is made for Websense Enterprise, customers enter into asubscription agreement, which is generally 12, 24 or 36 months in duration andfor a fixed number of users. Other services such as upgrades/enhancements andstandard post-contract technical support services are sold together withWebsense Enterprise and provided throughout the subscription term. We recognizerevenue on a monthly straight-line basis over the term of the subscriptionagreement provided collectibility is reasonably assured. Upon entering into asubscription arrangement for a fixed or determinable fee, we electronicallydeliver access codes to users and then promptly invoice customers for the fullamount of their subscriptions. Payment is due for the full term of thesubscription, generally within 30 days of the invoice. We record amounts billedto customers in excess of recognizable revenue as deferred revenue on ourbalance sheet. Upon expiration of the subscription, customers who wish tore-subscribe typically must do so at then current rates to continue usingWebsense Enterprise. Our revenue is significantly influenced by new and renewalsubscriptions, and a decrease in subscription amounts could negatively impactour future revenue.

** **

***Allowance for Doubtful Accounts.***We maintain an allowance for doubtful accounts for estimated lossesresulting from the inability or unwillingness of our customers to pay theirinvoice(s). If the financial condition of our customers were to deteriorate,resulting in an impairment of their ability to make payments, additionalallowances may be required.

** **

*Deferred Tax Assets.* As required by Statement of FinancialAccounting Standards No. 109 (“SFAS 109”), we recognize tax assets on thebalance sheet if it is “more likely than not” that they will be realized onfuture tax returns.  Based on ourearnings history and anticipated future taxable income, we believe that it ismore likely than not that our U.S. deferred tax assets will be realized.However, should we determine that we would not be able to realize all or partof our deferred tax assets in the future, an adjustment to the deferred taxassets would be charged against income in the period such determination wasmade. As of December 31, 2003, we had $17.4 million in deferred tax assets.

 

 

11

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# **Resultsof Operations**

 

***Three months ended September30, 2004, compared with the three months ended September 30, 2003***

 

The following table summarizes our operating results as a percentage oftotal revenue for each of the periods shown.

 
| ** **                 | ** ** | **Three Months  Ended** | ** ** |
|----------------------------|------------|-------------------------|------------|
| ** **                 | ** ** | **September  30, 2004** | ** ** | **September  30, 2003** | ** ** |
| ** **                 | ** ** | **(Unaudited)**         | ** ** |
|                       |       |                    |       |   |   |
| Revenue                    |       | 100                     | %          | 100 | % |
|                       |       |                    |       |   |   |
| Cost of revenue            |       | 7                       |       | 7 |   |
|                       |       |                    |       |   |   |
| Gross margin               |       | 93                      |       | 93 |   |
|                       |       |                    |       |   |   |
| Operating expenses:        |       |                    |       |   |   |
| Selling and marketing      |       | 37                      |       | 39 |   |
| Research and development   |       | 12                      |       | 15 |   |
| General and administrative |       | 7                       |       | 9 |   |
| Total operating expenses   |       | 56                      |       | 63 |   |
|                       |       |                    |       |   |   |
| Income from operations     |       | 37                      |       | 30 |   |
|                       |       |                    |       |   |   |
| Other income, net          |       | 2                       |       | 2 |   |
|                       |       |                    |       |   |   |
| Income before income taxes |       | 39                      |       | 32 |   |
|                       |       |                    |       |   |   |
| Provision for income taxes |       | 14                      |       | 12 |   |
|                       |       |                    |       |   |   |
| Net income                 |       | 25                      | %          | 20 | % |

 

12

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# **Revenue**

# ** **

# **Revenueincreased to $28.9 million in the third quarter of 2004 from $21.0 million inthe third quarter of 2003. The increase was primarily a result of the additionof new, renewed and upgraded subscriptions from our customers. Approximately35% of subscription revenue recognized in the third quarter of 2004 was derivedfrom sales to first-time customers, who initially purchased one-, two-, orthree-year subscriptions to Websense Enterprise in 2004 or prior years. Theremaining 65% of subscription revenue was generated from existing customers. Weexpect total revenue growth in 2004 to exceed total revenue growth in 2003,although the percentage revenue growth rate may be lower in 2004 than in 2003 asa result of the larger revenue base in 2004 as compared with 2003.**

# ** **

# **Cost of Revenue**

# ** **

# **Cost ofrevenue consists of the costs of content review, technical support andinfrastructure costs associated with maintaining our databases. Cost of revenueincreased to $2.0 million in the third quarter of 2004 from $1.4 million in thethird quarter of 2003. The increase was primarily due to the costs associatedwith additional personnel in our technical support and database groups. Weexpect cost of revenue to increase in the future as we support the growth andmaintenance of our databases as well as the technical support needs of ourcustomers. As a percentage of revenue, cost of revenue remained unchanged at 7%during the third quarters of 2004 and 2003. We expect that cost of revenue, asa percentage of revenue, will remain below 10% of revenue for the foreseeablefuture.**

# ** **

# **Gross Margin**

# ** **

# **Grossmargin increased to $26.9 million in the third quarter of 2004 from $19.6million in the third quarter of 2003. The increase was primarily due toincreased revenue. As a percentage of revenue, gross margin remained unchangedat 93% in the third quarters of 2004 and 2003.**Weexpect that gross margin, as a percentage of revenue, will remain in excess of90% of revenue for the foreseeable future.

 

# **Operating Expenses**

# *** ***

# ***Selling and marketing***.Selling and marketing expenses consist primarily of salaries, commissions andbenefits related to personnel engaged in selling, marketing and customersupport functions, along with costs related to public relations, investorrelations, advertising, promotions and travel as well as allocated facilitiescosts and depreciation expenses. Selling and marketing expenses increased to$10.6 million in the third quarter of 2004 from $8.2 million in the third quarterof 2003. The increase in selling and marketing expenses of $2.4 million wasprimarily due to increased headcount costs and related travel and allocatedcosts as well as higher commission and co-op marketing expenses related tohigher sales levels. We expect selling and marketing expenses to increase inabsolute dollars in the future as more personnel are added to support ourexpanding selling and marketing efforts worldwide and as increased sales resultin higher overall sales commission expenses.

# *** ***

*Research and development.*****Research and development expenses consistprimarily of salaries and benefits for software developers, contractprogrammers, and allocated facilities costs and equipment depreciation.Research and development expenses increased to $3.6 million in the thirdquarter of 2004 from $3.2 million in the third quarter of 2003. The increase of$400,000 in research and development expenses was primarily a result of increasedcompensation costs as well as allocated costs to support our expanding list oftechnology partners, the enhancements of Websense Enterprise and additionalproducts. We expect research and development expenses to increase in absolutedollars in future periods as a result of our continued enhancements of WebsenseEnterprise and additional products.

 

13

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*General and administrative*.General and administrative expenses consist primarily of salaries, benefits andrelated expenses for our executive, finance, human resources and administrativepersonnel, third party professional service fees, allocated facilities costsand depreciation expenses. General and administrative expenses increased to $2.0million in the third quarter of 2004 from $1.8 million in the third quarter of2003. The $200,000 increase in general and administrative expenses is primarilya result of an increase in professional accounting fees, driven primarily bycompliance with the Sarbanes-Oxley Act of 2002, allocated costs and additionalpersonnel needed to support our growing operations. We expect general andadministrative expenses to increase in absolute dollars in future periods,reflecting growth in operations, increasing expenses associated with being apublic company and expansion of our international operations.

# *** ***

# **Other Income, Net**

# ** **

# **Netother income increased to $598,000 in the third quarter of 2004 from $418,000in the third quarter of 2003. The increase is due primarily to higher interestrates earned by our increased balance of cash, cash equivalents and marketablesecurities as of September 30, 2004 compared with September 30, 2003. Themajority of our total cash and cash equivalents and marketable securities are tax-exempt.We expect the majority of our cash and cash equivalents and marketablesecurities will continue to be held in tax-exempt investments during theforeseeable future.**

# ** **

# **Provision for Income Taxes**

** **

# **Provisionfor income taxes consist primarily of federal and state income taxes as well astaxes related to our wholly owned subsidiaries in Ireland, the United Kingdom,Japan, Australia, France and Germany. Provision for income taxes increased to $4.2million in the third quarter of 2004 from $2.5 million in the third quarter of2003. The $1.7 million increase in the provision for income taxes is primarilya result of the increase in net income before income taxes partially offset bythe decreasing effective tax rate from 38% in the third quarter of 2003 to 37%in the third quarter of 2004.**Thedecrease in effective tax rate is primarily attributable to an increase intax-exempt investments. An increase in foreign income taxed at lower statutoryrates also contributed to the effective tax rate reduction. We expect aneffective tax rate of approximately 37% for 2004. Subsequent to 2004, oureffective tax rate may decrease over time due to benefits derived from lowertax rates associated with foreign income.

 

14

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***Nine months ended September30, 2004, compared with the nine months ended September 30, 2003***

 

The following table summarizes our operating results as a percentage oftotal revenue for each of the periods shown.

 
| ** **                 | ** ** | **Nine Months  Ended**  | ** ** |
|----------------------------|------------|-------------------------|------------|
| ** **                 | ** ** | **September  30, 2004** | ** ** | **September  30, 2003** | ** ** |
| ** **                 | ** ** | **(Unaudited)**         | ** ** |
|                       |       |                    |       |   |   |
| Revenue                    |       | 100                     | %          | 100 | % |
|                       |       |                    |       |   |   |
| Cost of revenue            |       | 7                       |       | 7 |   |
|                       |       |                    |       |   |   |
| Gross margin               |       | 93                      |       | 93 |   |
|                       |       |                    |       |   |   |
| Operating expenses:        |       |                    |       |   |   |
| Selling and marketing      |       | 38                      |       | 38 |   |
| Research and development   |       | 13                      |       | 16 |   |
| General and administrative |       | 8                       |       | 9 |   |
| Total operating expenses   |       | 59                      |       | 63 |   |
|                       |       |                    |       |   |   |
| Income from operations     |       | 34                      |       | 30 |   |
|                       |       |                    |       |   |   |
| Other income, net          |       | 2                       |       | 3 |   |
|                       |       |                    |       |   |   |
| Income before income taxes |       | 36                      |       | 33 |   |
|                       |       |                    |       |   |   |
| Provision for income taxes |       | 13                      |       | 13 |   |
|                       |       |                    |       |   |   |
| Net income                 |       | 23                      | %          | 20 | % |

 

 

15

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# **Revenue**

# ** **

# **Revenueincreased to $80.2 million in the first nine months of 2004 from $59.0 millionin the first nine months of 2003. The increase was primarily a result of theaddition of new, renewed and upgraded subscriptions from our customers.Approximately 35% of subscription revenue recognized in the first nine monthsof 2004 was derived from sales to first-time customers, who initially purchasedone-, two-, or three-year subscriptions to Websense Enterprise in 2004 or prioryears. The remaining 65% of subscription revenue was generated from existingcustomers. We expect total revenue growth in 2004 to exceed total revenuegrowth in 2003, although the percentage revenue growth rate may be lower in2004 than in 2003 as a result of the larger revenue base in 2004 as comparedwith 2003.**

# ** **

# **Cost of Revenue**

# ** **

# **Cost ofrevenue increased to $5.5 million in the first nine months of 2004 from $4.0million in the first nine months of 2003. The increase was primarily due to thecosts associated with additional personnel in our technical support anddatabase groups. We expect cost of revenue to increase in the future as wesupport the growth and maintenance of our databases as well as the technicalsupport needs of our customers. As a percentage of revenue, cost of revenueremained unchanged at 7% during the first nine months of 2004 and 2003. Weexpect that cost of revenue, as a percentage of revenue, will remain below 10%of revenue for the foreseeable future.**

# ** **

# **Gross Margin**

# ** **

# **Grossmargin increased to $74.7 million in the first nine months of 2004 from $55.0million in the first nine months of 2003. The increase was primarily due toincreased revenue. As a percentage of revenue, gross margin remained unchangedat 93% in the first nine months of 2004 and 2003.**Weexpect that gross margin, as a percentage of revenue, will remain in excess of90% of revenue for the foreseeable future.

# ** **

# **Operating Expenses**

# *** ***

# ***Selling and marketing***.Selling and marketing expenses increased to $30.5 million in the first ninemonths of 2004 from $22.4 million in the first nine months of 2003. Theincrease in selling and marketing expenses of $8.1 million was primarily due toincreased headcount costs and related travel and allocated costs as well ashigher commission and co-op marketing expenses related to higher sales levels.We expect selling and marketing expenses to increase in absolute dollars in thefuture as more personnel are added to support our expanding selling andmarketing efforts worldwide and as increased sales result in higher overallsales commission expenses.

# *** ***

*Research and development.*****Research and development expensesincreased to $10.7 million in the first nine months of 2004 from $9.5 millionin the first nine months of 2003. The increase of $1.2 million in research anddevelopment expenses was primarily a result of increased compensation costs aswell as allocated costs to support our expanding list of technology partners,the enhancements of Websense Enterprise and additional products. We expectresearch and development expenses to increase in absolute dollars in futureperiods as a result of our continued enhancements of Websense Enterprise andadditional products.

 

*General and administrative*.General and administrative expenses increased to $6.4 million in the first ninemonths of 2004 from $5.0 million in the first nine months of 2003. The $1.4million increase in general and administrative expenses is primarily a resultof an increase in professional accounting fees

 

16

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driven primarily by compliance with the Sarbanes-Oxley Act of 2002,allocated costs and additional personnel needed to support our growingoperations. We expect general and administrative expenses to increase inabsolute dollars in future periods, reflecting growth in operations, increasingexpenses associated with being a public company and expansion of ourinternational operations.

 

# **Other Income, Net**

# ** **

# **Netother income decreased to $1.5 million in the first nine months of 2004 from$1.9 million in the first nine months of 2003. The decrease is due primarily tolower interest rates generated by our cash, cash equivalents and marketablesecurities despite increased balances as of September 30, 2004 as compared withSeptember 30, 2003. The lower interest rates are substantially the result ofour strategy beginning in the third quarter of 2003 to purchase lower interesttax-exempt investments in order to maximize the after-tax return on ourinvestments. Also contributing to the decrease were realized losses fromsettled foreign exchange contracts. The majority of our total cash and cashequivalents and marketable securities are tax-exempt. We expect the majority ofour cash and cash equivalents and marketable securities will continue to beheld in tax-exempt investments during the foreseeable future.**

# ** **

# **Provision for Income Taxes**

** **

# **In thefirst nine months of 2004, our provision for income taxes consist primarily offederal and state income taxes as well as taxes related to our wholly ownedsubsidiaries in Ireland, the United Kingdom, Japan, Australia, France andGermany. Provision for income taxes increased to $10.6 million in the first ninemonths of 2004 from $7.7 million in the first nine months of 2003. The $2.9million increase in the provision for income taxes is primarily a result of theincrease in net income before income taxes partially offset by the decreasingeffective tax rate from 39% in the first nine months of 2003 to 37% in thefirst nine months of 2004.**The decrease in effective tax rate isprimarily attributable to an increase in tax-exempt investments. An increase inforeign income taxed at lower statutory rates also contributed to the effectivetax rate reduction. We expect an effective tax rate of approximately 37% for2004. Subsequent to 2004, our effective tax rate may decrease over time due tobenefits derived from lower tax rates associated with foreign income.

 

**Liquidity and Capital Resources**

 

As of September 30, 2004, we had cash and cash equivalents of $33.1million, investments in marketable securities of $192.8 million and accumulatedearnings of $33.8 million.

 

**Net cashprovided by operating activities was $46.6 million in the first nine months of2004 compared with $30.0 million in the first nine months of 2003. The $16.6million increase in cash provided by operating activities in the first ninemonths of 2004 was primarily due to an increase in our net income and anincrease in deferred revenue (subscription amounts in excess of recognizablerevenue are recorded as deferred revenue). Our operating cash flow and revenueare significantly influenced by subscription renewals and a decrease insubscription renewals would negatively impact our operating cash flow andrevenue.**

 

Net cash used in investing activities was $47.8 million in the first ninemonths of 2004 compared with net cash used in investing activities of $29.6million in the first nine months of 2003. The $18.2 million increase in cashused by investing activities in the first nine months of 2004 was primarily dueto more purchases of marketable securities offset by maturities and sales ofmarketable securities.

 

Net cash used by financing activities was $947,000 in the first ninemonths of 2004 which was consistent with net cash used by financing activitiesof $944,000 in the first nine months of 2003.

 

17

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We have operating lease commitments of approximately $0.4 millionduring the remainder of 2004, $1.9 million in 2005, $2.1 million in 2006, $2.0million in 2007 and $0.3 million in 2008. A significant majority of our operatinglease commitments are related to our corporate headquarters lease, which wasrenewed in April 2002, and was most recently amended in July 2004 to addadditional space for our corporate headquarters and to extend the lease through2008. The lease renewal incentives resulted in no rent payments in the thirdand fourth quarters of 2002 and escalating rent payments from 2004 to 2008. Therent expense related to our corporate headquarters lease renewal is recordedmonthly on a straight-line basis in accordance with generally acceptedaccounting principles.

 

Future minimum annual payments under non-cancelable operating leases andsoftware licenses at September 30, 2004 are as follows (in thousands):

 
| ** ** | ** ** | **Operating  Leases** | ** ** | **Software  Licenses** | ** ** | **Total** | ** ** |
|------------|------------|-----------------------|------------|------------------------|------------|-----------|------------|
|       |       |                  |       |                   |       |      |       |
| 2004       |       | $                     | 362        |                   | $          | 46        |       | $ | 408 |   |
| 2005       |       | 1,741                 |       | 184                    |       | 1,925     |       |
| 2006       |       | 1,889                 |       | 184                    |       | 2,073     |       |
| 2007       |       | 1,937                 |       | 46                     |       | 1,983     |       |
| 2008       |       | 325                   |       | —                 |       | 325       |       |
|       |       | $                     | 6,254      |                   | $          | 460       |       | $ | 6,714 |   |

 

As of September30, 2004 and 2003, we did not have any relationships with unconsolidatedentities or financial partners, such as entities often referred to asstructured finance or special purpose entities, which would have beenestablished for the purpose of facilitating off-balance sheet arrangements orother contractually narrow or limited purposes. As such, we are not materiallyexposed to any financing, liquidity, market or credit risk that could arise ifwe had engaged in such relationships.

 

On April 3, 2003, we announced that our Board of Directors authorized astock repurchase program of up to 2 million shares of our common stock. Therepurchases will be made from time to time on the open market at prevailingmarket prices or in privately negotiated transactions. Depending on marketconditions and other factors, purchases under this program may be commenced orsuspended at any time, or from time to time, without prior notice. As of September30, 2004, we had repurchased 898,500 shares of our common stock under thisprogram, for an aggregate of $25.2 million at an average price of $28.09 pershare.

 

We believe that our cash and cash equivalents balances and investments in marketable securities will be sufficient to satisfy our cash requirements for the foreseeable future. We intend to continue to invest our cash in excess of current operating requirements in interest-bearing, investment-grade securities.

 

 

18

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**Risks and Uncertainties**

** **

**Risks and uncertainties that could impact ourbusiness, consolidated financial position, results of operations and cash flowsand cause future results to differ from our expectations include the following:customer acceptance of our services, products and fee structures; the successof our brand development efforts; the volatile and competitive nature of theInternet industry; changes in domestic and international market conditions andthe entry into and development of international markets for our products; risksrelating to intellectual property ownership; and the risks and uncertaintiesidentified in our Annual Report on Form 10-K for the fiscal year ended December31, 2003 and other filings with the Securities and Exchange Commission.**

 

In addition, we have been working to complete ourassessment of the effectiveness of our internal controls over financialreporting by the time we are required to file our next Annual Report on Form10-K, as required by Section 404 of the Sarbanes Oxley Act of 2002. Ourauditors have likewise been working to evaluate our assessment and to test thedesign and operating effectiveness of our internal controls over financialreporting. Especially since this is the first year of the new Section 404requirements and the requirements continue to evolve, it is difficult for us orour auditors to predict how long it will take to complete the assessment of theeffectiveness of our internal controls over financial reporting, including thefinal evaluation of the significance of control deficiencies. This results in aheightened risk of unexpected delays and obstacles to completing the project ona timely basis, as well as a lack of certainty with respect to the results ofthe assessment and testing process. We have a project plan in place which wecurrently anticipate will result in completion of the assessment and testingprocess in a satisfactory and timely fashion, although no assurance can begiven in this regard. We cannot assure that we will not find any materialweaknesses in connection with our assessments or that our auditors will be ableto attest that we have maintained effective internal control over financialreporting as of December 31, 2004. If we fail to complete the assessment ortesting process in a satisfactory or timely manner, possible consequences couldinclude sanction or investigation by regulatory authorities such as theSecurities and Exchange Commission or The Nasdaq National Market, incomplete orlate filing of our Annual Report on Form 10-K, civil or criminal liability, andour stock price and business could also be adversely affected.

** **

**Item 3. Quantitative andQualitative Disclosures About Market Risk**

** **

**Ourmarket risk exposures are related to our cash, cash equivalents andinvestments. We invest our excess cash in highly liquid short-term investments,municipal securities, commercial paper, corporate bonds, and mortgage-backedsecurities. These investments are not held for trading or other speculativepurposes. Changes in interest rates affect the investment income we earn on ourinvestments and therefore impact our cash flows and results of operations.**

** **

We are exposed to changes in interest ratesprimarily from our short-term available-for-sale investments. Under our currentpolicies, we do not use interest rate derivative instruments to manage exposureto interest rate changes. 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 financial instruments at September30, 2004. Changes in interest rates over time will, however, affect ourinterest income.

** **

For the quarter ended September 30, 2004, all of ourbillings, including those billed by our operations in Ireland, were denominatedin our functional currency, which is the U.S. dollar. Working funds necessaryto facilitate the short-term operations of our subsidiaries are kept in thelocal currencies in which they do business.

 

19

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We utilize foreign exchange contracts to hedge foreign currency market exposures of underlying assets and liabilities. Our objective is to reduce the risk to earnings and cash flows associated with changes in foreign currency exchange rates. We do not use foreign exchange contracts for speculative or trading purposes. As of September 30, 2004, we had committed to 6 foreign exchange contracts to purchase Euro and British Pounds for $2.1 million. Our Euro commitment represents 595,000 Euros at a weighted average forward rate of 1.279. Our British Pound commitment represents 745,000 British Pounds at a weighted average forward rate of 1.858. The fair value of these foreign exchange contracts was $2.1 million at September 30, 2004. All of the foreign exchange contracts will be settled before December 31, 2004.

 

**Item 4. Controls and Procedures**

 

**Disclosure Controls and Procedures**

** **

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

** **

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

 

20

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**Part II - Other Information**

 

**Item 1.    Legal Proceedings**

 

None.

 

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

 

**(a) Not applicable.**

 

**(b) Not applicable.**

 

**(c)  Issuer Purchasesof Equity Securities**

** **
| **Month**                             | ** ** | **Number of  shares  purchased  during month(1)** | ** ** | **Average  price paid per  share** | ** ** | **Cumulative  number of shares  purchased as part  of publicly  announced plan(2)** | ** ** | **Maximum number  of shares that may  yet be purchased  under the plan** | ** ** |
|---------------------------------------|------------|---------------------------------------------------|------------|------------------------------------|------------|-------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| July 1st  through 31st  of  2004      |       | —                                            |       | —                             |       | 601,000                                                                             |       | 1,399,000                                                                |       |
| August 1st  through 31st  of  2004    |       | 172,500                                           |       | $                                  | 38.90      |                                                                                | 773,500    |                                                                     | 1,226,500  |   |
| September 1st  through 30th  of  2004 |       | 125,000                                           |       | $                                  | 38.57      |                                                                                | 898,500    |                                                                     | 1,101,500  |   |
| Total                                 |       | 297,500                                           |       | $                                  | 38.76      |                                                                                | 898,500    |                                                                     | 1,101,500  |   |

 

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**(1)**          The purchases were made in open-markettransactions.

** **

**(2)**          On April 3, 2003, we announced that ourBoard of Directors authorized a stock repurchase program of up to 2 millionshares of our common stock.

 

**Item 3.    Defaultsupon Senior Securities**

** **

**None.**

** **

**Item 4.  Submissionof Matters to a Vote of Security Holders**

** **

**None.**

** **

**Item 5.    Other Information**

** **

**None.**

 

21

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**Item 6.    Exhibits**

** **

**Exhibits**

** **
| **3.1(1)** | ** ** | **Amended and Restated Certificate of Incorporation**                                                                                                                                           |
|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **3.2(1)** | ** ** | **Restated Bylaws**                                                                                                                                                                             |
| **4.1(1)** | ** ** | **Specimen Stock Certificate of Websense, Inc**                                                                                                                                                 |
| **10.19**  | ** ** | **Third Amendment to Lease between Websense, Inc. and  Sorrento Valley Road LLC, dated July 30, 2004.**                                                                                    |
| **31.1**   | ** ** | **Certification of Principal Executive Officer pursuant to  Exchange Act Rules 13a-14(a) or 15d-14(a).**                                                                                        |
| **31.2**   | ** ** | **Certification of Principal Financial Officer pursuant to  Exchange Act Rules 13a-14(a) or 15d-14(a).**                                                                                        |
| **32.1**   | ** ** | **Certification of Principal Executive Officer pursuant to  Exchange Act Rules 13a-14(b) or 15d-14(b) and Section 1350 of Chapter 63 of  Title 18 of the United States Code (18 U.S.C. 1350).** |
| **32.2**   | ** ** | **Certification of Principal Financial Officer pursuant to  Exchange Act Rules 13a-14(b) or 15d-14(b) and Section 1350 of Chapter 63 of  Title 18 of the United States Code (18 U.S.C. 1350).** |

 

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| ** ** | ** ** | **(1)** | **Previously filed as an exhibit to our Registration  Statement on Form S-1, as amended, (File No 333-95619) and incorporated  herein by reference.** |
|------------|------------|---------|-------------------------------------------------------------------------------------------------------------------------------------------------------|

 

22

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##### **SIGNATURES**

 

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

 
|                          | **WEBSENSE, INC.** |
|-------------------------------|--------------------|
|                          |               |   |
| Date:  November 5, 2004  | By:                | /s/ JOHN B. CARRINGTON |   |
|                          |               | John B. Carrington |
| * *                      | * *           | *Chairman  of the Board and* |
| * *                      | * *           | *Chief  Executive Officer* |
|                          |               |   |
| Date:   November 5, 2004 | By:                | /s/ DOUGLAS C. WRIDE |   |
|                          |               | Douglas C. Wride |
| * *                      | * *           | *Chief  Financial Officer* |

 

23

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                 |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                                      |
| **3.1(1)**          | ** ** | **Amended and Restated Certificate of Incorporation**                                                                                                                                           |
| **3.2(1)**          | ** ** | **Restated Bylaws**                                                                                                                                                                             |
| **4.1(1)**          | ** ** | **Specimen Stock Certificate of Websense, Inc**                                                                                                                                                 |
| **10.19**           | ** ** | **Third Amendment to Lease between Websense, Inc. and  Sorrento Valley Road LLC, dated July 30, 2004.**                                                                                    |
| **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)**    | **Previously filed as an exhibit to our Registration  Statement on Form S-1, as amended, (File No 333-95619) and incorporated  herein by reference.**                                           |

 

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