**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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

 

**For the quarterly period ended March 31, 2007**

 

**OR**

 

o                                  **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE 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**

(Addressof principal executive offices, zip code and telephone number, including areacode)

 

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

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one):

| Large Accelerated Filer x |   | Accelerated  Filer o |   | Non-Accelerated Filer o |
|--------------------------------|--------|---------------------------|--------|------------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act):  Yes o    Nox

The number of shares outstanding of the registrant’sCommon Stock, $.01 par value, as of April 30, 2007 was 44,973,164.

 

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**Websense, Inc.**

**Form 10-Q**

**For the Period Ended March 31, 2007**

**TABLE OF CONTENTS**
|                                | ** ** | **Page**  |
|--------------------------------|------------|-----------|
| Part  I. Financial Information |       | 3         |
|                           |       |      |   |   |   |   |
|                           |       | Item 1.   |   | Consolidated Financial Statements (Unaudited) |   | 3 |
|                           |       |      |   | Consolidated  Balance Sheets as of March 31, 2007 and December 31, 2006 |   | 3 |
|                           |       |      |   | Consolidated Statements of Income for the three months  ended March 31, 2007 and 2006 |   | 4 |
|                           |       |      |   | Consolidated Statement of Stockholders’ Equity for the  three months ended March 31, 2007 |   | 5 |
|                           |       |      |   | Consolidated Statements of Cash Flows for the three  months ended March 31, 2007 and 2006 |   | 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 |   | 23 |
|                           |       | Item 4.   |   | Controls and Procedures |   | 23 |
|                           |       |      |   |   |   |   |
| Part  II. Other Information    |       | 24        |
|                           |       |      |   |   |   |   |
|                           |       | Item  1.  |   | Legal  Proceedings |   | 24 |
|                           |       | Item  1A. |   | Risk  Factors |   | 24 |
|                           |       | Item 2.   |   | Unregistered Sales of Equity Securities and Use of  Proceeds |   | 35 |
|                           |       | Item 3.   |   | Defaults upon Senior Securities |   | 35 |
|                           |       | Item 4.   |   | Submission of Matters to a Vote of Security Holders |   | 35 |
|                           |       | Item  5.  |   | Other  Information |   | 35 |
|                           |       | Item 6.   |   | Exhibits |   | 36 |
|                           |       |      |   |   |   |   |
| Signatures                     |       | 37        |

 

 

2

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Part I — FinancialInformation

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

**Websense, Inc.**Consolidated BalanceSheets (Unaudited and in thousands)
| ** **                                      | ** ** | **March 31,   2007** | ** ** | **December 31,  2006** | ** ** |
|-------------------------------------------------|------------|--------------------------------|------------|-----------------------------|------------|
| ** **                                      | ** ** | ** **                     | ** ** | **(See Note 1)**  | ** ** |
| **Assets**                                      |       |                           |       |                        |       |
| Current assets:                                 |       |                           |       |                        |       |
| Cash and cash  equivalents                      |       | $                              | 27,238     |                        | $          | 83,523 |   |
| Marketable securities                           |       | 234,123                        |       | 243,382                     |       |
| Accounts receivable,  net                       |       | 36,866                         |       | 52,740                      |       |
| Prepaid income taxes                            |       | 113                            |       | —                      |       |
| Current portion of  deferred income taxes       |       | 18,073                         |       | 18,179                      |       |
| Other current assets                            |       | 5,212                          |       | 3,943                       |       |
| Total current  assets                           |       | 321,625                        |       | 401,767                     |       |
|                                            |       |                           |       |                        |       |
| Property and equipment,  net                    |       | 7,288                          |       | 5,793                       |       |
| Intangible assets, net                          |       | 14,897                         |       | 1,067                       |       |
| Goodwill                                        |       | 73,380                         |       | —                      |       |
| Deferred income taxes,  less current portion    |       | 16,713                         |       | 13,806                      |       |
| Deposits and other  assets                      |       | 2,513                          |       | 1,824                       |       |
| Total assets                                    |       | $                              | 436,416    |                        | $          | 424,257 |   |
| ** **                                      |       |                           |       |                        |       |
| **Liabilities and stockholders’  equity**  |       |                           |       |                        |       |
| Current liabilities:                            |       |                           |       |                        |       |
| Accounts payable                                |       | $                              | 1,935      |                        | $          | 2,712 |   |
| Accrued payroll and  related benefits           |       | 10,354                         |       | 9,164                       |       |
| Other accrued expenses                          |       | 9,495                          |       | 7,084                       |       |
| Current portion of  income taxes payable        |       | 2,232                          |       | 4,229                       |       |
| Current portion of  deferred revenue            |       | 143,509                        |       | 148,539                     |       |
| Total current  liabilities                      |       | 167,525                        |       | 171,728                     |       |
|                                            |       |                           |       |                        |       |
| Income taxes payable,  less current portion     |       | 9,248                          |       | —                      |       |
| Deferred revenue, less  current portion         |       | 69,935                         |       | 71,804                      |       |
|                                            |       |                           |       |                        |       |
| Stockholders’ equity:                      |       |                           |       |                        |       |
| Common stock                                    |       | 511                            |       | 509                         |       |
| Additional paid-in  capital                     |       | 242,750                        |       | 237,302                     |       |
| Treasury stock, at cost                         |       | (139,744                       | )          | (139,744                    | )          |
| Retained earnings                               |       | 86,239                         |       | 82,748                      |       |
| Accumulated other  comprehensive loss           |       | (48                            | )          | (90                         | )          |
| Total  stockholders’ equity                |       | 189,708                        |       | 180,725                     |       |
| Total liabilities and stockholders’ equity |       | $                              | 436,416    |                        | $          | 424,257 |   |

 

See accompanying notes.

3

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**Websense, Inc.Consolidated Statements of Income(Unaudited) (in thousands, except per share amounts)**

|                                                  | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|
| ** **                                       | ** ** | **March 31,  2007**         | ** ** | **March 31,  2006** | ** ** |
| Revenue                                          |       | $                                | 49,747     |   | $ | 42,060 |   |
|                                             |       |                             |       |   |   |
| Cost of revenues                                 |       |                             |       |   |   |
| Cost of revenues                                 |       | 4,028                            |       | 3,378 |   |
| Amortization of acquired technology              |       | 629                              |       | — |   |
| Total cost of revenues                           |       | 4,657                            |       | 3,378 |   |
| Gross margin                                     |       | 45,090                           |       | 38,682 |   |
| Operating  expenses:                             |       |                             |       |   |   |
| Selling and marketing                            |       | 24,913                           |       | 18,014 |   |
| Research and development                         |       | 7,126                            |       | 5,443 |   |
| General and administrative                       |       | 7,186                            |       | 5,208 |   |
| Write off of in-process research and development |       | 1,270                            |       | — |   |
| Total operating expenses                         |       | 40,495                           |       | 28,665 |   |
| Income from  operations                          |       | 4,595                            |       | 10,017 |   |
| Other income,  net                               |       | 2,440                            |       | 2,635 |   |
| Income before  income taxes                      |       | 7,035                            |       | 12,652 |   |
| Provision for  income taxes                      |       | 3,168                            |       | 4,708 |   |
| Net income                                       |       | $                                | 3,867      |   | $ | 7,944 |   |
| Net income per  share:                           |       |                             |       |   |   |
| Basic net income per share                       |       | $                                | 0.09       |   | $ | 0.17 |   |
| Diluted net income per share                     |       | $                                | 0.09       |   | $ | 0.16 |   |
| Weighted average shares — basic             |       | 44,830                           |       | 47,948 |   |
| Weighted average  shares — diluted          |       | 45,485                           |       | 49,047 |   |

 

See accompanyingnotes.

4

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**Websense, Inc.** Consolidated Statement of Stockholders’ Equity (Unaudited and in thousands)

 
| ** **                                                                                                                | ** ** | ** **       | ** ** | ** **  | ** ** | ** **     | ** ** | ** **   | ** ** | ** **   | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|-------------|------------|----------------|------------|--------------|------------|--------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                                                | ** ** | ** **       | ** ** | ** **  | ** ** | ** **     | ** ** | ** **   | ** ** | ** **   | ** ** | **other**              | ** ** | ** ** | ** ** |
| ** **                                                                                                                | ** ** | ** **       | ** ** | ** **  | ** ** | **Additional** | ** ** | ** **   | ** ** | ** **   | ** ** | **comprehensive**      | ** ** | **Total**  | ** ** |
| ** **                                                                                                                | ** ** | **Common stock** | ** ** | **paid-in** | ** ** | **Treasury**   | ** ** | **Retained** | ** ** | **income**   | ** ** | **stockholders’** | ** ** |
| ** **                                                                                                                | ** ** | **Shares**       | ** ** | **Amount**  | ** ** | **capital**    | ** ** | **stock**    | ** ** | **earnings** | ** ** | **(loss)**             | ** ** | **equity** | ** ** |
| Balance at  December 31, 2006                                                                                             |       | 44,785           |       | $           | 509        |           | $          | 237,302      |       | $            | (139,744   | )                      | $          | 82,748     |       | $ | (90 | ) | $ | 180,725 |   |
| Cumulative impact  of change in accounting for uncertainties in income taxes — upon adoption of  FIN 48 (see note 8) |       | —           |       | —      |       | (858           | )          | —       |       | (376         | )          | —                 |       | (1,234     | )          |
| Balance at  January 1, 2007 upon adoption of FIN 48                                                                       |       | 44,785           |       | 509         |       | 236,444        |       | (139,744     | )          | 82,372       |       | (90                    | )          | 179,491    |       |
| Issuance of common stock upon exercise of options                                                                         |       | 78               |       | 2           |       | 860            |       | —       |       | —       |       | —                 |       | 862        |       |
| Issuance of common stock from restricted stock units                                                                      |       | 24               |       | —      |       | —         |       | —       |       | —       |       | —                 |       | —     |       |
| Share-based compensation expense                                                                                          |       | —           |       | —      |       | 5,222          |       | —       |       | —       |       | —                 |       | 5,222      |       |
| Excess tax benefit of share-based compensation                                                                            |       | —           |       | —      |       | 224            |       | —       |       | —       |       | —                 |       | 224        |       |
| Net income                                                                                                                |       | —           |       | —      |       | —         |       | —       |       | 3,867        |       | —                 |       | 3,867      |       |
| Net change in unrealized gain on marketable  securities, net of tax                                                       |       | —           |       | —      |       | —         |       | —       |       | —       |       | 36                     |       | 36         |       |
| Net change in unrealized gain on fair market  valuation of foreign currency contracts, net of tax                         |       | —           |       | —      |       | —         |       | —       |       | —       |       | 6                      |       | 6          |       |
| Comprehensive income                                                                                                      |       |             |       |        |       |           |       |         |       |         |       |                   |       | 3,909      |       |
| Balance at March 31,  2007                                                                                                |       | 44,887           |       | $           | 511        |           | $          | 242,750      |       | $            | (139,744   | )                      | $          | 86,239     |       | $ | (48 | ) | 189,708 |   |
|                                                                                                                           |            |                  |            |             |            |                |            |              |            |              |            |                        |            |            |            |  |  |  |  |  |  |

 

See accompanying notes.

5

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**Websense, Inc.Consolidated Statements of Cash Flows(Unaudited and in thousands)**
| ** **                                                                                   | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                   | ** ** | **March 31,**               | ** ** | **March 31,** | ** ** |
| ** **                                                                                   | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| **Operating  activities:**                                                                   |       |                             |       |   |   |
| Net income                                                                                   |       | $                                | 3,867      |   | $ | 7,944 |   |
|                                                                                         |       |                             |       |   |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:           |       |                             |       |   |   |
| Depreciation                                                                                 |       | 1,082                            |       | 761 |   |
| Write-off of in-process research and development                                             |       | 1,270                            |       | — |   |
| Amortization of intangible assets                                                            |       | 880                              |       | — |   |
| Share-based compensation                                                                     |       | 5,222                            |       | 4,740 |   |
| Deferred revenue                                                                             |       | (6,899                           | )          | (108 | ) |
| Deferred income taxes                                                                        |       | (1,119                           | )          | (3,550 | ) |
| Unrealized gain on foreign exchange contracts                                                |       | 6                                |       | 59 |   |
| Excess tax benefit from share-based compensation                                             |       | (224                             | )          | (1,583 | ) |
| Changes in operating assets and liabilities, net of  effects from purchase of PortAuthority: |       |                             |       |   |   |
| Accounts receivable                                                                          |       | 16,609                           |       | 20,205 |   |
| Prepaid income taxes                                                                         |       | (113                             | )          | (8 | ) |
| Other current assets                                                                         |       | (1,942                           | )          | 26 |   |
| Deposits and other assets                                                                    |       | (437                             | )          | (24 | ) |
| Accounts payable                                                                             |       | (935                             | )          | (821 | ) |
| Accrued payroll and related benefits                                                         |       | (1,687                           | )          | (844 | ) |
| Other accrued expenses                                                                       |       | 2,023                            |       | 1,080 |   |
| Income taxes payable                                                                         |       | 3,665                            |       | 4,837 |   |
| Net cash  provided by operating activities                                                   |       | 21,268                           |       | 32,714 |   |
| ** **                                                                                   |       |                             |       |   |   |
| **Investing  activities:**                                                                   |       |                             |       |   |   |
| Cash paid to  acquire PortAuthority, net of cash acquired                                    |       | (81,967                          | )          | — |   |
| Purchases of  property and equipment                                                         |       | (1,753                           | )          | (1,277 | ) |
| Purchases of  marketable securities                                                          |       | (168,417                         | )          | (233,277 | ) |
| Maturities of  marketable securities                                                         |       | 177,712                          |       | 164,345 |   |
| Net cash used in  investing activities                                                       |       | (74,425                          | )          | (70,209 | ) |
| ** **                                                                                   |       |                             |       |   |   |
| **Financing  activities:**                                                                   |       |                             |       |   |   |
| Proceeds from  exercise of stock options                                                     |       | 862                              |       | 3,678 |   |
| Repayment of  PortAuthority loan                                                             |       | (4,214                           | )          | — |   |
| Excess tax  benefit from share-based compensation                                            |       | 224                              |       | 1,583 |   |
| Purchases of  treasury stock                                                                 |       | —                           |       | (8,904 | ) |
| Net cash used in  financing activities                                                       |       | (3,128                           | )          | (3,643 | ) |
|                                                                                         |       |                             |       |   |   |
| Decrease in cash  and cash equivalents                                                       |       | (56,285                          | )          | (41,138 | ) |
|                                                                                         |       |                             |       |   |   |
| Cash and cash  equivalents at beginning of period                                            |       | 83,523                           |       | 61,629 |   |
|                                                                                         |       |                             |       |   |   |
| Cash and cash  equivalents at end of period                                                  |       | $                                | 27,238     |   | $ | 20,491 |   |
| ** **                                                                                   |       |                             |       |   |   |
| **Supplemental  cash flow information:**                                                     |       |                             |       |   |   |
| Income taxes  paid                                                                           |       | $                                | 192        |   | $ | 195 |   |
| Unrealized gain on  marketable securities                                                    |       | $                                | 36         |   | $ | 179 |   |

 

See accompanying notes.

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**Websense,Inc.**

**Notes ToConsolidated Financial Statements (Unaudited)**

1. *Basis of Presentation*

The accompanyingunaudited consolidated financial statements have been prepared in conformitywith accounting principles generally accepted in the United States for interimfinancial statements and with the instructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, certain information or footnote disclosuresnormally included in complete financial statements prepared in accordance withaccounting principles generally accepted in the United States have beencondensed or omitted pursuant to the rules and regulations of the Securitiesand Exchange Commission. In the opinion of management, the statements includeall adjustments necessary, which are of a normal and recurring nature, for thefair presentation of our financial position and of the results for the interimperiods presented.

These financialstatements should be read in conjunction with the audited consolidatedfinancial statements and notes thereto for the year ended December 31, 2006,included in Websense, Inc.’s (Websense or the Company) Annual Report on Form10-K filed with the Securities and Exchange Commission. Operating results forthe three months ended March 31, 2007 are not necessarily indicative of theresults that may be expected for any other interim period or for the yearending December 31, 2007. The balance sheet at December 31, 2006 has beenderived from the audited financial statements at that date but does not includeall of the information and footnotes required by accounting principlesgenerally accepted in the United States for complete financial statements.

2. *Net Income Per Share*

Websense computes net income per share as permitted by the FinancialAccounting Standards Board (FASB) with Statement of Financial AccountingStandards (SFAS) No. 128, *Earnings Per Share*(EPS) (SFAS No. 128). Under the provisions of SFAS No. 128, basic netincome per share is computed by dividing the net income for the period by theweighted average number of common shares outstanding during the period. Dilutednet income per share is computed by dividing the net income for the period bythe weighted average number of common and common equivalent shares outstandingduring the period. Common equivalent shares consist of dilutive stock optionsand restricted stock units for 2007 and 2006. Dilutive securities include bothdilutive stock options and dilutive restricted stock units and are calculatedbased on the average share price for each fiscal period using the treasurystock method.

During the three monthsended March 31, 2007 and 2006, the difference between the weighted averageshares used in determining basic EPS versus diluted EPS related to dilutivesecurities totaling 655,000 and 1,099,000 shares, respectively. Potentiallydilutive securities totaling 5,378,000 and 3,367,000 shares for the threemonths ended March 31, 2007 and 2006, respectively, were excluded fromhistorical basic and diluted earnings per share because of their anti-dilutiveeffect.

 

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The following is areconciliation of the numerator and denominator used in calculating basic EPSto the numerator and denominator used in calculating diluted EPS for allperiods presented:
| ** **                      | ** ** | **Net Income**                                                   | ** ** | **Shares**        | ** ** | **Per Share** | ** ** |
|---------------------------------|------------|-----------------------------------------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                      | ** ** | **(Numerator)**                                                       | ** ** | **(Denominator)** | ** ** | **Amount**         | ** ** |
| ** **                      | ** ** | **(In thousands, except per share amounts)** | ** ** |
| **For the Three Months Ended:** | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| **March 31, 2007:**             | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| Basic EPS                       |       | $                                                                     | 3,867      |              | 44,830     |               | $          | 0.09 |   |
| Effect of  options              |       | —                                                                |       | 655               |       | (0.00              | )          |
| Diluted EPS                     |       | $                                                                     | 3,867      |              | 45,485     |               | $          | 0.09 |   |
| ** **                      | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| **March 31, 2006:**             | ** ** | ** **                                                            | ** ** | ** **        | ** ** | ** **         | ** ** |
| Basic EPS                       |       | $                                                                     | 7,944      |              | 47,948     |               | $          | 0.17 |   |
| Effect of  options              |       | —                                                                |       | 1,099             |       | (0.01              | )          |
| Diluted EPS                     |       | $                                                                     | 7,944      |              | 49,047     |               | $          | 0.16 |   |

 

3. *Comprehensive Income*

The components ofcomprehensive income, as required to be reported by SFAS No. 130, *Reporting Comprehensive Income*, were as follows (inthousands):

|                                                                                                    | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                         | ** ** | **March 31, 2007**     | ** ** | **March 31, 2006** | ** ** |
| Net income                                                                                         |       | $                                | 3,867      |   | $ | 7,944 |   |
| Net change in  unrealized gain on marketable securities, net of tax                                |       | 36                               |       | 179 |   |
| Net change in  unrealized gain on fair market valuation of foreign currency contracts, net  of tax |       | 6                                |       | 59 |   |
| Comprehensive income                                                                               |       | $                                | 3,909      |   | $ | 8,182 |   |

 

4.*Stockholders’ Equity*

**Share-Based Compensation**

*Employee Stock PurchasePlan*

Sharesavailable for issuance under the Company’s Employee Stock Purchase Plan are asfollows:

|                                                                                                | ** ** | **Number of   Shares** | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| Shares reserved for  issuance at December 31, 2006                                             |       | 1,483,241                        |       |
| Shares reserved for  issuance during 2007 based on the automatic increase in shares authorized |       | 447,845                          |       |
| Shares reserved for issuance at March 31, 2007                                                 |       | 1,931,086                        |       |

 

*Employee Stock Option Plan*

The Amended and Restated2000 Stock Incentive Plan (the 2000 Plan) provides for the grant of stockoptions to the Company’s directors, officers, employees and consultants. The2000 Plan provides for the grant of incentive and non-statutory stock options,restricted stock units and rights to purchase stock to employees, directors orconsultants of the Company. The 2000 Plan provides that incentive stock optionswill be granted only to employees and are subject to certain limitations as tofair value during a calendar year.  Todate, only non-statutory stock options and restricted stock units have beengranted under the 2000 Plan. Through March 31, 2007, the Company has granted 120,000restricted stock units.

8

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The unvestedrestricted stock units have a weighted average grant date fair value of $28.69and an aggregate intrinsic value (the amount by which the fair value exceedsthe award price) of $2.2 million as of March 31, 2007.

In addition, the 2000 Plan provides for automatic annual increases inthe number of shares authorized and reserved for issuance thereunder equal tothe lesser of (i) 4% of the Company’s outstanding shares on the last businessday in December of the calendar year immediately preceding or (ii) 3,000,000shares. At March 31, 2007, a total of 21,349,542 shares have been authorizedfor issuance under the 2000 Plan, of which 1,941,761 remain available forgrant.

On January 8, 2007, the Compensation Committee of Websense’sBoard of Directors adopted the Websense, Inc. 2007 Stock Incentive AssumptionPlan (the 2007 Plan).  In connection withthe acquisition of PortAuthority, the Company agreed to substitute unvestedstock options to purchase PortAuthority common stock that were granted underPortAuthority’s 2004 Global Share Option Plan (the PortAuthority Option Plan)and outstanding immediately prior to the effective time of the acquisition withoptions to purchase an aggregate of 74,891 shares of Websense common stock (theSubstitute Options).  The SubstituteOptions have the same contractual lives and vesting periods as they did underthe PortAuthority Option Plan.  The numberof shares and exercise prices of the Substitute Options were determined basedon the conversion ratio as defined by the merger agreement with PortAuthority.

The results for the threemonths ended March 31, 2007 and 2006 include share-based compensation expense(excluding tax effects) of $5.2 million and $4.7 million, respectively, in thefollowing expense categories of the consolidated statement of income (inthousands).

|                                                       | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                            | ** ** | **March 31, 2007**     | ** ** | **March 31, 2006** | ** ** |
| Share-based  compensation in:                         |       |                             |       |   |   |
| Cost of revenues                                      |       | $                                | 329        |   | $ | 326 |   |
| Total share-based  compensation in cost of revenues   |       | 329                              |       | 326 |   |
|                                                  |       |                             |       |   |   |
| Selling and  marketing                                |       | 2,013                            |       | 1,951 |   |
| Research and  development                             |       | 932                              |       | 841 |   |
| General and  administrative                           |       | 1,948                            |       | 1,622 |   |
| Total  share-based compensation in operating expenses |       | 4,893                            |       | 4,414 |   |
| Total share-based compensation                        |       | $                                | 5,222      |   | $ | 4,740 |   |

 

TheCompany used the following assumptions to estimate the fair value of stockoptions granted under the 2000 plan: 

|                                     | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|
| ** **                          | ** ** | **March 31, 2007**     | ** ** | **March 31, 2006** | ** ** |
| Average expected life  (years)      |       | 3.0                              |       | 4.6 |   |
| Average expected  volatility factor |       | 35.9                             | %          | 59.4 | % |
| Average risk-free  interest rate    |       | 4.7                              | %          | 4.6 | % |
| Average expected dividend yield     |       | —                           |       | — |   |

 

The Company used the followingassumptions to estimate the fair value of the options granted under the 2007Plan: 

|                                     | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|
| ** **                          | ** ** | **March 31, 2007**          | ** ** |
| Average expected life  (years)      |       | 5.5                              |       |
| Average expected  volatility factor |       | 55.7                             | %          |
| Average risk-free  interest rate    |       | 4.7                              | %          |
| Average expected dividend yield     |       | —                           |       |

 

** **

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**Treasury Stock**

As of March 31, 2007, the Company had repurchased8,170,060 shares of its common stock since April 2003 under the Board ofDirectors’ authorized stock repurchase program, for an aggregate of $170.4million at an average price of $20.86 per share.  Remaining shares authorized for repurchaseunder the Company’s stock repurchase program as of March 31, 2007 are asfollows:

|                                            | ** ** | **March 31, 2007** | ** ** |
|--------------------------------------------|------------|------------------------------|------------|
| Shares authorized for  stock repurchase    |       | 12,000,000                   |       |
| Shares repurchased to  date                |       | 8,170,060                    |       |
| Remaining shares authorized for repurchase |       | 3,829,940                    |       |

 

5. *Acquisition - PortAuthority*

On January 8, 2007, theCompany acquired all of the outstanding stock of PortAuthority Technologies Inc.,a provider of information leak prevention technology.  The Company acquired PortAuthority to combinethe two companies’ technologies to help customers prevent unauthorized use ordisclosure of confidential data while simultaneously protecting users and datafrom external malicious threats.  TheCompany expects to benefit from the acquisition by expanding its currentproduct offerings and increasing its revenues.  These are among thefactors that contributed to a purchase price for the PortAuthority acquisitionthat resulted in the recognition of goodwill of $73.4 million. PortAuthority’soperations were assumed as of the date of the acquisition and are included inthe Company’s results of operations beginning on January 9, 2007 and, as aresult, are not reflected in the Company’s results of operations for the threemonths ended March 31, 2006.

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

The total purchase priceof the acquisition was as follows (in thousands):

| Cash paid for PortAuthority  business |   | $     | 88,170 |   |
|---------------------------------------|--------|-------|--------|--------|
| Estimated transaction  costs          |   | 1,875 |   |
| Total estimated purchase price        |   | $     | 90,045 |   |

 

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

The total purchase pricehas been allocated as follows based on the assets and liabilities acquired asof January 8, 2007 (in thousands):
| Fair value of net  tangible assets acquired and liabilities assumed: |   |   |   |   |   |
|----------------------------------------------------------------------|--------|--------|--------|--------|--------|
| Cash and cash  equivalents                                           |   | $      | 8,078  |   |   |   |
| Other assets                                                         |   | 2,696  |   |   |   |
| Other  liabilities                                                   |   | (5,875 | )      |   |   |
| Long-term loan                                                       |   | (4,214 | )      |   |   |
|                                                                 |   |   |   | 685    |   |
| Fair value of  identifiable intangible assets acquired:              |   |   |   |   |   |
| Technology                                                           |   | 12,700 |   |   |   |
| Non-compete  agreements                                              |   | 800    |   |   |   |
| Customer  relationships                                              |   | 700    |   |   |   |
| Trade name                                                           |   | 510    |   |   |   |
|                                                                 |   |   |   | 14,710 |   |
| In-process research and  development                                 |   |   |   | 1,270  |   |
| Goodwill                                                             |   |   |   | 73,380 |   |
| Total purchase price                                                 |   |   |   | $      | 90,045 |   |
|                                                                 |   |   |   |   |   |
|                                                                      |        |        |        |        |        |  |  |

 

 

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

The amount allocated toin-process technology represents the fair value of an acquired, to-be-completedresearch project. The estimated value of approximately $1.3 million of theresearch project was determined by estimating the costs to develop the acquiredtechnology into a commercially viable product, estimating the future net cashflows from the project once commercially viable, and discounting the net cashflows to their present value. As of the acquisition date, this project was notexpected to have reached technological feasibility and will have no alternativefuture use. Accordingly, the amount allocated to in-process technology wascharged to Websense’s statement of income for the three months ended March 31,2007.

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

|                       | ** ** | **Three Months Ended** | ** ** |
|-----------------------|------------|----------------------------------|------------|
| ** **            | ** ** | **March 31, 2007**     | ** ** | **March 31, 2006** | ** ** |
| Revenue               |       | $                                | 49,747     |   | $ | 42,136 |   |
| Net Income            |       | $                                | 3,761      |   | $ | 5,541 |   |
| Net income per share: |       |                             |       |   |   |
| Basic                 |       | $                                | 0.08       |   | $ | 0.12 |   |
| Diluted               |       | $                                | 0.08       |   | $ | 0.11 |   |

 

The above pro formaunaudited results of operations do not include pro forma adjustments relatingto costs of integration or post-integration cost reductions that may beincurred or realized by the Company in excess of actual amounts incurred orrealized through March 31, 2007.

6. *Goodwill and  Intangible Assets*

As ofMarch 31, 2007, the Company’s goodwill balance of $73.4 million solelyrelates to the Company’s acquisition of PortAuthority on January 8, 2007.  The Company did not have any goodwill orintangible assets at March 31, 2006.

The Company recordsgoodwill when the purchase price of net tangible and intangible assets acquiredexceeds their fair value. In accordance with SFAS 142, *“Goodwill and Other Intangible Assets,”*the Company reviews goodwill that has an infinite useful life for impairment atleast annually in its fourth fiscal quarter, or more frequently if an eventoccurs indicating the potential for impairment. Intangible assets are carriedat cost less accumulated amortization. The Company amortizes the cost ofidentified intangible assets on a straight-line basis over their expectedeconomic lives. In accordance with SFAS 144, “*Accountingfor the Impairment or Disposal of Long-Lived Assets*,” the Companyreviews intangible assets that have finite useful lives when an event occursindicating the potential for impairment.

The Company reviews forimpairment by facts or circumstances, either internal or external, indicatingthat it may not recover the carrying value of the asset. The Company measuresimpairment losses related to long-lived assets based on the amount by which thecarrying amounts of these assets exceed their fair values.  The Company measures fair value under SFAS144, which is generally based on the present value of estimated futurediscounted cash flows. The Company’s analysis is based on available informationand on assumptions and projections it considers to be reasonable andsupportable. The discounted cash flow analysis considers the likelihood ofpossible outcomes and is based on the Company’s best estimate of projectedfuture cash flows. If necessary, the Company performs subsequent calculationsto measure the amount of the impairment loss based on the excess of thecarrying value over the fair value of the impaired assets.

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Intangible assets,subject to amortization, were as follows as of March 31, 2007 (inthousands):

|                        | ** ** | **Weighted  Average  Life  (years)** | ** ** | **Cost** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|------------------------|------------|--------------------------------------|------------|----------|------------|-------------------------------|------------|---------|------------|
|                   |       |                                 |       |     |       |                          |       |    |       |
| Technology             |       | 5.7                                  |       | $        | 13,900     |                          | $          | (762    | )          | $ | 13,138 |   |
| Non-compete agreements |       | 1                                    |       | 800      |       | (200                          | )          | 600     |       |
| Customer relationships |       | 7                                    |       | 700      |       | (25                           | )          | 675     |       |
| Trade name             |       | 5                                    |       | 510      |       | (26                           | )          | 484     |       |
| Total                  |       |                                 |       | $        | 15,910     |                          | $          | (1,013  | )          | $ | 14,897 |   |

 

Amortization expense, asof March 31, 2007, is expected to be as follows (in thousands):

| Years Ending December 31: | ** ** | ** ** | ** ** | ** ** |   |
|------------------------------------------|------------|------------|------------|------------|--------|
| 2007                                     |       | $          | 2,639      |       |
| 2008                                     |       | 2,719      |       |
| 2009                                     |       | 2,585      |       |
| 2010                                     |       | 2,319      |       |
| 2011                                     |       | 2,319      |       |
| Thereafter                               |       | 2,316      |       |
| Total expected  amortization expense     |       | $          | 14,897     |       |

 

7.*Foreign Currency Hedges*

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

During the three months ended March 31, 2007 and 2006, the Company utilized Euro foreign currency forward contracts to hedge anticipated Euro denominated accounts receivable. All such contracts entered into were designated as fair value hedges and were not required to be tested for effectiveness as hedge accounting was not elected. None of the contracts were terminated prior to settlement. Net realized losses related to the contracts designated as fair value hedges settled during 2007 and 2006 are included in other income, net, in the accompanying consolidated income statements and amounted to approximately $85,000  and $47,000 for the three months ended March 31, 2007 and 2006, respectively.

During the three months ended March 31, 2007 and 2006, the Company utilized British Pound zero-cost collar contracts to hedge anticipated operating expenses. All such contracts entered into were designated as cash flow hedges and were considered effective as defined by SFAS No. 133,*Accounting for Derivative Instruments and Hedging Activities* (SFAS No. 133), as amended. None of the contracts were terminated prior to settlement. Net realized losses related to the contracts designated as cash flow hedges settled during the first quarters of 2007 and 2006 are included in the respective operating categories the Company hedges its British Pound expenditures against. These net realized losses amounted to approximately $23,000 and $20,000 for the three months ended March 31, 2007 and 2006, respectively.

Notional and fair values of the Company’s hedging position at March 31, 2007 and 2006 are presented in the table below (in thousands):
| ** **    | ** ** | **March 31, 2007**         | ** ** | **March 31, 2006** | ** ** |
|---------------|------------|--------------------------------------|------------|------------------------------|------------|
| ** **    | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD**     | ** ** | **Fair Value  USD** | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD** | ** ** | **Fair Value  USD** | ** ** |
| Euro          |       | €                               | 2,000      |                         | $          | 2,627 |   | $ | 2,577 |   | € | 2,350 |   | $ | 2,835 |   | $ | 2,819 |   |
| British Pound |       | £                               | 1,200      |                         | 2,356      |   | 2,351 |   | £ | 2,550 |   | 4,494 |   | 4,453 |   |
| Total         |       |                                 |       | $                            | 4,983      |   | $ | 4,928 |   |   |   | $ | 7,329 |   | $ | 7,272 |   |

 

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Euroforward contracts at March 31, 2007 and 2006 were designated as fair valuehedges and were not required to be tested for effectiveness as hedge accountingwas not selected. All Euro contracts will be settled before June 30, 2007.Realized gains or losses related to the settlements, if any, will be recordedin other income, net at the time of settlement.

AllBritish Pound contracts were designated as cash flow hedges and were determinedeffective as of March 31, 2007 and 2006. All British Pound contracts will besettled before June 30, 2007. Realized gains and losses related to thesettlements, if any, will be recorded in the respective operating categoriesthe Company hedges its British Pound expenditures against.

8. *Tax Matters*

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

Estimated interest and penalties related to theunderpayment of income taxes are classified as a component of Provision forIncome Taxes in the Consolidated Statements of Income and totaled $51,000 inthe quarter ended March 31, 2007. Accrued interest and penalties were $0.4million as of January 1, 2007.

TheCompany and its subsidiaries are subject to U.S. federal income tax as well asincome tax of multiple state and foreign jurisdictions. The Company hassubstantially concluded all U.S. federal and state income tax audits for yearsthrough 2002. Substantially all material foreign income tax audits have beenconcluded for years through 2002. California income tax returns for 2003 and2004 are currently under examination. The Company does not anticipate thattotal unrecognized tax benefits will significantly change due to the settlementof audits and the expiration of statute of limitations prior to March 31,2008.  At March 31, 2007, the Company haddeferred tax assets of $34.8 million.

TheCompany has requested a ruling regarding unrecognized state income taxbenefits. It is reasonably possible within 12 months of the reporting date thatthe uncertain tax position established for the 2006 tax year could be decidedin the Company’s favor resulting in the reduction of the gross uncertain taxliability in an amount up to $1.7 million.

*9.Litigation*

OnSeptember 29, 2006, Jason Tauber filed a purported class action againstthe Company and other unidentified individuals in California Superior Court forthe County of San Diego, captioned Tauber v. Websense. The complaint allegesthat the plaintiff and a putative class of certain software engineers andcomputer professionals who worked for the Company as exempt employees duringthe period from September 15, 2002 through the present should have beenclassified as non-exempt employees under California law and should have beenpaid for overtime. The complaint also alleges related wage and hour violationsof the California Labor Code arising from the alleged misclassification andthat the failure to pay overtime constitutes an unfair business practice underCalifornia Business and Professions Code § 17200. The complaint seeksunspecified damages for unpaid overtime, prejudgment interest, attorneys’ feesand other costs, statutory penalties for alleged violations, and other properrelief. The Company denies all material allegations and intends to defend theaction vigorously.

TheCompany is involved in various legal actions in the normal course of business.Based on current information, including consultation with the Company’slawyers, the Company believes that any ultimate liability that may result fromthese actions, including Tauber v. Websense, would not materially affect theCompany’s consolidated financial positions, results of operation or cash flows.The Company’s evaluation of the likely impact of these actions could change inthe future and unfavorable outcomes and/or defense costs, depending upon theamount and timing, could have a material adverse effect on the Company’sresults of operations or cash flows in a future period.

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10. *Recently Issued Accounting Standards*

In September 2006, the FASBissued SFAS No. 157 *FairValue Measurement* (SFAS No. 157), which provides guidance forusing fair value to measure assets and liabilities. In addition, SFASNo. 157 also provides guidance for expanded information about the extentto which companies measure assets and liabilities at fair value, theinformation used to measure fair value, and the effect of fair valuemeasurements on earnings. SFAS No. 157 applies whenever other standardsrequire (or permit) assets or liabilities to be measured at fair value, butdoes not expand the use of fair value in any new circumstances. The accountingprovisions of SFAS No. 157 will be effective for the Company beginningJanuary 1, 2008. The Company is in the process of determining the effectthe adoption of SFAS No. 157 will have on its financial statements.

In February 2007, the FASB issued SFASNo. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities—Including an Amendment of FASBStatement No. 115(SFAS No. 159).* This standard permits anentity to choose to measure many financial instruments and certain other itemsat fair value. Most of the provisions in SFAS No. 159 are elective;however, the amendment to SFAS No. 115, *Accountingfor Certain Investments in Debt and Equity Securities,* applies toall entities with available-for-sale and trading securities. The fair valueoption established by SFAS No. 159 permits all entities to choose tomeasure eligible items at fair value at specified election dates. A businessentity will report unrealized gains and losses on items for which the fairvalue option has been elected in earnings at each subsequent reporting date.The fair value option: (a) may be applied instrument by instrument, with afew exceptions, such as investments otherwise accounted for by the equitymethod; (b) is irrevocable (unless a new election date occurs); and(c) is applied only to entire instruments and not to portions ofinstruments. The accounting provisions of SFAS No. 159 will be effectivefor the Company beginning January 1, 2008. The Company is in the processof determining the effect the adoption of SFAS No. 159 will have on itsfinancial statements.

11. *Subsequent event*

TheCompany announced on April 26, 2007 that it has made a pre-conditional cashoffer to acquire all of the issued and to-be-issued ordinary shares, excludingtreasury shares, of SurfControl plc, a provider of on-demand and software-basedWeb and email security solutions.  Underthe terms of the proposal, SurfControl shareholders will receive 700 pence(approximately $14) in cash for each SurfControl share.  The proposal values SurfControl’s existingissued share capital at approximately £201 million (approximately $400million).  The Company is obligated topay the purchase price in British Pounds and has purchased a currency hedgeagainst £244 million at $2.10 for 15 months, corresponding to the funds certainperiod under the credit facilities described below and the long stop date underthe transaction agreement with SurfControl.

Thetransaction is expected to close approximately four months following regulatoryapproval by United States (US) and United Kingdom (UK) agencies.  The transaction is expected to be financedthrough a combination of the Company’s cash resources at the close of thetransaction and the new senior credit facility. The transaction, which has been unanimously approved by the boards ofboth companies, is subject to the conditions and the satisfaction or waiver ofthe Pre-Conditions which relate to the obtaining of regulatory clearances fromthe relevant UK and US regulatory authorities.* *As of March 31, 2007, the Companyhas incurred approximately $1.8 million of transaction costs in connection withthis offer, which are reflected in the deposits and other assets and otheraccrued expenses line items on the Company’s consolidated balance sheet.

**Inconnection with the SurfControl announcement, the Company entered into anagreement with Morgan Stanley Senior Funding Inc. and Bank of America, NationalAssociation, for a $300 million senior credit facility.  The senior facility will consist of up to a$285 million six-year term loan and a $15 million revolving creditfacility.  The Company currently expectsto borrow approximately $180 million to $200 million of the available seniorcredit facility at the closing of the acquisition.  The senior credit facility is only availablefor funding the acquisition and related transaction costs.  At funding, the senior credit facility willbe secured by substantially all of the Company’s assets, including pledges ofthe Company’s first tier subsidiaries’ stock (except for limits on the stockpledges of foreign subsidiaries) and will be guaranteed by the Company’sdomestic subsidiaries.  Loans made underthe term loan amortize at 1.0% per year for years one through five, with theremaining 95% due in the sixth year of the agreement.  The Company is required to use up to 50% ofexcess cash flow to make mandatory prepayments of principal, which are notsubject to any prepayment penalties.  TheCompany will have the option to borrow at prime rate or at a Eurodollar base rateplus, in each case, an applicable margin based on the Company’s corporatecredit rating at the time of funding. The senior credit facility contains financial covenants, as defined perthe senior credit agreement, comprised of a consolidated leverage ratio and aconsolidated interest coverage ratio. The senior credit agreement also contains affirmative and negativecovenants.  In addition, the Company hasentered into an interim credit facility with the same lenders that iscollateralized by $217 million of the Company’s cash, cash equivalents andmarketable securities that are deposited in restricted accounts and notavailable to the Company for any other uses while the**

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**acquisition of SurfControl ispending.  The Company expects to use therestricted funds to pay for a portion of the purchase price ofSurfControl.  The interim credit facilitywas entered into as part of a funds certain process for cash acquisitions of UKpublic companies that are subject to the City Code.  Under the City Code, Morgan Stanley asfinancial adviser has indicated that it is satisfied that sufficient financialresources will be made available to the Company to satisfy the maximum cashconsideration that would be payable under the terms of the proposal.  The Company does not expect to borrow anyamounts under the interim credit agreement.**

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

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

**ForwardLooking Statements**

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

·                  anticipatedtrends in revenue;

·                  growthopportunities in domestic and international markets;

·                  new and enhancedchannels of distribution;

·                  customeracceptance and satisfaction with our products;

·                  expected trendsin operating and other expenses;

·                  anticipated cashand intentions regarding usage of cash;

·                  changes ineffective tax rates; and

·                  anticipatedproduct enhancements or releases.

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

**Overview**

Our products help organizations manage their networksand computing resources to provide a secure and productive computingenvironment. We provide Web filtering and Web security software products thatenable organizations to protect employees and confidential information fromexternal Web-based attacks such as spyware, and phishing, as well as analyze,report and manage how employees use computing resources and the Internet. In January 2007,we acquired our technology development partner for information leak preventionsolutions, PortAuthority Technologies Inc. (PortAuthority). As a result,in addition to our Web filtering and Web security software products, we offersoftware that helps prevent the loss of confidential information from internalthreats, such as ineffective business process controls, employee error andmalfeasance.

At the foundation of our Web filtering and Websecurity product offering is the Websense Enterprise® software application,which serves as a central policy engine and management and reporting platformfor our Web filtering and related add-on Web security products. WebsenseEnterprise gives organizations the ability to enhance network security, improveemployee productivity, mitigate potential legal liability and conserve networkbandwidth by allowing organizations to identify potential risk areas andimplement and automate Web access and application usage policies that reducethese risks. When combined with our Web security products that utilize ourThreatSeekerTM technology including Security Filtering, Remote Filtering andClient Policy ManagerTM, Websense Enterprise allows organizations to enhancenetwork and content security by blocking access to malicious Web sites andpreventing the transmission of data to known spyware destination sites. Tosimplify the purchase process for our value-added resellers and customers, wehave created a suite of Websense Enterprise and our most popular add-onsecurity products and services, known as the Websense® Web Security SuiteTM. Wecurrently derive a significant percentage of our revenue from subscriptions tothe Websense Enterprise-based solutions and expect this to continue in thefuture.

The Websense Content Protection Suite is an integratedinformation leak prevention solution that protects organizations frominformation leaks and data loss by discovering the location of sensitive datainside the network, monitoring the data as it attempts to travel inside oroutside the organization, and  protectingthe data, with policy-based controls that align to business processes.  The Content Protection Suite providesprotection for data at rest, data in use, and data in motion, and is availablewith two modules: the Content Auditor and the Content Enforcer.  Content Auditor is a proactive solution thatfinds sensitive 

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data in the network and identifies who is using it andhow it is being used.  Content Enforceradds the ability to enforce user-defined data security policies.  Sales of our newly acquired information leakprevention products and other products under development will comprise only avery small portion of our overall sales in 2007.

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

During the three months ended March 31, 2007, wederived 39% of revenue from international sales, compared with 35% for thethree months ended March 31, 2006, with the United Kingdom comprisingapproximately 10% of our total revenue in both years. We believe internationalmarkets continue to represent a significant growth opportunity and we arecontinuing to expand our international operations, particularly in selectedcountries in the European, Asia/Pacific and Latin American markets.  On April 26, 2007, we announced that we areacquiring  SurfControl plc (a Londonstock exchange listed company) through a pre-conditional cash offer to acquireall of the ordinary shares of SurfControl for 700 pence per share (or anaggregate of approximately $400 million based upon the current exchange rate)through a scheme of arrangement. SurfControl has substantial international operations, including in theUnited Kingdom, Australia, China and Israel and we expect the acquisition toaccelerate our international growth.

We sell Websense Enterprise through both indirectchannels and directly. Sales through indirect channels currently account formore than 85% of our revenue, and we plan to increase the percentage of ourrevenue obtained through indirect channels. Our strategy is to increase new andrenewal customer sales through independent software distributors and resellersand increase the focus of our internal sales and marketing force on supportingour channel strategy. In August 2006, we announced a new two-tier distributionstrategy in North America and entered into a relationship with Ingram Micro todistribute, market and support our Web security and Web filtering software inNorth America. Through joint marketing programs with Websense, Ingram Microwill focus its efforts on recruiting new resellers, especially resellersfocused on selling to small and medium-sized businesses (SMB), and on buildingawareness and demand within our existing North America channel partner base.

As described elsewhere in this report, we recognizerevenue from subscriptions to our products, including add-on modules, on adaily straight line basis commencing on the day the term of the subscriptionbegins, over the term of the subscription agreement. We recognize the operatingexpenses related to these sales as they are incurred. These operating expensesinclude sales commissions, which are based on the total amount of thesubscription contract and are fully expensed in the period the product isdelivered. Operating expenses have continued to increase as compared with priorperiods due to expanded selling and marketing efforts, continued productresearch and development and investments in administrative infrastructure tosupport subscription sales that we 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 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 WebsenseEnterprise and provided throughout the subscription term. We recognize revenueon a daily straight-line basis, commencing with the day the subscriptionbegins, over the term of the subscription agreement, provided collectibility isreasonably assured. Upon entering into a subscription arrangement for a fixedor determinable fee, we electronically deliver access codes to users and thenpromptly invoice customers for the full amount of their subscriptions. Paymentis due for the full term of the subscription, generally within 30 to 60 days ofthe invoice. Taxes invoiced, collected and remitted to governmental authoritiesare presented on a net basis in our consolidated statements of income. Werecord amounts billed to customers in excess of recognizable revenue asdeferred revenue on our balance sheet. Upon expiration of the subscription,customers who wish to re-subscribe typically must do so at the then currentrates to continue using our products. Our revenue is significantly influencedby new and renewal subscriptions, and a decrease in subscription amounts couldnegatively impact our future revenue.

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We record channel marketing payments and channelrebates as an offset to revenue. We recognize channel marketing payments as anoffset to revenue as the marketing service is provided. We recognize channelrebates as an offset to revenue on a straight-line basis over the term of thesubscription agreement.

***Goodwill and Intangible Assets.*** We record goodwill when the purchase price of net tangible andintangible assets we acquire exceeds their fair value. In accordance with SFAS142, “Goodwill and Other Intangible Assets,” we review goodwill that has aninfinite useful life for impairment at least annually in our fourth fiscalquarter, or more frequently if an event occurs indicating the potential forimpairment. Intangible assets are carried at cost, less accumulatedamortization. We amortize the cost of identified intangible assets on astraight-line basis over their expected economic lives. In accordance with SFAS144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” wereview intangible assets that have finite useful lives when an event occursindicating the potential for impairment.

**We reviewfor impairment by facts or circumstances, either internal or external,indicating that we may not recover the carrying value of the asset.  We measure impairment losses related tolong-lived assets based on the amount by which the carrying amounts of theseassets exceed their fair values.  Wemeasure fair value under SFAS 144, which is generally based on the presentvalue of estimated future discounted cash flows. Our analysis is based onavailable information and on assumptions and projections that we consider to bereasonable and supportable. The discounted cash flow analysis considers thelikelihood of possible outcomes and is based on our best estimate of projectedfuture cash flows. If necessary, we perform subsequent calculations to measurethe amount of the impairment loss based on the excess of the carrying valueover the fair value of the impaired assets.**

*Share-BasedCompensation.***OnJanuary 1, 2006, we adopted the provisions of Statement No. 123R and SAB No.107 requiring the measurement and recognition of all share-based compensationunder the fair value method.  Share-basedcompensation expense related to stock options is recorded based on the fairvalue of the award on its grant date which we estimate using the Black-Scholesvaluation model based on the provisions prescribed under Statement No. 123R andSAB No. 107.  Share-based compensationexpense related to restricted stock unit awards is calculated based on themarket price of our common stock on the grant date.

*Deferred Tax Assets.*   Asrequired by SFAS No. 109, we recognize tax assets on the balance sheet ifit is “more likely than not” that they will be realized on future tax returns.At March 31, 2007, we had deferred tax assets of $34.8 million. We believe thatit is more likely than not that our deferred tax assets will be realized.Factors considered by us included: our earnings history, projected earningsbased on current operations, and projected future taxable income. However,should we determine that we would not be able to realize all or part of ourdeferred tax assets in the future, an adjustment to the deferred tax assetswould be charged against income in the period such determination was made.

*IncomeTax Provision and Uncertain Tax Positions.*   Significantjudgment is required in determining our consolidated income tax provision andevaluating our U.S. and foreign tax positions. In July 2006, the FASB issuedInterpretation 48, *Accounting forUncertainty in Income Taxes* (FIN 48), which became effective for usbeginning in 2007. FIN 48 addressed the determination of how tax benefitsclaimed or expected to be claimed on a tax return should be recorded in thefinancial statements. Under FIN 48, we must recognize the tax benefit from anuncertain tax position only if it is more likely than not that the tax positionwill be sustained on examination by the taxing authorities, based on thetechnical merits of the position. The tax benefits recognized in the financialstatements from such a position are measured based on the largest benefit thathas a greater than fifty percent likelihood of being realized upon ultimateresolution. The impact of our reassessment of tax positions in accordance withFIN 48 did not have a material impact on the results of operations, financialcondition or liquidity.

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# **Results of Operations**

***Three months endedMarch 31, 2007 compared with the three months ended March 31, 2006***

The following table summarizes our operating resultsas a percentage of total revenue for each of the periods shown.
| ** **                                       | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|
| ** **                                       | ** ** | **March 31, 2007**     | ** ** | **March 31, 2006** | ** ** |
| ** **                                       | ** ** | **(Unaudited)**                  | ** ** |
| Revenue                                          |       | 100                              | %          | 100 | % |
|                                             |       |                             |       |   |   |
| Cost of revenues:                                |       |                             |       |   |   |
| Cost of revenues                                 |       | 8                                |       | 8 |   |
| Amortization of acquired technology              |       | 1                                |       | — |   |
| Total cost of revenues                           |       | 9                                |       | 8 |   |
|                                             |       |                             |       |   |   |
| Gross margin                                     |       | 91                               |       | 92 |   |
|                                             |       |                             |       |   |   |
| Operating  expenses:                             |       |                             |       |   |   |
| Selling and marketing                            |       | 50                               |       | 43 |   |
| Research and development                         |       | 14                               |       | 13 |   |
| General and administrative                       |       | 15                               |       | 12 |   |
| Write off of in-process research and development |       | 3                                |       | — |   |
| Total operating expenses                         |       | 82                               |       | 68 |   |
|                                             |       |                             |       |   |   |
| Income from  operations                          |       | 9                                |       | 24 |   |
|                                             |       |                             |       |   |   |
| Other income,  net                               |       | 5                                |       | 6 |   |
|                                             |       |                             |       |   |   |
| Income before  income taxes                      |       | 14                               |       | 30 |   |
|                                             |       |                             |       |   |   |
| Provision for  income taxes                      |       | 6                                |       | 11 |   |
|                                             |       |                             |       |   |   |
| Net income                                       |       | 8                                | %          | 19 | % |

 

# **Revenue**

Revenueincreased to $49.7 million in the first quarter of 2007, from $42.1 million inthe first quarter of 2006. The increase was primarily a result of the additionof new, renewed and upgraded subscriptions from our customers that resulted ina 1.5 million increase in the number of seats under subscription from March 31,2006 to March 31, 2007. As a percentage of subscription revenue, new businessincreased to 39% in the first quarter of 2007 from 33% in the first quarter of2006. We expect revenue to increase in the future as a result of our deferredrevenue under existing subscriptions, our renewal business, ourrecently-acquired information leak prevention business and expected worldwidegrowth and expected growth in SMB business, partially offset by increaseddistributor marketing payments and channel payments.

# **Cost of Revenues**

*Cost of revenues.* Cost ofrevenues consist of the costs of content review, technical support andinfrastructure costs associated with maintaining our databases. Cost ofrevenues, excluding amortization of acquired technology, increased to $4.0million in the first quarter of 2007 from $3.4 million in the first quarter of2006. The increase of $0.6 million was primarily due to additional personnel inour technical support and database groups, and allocated costs. We allocate thetotal costs for human resources, employee benefits, payroll taxes, informationtechnology, facilities, fixed asset depreciation and 

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legalcosts to each of our functional areas based on salaries and headcount data. Weexpect cost of revenues to increase in the future to support the growth andmaintenance of our databases as well as the technical support needs of ourcustomers. As a percentage of revenue, cost of revenues, excluding amortizationof acquired technology, remained the same during the first quarter of 2007 and2006.

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

# **Gross Margin**

Gross margin increased to $45.1 million in the firstquarter of 2007 from $38.7 million in the first quarter of 2006. The increasewas due to increased revenue. As a percentage of revenue, gross margindecreased to 91% in the first quarter of 2007 from 92% in the first quarter of2006 primarily due to the increased costs as described in the Costs of Revenuessection above.

# **Operating Expenses**

*Selling and marketing*.Selling and marketing expenses consist primarily of salaries, commissions andbenefits related to personnel engaged in selling, marketing and customersupport functions, including costs related to public relations, advertising,promotions and travel as well as allocated costs. Selling and marketingexpenses do not include payments to channel partners for marketing services andrebates.  Selling and marketing expensesincreased to $24.9 million, or 50% of revenue, in the first quarter of 2007,from $18.0 million, or 43% of revenue, in the first quarter of 2006. Theincrease in selling and marketing expenses of $6.9 million was primarily due toexpenses associated with our new channel strategy, increased personnel costsand related travel, including new personnel added from the PortAuthorityacquisition in January 2007, and allocated costs. We expect selling andmarketing expenses to increase in absolute dollars in the future as morepersonnel are added to support our expanding selling and marketing effortsworldwide, including for our recently acquired information leak preventionproducts from PortAuthority, and as increased sales result in higher overallsales commission expenses.

*Researchand development.* Researchand development expenses consist primarily of salaries and benefits forsoftware developers and allocated costs. Research and development expensesincreased to $7.1 million, or 14% of revenue, in the first quarter of 2007 from$5.4 million, or 13% of revenue, in the first quarter of 2006. The increase of$1.7 million in research and development expenses was  primarily due to increased personnel,including new personnel added from the PortAuthority acquisition in January2007, needed to support our expanding list of technology partners, theenhancements of Websense Enterprise including our new SMB products underdevelopment and additional products, enhancements to our new information leakprevention products and allocated costs. We expect research and developmentexpenses to increase in absolute dollars in the future due to our acquisitionof PortAuthority and its engineering team, and as more personnel are added tosupport our continued enhancements of our existing products and new products.

*General and administrative*.General and administrative expenses consist primarily of salaries, benefits andrelated expenses for our executive, finance, administrative personnel, thirdparty professional service fees, and allocated costs. General andadministrative expenses increased to $7.2 million, or 15% of revenue, in thefirst quarter of 2007 from $5.2 million, or 12% of revenue, in the firstquarter of 2006. The $2.0 million increase in general and administrativeexpenses was primarily due to additional personnel needed to support ourgrowing operations, including the acquisition of PortAuthority in January 2007,and allocated costs. We expect general and administrative expenses to increasein absolute dollars in the future periods due to our growth in operations,increasing expenses associated with being a public company and expansion of ourinternational operations.

*Write off of in-process research and development.*Write off of in-process research and development**representsthe fair value of an acquired, to be completed research project obtained fromthe PortAuthority acquisition that had not reached technological feasibility atthe acquisition date and is not expected to have an alternative futureuse.  Accordingly, the $1.3 million ofin-process research and development was charged to our statement of incomeduring the quarter ended March 31, 2007.

# **Other Income, Net**

Other income, net decreased to $2.4 million in thefirst quarter of 2007 from $2.6 million in the first quarter of 2006. 

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Thedecrease was primarily due to lower cash, cash equivalents and marketablesecurities balances during the first quarter of 2007 compared to the firstquarter of 2006, principally related to the acquisition of PortAuthority forapproximately $90 million in January 2007 and partially offset by higherinterest rates during the first quarter of 2007 compared to the first quarterof 2006. The majority of our investments of cash and cash equivalents andmarketable securities are tax-exempt.

In connection with our recently announced acquisitionof SurfControl, we entered into two new credit facilities with Morgan StanleySenior Funding and Bank of America, NA, including a $207 million interim creditfacility that was required to be entered into in order to satisfy the fundscertain requirement for cash takeovers of UK public companies.  The interim credit facility is collateralizedwith $217 million of our cash equivalents and marketable securities inrestricted accounts, and we expect to use these restricted funds to fund aportion of the purchase price of SurfControl. We will continue to earn income on the restricted funds until theclosing of the SurfControl acquisition. We expect that the majority of our cash, cash equivalents and marketablesecurities, including cash we continue to generate through operations, willcontinue to be held in tax-exempt investments during the foreseeable future.

# **Provision for Income Taxes**

In the first quarter of 2007, United States andforeign income tax expense was $3.2 million, compared to $4.7 million for thefirst quarter of 2006.  The effectiveincome tax rate increased to 45% in the first quarter of 2007 from 37% in thefirst quarter of 2006. The increase in the tax rate is primarily related to awrite-off in the current quarter of non-deductible in-process R&D acquiredin the Port Authority acquisition, less tax exempt interest income and highereffective state income tax rate. Our effective tax rate may change in futureperiods due to the composition of taxable income between domestic andinternational operations along with potential changes or interpretations in taxrules and legislation, or corresponding accounting rules. We expect theeffective income tax rate to decrease in the second quarter of 2007 compared tothe first quarter of 2007 due to the non-recurrence of the write-off ofnon-deductible in-process R&D.

**Liquidity and Capital Resources**

As of March 31, 2007, we had cash and cash equivalentsof $27.2 million, investments in marketable securities of $234.1 million andretained earnings of $86.2 million. As of December 31, 2006, we had cash andcash equivalents of $83.5 million, investments in marketable securities of$243.4 million and retained earnings of $82.7 million.

**Net cashprovided by operating activities was $21.3 million in the first three months of2007 compared with $32.7 million in the first three months of 2006. The $11.4million decrease in cash provided by operating activities was primarily due todecreased growth in deferred revenue as a result of higher growth in recognizedrevenue than growth in subscription amounts and increased accounts receivablesfrom sales of our products compared to the first three months of 2006. Ouroperating cash flow is significantly influenced by subscription renewals andaccounts receivable collections, and deferred revenue.  A decrease in subscription renewals or accountsreceivable collections, or a lower deferred revenue balance, would negativelyimpact our operating cash flow.**

Net cash used in investing activities was $74.4million in the first three months of 2007 compared with net cash used ininvesting activities of $70.2 million in the first three months of 2006. The$4.2 million increase of net cash used in investing activities was primarilydue to cash used to purchase PortAuthority in January 2007 partially offset bycash provided by the net of purchases and maturities of marketable securities.

Net cash used in financing activities was $3.1 millionin the first three months of 2007 compared with net cash used in financingactivities of $3.6 million in the first three months of 2006. The $0.5 milliondecrease of net cash used in financing activities was primarily due todecreased proceeds of $2.8 million for exercises of stock options, decreasedexcess tax benefit from share-based compensation of $1.4 million, repayment ofa $4.2 million loan acquired from PortAuthority offset by no purchases oftreasury stock during the three months ended March 31, 2007 (compared totreasury stock purchases totaling $8.9 million during the three months endedMarch 31, 2006).

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Wehave operating lease and software license commitments of approximately $19.9million as of March 31, 2007. A majority of our operating lease commitments arerelated to our corporate headquarters lease, which extends throughDecember 2013.  Our corporateheadquarters lease includes escalating rent payments from 2007 to 2013. Therent expense related to our worldwide office space leases are recorded monthlyon a straight-line basis in accordance with generally accepted accountingprinciples. Future minimum annual payments under non-cancelable operating leasesand software license agreements at March 31, 2007 are as follows (inthousands):
| **Years Ending December 31:** | ** ** | **Operating  Leases** | ** ** | **Software License** | ** ** | **Total** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|---------------------------|------------|-----------|------------|
| 2007                                         |       | $                     | 5,026      |                      | $          | —    |       | $ | 5,026 |   |
| 2008                                         |       | 2,409                 |       | 307                       |       | 2,716     |       |
| 2009                                         |       | 2,209                 |       | 307                       |       | 2,516     |       |
| 2010                                         |       | 2,285                 |       | —                    |       | 2,285     |       |
| 2011                                         |       | 2,361                 |       | —                    |       | 2,361     |       |
| 2012                                         |       | 2,450                 |       | —                    |       | 2,450     |       |
| 2013                                         |       | 2,539                 |       | —                    |       | 2,539     |       |
|                                         |       | $                     | 19,279     |                      | $          | 614       |       | $ | 19,893 |   |

 

Asof March 31, 2007 and 2006, we did not have any relationships withunconsolidated entities or financial partners, such as entities often referredto as structured finance or special purpose entities, which would have beenestablished for the purpose of facilitating off-balance sheet arrangements orother contractually narrow or limited purposes. As such, we are not exposed toany financing, liquidity, market or credit risk that could arise if we hadengaged in such relationships.

On April 3, 2003, we announced that our Board ofDirectors authorized a stock repurchase program of up to 4 million shares ofour common stock.  On August 15, 2005, weannounced that our Board of Directors increased the size of the stockrepurchase program by an additional 4 million shares, for a total program sizeof up to 8 million shares. On July 25, 2006, we announced that our Board ofDirectors increased the size of the stock repurchase program by an additional 4million shares, for a total program size of up to 12 million shares.Repurchases may be made from time to time on the open market at prevailingmarket prices or in privately negotiated transactions. Depending on 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 March31, 2007, we had repurchased 8,170,060 shares of our common stock under thisprogram, for an aggregate of $170.4 million at an average price of $20.86 pershare. Under the terms of our new senior credit facility, we are restrictedfrom repurchasing our stock for a purchase price that exceeds 50% of ourconsolidated net income during the period from the effective date of thefacility through the most recent quarter end for which we have filed quarterlyfinancial statements.

**On April26, 2007, we entered into an agreement with Morgan Stanley Senior Funding Inc.and Bank of America, National Association for a $300 million senior creditfacility.  Our senior facility consistsof up to a $285 million six-year term loan and a $15 million revolving creditfacility.  We intend to use the proceedsof the loan to fund, in part, the acquisition of SurfControl that we announcedon April 26, 2007.  We currently expectto borrow approximately $180 to $200 million of the available senior creditfacility at the closing of the acquisition. The senior credit facility is not available for borrowing for any otherpurpose.  At funding, the senior creditfacility will be secured by substantially all of our assets, including pledgesof our first tier subsidiaries’ stock (except for limits on the stock pledgesof foreign subsidiaries) and is guaranteed by our domestic subsidiaries.  Loans made under the term loan amortize at1.0% per year for years one through five, with the remaining 95% due in thesixth year of the agreement.  We arerequired to use up to 50% of excess cash flow to make mandatory prepayments ofprincipal, which are not subject to any prepayment penalties.  We will have the option to borrow at primerate or at a Eurodollar base rate plus, in each case, an applicable marginbased on our corporate credit rating at the time of funding  The senior credit facility contains financialcovenants, as defined per the senior credit agreement, comprised of aconsolidated leverage ratio and a consolidated interest coverage ratio.  In addition, we have entered into an interimcredit facility with the same lenders that is collateralized by $217 million ofour cash, cash equivalents and marketable securities that are deposited inrestricted accounts and not available to us for any other uses while theacquisition of SurfControl is pending. We expect to use our restricted funds to pay for a portion of thepurchase price of SurfControl.  Inconnection with the financing for the acquisition, we purchased a currencyhedge against £244 million for the 15 month period until the long stop dateunder the transaction agreement with SurfControl.**

We believe that our unrestricted cash and cash equivalents balances, investments in marketable securities and our ongoing cash flow from operations will be sufficient to satisfy our cash requirements, including our capital expenditures and stock repurchases, if any, exclusive of the purchase price of SurfControl, for at least the next 12 months.  We expect to fund the purchase of SurfControl from our $217 million in restricted cash equivalents and marketable securities, and proceeds from our senior credit facility.  Our cash requirements may increase for reasons we do not currently foresee or we may make acquisitions as part of our growth strategy that increase our cash requirements.  We may elect to raise funds for these purposes through capital markets transactions or debt or private equity transactions as appropriate, subject to the restrictions on incurring additional debt in our senior credit facility and our obligation to use all of the proceeds of any equity offering to make mandatory prepayments of principal under our senior credit facility.  We intend to continue to invest our cash in excess of current operating requirements in interest-bearing, investment-grade securities.

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**Off-BalanceSheet Arrangements**

As of March 31, 2007, we did not have any material off-balance sheet arrangements as defined in Regulation S-K Item 303 (a)(4).

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

**Our market risk exposures are related to our cash, cashequivalents and investments in marketable securities. We invest our excess cashin highly liquid short-term investments, municipal securities, commercial paperand corporate bonds. These investments are not held for trading or otherspeculative purposes. Changes in interest rates affect the investment income weearn on our investments and therefore impact our cash flows and results ofoperations.**

**We are exposed to changes in interest rates primarily fromour short-term available-for-sale investments. If our acquisition ofSurfControl closes, we will be subject to changes in interest rates for ourborrowings under our variable rate senior credit facility.  Under our current policies, we do not useinterest rate derivative instruments to manage exposure to interest ratechanges. A hypothetical 100 basis point adverse move in interest rates alongthe entire interest rate yield curve would not materially affect the fair valueof our interest sensitive financial instruments at March 31, 2007. Changes ininterest rates over time will, however, affect our interest income.**

We utilize foreign currency forward contracts andzero-cost collar contracts to hedge foreign currency market exposures ofunderlying assets and liabilities.  Inaddition, working funds necessary to facilitate the short-term operations ofour subsidiaries are kept in the local currencies in which they do business.Our objective is to reduce the risk to earnings and cash flows associated withchanges in foreign currency exchange rates. We do not use foreign currencycontracts for speculative or trading purposes.

Notional and fair values of our hedging positions at March 31, 2007 and 2006 are presented in the table below (in thousands):
| ** **    | ** ** | **March 31, 2007**         | ** ** | **March 31, 2006** | ** ** |
|---------------|------------|--------------------------------------|------------|------------------------------|------------|
| ** **    | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD**     | ** ** | **Fair Value  USD** | ** ** | **Notional  Value  Local  Currency** | ** ** | **Notional  Value  USD** | ** ** | **Fair Value  USD** | ** ** |
| Euro          |       | €                               | 2,000      |                         | $          | 2,627 |   | $ | 2,577 |   | € | 2,350 |   | $ | 2,835 |   | $ | 2,819 |   |
| British Pound |       | £                               | 1,200      |                         | 2,356      |   | 2,351 |   | £ | 2,550 |   | 4,494 |   | 4,453 |   |
| Total         |       |                                 |       | $                            | 4,983      |   | $ | 4,928 |   |   |   | $ | 7,329 |   | $ | 7,272 |   |

 

The $0.2 million notional decrease in our Euro hedgedposition at March 31, 2007 compared to March 31, 2006 is primarily due toincreased spending in Euros which creates a natural hedge against Eurobillings. All of the Euro hedging contracts will be settled before June 30,2007.  For the quarter ended March 31,2007, less than 15% of our total billings were denominated in the Euro. We donot expect Euro billings to represent more than 15% of our total billingsduring 2007.

The $2.1 million notionaldecrease in our British Pound hedged position at March 31, 2007 compared toMarch 31, 2006 is primarily due to a decrease in the percentage of workingfunds hedged. All of the British Pound hedging contracts will be settled beforeJune 30, 2007.** **We expect our British Poundhedge commitments to reduce as we begin billing in the British Pound, in thesecond quarter of 2007, and create a natural hedge against our British Poundexpenditures.

The Company is obligated to pay the purchase price forSurfControl in British Pounds and has purchased a currency hedge against £244million at $2.10 for 15 months, corresponding to the funds certain period underthe credit facilities and the long stop date under the transaction agreementwith SurfControl.

Given our foreign exchange position, a 10% change inforeign exchange rates upon which these foreign exchange contracts are basedwould result in exchange gains and losses. In all material aspects, theseexchange gains and losses would be fully offset by exchange gains and losses onthe underlying net monetary exposures for which the contracts are designated ashedges. We do not expect material exchange rate gains and losses from unhedgedforeign currency exposures.

**Item 4. Controls and Procedures**

**Disclosure Controls andProcedures**

**Wemaintain disclosure controls and procedures (as defined in Rules 13a — 15(e)and 15d — 15(e) of the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) designed to ensure that we are able to collect the information we**

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are required to disclose in the reports we file underthe Exchange Act, and to record, process, summarize and report this informationwithin the time periods specified in the rules of the Securities and ExchangeCommission. Our Chief Executive Officer and Chief Financial Officer evaluatedour disclosure controls and procedures as of the end of the period covered bythis report. Based on their evaluation, our Chief Executive Officer and ChiefFinancial Officer have concluded that these controls and procedures areeffective as of the end of the period covered by this Quarterly Report.

**Changes In Internal ControlOver Financial Reporting**

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

**Part II - Other Information**

**Item 1. Legal Proceedings**

OnSeptember 29, 2006, Jason Tauber filed a purported class action against usand other unidentified individuals in California Superior Court for the Countyof San Diego, captioned Tauber v. Websense. The complaint alleges that theplaintiff and a putative class of certain software engineers and computerprofessionals who worked for us as exempt employees during the period fromSeptember 15, 2002 through the present should have been classified asnon-exempt employees under California law and should have been paid forovertime. The complaint also alleges related wage and hour violations of theCalifornia Labor Code arising from the alleged misclassification and that thefailure to pay overtime constitutes an unfair business practice underCalifornia Business and Professions Code § 17200. The complaint seeksunspecified damages for unpaid overtime, prejudgment interest, attorneys’ feesand other costs, statutory penalties for alleged violations, and other properrelief. We deny all material allegations and intend to defend the actionvigorously.

Weare involved in various legal actions in the normal course of business. Basedon current information, including consultation with our lawyers, we believethat any ultimate liability that may result from these actions, includingTauber v. Websense, would not materially affect our consolidated financialpositions, results of operations or cash flows. Our evaluation of the likelyimpact of these actions could change in the future and unfavorable outcomesand/or defense costs, depending upon the amount and timing, could have amaterial adverse effect on our results of operations or cash flows in a futureperiod.

**Item 1A. Risk Factors**

You should carefully consider the following informationin addition to other information in this report before you decide to purchaseour common stock.  The risks anduncertainties described below are those that we currently deem to be materialand that we believe are specific to our company and our industry.  In addition to these risks, our business maybe subject to risks currently unknown to us. If any of these or other risks actually occur, our business may beadversely affected, the trading price of our common stock could decline, andyou may lose all or part of your investment in Websense.

We have marked with an asterisk (*) those risk factorsthat reflect material changes from the risk factors included in our AnnualReport on Form 10-K filed with the Securities and Exchange Commission onFebruary 28, 2007.

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

During the first half of 2006, we were unable tosustain our growth rates for sales of Web filtering products to largeenterprises, particularly for new sales to this market segment. During thesecond half of 2006, we expanded our focus on increasing sales to small andmedium sized business (SMB) customers in North America and Western Europe whilesales growth rates in the large enterprise market segment slowed down. Ourgrowth plans for new sales in North America and Western Europe in 2007 arelargely dependent on our ability to increase sales in the SMB segment. To besuccessful, we must develop products specifically targeted at the SMB segment.We are scheduled to release the first such product in July 2007. We willalso need to increase our reliance on our new two-tier distribution channel inNorth America and establish similar two-tier distribution arrangements inWestern Europe that target SMB customers. Numerous competitors target the SMB segmentfor Web filtering and security sales, many of whom are different competitorsfrom our primary competitors in the large enterprise space. If we cannotdevelop new products for the SMB segment or compete effectively for volumebusiness through our existing or a newly established two-tier distributionmodel, our financial results will be negatively affected.

*We are moving towards atwo-tier distribution channel in North America which is intended to increasethe quantity of our indirect sales.*

As we move toward a two-tier indirect sales model inNorth America, our revenue will be derived almost entirely from sales throughindirect channels, including value-added resellers, distributors that sell ourproducts to end-users, providers of managed Internet services and otherresellers. Currently, Ingram Micro is our only broad-line distributor in NorthAmerica, so the success of our North American sales efforts is reliant onIngram Micro’s success in selling our products to their reseller network. Ourindirect sales model involves a number of additional risks, including:

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

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

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

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

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

Ourability to meaningfully increase the amount of our products sold through oursales channels also depends on our ability to adequately and efficientlysupport these channel partners with, among other things, appropriate financialincentives to encourage pre-sales investment and sales tools, such as salestraining, technical training and product collateral needed to support theircustomers and prospects. Additionally, we are continually evaluating thechanges to our internal ordering and partner management systems in order toeffectively execute our new two-tier distribution strategy. Any failure toproperly and efficiently support our sales channels will result in lost salesopportunities.

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

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

Subscriptionsfor our Web filtering and security products typically have durations of 12, 24or 36 months. Our customers have no obligation to renew their subscriptionsupon expiration. Our revenue also depends upon maintaining a high rate of salesof renewal subscriptions and in selling further subscriptions to existingcustomers in order to add additional 

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seats or product offerings within their respectiveorganizations. This may require increasingly costly sales efforts targetingsenior management and other management personnel associated with our customers’Internet and security infrastructure. We may not be able to maintain orcontinue to generate increasing revenue from existing customers*.*

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

Ourfuture financial performance depends on our ability to diversify our offeringsby successfully developing, introducing and gaining customer acceptance of ournew products and services, particularly our security offerings. OnJanuary 8, 2007, we acquired PortAuthority Technologies, Inc., and asa result of that acquisition, we now sell information leak prevention productsin the content security market. We may not be successful in achieving marketacceptance of these or any new products that we develop. Moreover, our recentincreased emphasis on the development, marketing and sale of our securityofferings and information leak prevention products could distract us from salesof our core Web filtering and Web security offerings, negatively impacting ouroverall sales. Any failure or delay in diversifying our existing offerings, ordiversification at the detriment to our core Web filtering and Web securityofferings, could harm our business, results of operations and financialcondition.

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

Themarket for our products is intensely competitive and is likely to become evenmore so in the future.  Our currentprincipal Web filtering competitors frequently offer their products at asignificantly lower price than our products, which has resulted in pricingpressures on sales of our product and potentially could result in thecommoditization of products in our space. We also face current and potentialcompetition from vendors of Internet servers, operating systems and networkinghardware, many of which now, or may in the future, develop and/or bundle Webfiltering or other competitive products with their products. Increased competitionmay cause price reductions or a loss of market share, either of which couldhave a material adverse effect on our business, results of operations andfinancial condition. If we are unable to maintain the current pricing on salesof our products or increase our pricing in the future, our profitability couldbe negatively impacted. Even if our products provide greater functionality andare more effective than certain other competitive products, potential customersmight accept this limited functionality in lieu of purchasing our products. Inaddition, our own indirect sales channels may decide to develop or sellcompeting products instead of our products. Pricing pressures and increasedcompetition generally could result in reduced sales, reduced margins or thefailure of our products to achieve or maintain more widespread marketacceptance, any of which could have a material adverse effect on our business,results of operations and financial condition.

Our current principal competitors include:

·       companies offering Websecurity solutions, such as Microsoft, Symantec, McAfee, Juniper Networks,Message Labs, Trend Micro and Postini;

·       companies offering Webfiltering products, such as SurfControl, Secure Computing, Symantec, DigitalArts, Computer Associates, Microsoft, St. Bernard Software, Finjan, Barracuda,ScanSafe, Cisco Systems and Trend Micro;

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

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

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

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

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

·       greater name recognitionand larger marketing budgets and resources;

·       established marketingrelationships and access to larger customer bases; and

·       substantially greaterfinancial, technical and other resources.

As aresult, we may be unable to gain sufficient traction as a provider of Websecurity solutions, and our competitors may be able to respond more quickly andeffectively than we can to new or emerging technologies and changes in customerrequirements, or devote greater resources to the development, marketing,promotion and sale of their products than we can. Current and potentialcompetitors have established or may establish cooperative relationships amongthemselves or with third parties to increase the functionality and marketacceptance of their products. In addition, our competitors may be able toreplicate our products, make more attractive offers to existing and potentialemployees and strategic partners, develop new products or enhance existingproducts and services more quickly. Accordingly, new competitors or alliancesamong competitors may emerge and rapidly acquire significant market share. Inaddition, we also expect that competition will increase as a result of industryconsolidation. For all of the foregoing reasons, we may not be able to competesuccessfully against our current and future competitors.

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

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

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

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

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

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

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

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

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

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

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

·       costs and delays associatedwith developing software in multiple languages.

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

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

We market and sell our products outside the UnitedStates through value-added resellers, distributors and other resellers.International sales represented approximately 39% of our total revenuegenerated during the quarter ended March 31, 2007 compared with 35% of ourtotal revenue during the quarter ended March 31, 2006. As a key component ofour business strategy to generate new business sales, we intend to expand ourinternational sales, but success cannot be assured. In addition to the risksassociated with our domestic sales, our international sales are subject to thefollowing risks:

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

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

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

·       laws and business practicesfavoring local competitors;

·       dependence on foreigndistributors and their sales channels;

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

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

·       regional economic andpolitical conditions.

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

Ourinternational revenue is currently primarily denominated in U.S. dollars. As aresult, fluctuations in the value of the U.S. dollar and foreign currencies maymake our products more expensive for international customers, which could harmour business. We currently bill certain international customers in Euros. Thismay increase our risks associated with fluctuations in foreign currencyexchange rates since we cannot be assured of receiving the same U.S. dollarequivalent as when we bill exclusively in U.S. dollars. We engage in currencyhedging activities with the intent of limiting the risk of exchange ratefluctuation. Our hedging activities also involve inherent risks that couldresult in an unforeseen loss. If we fail to properly forecast rate fluctuationsthese activities could have a negative impact.

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

InJanuary 2007, we acquired PortAuthority Technologies Inc., and on April 26,2007 we announced that we are acquiring SurfControl.  We may acquire additional companies, servicesand technologies in the future as part of our efforts to expand and diversifyour business. 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 acquiredcompanies may disrupt or slow the momentum of the activities of our business.

Inthe case of the SurfControl acquisition, we expect to achieve costs synergiesfrom restructuring of the combined businesses following the closing.  Our estimates of costs synergies are basedupon our review of SurfControl’s business and our familiarity with the industryand markets.  Our estimates are basedupon numerous assumptions that are subject to risks and uncertainties and theactual amount of costs synergies achieved could deviate materially from ourestimates.  The timing of the achievementof synergies may also deviate from our estimates depending upon the success ofthe integration process.  While we expectto satisfy the regulatory pre-conditions to acquiring SurfControl, the timing,costs and ultimate outcome of the regulatory processes are not in the Company’scontrol, and can be extremely costly and time-consuming.  A positive outcome in the regulatory processescannot be assured.  Also, while we expectthe stockholders of SurfControl to approve the scheme of arrangement by therequisite vote, we have not obtained irrevocable undertakings from thestockholders of SurfControl, other than the members of SurfControl’s board ofdirectors, to support the proposed acquisition. It is possible that SurfControlcould receive a competing offer or the SurfControl stockholders could declineto support the transaction.

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Acquisitions involve numerous risks, including:

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

·       diversion of financial andmanagement resources from existing operations;

·       risk of entering newmarkets;

·       potential loss of keyemployees of the acquired company;

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

·       integrating personnel withdiverse business and cultural backgrounds;

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

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

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

Acquisitions may also cause us to:

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

·       assume certain liabilities;

·       incur additional debt;

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

·       become subject tointellectual property or other litigation; and

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

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

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

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

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

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

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

Werely upon a combination of automated filtering technology and human review tocategorize URLs and software applications in our proprietary databases. Ourcustomers may not agree with our determinations that particular URLs andsoftware applications should be included or not included in specific categoriesof our databases. In addition, it is possible that our filtering processes mayplace objectionable or security risk material in categories that are generallyunrestricted by our users’ Internet and computer access policies, which couldresult in such material not being blocked from the network. Anymiscategorization could result in customer dissatisfaction and harm ourreputation. Any failure to effectively categorize and filter URLs and softwareapplications according to our customers’ expectations will impair the growth ofour business. Our databases and database technologies may not be able to keeppace with the growth in the number of URLs and software applications,especially the growing amount of content utilizing foreign languages and theincreasing sophistication of malicious code and the delivery mechanismsassociated with spyware, phishing and other hazards associated with theInternet.

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

Ourproducts are complex and are deployed in a wide variety of complex networkenvironments. Our products may have errors or defects that users identify afterdeployment, which could harm our reputation and our business. In addition,products as complex as ours frequently contain undetected errors when firstintroduced or when new versions or enhancements are released. We have from timeto time found errors in versions of our products, and we may find such errorsin the future. Because customers rely on our products to manage employeebehavior to protect against security risks and prevent the loss of sensitivedata, any significant defects or errors in our products may result in negativepublicity or legal claims. For example, an actual or perceived breach ofnetwork or computer security at one of our customers, regardless of whether thebreach is attributable to our products, could adversely affect the market’sperception of our security products. Moreover, parties whose Web sites orsoftware applications are placed in security-risk categories or othercategories with negative connotations may seek redress against us for falselylabeling them or for interfering with their business. The occurrence of errorscould adversely affect sales of our products, divert the attention ofengineering personnel from our product development efforts and cause significantcustomer relations or legal problems.

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

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

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

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

Inthe future, vendors of hardware and of operating system software or othersoftware may continue to enhance their products or bundle separate products toinclude functions that are currently provided primarily by network securitysoftware. If network security functions become standard features of computerhardware or of operating system software or other software, our products maybecome obsolete and unmarketable, particularly if the quality of these networksecurity features is comparable to that of our products. Furthermore, even ifthe network security and/or management functions provided as 

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standard features by hardware providers or operatingsystems or other software is more limited than that of our products, ourcustomers might accept this limited functionality in lieu of purchasingadditional software. Sales of our products would suffer materially if we werethen unable to develop new Web filtering, security and information leakprevention products to further enhance operating systems or other software andto replace any obsolete products.

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

Significantjudgment is required in determining our worldwide provision for income taxesand for our accruals for other state, federal and international taxes such assales and VAT taxes. In the ordinary course of a global business, there aremany transactions for which the ultimate tax outcome is uncertain. Some ofthese uncertainties arise as a consequence of intercompany arrangements toshare revenue and costs. In such arrangements there are uncertainties about theamount and manner of such sharing, which could ultimately result in changesonce the arrangements are reviewed by taxing authorities. Although we believethat our approach to determining the amount of such arrangements is reasonable,no assurance can be given that the final tax authority review of these matterswill not be materially different than that which is reflected in our historicalincome tax provisions and other tax accruals. Such differences could have amaterial effect on our income tax provisions or benefits, or other taxaccruals, in the period in which such determination is made, and consequently,on our results of operations for such period.

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

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

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

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

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

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

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

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

·       any of our pending patentapplications will result in issued patents;

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

·       we will develop additionalproprietary technologies that are patentable; or

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

Furthermore,legal standards relating to the validity, enforceability and scope ofprotection of intellectual property rights are uncertain. Effective patent,trademark, copyright and trade secret protection may not be available to us inevery country in which our products are available. The laws of some foreigncountries may not be as protective of intellectual property rights as U.S.laws, and mechanisms for enforcement of intellectual property rights may beinadequate. As a result our means of protecting our proprietary technology andbrands may not be adequate. Furthermore, despite our efforts, we may be unableto prevent third parties from infringing upon or misappropriating ourintellectual property, including the misappropriation or misuse of the contentof our proprietary databases of universal resource locators (URLs) and softwareapplications. Any such infringement or misappropriation could have a materialadverse effect on our business, results of operations and financial condition.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

·       changes in the pricingpolicies of our competitors; and

·       changes in governmentregulations.

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

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

·       changes in our pricingpolicies; and

·       quarterly variations in ourrevenues and operating expenses.

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

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

Oursuccess depends largely upon the continued services of our executive officersand other key management personnel. We are also substantially dependent on thecontinued service of our existing engineering personnel because of thecomplexity of our products and technologies. We do not have employmentagreements with a majority of our executive officers, key management ordevelopment 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 and financialcondition. In such an event we may be unable to recruit personnel to replacethese individuals in a timely manner, or at all, on acceptable terms.

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

Toexecute our growth plan, we must attract and retain highly qualified personnel.We need to hire additional personnel in virtually all operational areas,including selling and marketing, research and development, operations andtechnical support, customer service and administration. Competition for thesepersonnel is intense, especially for engineers with high levels of experiencein designing and developing software and Internet-related products. We may notbe successful in attracting and retaining qualified personnel. We have fromtime to time in the past experienced, and we expect to continue to experiencein the future, difficulty in hiring and retaining highly skilled employees withappropriate qualifications. In order to attract and retain personnel in acompetitive marketplace, we believe that we must provide a competitivecompensation package, including cash and equity based compensation. Thevolatility 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 

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have greater resources than we have. If we fail toattract new personnel or retain and motivate our current personnel, ourbusiness and future growth prospects could be severely harmed.

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

Changinglaws, regulations and standards relating to corporate governance, accountingprinciples and public disclosure, including the Sarbanes-Oxley Act of 2002, newSEC regulations and NASDAQ Global Select Market rules, are creating uncertaintyfor companies such as ours. These new or changed laws, regulations andstandards are subject to varying interpretations in many cases due to theirlack of specificity and, as a result, their application in practice may evolveover time. Further guidance by regulatory and governing bodies can result incontinuing uncertainty regarding compliance matters and higher costs related tothe ongoing revisions to accounting, disclosure and governance practices. Ourefforts to comply with evolving laws, regulations and standards have resultedin, and are likely to continue to result in, increased general andadministrative expenses and a diversion of management time and attention fromrevenue-generating activities to compliance activities. In particular, ourefforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 andthe related regulations regarding our required assessment of our internalcontrols over financial reporting and our external auditors’ audit of thatassessment has required the commitment of significant financial and managerialresources. If our efforts to comply with new or changed laws, regulations andstandards differ from the activities intended by regulatory or governing bodiesdue to ambiguities related to practice, our reputation may be harmed.

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

**Oursenior 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 other than the pending acquisition of SurfControl.  An event of default under our senior creditfacility could allow the lenders to declare all amounts outstanding withrespect to the senior credit facility to be immediately due and payable.  A major event of default under the seniorcredit facility occurring between signing and the closing of the SurfControlacquisition, could allow the lenders not to fund the loan needed to close theacquisition of SurfControl.  At fundingof the loan, we will pledge substantially all of our consolidated assets andthe stock of our subsidiaries (subject to limitations with respect to foreignsubsidiaries) to secure the debt under our senior credit facility.  If the amounts outstanding under the seniorcredit facility were accelerated, the lenders could proceed against those consolidatedassets and the stock of our subsidiaries. Any event of default, therefore, could have a material adverse effect onour business.  Our senior credit facilityalso requires us to maintain specified financial ratios.  Our ability to meet these financial ratioscan be affected by events beyond our control, and we cannot assure you that wewill meet those ratios.**

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

The amount of our debt expected to be outstanding as of the closing ofthe SurfControl acquisition,  thelimitations our senior credit facility impose on us and the restrictions on$217 million of our cash resources pending the acquisition of SurfControl couldhave important consequences, including:

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

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

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

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

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

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

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

If we fail tomanage our internal growth and the integration of acquired businesses in amanner that minimizes strains on our resources, we could experience disruptionsin our operations that could negatively affect our revenue, billings orprofitability.  We are pursuing astrategy of organic growth through implementation of two-tier distribution,international expansion, introduction of new products and expansion of ourproduct sales to the small and medium sized businesses. We also have pursuedtwo strategic acquisitions, and are in the process of integrating PortAuthorityand await regulatory approval to complete our acquisition of SurfControl.  Finally, we have opened or acquiredengineering centers in China and Israel. Each of these initiatives requires an investment of our financial andemployee resources and involves risks that may result in a lower return on ourinvestments than we expect. These initiatives also may limit the opportunitieswe pursue or investments we would otherwise make, which may in turn impact ourprospects.

*It may be difficult for athird party to acquire us, even if doing so would be beneficial to ourstockholders.**

Some provisions ofour certificate of incorporation and bylaws, as well as some provisions ofDelaware law, may discourage, delay or prevent third parties from acquiring us,even if doing so would be beneficial to our stockholders. For example, ourcertificate of incorporation provides for a classified board, with each boardmember serving a staggered three-year term. It also provides that stockholdersmay not fill board vacancies, call stockholder meetings or act by writtenconsent. Our bylaws further provide that advance written notice is requiredprior to stockholder proposals. Each of these provisions makes it moredifficult for stockholders to obtain control of our board or initiate actionsthat are opposed by the then current board. Additionally, we have authorizedpreferred stock that is undesignated, making it possible for the board to issueup to 5,000,000 shares of preferred stock with voting or other rights andpreferences that could impede the success of any attempted change of control.Delaware law also could make it more difficult for a third party to acquire us.Section 203 of the Delaware General Corporation Law has an anti-takeovereffect with respect to transactions not approved in advance by our board,including discouraging attempts that might result in a premium over the marketprice of the shares of common stock held by our stockholders.

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

*We do not intend to pay dividends.**

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

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

**None.**

**Item 3.    Defaults upon Senior Securities**

**None.**

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

**None.**

**Item 5.    Other Information**

**None.**

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**Item 6.    Exhibits**

**Exhibits**
| 2.1(1) | Agreement and Plan of Merger and Reorganization  dated December 20, 2006, by and among Websense, Inc., Leap Acquisition Corp.,  a wholly-owned subsidiary of Websense, Inc., PortAuthority Technologies,  Inc., PortAuthority Technologies Israel, Ltd., a wholly-owned subsidiary of  PortAuthority Technologies, Inc., and Donald Sullivan, as the Stockholders’  Representative. |
|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(2) | Amended and Restated Certificate of Incorporation.                                                                                                                                                                                                                                                                                                                                       |
| 3.2(3) | Restated Bylaws.                                                                                                                                                                                                                                                                                                                                                                         |
| 4.1(2) | 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).                                                                                                                                                                                         |

 

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(1)             Filedas an Exhibit to our Current Report on Form 8-K (No 000-30093) filed on January12, 2007.

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

(3)             Filed as an Exhibitto our Current Report on Form 8-K (No 000-30093) filed on April 19, 2007.

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##### **SIGNATURES**

Pursuant to the requirements of the Securities Exchange Actof 1934, the registrant has duly caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.
|                    | **WEBSENSE, INC.**        | ** **           |
|--------------------|---------------------------|----------------------|
|               |                      |                 |
| Date: May 9,  2007 | By:                       | /s/ GENE HODGES      |
|               | Gene Hodges               |                 |
|               | *Chief Executive Officer* | * *             |
|               |                      |                 |
| Date: May 9,  2007 | By:                       | /s/ DOUGLAS C. WRIDE |
| ** **         | Douglas C. Wride          |                 |
| ** **         | *President and*           | * *             |
| ** **         | *Chief Financial Officer* | * *             |
|                    |                           |                      |  |  |

 

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**EXHIBIT INDEX**
| Exhibit    | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                               |
|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                          |
| 2.1(1)     |       | Agreement and Plan of Merger and Reorganization  dated December 20, 2006, by and among Websense, Inc., Leap Acquisition Corp.,  a wholly-owned subsidiary of Websense, Inc., PortAuthority Technologies,  Inc., PortAuthority Technologies Israel, Ltd., a wholly-owned subsidiary of  PortAuthority Technologies, Inc., and Donald Sullivan, as the Stockholders’  Representative. |
| 3.1(2)     |       | Amended and Restated Certificate of Incorporation.                                                                                                                                                                                                                                                                                                                                       |
| 3.2(3)     |       | Restated Bylaws.                                                                                                                                                                                                                                                                                                                                                                         |
| 4.1(2)     |       | 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).                                                                                                                                                                                              |

 

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(1)             Filedas an Exhibit to our Current Report on Form 8-K (No 000-30093) filed on January12, 2007.

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

(3)             Filed as an Exhibitto our Current Report on Form 8-K (No 000-30093) filed on April 19, 2007.

 

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