**FORM10-Q**

 

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**(MarkOne)**

 

**ý****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended June 30, 2004**

 

**OR**

 

**o****TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**Forthe Transition Period from            to           **

 

**Commission File Number 000-30093**

 

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**Websense, Inc.**

(Exact name of registrant as specified in itscharter)

 

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

 

**10240 Sorrento Valley Road**

**San Diego, California 92121**

**858-320-8000**

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

 

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Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.Yes ý  No o

 

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

 

The number of sharesoutstanding of the registrant’s Common Stock, $.01 par value, as of July 31,2004 was 23,276,691.

 

 

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**Websense, Inc.**

**Form 10-Q**

**For the Period Ended June 30, 2004**

 

**TABLE OF CONTENTS**

 
|                          | **Page** |
|-------------------------------|----------|
| Part I. Financial Information |     |
|                          |     |   |   |
|                          | Item 1.  | Consolidated Financial Statements (Unaudited) |   |
|                          |     | Consolidated Balance Sheets  as of June 30, 2004 and December 31, 2003 | 1 |
|                          |     | Consolidated  Statements of Income for the three and six months ended June 30, 2004 and  2003 | 2 |
|                          |     | Consolidated  Statement of Stockholders’ Equity for the six months ended June 30, 2004 | 3 |
|                          |     | Consolidated  Statements of Cash Flows for the six months ended June 30, 2004 and 2003 | 4 |
|                          |     | Notes to Consolidated  Financial Statements | 5 |
|                          | Item 2.  | Management’s Discussion and Analysis of Financial  Condition and Results of Operations | 9 |
|                          | Item 3.  | Quantitative and Qualitative Disclosures About  Market Risk | 18 |
|                          | Item 4.  | Controls and Procedures | 18 |
|                          |     |   |   |
| Part II. Other Information    | 20       |
|                          |     |   |   |
|                          | Item 1.  | Legal Proceedings | 20 |
|                          | Item  2. | Changes  in Securities, Use of Proceeds and Issuer Purchases of Securities | 20 |
|                          | Item 3.  | Defaults upon Senior  Securities | 21 |
|                          | Item  4. | Submission  of Matters to a Vote of Security Holders | 21 |
|                          | Item 5.  | Other Information | 22 |
|                          | Item 6.  | Exhibits and Reports on Form 8-K | 22 |
|                          |     |   |   |
| Signatures                    | 23       |

 

i

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**Part I** – FinancialInformation

 

**Item 1.****Consolidated FinancialStatements (Unaudited)**

 

**Websense,Inc.**

**ConsolidatedBalance Sheets**

**(Unaudited and in thousands)**

 
| ** **                                                   | ** ** | **June 30,  2004** | ** ** | **December 31,   2003** | ** ** |
|--------------------------------------------------------------|------------|--------------------|------------|-------------------------|------------|
| ** **                                                   | ** ** | ** **         | ** ** | **(See Note 1)**        | ** ** |
| **Assets**                                                   |       |               |       |                    |       |
| Current assets:                                              |       |               |       |                    |       |
| Cash and cash equivalents                                    |       | $                  | 34,382     |                    | $          | 35,324 |   |
| Marketable securities                                        |       | 178,446            |       | 147,535                 |       |
| Accounts receivable, net of allowance for  doubtful accounts |       | 28,558             |       | 27,999                  |       |
| Deferred income taxes                                        |       | 8,733              |       | 8,733                   |       |
| Other current assets                                         |       | 1,812              |       | 1,271                   |       |
| Total current assets                                         |       | 251,931            |       | 220,862                 |       |
|                                                         |       |               |       |                    |       |
| Property and equipment, net                                  |       | 3,680              |       | 2,997                   |       |
| Deferred income taxes, less current portion                  |       | 8,672              |       | 8,672                   |       |
| Deposits and other assets                                    |       | 453                |       | 418                     |       |
| Total assets                                                 |       | $                  | 264,736    |                    | $          | 232,949 |   |
|                                                         |       |               |       |                    |       |
| **Liabilities and stockholders’ equity**                |       |               |       |                    |       |
| Current liabilities:                                         |       |               |       |                    |       |
| Accounts payable                                             |       | $                  | 1,360      |                    | $          | 743 |   |
| Accrued payroll and related benefits                         |       | 5,035              |       | 5,241                   |       |
| Other accrued expenses                                       |       | 4,608              |       | 3,835                   |       |
| Income taxes payable                                         |       | 3,445              |       | 241                     |       |
| Current portion of deferred revenue.                         |       | 73,494             |       | 65,480                  |       |
| Total current liabilities                                    |       | 87,942             |       | 75,540                  |       |
|                                                         |       |               |       |                    |       |
| Deferred revenue, less current portion                       |       | 31,518             |       | 28,480                  |       |
|                                                         |       |               |       |                    |       |
| Stockholders’ equity:                                   |       |               |       |                    |       |
| Common stock                                                 |       | 238                |       | 228                     |       |
| Additional paid-in capital                                   |       | 132,578            |       | 120,639                 |       |
| Treasury stock                                               |       | (13,711            | )          | (7,684                  | )          |
| Retained earnings                                            |       | 26,665             |       | 15,731                  |       |
| Accumulated other comprehensive income  (loss)               |       | (494               | )          | 15                      |       |
| Total stockholders’ equity                              |       | 145,276            |       | 128,929                 |       |
| Total liabilities and stockholders’ equity              |       | $                  | 264,736    |                    | $          | 232,949 |   |

 

See accompanying notes.

 

1

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**Websense, Inc.**

**ConsolidatedStatements of Income**

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

 
| ** **                               | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                               | ** ** | **June 30,  2004**     | ** ** | **June 30,  2003**   | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
|                                     |       |                   |       |                 |       |   |   |   |   |
| Revenue                                  |       | $                      | 26,643     |                 | $          | 19,524 |   | $ | 51,254 |   | $ | 38,028 |   |
|                                     |       |                   |       |                 |       |   |   |   |   |
| Cost of revenue                          |       | 1,774                  |       | 1,290                |       | 3,465 |   | 2,595 |   |
|                                     |       |                   |       |                 |       |   |   |   |   |
| Gross margin                             |       | 24,869                 |       | 18,234               |       | 47,789 |   | 35,433 |   |
|                                     |       |                   |       |                 |       |   |   |   |   |
| Operating expenses:                      |       |                   |       |                 |       |   |   |   |   |
| Selling and marketing                    |       | 10,449                 |       | 7,546                |       | 19,865 |   | 14,181 |   |
| Research and development                 |       | 3,534                  |       | 3,106                |       | 7,101 |   | 6,324 |   |
| General and administrative               |       | 2,133                  |       | 1,672                |       | 4,352 |   | 3,216 |   |
| Amortization of stock-based compensation |       | —                 |       | 22                   |       | — |   | 65 |   |
| Total operating expenses                 |       | 16,116                 |       | 12,346               |       | 31,318 |   | 23,786 |   |
|                                     |       |                   |       |                 |       |   |   |   |   |
| Income from operations                   |       | 8,753                  |       | 5,888                |       | 16,471 |   | 11,647 |   |
|                                     |       |                   |       |                 |       |   |   |   |   |
| Other income, net                        |       | 456                    |       | 780                  |       | 869 |   | 1,455 |   |
|                                     |       |                   |       |                 |       |   |   |   |   |
| Income before income taxes               |       | 9,209                  |       | 6,668                |       | 17,340 |   | 13,102 |   |
|                                     |       |                   |       |                 |       |   |   |   |   |
| Provision for income taxes               |       | 3,402                  |       | 2,580                |       | 6,406 |   | 5,154 |   |
|                                     |       |                   |       |                 |       |   |   |   |   |
| Net income                               |       | $                      | 5,807      |                 | $          | 4,088 |   | $ | 10,934 |   | $ | 7,948 |   |
|                                     |       |                   |       |                 |       |   |   |   |   |
| Net income per share:                    |       |                   |       |                 |       |   |   |   |   |
|                                     |       |                   |       |                 |       |   |   |   |   |
| Basic net income per share               |       | $                      | 0.25       |                 | $          | 0.19 |   | $ | 0.48 |   | $ | 0.36 |   |
| Diluted net income per share             |       | $                      | 0.24       |                 | $          | 0.18 |   | $ | 0.46 |   | $ | 0.35 |   |
| Weighted average shares – basic     |       | 22,971                 |       | 21,882               |       | 22,824 |   | 21,838 |   |
| Weighted average shares – diluted   |       | 23,928                 |       | 22,613               |       | 23,806 |   | 22,673 |   |

 

See accompanying notes.

 

2

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**Websense, Inc.**

 

**Consolidated Statement of Stockholders’ Equity**

** **

**(Unaudited and in thousands)**

 
| ** **                                                              | ** ** | **Common stock** | ** ** | **Additional  paid-in capital** | ** ** | **Treasury  stock** | ** ** | **Retained  earnings** | ** ** | **Accumulated  other  comprehensive  income (loss)** | ** ** | **Total  stockholders’  equity** | ** ** |
|-------------------------------------------------------------------------|------------|------------------|------------|---------------------------------|------------|---------------------|------------|------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                              | ** ** | **Shares**       | ** ** | **Amount**                      | ** ** | ** **          | ** ** | ** **             | ** ** | ** **                                           |
| Balance at December 31, 2003                                            |       | 22,445           |       | $                               | 228        |                | $          | 120,639                |       | $                                                    | (7,684     | )                                     | $          | 15,731 |   | $ | 15 |   | $ | 128,929 |   |
| Issuance of common stock upon exercise of options                       |       | 812              |       | 9                               |       | 10,689              |       | —                 |       | —                                               |       | —                                |       | 10,698 |   |
| Issuance of common stock for purchase plan                              |       | 97               |       | 1                               |       | 1,250               |       | —                 |       | —                                               |       | —                                |       | 1,251 |   |
| Issuance of common stock upon exercise of warrant                       |       | 8                |       | —                          |       | —              |       | —                 |       | —                                               |       | —                                |       | — |   |
| Purchase of treasury stock                                              |       | (205             | )          | —                          |       | —              |       | (6,027                 | )          | —                                               |       | —                                |       | (6,027 | ) |
| Comprehensive income:                                                   |       |             |       |                            |       |                |       |                   |       |                                                 |       |                                  |       |   |   |
| Net income                                                              |       | —           |       | —                          |       | —              |       | —                 |       | 10,934                                               |       | —                                |       | 10,934 |   |
| Unrealized loss on securities available for sale                        |       | —           |       | —                          |       | —              |       | —                 |       | —                                               |       | (345                                  | )          | (345 | ) |
| Unrealized loss on fair market valuation of foreign exchange  contracts |       | —           |       | —                          |       | —              |       | —                 |       | —                                               |       | (164                                  | )          | (164 | ) |
| Comprehensive income                                                    |       |             |       |                            |       |                |       |                   |       |                                                 |       |                                  |       | 10,425 |   |
| Balance at June 30, 2004                                                |       | 23,157           |       | $                               | 238        |                | $          | 132,578                |       | $                                                    | (13,711    | )                                     | $          | 26,665 |   | $ | (494 | ) | $ | 145,276 |   |

 

See accompanying notes.

 

3

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**Websense, Inc.**

 

**Consolidated Statements of Cash Flows**

** **

**(Unaudited and in thousands)**

 
| ** **                                                                         | ** ** | **Six months ended** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                         | ** ** | **June 30,  2004**   | ** ** | **June 30,  2003** | ** ** |
| **Operating activities:**                                                          | ** ** | ** **           | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                    | 10,934     |   | $ | 7,948 |   |
|                                                                               |       |                 |       |   |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                 |       |   |   |
| Depreciation                                                                       |       | 1,066                |       | 979 |   |
| Amortization of deferred compensation                                              |       | —               |       | 65 |   |
| Deferred revenue                                                                   |       | 11,052               |       | 6,414 |   |
| Unrealized loss on foreign exchange contracts                                      |       | (164                 | )          | — |   |
| Changes in operating assets and liabilities:                                       |       |                 |       |   |   |
| Accounts receivable                                                                |       | (559                 | )          | 1,382 |   |
| Deposits and other assets                                                          |       | (576                 | )          | (273 | ) |
| Accounts payable                                                                   |       | 617                  |       | 16 |   |
| Accrued payroll and related benefits                                               |       | (206                 | )          | 322 |   |
| Other accrued expenses                                                             |       | 773                  |       | (465 | ) |
| Income taxes payable                                                               |       | 3,204                |       | 2,571 |   |
| Net cash provided by operating activities                                          |       | 26,141               |       | 18,959 |   |
|                                                                               |       |                 |       |   |   |
| **Investing activities:**                                                          |       |                 |       |   |   |
| Purchases of property and equipment                                                |       | (1,749               | )          | (997 | ) |
| Purchases of marketable securities                                                 |       | (147,553             | )          | (61,553 | ) |
| Maturities of marketable securities                                                |       | 109,329              |       | 61,473 |   |
| Sales of marketable securities                                                     |       | 6,968                |       | 27,511 |   |
| Net cash provided by (used in) investing activities                                |       | (33,005              | )          | 26,434 |   |
|                                                                               |       |                 |       |   |   |
| **Financing activities:**                                                          |       |                 |       |   |   |
| Proceeds from exercise of stock options                                            |       | 10,698               |       | 401 |   |
| Proceeds from issuance of common stock for stock purchase plan                     |       | 1,251                |       | 853 |   |
| Purchases of treasury stock                                                        |       | (6,027               | )          | (2,416 | ) |
| Net cash provided by (used in) financing activities                                |       | 5,922                |       | (1,162 | ) |
|                                                                               |       |                 |       |   |   |
| Increase (decrease) in cash and cash equivalents                                   |       | (942                 | )          | 44,231 |   |
|                                                                               |       |                 |       |   |   |
| Cash and cash equivalents at beginning of period                                   |       | 35,324               |       | 29,263 |   |
|                                                                               |       |                 |       |   |   |
| Cash and cash equivalents at end of period                                         |       | $                    | 34,382     |   | $ | 73,494 |   |

 

See accompanying notes.

 

4

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**Websense, Inc.**

 

**Notes ToConsolidated Financial****Statements(Unaudited)**

 

1.  *Basis of Presentation*

 

The accompanying unaudited consolidatedfinancial statements have been prepared in conformity with accountingprinciples generally accepted in the United States for interim financialstatements and with the instructions to Form 10-Q and Article 10 of RegulationS-X. Accordingly, certain information or footnote disclosures normally includedin complete financial statements prepared in accordance with accountingprinciples generally accepted in the United States have been condensed oromitted pursuant to the rules and regulations of the Securities and ExchangeCommission. In the opinion of management, the statements include alladjustments necessary, which are of a normal and recurring nature, for the fairpresentation of our financial position and of the results for the interimperiods presented.

 

These financial statements should be read inconjunction with the audited consolidated financial statements and notesthereto for the year ended December 31, 2003, included in Websense, Inc.’sAnnual Report on Form 10-K filed with the Securities and ExchangeCommission.  Operating results for thethree months ended June 30, 2004 are not necessarily indicative of the resultsthat may be expected for any other interim period or for the year endingDecember 31, 2004.  The balance sheet atDecember 31, 2003 has been derived from the audited financial statements atthat date but does not include all of the information and footnotes required byaccounting principles generally accepted in the United States for completefinancial statements.

 

2.  *Net Income Per Share*

 

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

 

Dilutive securities include stock options,warrants and restricted stock subject to vesting. During the quarters endedJune 30, 2004 and 2003, the difference between the weighted average shares usedin determining basic EPS versus diluted EPS related to dilutive stock optionsand warrants totaling 957,000 and 731,000, respectively. Potentially dilutivesecurities totaling 163,000 and 2,407,000 for the quarters ended June 30, 2004and 2003, respectively, were excluded from historical basic and dilutedearnings per share because of their anti-dilutive effect as a result of stockoptions which have exercise prices greater than the average market price of thecommon shares.

 

During the first six months of 2004 and 2003,the difference between the weighted average shares used in determining basicEPS versus diluted EPS related to dilutive stock options and warrants totaling982,000 and 835,000, respectively. Potentially dilutive securities totaling143,000 and 1,814,000 for the first six months of 2004 and 2003, respectively,were excluded from historical basic and diluted earnings per share because oftheir anti-dilutive effect as a result of stock options which have exerciseprices greater than the average market price of the common shares.

 

5

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

 
| ** **                      | ** ** | **Net Income  (Numerator)**                  | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
|---------------------------------|------------|----------------------------------------------|------------|---------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **(In thousands, except per share amounts)** | ** ** |
| **For the Three Months Ended:** |       |                                         |       |                      |       |                  |       |
| **June 30, 2004:**              |       |                                         |       |                      |       |                  |       |
| Basic EPS                       |       | $                                            | 5,807      |                      | 22,971     |                  | $          | 0.25 |   |
| Effect of options               |       | —                                       |       | 957                       |       | (0.01                 | )          |
| Diluted EPS                     |       | $                                            | 5,807      |                      | 23,928     |                  | $          | 0.24 |   |
|                            |       |                                         |       |                      |       |                  |       |
| **June 30, 2003:**              |       |                                         |       |                      |       |                  |       |
| Basic EPS                       |       | $                                            | 4,088      |                      | 21,882     |                  | $          | 0.19 |   |
| Effect of options               |       | —                                       |       | 731                       |       | (0.01                 | )          |
| Diluted EPS                     |       | $                                            | 4,088      |                      | 22,613     |                  | $          | 0.18 |   |
|                            |       |                                         |       |                      |       |                  |       |
| **For the Six Months Ended:**   |       |                                         |       |                      |       |                  |       |
| **June 30, 2004:**              |       |                                         |       |                      |       |                  |       |
| Basic EPS                       |       | $                                            | 10,934     |                      | 22,824     |                  | $          | 0.48 |   |
| Effect of options               |       | —                                       |       | 982                       |       | (0.02                 | )          |
| Diluted EPS                     |       | $                                            | 10,934     |                      | 23,806     |                  | $          | 0.46 |   |
|                            |       |                                         |       |                      |       |                  |       |
| **June 30, 2003:**              |       |                                         |       |                      |       |                  |       |
| Basic EPS                       |       | $                                            | 7,948      |                      | 21,838     |                  | $          | 0.36 |   |
| Effect of options               |       | —                                       |       | 835                       |       | (0.01                 | )          |
| Diluted EPS                     |       | $                                            | 7,948      |                      | 22,673     |                  | $          | 0.35 |   |

 

3. *Amortization of Stock-Based Compensation*

 

For the three and six months ended June 30,2004, the Company recorded no amortization of stock-based compensation. Theallocation of the expense by operating expense category in the three and sixmonths ended in the prior year is as follows (in thousands):

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                      | ** ** | **June 30, 2003**      | ** ** | **June 30, 2003**    | ** ** |
| Selling and marketing                           |       | $                      | 10         |                 | $          | 24 |   |
| Research and development                        |       | 5                      |       | 13                   |       |
| General and administrative                      |       | 7                      |       | 28                   |       |
| Total amortization of stock-based  compensation |       | $                      | 22         |                 | $          | 65 |   |

 

6

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4. *Comprehensive Income*

 

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

 
| ** **                                                                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                               | ** ** | **June 30, 2004**      | ** ** | **June 30, 2003**    | ** ** | **June 30, 2004** | ** ** | **June 30, 2003** | ** ** |
| Net income                                                                               |       | $                      | 5,807      |                 | $          | 4,088 |   | $ | 10,934 |   | $ | 7,948 |   |
| Change in unrealized gain (loss) on investments                                          |       | (348                   | )          | (276                 | )          | (345 | ) | (410 | ) |
| Change in unrealized gain (loss) on fair  market valuation of foreign exchange contracts |       | 36                     |       | —               |       | (164 | ) | — |   |
| Comprehensive income                                                                     |       | $                      | 5,495      |                 | $          | 3,812 |   | $ | 10,425 |   | $ | 7,538 |   |

 

Accumulated other comprehensive income (loss)totaled $(494,000) and $15,000 at June 30, 2004 and December 31, 2003,respectively.

 

5.* **Stock-BasedCompensation*

 

Pro forma information regarding net income(loss) is required by SFAS No. 123, Accounting for Stock-Based Compensation, asamended by SFAS 148, Accounting for Stock-Based Compensation – Transition andDisclosure, and has been determined as if the Company has accounted for itsemployee stock options and shares purchased under the employee stock purchaseplan under the fair value method of SFAS 123, as amended by SFAS 148. The proforma effects of stock-based compensation on net income and net income pershare have been estimated at the date of grant using the Black-Scholes optionpricing model based on the following weighted average assumptions since theCompany’s initial public offering in March of 2000: risk free interest rates of2.36% to 6.0%, dividend yields of 0%, expected volatility of 54% to 132%, andlife of 5 years.

 

7

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The Company’s adjusted pro forma informationis as follows (in thousands, except per share amounts):

 
| ** **                                                                                 | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                 | ** ** | **June 30,  2004**     | ** ** | **June 30,  2003**   | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
| Net income as reported                                                                     |       | $                      | 5,807      |                 | $          | 4,088 |   | $ | 10,934 |   | $ | 7,948 |   |
| Stock based employee compensation cost  included in net income as reported, net of tax (1) |       | —                 |       | 13                   |       | — |   | 40 |   |
| Compensation expense under FAS 123, net of  tax (2)                                        |       | (2,568                 | )          | (2,149               | )          | (5,166 | ) | (4,203 | ) |
| Pro forma net income                                                                       |       | $                      | 3,239      |                 | $          | 1,952 |   | $ | 5,768 |   | $ | 3,785 |   |
|                                                                                       |       |                   |       |                 |       |   |   |   |   |
| Basic net income per share as reported                                                     |       | $                      | 0.25       |                 | $          | 0.19 |   | $ | 0.48 |   | $ | 0.36 |   |
| Pro forma basic net income per share                                                       |       | $                      | 0.14       |                 | $          | 0.09 |   | $ | 0.25 |   | $ | 0.17 |   |
|                                                                                       |       |                   |       |                 |       |   |   |   |   |
| Diluted net income per share as reported                                                   |       | $                      | 0.24       |                 | $          | 0.18 |   | $ | 0.46 |   | $ | 0.35 |   |
| Pro forma diluted net income per share                                                     |       | $                      | 0.14       |                 | $          | 0.09 |   | $ | 0.24 |   | $ | 0.17 |   |

 

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(1)   The Company was recognizing deferred stock-based compensationexpense on the deemed fair value of options granted prior to the initial publicoffering in March 2000.  This expense wasamortized on an accelerated basis, in accordance with FIN 28, overapproximately a four-year period, which began in March 2000 and ended inDecember 2003.

 

(2)   The Company had an effective tax rate of 37% and 39% in thethree months ended June 30, 2004 and 2003, respectively.  The Company had an effective tax rate of 37%and 39% in the six months ended June 30, 2004 and 2003, respectively.

 

For purposes of pro formadisclosures, the estimated fair value is amortized to expense over the optionsvesting period.  The effect of applyingSFAS 123, as amended by SFAS 148, for purposes of providing pro formadisclosures may not be representative of the effects on our operating resultsin future years.

 

*6. Tax Matters*

 

From time totime, the Company is audited by various state, federal and internationalauthorities relating to tax matters. The Company fully cooperates with allaudits, but defends its positions vigorously. The Company’s audits are invarious stages of completion; however, no outcome for a particular audit can bedetermined with certainty prior to the conclusion of the audit and appealsprocess. As each audit is concluded, adjustments, if any, are appropriatelyrecorded in the Company’s financial statements in the period determined. Toprovide for potential tax exposures, the Company maintains allowances for taxcontingencies based on reasonable estimates of the Company’s potential exposurewith respect to the tax liabilities that may result from such audits. However,if the reserves are insufficient upon completion of any audits, there could bean adverse impact on the Company’s financial position and results ofoperations.

 

7. *Reclassifications*

 

Certainreclassifications have been made for consistent presentation.

 

8

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**Item 2.****Management’s Discussion and Analysis of Financial Condition andResults of Operations**

 

The followingdiscussion and analysis should be read in conjunction with the financialstatements and related notes contained elsewhere in this report. See “Risks andUncertainties” regarding certain factors known to us that could cause reportedfinancial information not to be necessarily indicative of future results.

 

**Forward Looking Statements**

 

This report onForm 10-Q may contain “forward-looking statements” within the meaning of thefederal securities laws made pursuant to the safe harbor provisions of thePrivate 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.Such statements may include but are not limited to statements concerning thefollowing:

 

•                  anticipatedtrends in revenue;

•                  growthopportunities in domestic and international markets;

•                  customeracceptance and satisfaction with our products;

•                  expected trendsin operating and other expenses;

•                  anticipated cashand intentions regarding usage of cash;

•                  changes ineffective tax rates; and

•                  anticipatedproduct enhancements or releases.

 

**These forward-looking statements are subject torisks and uncertainties that could cause actual results to differ materiallyfrom those anticipated as of the date of this report. We assume no obligationto update any forward-looking statements to reflect events or circumstancesarising after the date of this report.**

 

**Overview**

 

**We provide Employee Internet Management, orEIM, solutions that enable organizations to analyze, report and manage howtheir employees use computing resources at work, including Internet access,instant messaging, peer-to-peer file sharing, network bandwidth and desktopapplications. Our primary product, Websense Enterprise®, gives organizationsthe ability to rapidly implement and configure Internet access policies insupport of their efforts to improve employee productivity, conserve networkbandwidth, mitigate potential legal liability and enhance network security. In1996, we released our first software product, Websense Internet ScreeningSystem, and since that time, we have focused our business on developing andselling EIM solutions. In December 1999, we released Websense EnterpriseVersion 4, which was sold through March 2003. We launched the next generationof Websense software - Websense Enterprise Version 5 - in March 2003, includingenhanced EIM capabilities.  We have alsointroduced Premium GroupTM databases and add-on modules featuringnew network and application management technology such as Client Policy ManagerTM,Bandwidth OptimizerTM and Instant Messaging Attachment ManagerTM. We currentlyderive nearly all of our revenue from subscriptions to the Websense Enterprisesolution and expect this trend to continue in the future as more offerings areadded to the Websense Enterprise platform.**

 

**9**

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**During the six months ended June 30, 2004, wederived 32% of revenue from international sales compared with 29% for the sixmonths ended June 30, 2003. International revenue increased 55% in the second quarter of 2004 overthe second quarter of 2003, with the United Kingdom comprising approximately 9%of our total revenue. We believe international markets represent a significantgrowth opportunity and we are continuing to expand our internationaloperations, particularly in selected countries in the European and Asia/Pacificmarkets.**

 

**We sell Websense Enterprise through bothindirect and direct channels. Sales through indirect channels currently accountfor more than 80% of our revenue, and our strategy is to continue to rely onindirect sales channels for a significant majority of our sales.**

 

**As described elsewhere in this report, werecognize revenue from subscriptions to Websense Enterprise on a monthlystraight-line basis over the term of the subscription. We recognize theoperating expenses related to these sales as they are incurred. These operatingexpenses include 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 subsequentperiods.**

 

**CriticalAccounting Policies**

 

**We believe the following critical accountingpolicies affect our more significant judgments and estimates used in thepreparation of our consolidated financial statements.**

 

***Revenue Recognition.***When a purchasedecision is made for Websense Enterprise, 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 monthly straight-line basis over the term of the subscription agreementprovided collectibility is reasonably assured. Upon entering into asubscription arrangement for a fixed or determinable fee, we electronicallydeliver access codes to users and then promptly invoice customers for the fullamount of their subscriptions. Payment is due for the full term of thesubscription, generally within 30 days of the invoice. We record amounts billedto customers in excess of recognizable revenue as deferred revenue on ourbalance sheet. Upon expiration of the subscription, customers who wish tore-subscribe typically must do so at then current rates to continue usingWebsense Enterprise. Our revenue is significantly influenced by new and renewalsubscriptions, and a decrease in subscription amounts could negatively impact ourfuture revenue.

 

***Allowance forDoubtful Accounts.***Wemaintain an allowance for doubtful accounts for estimated losses resulting fromthe inability or unwillingness of our customers to make required payments topay their invoice(s). If the financial condition of our customers were todeteriorate, resulting in an impairment of their ability to make payments,additional allowances may be required.

 

*DeferredTax Assets.* Asrequired by Statement of Financial Accounting Standards No. 109 (“SFAS 109”),we recognize tax assets on the balance sheet if it is “more likely than not”that they will be realized on future tax returns.  Based on our earnings history and anticipatedfuture taxable income, we believe that it is more likely than not that our U.S.deferred tax assets will be realized. However, should we determine that wewould not be able to realize all or part of our deferred tax assets in thefuture, an adjustment to the deferred tax assets would be charged againstincome in the period such determination was made. As of December 31, 2003, wehad $17.4 million in deferred tax assets.

 

10

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# **Results ofOperations**

 

***Three months ended June 30, 2004, comparedwith the three months ended June 30, 2003***

 

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

 
| ** **                 | ** ** | **Three Months  Ended** | ** ** |
|----------------------------|------------|-------------------------|------------|
| ** **                 | ** ** | **June 30, 2004**       | ** ** | **June 30, 2003** | ** ** |
| ** **                 | ** ** | **(Unaudited)**         | ** ** |
|                       |       |                    |       |   |   |
| Revenue                    |       | 100                     | %          | 100 | % |
|                       |       |                    |       |   |   |
| Cost of revenue            |       | 7                       |       | 7 |   |
|                       |       |                    |       |   |   |
| Gross margin               |       | 93                      |       | 93 |   |
|                       |       |                    |       |   |   |
| Operating expenses:        |       |                    |       |   |   |
| Selling and marketing      |       | 39                      |       | 39 |   |
| Research and development   |       | 13                      |       | 16 |   |
| General and administrative |       | 8                       |       | 8 |   |
| Total operating expenses   |       | 60                      |       | 63 |   |
|                       |       |                    |       |   |   |
| Income from operations     |       | 33                      |       | 30 |   |
|                       |       |                    |       |   |   |
| Other income, net          |       | 2                       |       | 4 |   |
|                       |       |                    |       |   |   |
| Income before income taxes |       | 35                      |       | 34 |   |
|                       |       |                    |       |   |   |
| Provision for income taxes |       | 13                      |       | 13 |   |
|                       |       |                    |       |   |   |
| Net income                 |       | 22                      | %          | 21 | % |

 

# **Revenue**

 

# **Revenue increased to $26.6 million in the second quarter of2004 from $19.5 million in the second quarter of 2003. The increase wasprimarily a result of the addition of new, renewed and upgraded subscriptionsfrom our customers. Approximately 35% of subscription revenue recognized in thesecond quarter of 2004 was derived from sales to first-time customers, whoinitially purchased one-, two-, or three-year subscriptions to WebsenseEnterprise in 2004 or prior years. The remaining 65% of subscription revenuewas generated from existing customers. We expect total revenue growth in 2004to exceed total revenue growth in 2003, although the percentage revenue growthrate may be lower in 2004 than in 2003 as a result of the larger revenue basein 2004 as compared with 2003.**

 

11

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# **Costof Revenue**

 

# **Cost of revenue consists of the costs of content review,technical support and infrastructure costs associated with maintaining ourdatabases. Cost of revenue increased to $1.8 million in the second quarter of2004 from $1.3 million in the second quarter of 2003. The increase wasprimarily due to the costs associated with additional personnel in ourtechnical support and database groups. We expect cost of revenue to increase inthe future as we support the growth and maintenance of our databases as well asthe technical support needs of our customers. As a percentage of revenue, costof revenue remained unchanged at 7% during the second quarters of 2004 and2003. We expect that cost of revenue, as a percentage of revenue, will remainbelow 10% of revenue for the foreseeable future.**

 

# **GrossMargin**

 

# **Gross margin increased to $24.9 million in the secondquarter of 2004 from $18.2 million in the second quarter of 2003. The increasewas primarily due to increased revenue. As a percentage of revenue, grossmargin remained unchanged at 93% in the second quarters of 2004 and 2003.**We expect that gross margin, as a percentage ofrevenue, will remain in excess of 90% of revenue for the foreseeable future.

 

# **OperatingExpenses**

 

# ***Selling and marketing***. Selling and marketingexpenses consist primarily of salaries, commissions and benefits related topersonnel engaged in selling, marketing and customer support functions, alongwith costs related to public relations, investor relations, advertising,promotions and travel as well as allocated facilities costs and depreciationexpenses. Selling and marketing expenses increased to $10.4 million in thesecond quarter of 2004 from $7.5 million in the second quarter of 2003. Theincrease in selling and marketing expenses of $2.9 million was primarily due toincreased headcount costs and related travel and allocated costs as well ashigher commission and co-op marketing expenses related to higher sales levels.We expect selling and marketing expenses to increase in the future as morepersonnel are added to support our expanding selling and marketing effortsworldwide and as increased sales result in higher overall sales commissionexpenses.

 

*Research and development.*****Research and development expenses consistprimarily of salaries and benefits for software developers, contractprogrammers, and allocated facilities costs and equipment depreciation.Research and development expenses increased to $3.5 million in the secondquarter of 2004 from $3.1 million in the second quarter of 2003. The increase of$400,000 in research and development expenses was primarily a result ofallocated costs as well as personnel added to support our expanding list oftechnology partners, the enhancements of Websense Enterprise and additionalproducts. We expect research and development expenses to increase in absolutedollars in future periods as a result of our continued enhancements of WebsenseEnterprise and additional products.

 

*General and administrative*.General and administrative expenses consist primarily of salaries, benefits andrelated expenses for our executive, finance, human resources and administrativepersonnel, third party professional service fees, allocated facilities costsand depreciation expenses. General and administrative expenses increased to $2.1million in the second quarter of 2004 from $1.7 million in the second quarterof 2003. The $400,000 increase in general and administrative expenses isprimarily a result of an increase in professional accounting fees, drivenprimarily by compliance with the Sarbanes-Oxley Act of 2002, and additionalpersonnel needed to support our growing operations, both domestically andinternationally. We expect general and administrative expenses to increase inabsolute dollars in future periods, reflecting growth in operations, increasingexpenses associated with being a public company and expansion of ourinternational operations.

 

12

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# **OtherIncome, Net**

 

# **Net other income decreased to $456,000 in the secondquarter of 2004 from $780,000 in the second quarter of 2003. The decrease isdue primarily to lower interest rates generated by our cash, cash equivalentsand marketable securities despite increased balances as of June 30, 2004 ascompared with June 30, 2003. The lower interest rates are substantially theresult of our strategy to maximize the after-tax return on our investments bypurchasing lower interest tax-exempt investments beginning in the secondquarter of 2003. As of June 30, 2004, the majority of our total cash and cashequivalents and marketable securities were tax-exempt, compared to less thanhalf at June 30, 2003. Also contributing to the decrease were realized lossesfrom settled foreign exchange contracts. We expect the majority of our cash andcash equivalents and marketable securities will continue to be held intax-exempt investments during the foreseeable future.**

 

# **Provisionfor Income Taxes**

 

# **Provision for income taxes consist primarilyof federal and California income taxes as well as taxes related to our whollyowned subsidiaries in the United Kingdom, Japan, Australia, France and Germany.Provision for income taxes increased to $3.4 million in the second quarter of2004 from $2.6 million in the second quarter of 2003. The $800,000 increase inthe provision for income taxes is primarily a result of the increase in netincome before income taxes partially offset by the decreasing effective taxrate from 39% in the second quarter of 2003 to 37% in the second quarter of2004.**The decrease ineffective tax rate is primarily attributable to an increase in tax-exemptinvestments. An increase in foreign income taxed at lower statutory rates alsocontributed to the effective tax rate reduction. We expect an effective taxrate of approximately 37% for 2004. Subsequent to 2004, our effective tax ratemay decrease over time due to benefits derived from lower tax rates associatedwith foreign income.

 

13

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***Six months ended June 30, 2004, compared withthe six months ended June 30, 2003***

 

The followingtable summarizes our operating results as a percentage of total revenue foreach of the periods shown.

 
| ** **                 | ** ** | **Six Months  Ended** | ** ** |
|----------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **June 30, 2004**     | ** ** | **June 30, 2003** | ** ** |
| ** **                 | ** ** | **(Unaudited)**       | ** ** |
|                       |       |                  |       |   |   |
| Revenue                    |       | 100                   | %          | 100 | % |
|                       |       |                  |       |   |   |
| Cost of revenue            |       | 7                     |       | 7 |   |
|                       |       |                  |       |   |   |
| Gross margin               |       | 93                    |       | 93 |   |
|                       |       |                  |       |   |   |
| Operating expenses:        |       |                  |       |   |   |
| Selling and marketing      |       | 39                    |       | 37 |   |
| Research and development   |       | 14                    |       | 17 |   |
| General and administrative |       | 8                     |       | 8 |   |
| Total operating expenses   |       | 61                    |       | 62 |   |
|                       |       |                  |       |   |   |
| Income from operations     |       | 32                    |       | 31 |   |
|                       |       |                  |       |   |   |
| Other income, net          |       | 2                     |       | 4 |   |
|                       |       |                  |       |   |   |
| Income before income taxes |       | 34                    |       | 35 |   |
|                       |       |                  |       |   |   |
| Provision for income taxes |       | 13                    |       | 14 |   |
|                       |       |                  |       |   |   |
| Net income                 |       | 21                    | %          | 21 | % |

 

14

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# **Revenue**

 

# **Revenue increased to $51.3 million in the first six monthsof 2004 from $38.0 million in the first six months of 2003. The increase wasprimarily a result of the addition of new, renewed and upgraded subscriptionsfrom our customers. Approximately 35% of subscription revenue recognized in thefirst six months of 2004 was derived from sales to first-time customers, whoinitially purchased one-, two-, or three-year subscriptions to WebsenseEnterprise in 2004 or prior years. The remaining 65% of subscription revenue wasgenerated from existing customers. We expect total revenue growth in 2004 toexceed total revenue growth in 2003, although the percentage revenue growthrate may be lower in 2004 than in 2003 as a result of the larger revenue basein 2004 as compared with 2003.**

#  

# **Costof Revenue**

#  

# **Cost of revenue increased to $3.5 million in the first sixmonths of 2004 from $2.6 million in the first six months of 2003. The increasewas primarily due to the costs associated with additional personnel in ourtechnical support and database groups. We expect cost of revenue to increase inthe future as we support the growth and maintenance of our databases as well asthe technical support needs of our customers. As a percentage of revenue, costof revenue remained unchanged at 7% during the first six months of 2004 and2003. We expect that cost of revenue, as a percentage of revenue, will remainbelow 10% of revenue for the foreseeable future.**

#  

# **GrossMargin**

#  

# **Gross margin increased to $47.8 million in the first sixmonths of 2004 from $35.4 million in the first six months of 2003. The increasewas primarily due to increased revenue. As a percentage of revenue, grossmargin remained unchanged at 93% in the first six months of 2004 and 2003.**We expect that gross margin, as a percentage ofrevenue, will remain in excess of 90% of revenue for the foreseeable future.

#  

# **OperatingExpenses**

#  

# ***Selling and marketing***. Selling and marketingexpenses increased to $19.9 million in the first six months of 2004 from $14.2million in the first six months of 2003. The increase in selling and marketingexpenses of $5.7 million was primarily due to increased headcount costs andrelated travel and allocated costs as well as higher commission and co-opmarketing expenses related to higher sales levels. We expect selling andmarketing expenses to increase in the future as more personnel are added tosupport our expanding selling and marketing efforts worldwide and as increasedsales result in higher overall sales commission expenses.

#  

*Research and development.*****Research and development expensesincreased to $7.1 million in the first six months of 2004 from $6.3 million inthe first six months of 2003. The increase of $800,000 in research anddevelopment expenses was primarily a result of allocated costs as well aspersonnel added to support our expanding list of technology partners, theenhancements of Websense Enterprise and additional products. We expect researchand development expenses to increase in absolute dollars in future periods as aresult of our continued enhancements of Websense Enterprise and additionalproducts.

 

*General and administrative*.General and administrative expenses increased to $4.4 million in the first sixmonths of 2004 from $3.2 million in the first six months of 2003. The $1.2million increase in general and administrative expenses is primarily a resultof an increase in professional accounting fees driven primarily by compliancewith the Sarbanes-Oxley Act of 2002, state sales tax expenses and additional

 

15

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personnel needed to support our growing operations, both domesticallyand internationally. We expect general and administrative expenses to increasein absolute dollars in future periods, reflecting growth in operations,increasing expenses associated with being a public company and expansion of ourinternational operations.

 

# **OtherIncome, Net**

#  

# **Net other income decreased to $869,000 in the first sixmonths of 2004 from $1.5 million in the first six months of 2003. The decreaseis due primarily to lower interest rates generated by our cash, cashequivalents and marketable securities despite increased balances as of June 30,2004 as compared with June 30, 2003. The lower interest rates are substantiallythe result of our strategy to maximize the after-tax return on our investmentsby purchasing lower interest tax-exempt investments beginning in the secondquarter of 2003. As of June 30, 2004, the majority of our total cash and cashequivalents and marketable securities were tax-exempt, compared to less thanhalf at June 30, 2003. Also contributing to the decrease were realized lossesfrom settled foreign exchange contracts. We expect the majority of our cash andcash equivalents and marketable securities will continue to be held in tax-exemptinvestments during the foreseeable future.**

#  

# **Provisionfor Income Taxes**

#  

# **In the first six months of 2004, ourprovision for income taxes consist primarily of federal and California incometaxes as well as taxes related to our wholly owned subsidiaries in the UnitedKingdom, Japan, Australia, France and Germany. Provision for income taxesincreased to $6.4 million in the first six months of 2004 from $5.2 million inthe first six months of 2003. The $1.2 million increase in the provision forincome taxes is primarily a result of the increase in net income before incometaxes partially offset by the decreasing effective tax rate from 39% in thefirst six months of 2003 to 37% in the first six months of 2004.**The decrease in effective tax rate is primarilyattributable to an increase in tax-exempt investments. An increase in foreignincome taxed at lower statutory rates also contributed to the effective taxrate reduction. We expect an effective tax rate of approximately 37% for 2004.Subsequent to 2004, our effective tax rate may decrease over time due tobenefits derived from lower tax rates associated with foreign income.

#  

**Liquidityand Capital Resources**

 

As of June 30, 2004, we had cash and cash equivalents of $34.4 million,investments in marketable securities of $178.4 million and accumulated earningsof $26.7 million.

 

**Net cash provided by operating activities was $26.1 million in thefirst six months of 2004 compared with $19.0 million in the first six months of2003. The $7.1 million increase in cash provided by operating activities in thefirst six months of 2004 was primarily due to an increase in our net income andan increase in deferred revenue (subscription amounts in excess of recognizablerevenue are recorded as deferred revenue). Our operating cash flow and revenueare significantly influenced by subscription renewals and a decrease insubscription renewals would negatively impact our operating cash flow andrevenue.**

 

Net cash used in investing activities was $33.0 million in the firstsix months of 2004 compared with net cash provided by investing activities of$26.4 million in the first six months of 2003. The $59.4 million increase incash used by investing activities in the first six months of 2004 was primarilydue to fewer maturities and sales of marketable securities to offset purchasesof marketable securities as we shifted our investment strategy to purchase moretax-exempt investments.

 

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Net cash provided by financing activities was $5.9 million in the firstsix months of 2004 compared with net cash used by financing activities of $1.2million in the first six months of 2003. The $7.1 million increase in net cashprovided by financing activities in the first six months of 2004 is primarilydue to the proceeds from stock options exercised by employees, partially offsetby the use of $6.0 million for the repurchase of 205,000 shares of our commonstock.

 

We have operating lease commitments of approximately $0.8 millionduring the remainder of 2004, $1.5 million in 2005, $1.5 million in 2006 and$1.4 million in 2007. A significant majority of our operating lease commitmentsare related to our corporate headquarters lease, which was renewed in April2002. The lease renewal incentives resulted in no rent payments in the thirdand fourth quarters of 2002 and escalating rent payments from 2004 to 2007. Therent expense related to our corporate headquarters lease renewal is recordedmonthly on a straight-line basis in accordance with generally acceptedaccounting principles.

 

Future minimum annual lease payments undernon-cancelable operating leases at June 30, 2004 are as follows (in thousands):

 
| 2004   |   | $     | 809    |   |
|--------|--------|-------|--------|--------|
| 2005   |   | 1,463 |   |
| 2006   |   | 1,501 |   |
| 2007   |   | 1,389 |   |
|   |   | $     | 5,162  |   |

 

As of June30, 2004 and 2003, we did not have any relationships with unconsolidatedentities or financial partners, such as entities often referred to asstructured finance or special purpose entities, which would have beenestablished for the purpose of facilitating off-balance sheet arrangements orother contractually narrow or limited purposes. As such, we are not materiallyexposed to any financing, liquidity, market or credit risk that could arise ifwe had engaged in such relationships.

 

On April 3, 2003, we announced that our Board of Directors authorized astock repurchase program of up to 2 million shares of our common stock. Therepurchases will be made from time to time on the open market at prevailingmarket prices or in privately negotiated transactions. Depending on marketconditions and other factors, purchases under this program may be commenced orsuspended at any time, or from time to time, without prior notice. As of June30, 2004, we had repurchased 601,000 shares of our common stock under thisprogram, for an aggregate of $13.7 million at an average price of $22.81 pershare.

 

We believethat our cash and cash equivalents balances and investments in marketablesecurities will be sufficient to satisfy our cash requirements for theforeseeable future. We intend to continue to invest our cash in excess ofcurrent operating requirements in interest-bearing, investment-gradesecurities.

 

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**Risks andUncertainties**

 

Risks anduncertainties that could impact our business, consolidated financial position,results of operations and cash flows and cause future results to differ fromour expectations include the following: customer acceptance of our services,products and fee structures; the success of our brand development efforts; thevolatile and competitive nature of the Internet industry; changes in domesticand international market conditions and the entry into and development ofinternational markets for our products; risks relating to intellectual propertyownership; and the risks and uncertainties identified in our Annual Report onForm 10-K for the fiscal year ended December 31, 2003 and other filings withthe Securities and Exchange Commission.

 

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

 

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

 

We are exposed to changes in interest rates primarily from ourshort-term available-for-sale investments. Under our current policies, we donot use interest rate derivative instruments to manage exposure to interestrate changes. A hypothetical 100 basis point adverse move in interest ratesalong the entire interest rate yield curve would not materially affect the fairvalue of our interest sensitive financial instruments at June 30, 2004. Changesin interest rates over time will, however, affect our interest income.

 

For the quarter ended June 30, 2004, all of our billings, includingthose billed by our operations in Ireland, were denominated in our functionalcurrency, which is the U.S. dollar. Working funds necessary to facilitate theshort-term operations of our subsidiaries are kept in the local currencies in whichthey do business.

 

We utilizeforeign exchange contracts to hedge foreign currency market exposures ofunderlying assets and liabilities. Our objective is to reduce the risk toearnings and cash flows associated with changes in foreign currency exchangerates. We do not use foreign exchange contracts for speculative or tradingpurposes. As of June 30, 2004, we had committed to 12 foreign exchangecontracts to purchase Euro and British Pounds for $4.2 million. Our Eurocommitment represents 1.2 million Euros at a weighted average forward rate of1.2797. Our British Pound commitment represents 1.4 million British Pounds at aweighted average forward rate of 1.8645. The fair value of these foreignexchange contracts was $4.0 million at June 30, 2004. All of the foreignexchange contracts will be settled before December 31, 2004.

 

**Item 4.** Controls and Procedures

** **

**DisclosureControls and Procedures**

 

**We maintain disclosure controls andprocedures (as defined in Rules 13a – 15(e) and 15d – 15(e) of the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”)) designed to ensure thatwe are able to collect the information we are required to disclose in thereports we file under the Exchange Act, and to record, process, summarize andreport this information within the time periods specified in the rules of theSecurities and Exchange Commission.**Our Chief Executive andChief Financial Officers evaluated our

 

**18**

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**disclosure controls and procedures as of theend of the period covered by this report. Based on their evaluation, our ChiefExecutive and Chief Financial Officers have concluded that these controls andprocedures are effective.**

 

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

 

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**Part II****- Other Information**

 

**Item 1.****           Legal Proceedings**

 

None.

 

**Item 2.****           Changes in Securities, Use of Proceeds and IssuerPurchases of Securities**

 

(a) Not applicable.

 

(b) Not applicable.

 

(c) Not applicable.

 

(d) On March 28, 2000, wecompleted our initial public offering for the sale of 4,000,000 shares ofcommon stock at a price to the public of $18 per share, which resulted in netproceeds of $65.7 million after payment of the underwriters’ commissions anddeductions of offering expenses.  Theregistration statement (No. 333-95619) relating to our initial public offeringwas declared effective on March 28, 2000. Subsequent to our initial public offering, a portion of the offeringproceeds were used to repay the $1.5 million balance of our fixed term loanagreements with financial institutions. The remaining proceeds have conformedwith our intended use outlined in the prospectus related to such offering.  We currently have approximately $64.2 millionremaining from the proceeds of our initial public offering.

 

20

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(e)  Purchases of Equity Securities by the Issuerand Affiliated Purchasers

** **
| **Month**                       | ** ** | **Number of  shares  purchased  during month(1)** | ** ** | **Average  price paid per  share** | ** ** | **Cumulative  number of shares  purchased as part  of publicly  announced plan(2)** | ** ** | **Maximum number  of shares that may  yet be purchased  under the plan** | ** ** |
|---------------------------------|------------|---------------------------------------------------|------------|------------------------------------|------------|-------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| April 1st  through 30th of 2004 |       | —                                            |       | —                             |       | 496,000                                                                             |       | 1,504,000                                                                |       |
| May 1st  through 31st of 2004   |       | 105,000                                           |       | $                                  | 29.24      |                                                                                | 601,000    |                                                                     | 1,399,000  |   |
| June 1st  through 30th of 2004  |       | —                                            |       | —                             |       | 601,000                                                                             |       | 1,399,000                                                                |       |
| Total                           |       | 105,000                                           |       | $                                  | 29.24      |                                                                                | 601,000    |                                                                     | 1,399,000  |   |

 

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

 

2.               On April 3, 2003, we announced that our Board of Directorsauthorized a stock repurchase program of up to 2 million shares of our commonstock.

 

**Item 3.****           Defaults upon Senior Securities**

 

None.

 

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

 

The Annual Meeting ofStockholders was held on Wednesday, June 2, 2004.  The following matters were voted upon at themeeting and were adopted by the margins indicated:

 

1. The stockholders elected two Directors to hold office for a termexpiring upon the 2007 Annual Meeting of Stockholders.

** **
| ** **                    | ** ** | **Number of Shares** | ** ** |
|-------------------------------|------------|----------------------|------------|
| **Name  of Director Elected** | ** ** | **For**              | ** ** | **Withheld** | ** ** |
| ** **                    | ** ** | ** **           | ** ** | ** ** | ** ** |
| John B. Carrington            |       | 21,458,792           |       | 290,777 |   |
| Gary E. Sutton                |       | 21,213,618           |       | 535,951 |   |

 

The following individuals are continuing directors with terms expiringupon the 2005 Annual Meeting of Stockholders: Mark S. St.Clare and Peter C. Waller.

 

The following individuals are continuing directors with terms expiringupon the 2006 Annual Meeting of Stockholders: Bruce T. Coleman and John F. Schaefer.

 

21

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2. The stockholders ratified the appointment of Ernst & Young LLPas our independent auditors for the fiscal year ending December 31, 2004.

 

| For     |   | 21,047,831 |   |
|---------|--------|------------|--------|
| Against |   | 700,185    |   |
| Abstain |   | 1,553      |   |

 

**Item 5.****           OtherInformation**

 

None.

 

**Item 6.****           Exhibitsand Reports on Form 8-K**

 

(a) Exhibits

** **
| ** ** | 3.1(1) | Amended and  Restated Certificate of Incorporation                                                                                                                                           |
|------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | 3.2(1) | Restated  Bylaws                                                                                                                                                                             |
| ** ** | 4.1(1) | 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)                Previouslyfiled as an exhibit to our Registration Statement on Form S-1, as amended,(File No 333-95619) and incorporated herein by reference.

 

(b) Reports on Form 8-K

 

On April 27, 2004, the Companyfiled a Current Report on Form 8-K reporting that financial results for itsfirst quarter ended March 31, 2004 were available in a press release datedApril 27, 2004.

 

22

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##### **SIGNATURES**

##### ** **

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

 
|                       | **WEBSENSE, INC.** |
|----------------------------|--------------------|
|                       |               |
| Date:  August 6, 2004 | By:                |   /s/  JOHN B. CARRINGTON |   |
|                       |               |   John  B. Carrington |
| * *                   | * *           | *  Chairman of the Board and* |
| * *                   | * *           | *  Chief Executive Officer* |
|                       |               |   |
| Date:  August 6, 2004 | By:                |   /s/  DOUGLAS C. WRIDE |   |
|                       |               |   Douglas  C. Wride |
| * *                   | * *           | *  Chief Financial Officer* |
|                            |                    |  |  |  |  |

 

23

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                   |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                                        |
| 3.1(1)              | ** ** | Amended and  Restated Certificate of Incorporation                                                                                                                                                |
| 3.2(1)              | ** ** | Restated  Bylaws                                                                                                                                                                                  |
| 4.1(1)              | ** ** | Specimen  Stock Certificate of Websense, Inc                                                                                                                                                      |
| 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)                Previouslyfiled as an exhibit to our Registration Statement on Form S-1, as amended,(File No 333-95619) and incorporated herein by reference.

 

 

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