**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

**(MarkOne)**

 

| **ý****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
|--------------------------------------------------------------------------------------------------------|
|                                                                                                   |
| **For the quarterly period ended March 31,  2004**                                                     |
|                                                                                                   |
| **OR**                                                                                                 |
|                                                                                                   |
| **o****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES 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 its charter)

 

| **Delaware**                                                             |   | **51-0380839**                           |
|--------------------------------------------------------------------------|--------|------------------------------------------|
| (State or other jurisdiction of incorporation or organization)           |   | (I.R.S. Employer Identification  Number) |
|                                                                     |   |                                     |
| **10240 Sorrento Valley Road**                                           |
| **San Diego, California 92121**                                          |
| **858-320-8000**                                                         |
| (Address of principal executive offices, zip code and telephone  number) |

 

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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. (1)Yes ý  No o  (2) Yes ý  No o

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Exchange Act Rule12(b)-2): Yes ý  No o

 

The number of sharesoutstanding of the registrant’s Common Stock, $.01 par value, as of April 30,2004 was 22,937,426.

 

 

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**Websense, Inc.**

**Form 10-Q**

**For the Period Ended March 31, 2004**

 

**TABLE OF CONTENTS**
| Part I. Financial  Information | Page     |
|--------------------------------|----------|
|                           |     |   |   |
|                           | Item 1.  | Consolidated Financial Statements (Unaudited) |   |
|                           |     | Consolidated Balance Sheets  as of March 31, 2004 and December 31, 2003 | 1 |
|                           |     | Consolidated  Statements of Income for the three months ended March 31, 2004 and 2003 | 2 |
|                           |     | Consolidated  Statement of Stockholders’ Equity for the three months ended March 31, 2004 | 3 |
|                           |     | Consolidated  Statements of Cash Flows for the three months ended March 31, 2004 and 2003 | 4 |
|                           |     | Notes  to Consolidated Financial Statements | 5 |
|                           | Item 2.  | Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 8 |
|                           | Item  3. | Quantitative  and Qualitative Disclosures About Market Risk | 14 |
|                           | Item 4.  | Controls and Procedures | 14 |
|                           |     |   |   |
| Part II. Other Information     |     |
|                           |     |   |   |
|                           | Item 1.  | Legal Proceedings | 15 |
|                           | Item 2.  | Changes in Securities, Use of Proceeds and  Issuer Purchases of Securities | 15 |
|                           | Item 3.  | Defaults upon Senior Securities | 16 |
|                           | Item 4.  | Submission of Matters to a Vote of Security  Holders | 16 |
|                           | Item 5.  | Other Information | 16 |
|                           | Item 6.  | Exhibits  and Reports on Form 8-K | 16 |
|                           |     |   |   |
| Signatures                     | 17       |

 

i

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**PartI – Financial Information**

 

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

 

**Websense, Inc.**

**ConsolidatedBalance Sheets**

**(Unaudited and in thousands)**

 
|                                                         |   | **March 31,  2004** |       | **December 31,  2003** |       |
|--------------------------------------------------------------|--------|---------------------|------------|------------------------|------------|
|                                                         |   |                | ** ** | **(See Note 1)**       | ** ** |
| **Assets**                                                   |   |                |       |                   |       |
| Current assets:                                              |   |                |       |                   |       |
| Cash and cash equivalents                                    |   | $                   | 30,439     |                   | $          | 35,324 |   |
| Marketable securities                                        |   | 169,782             |       | 147,535                |       |
| Accounts receivable, net of allowance for  doubtful accounts |   | 21,479              |       | 27,999                 |       |
| Deferred income taxes                                        |   | 8,733               |       | 8,733                  |       |
| Other current assets                                         |   | 2,463               |       | 1,271                  |       |
| Total current assets                                         |   | 232,896             |       | 220,862                |       |
|                                                         |   |                |       |                   |       |
| Property and equipment, net                                  |   | 3,343               |       | 2,997                  |       |
| Deferred income taxes, less current portion                  |   | 8,672               |       | 8,672                  |       |
| Deposits and other assets                                    |   | 430                 |       | 418                    |       |
| Total assets                                                 |   | $                   | 245,341    |                   | $          | 232,949 |   |
|                                                         |   |                |       |                   |       |
| **Liabilities and stockholders’ equity**                |   |                |       |                   |       |
| Current liabilities:                                         |   |                |       |                   |       |
| Accounts payable                                             |   | $                   | 1,171      |                   | $          | 743 |   |
| Accrued payroll and related benefits                         |   | 5,001               |       | 5,241                  |       |
| Other accrued expenses                                       |   | 4,790               |       | 3,835                  |       |
| Income taxes payable                                         |   | 2,199               |       | 241                    |       |
| Current portion of deferred revenue                          |   | 67,619              |       | 65,480                 |       |
| Total current liabilities                                    |   | 80,780              |       | 75,540                 |       |
|                                                         |   |                |       |                   |       |
| Deferred revenue, less current portion                       |   | 28,181              |       | 28,480                 |       |
|                                                         |   |                |       |                   |       |
| Stockholders’ equity:                                   |   |                |       |                   |       |
| Common stock                                                 |   | 233                 |       | 228                    |       |
| Additional paid-in capital                                   |   | 126,111             |       | 120,639                |       |
| Treasury stock                                               |   | (10,640             | )          | (7,684                 | )          |
| Retained earnings                                            |   | 20,858              |       | 15,731                 |       |
| Accumulated other comprehensive income  (loss)               |   | (182                | )          | 15                     |       |
| Total stockholders’ equity                              |   | 136,380             |       | 128,929                |       |
| Total liabilities and stockholders’ equity              |   | $                   | 245,341    |                   | $          | 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** |   |
|------------------------------------------|--------|-------------------------|--------|
|                                     |   | **March 31,  2004**     |   | **March 31,  2003** |   |
|                                     |   |                    |   |   |   |
| Revenue                                  |   | $                       | 24,611 |   | $ | 18,504 |   |
|                                     |   |                    |   |   |   |
| Cost of revenue                          |   | 1,691                   |   | 1,305 |   |
|                                     |   |                    |   |   |   |
| Gross margin                             |   | 22,920                  |   | 17,199 |   |
|                                     |   |                    |   |   |   |
| Operating expenses:                      |   |                    |   |   |   |
| Selling and marketing                    |   | 9,416                   |   | 6,635 |   |
| Research and development                 |   | 3,567                   |   | 3,218 |   |
| General and administrative               |   | 2,219                   |   | 1,544 |   |
| Amortization of stock-based compensation |   | —                  |   | 43 |   |
| Total operating expenses                 |   | 15,202                  |   | 11,440 |   |
|                                     |   |                    |   |   |   |
| Income from operations                   |   | 7,718                   |   | 5,759 |   |
|                                     |   |                    |   |   |   |
| Other income, net                        |   | 413                     |   | 675 |   |
|                                     |   |                    |   |   |   |
| Income before income taxes               |   | 8,131                   |   | 6,434 |   |
|                                     |   |                    |   |   |   |
| Provision for income taxes               |   | 3,004                   |   | 2,574 |   |
|                                     |   |                    |   |   |   |
| Net income                               |   | $                       | 5,127  |   | $ | 3,860 |   |
|                                     |   |                    |   |   |   |
| Net income per share:                    |   |                    |   |   |   |
|                                     |   |                    |   |   |   |
| Basic net income per share               |   | $                       | 0.23   |   | $ | 0.18 |   |
| Diluted net income per share             |   | $                       | 0.22   |   | $ | 0.17 |   |
| Weighted average shares – basic     |   | 22,677                  |   | 21,795 |   |
| Weighted average shares – diluted   |   | 23,676                  |   | 22,716 |   |

 

See accompanying notes.

 

2

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**Websense, Inc.**

**Consolidated Statement of Stockholders’ Equity**

**(Unaudited and in thousands)**

 
|                                                                    |   |       |   |   |   | **Additional  paid-in capital** |   | **Treasury  stock** |   | **Retained  earnings** |    | **Accumulated  other  comprehensive income (loss)** |   | **Total  stockholders’  equity** |   |
|-------------------------------------------------------------------------|--------|------------|--------|--------|--------|---------------------------------|--------|---------------------|--------|------------------------|---------|----------------------------------------------------------|--------|---------------------------------------|--------|
|                                                                    |   |       |
| **Common  stock**                                                       |
| **Shares**                                                              |   | **Amount** |
|                                                                    |   |       |   |   |   |                            |   |                |   |                   |    |                                                     |   |                                  |   |
| Balance at December 31, 2003                                            |   | 22,445     |   | $      | 228    |                            | $      | 120,639             |   | $                      | (7,684  | )                                                        | $      | 15,731                                |   | $ | 15 |   | $ | 128,929 |   |
| Issuance of common stock upon exercise of options                       |   | 445        |   | 5      |   | 5,472                           |   | —              |   | —                 |    | —                                                   |   | 5,477                                 |   |
| Purchase of treasury stock                                              |   | (100       | )      | — |   | —                          |   | (2,956              | )      | —                 |    | —                                                   |   | (2,956                                | )      |
| Comprehensive income:                                                   |   |       |   |   |   |                            |   |                |   |                   |    |                                                     |   |                                  |   |
| Net income                                                              |   | —     |   | — |   | —                          |   | —              |   | 5,127                  |    | —                                                   |   | 5,127                                 |   |
| Unrealized gain on securities available for sale                        |   |       |   |   |   |                            |   |                |   |                   |    | 3                                                        |   | 3                                     |   |
| Unrealized loss on fair market valuation of foreign exchange  contracts |   | —     |   | — |   | —                          |   | —              |   | —                 |    | (200                                                     | )      | (200                                  | )      |
| Comprehensive income                                                    |   |       |   |   |   |                            |   |                |   |                   |    |                                                     |   | 4,930                                 |   |
| Balance at March 31, 2004                                               |   | 22,790     |   | $      | 233    |                            | $      | 126,111             |   | $                      | (10,640 | )                                                        | $      | 20,858                                |   | $ | (182 | ) | $ | 136,380 |   |

 

See accompanying notes.

 

3

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**Websense, Inc.**

**Consolidated Statements of Cash Flows**

**(Unaudited and in thousands)**

 
|                                                                               |   | **Three  months ended** |   |
|------------------------------------------------------------------------------------|--------|-------------------------|--------|
|                                                                               |   | **March 31,  2004**     |   | **March 31,  2003** |   |
| **Operating activities:**                                                          |   |                    |   |   |   |
| Net income                                                                         |   | $                       | 5,127  |   | $ | 3,860 |   |
|                                                                               |   |                    |   |   |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |   |                    |   |   |   |
| Depreciation                                                                       |   | 511                     |   | 489 |   |
| Amortization of deferred compensation                                              |   | —                  |   | 43 |   |
| Deferred revenue                                                                   |   | 1,840                   |   | 184 |   |
| Unrealized loss on foreign exchange contracts                                      |   | (200                    | )      | — |   |
| Changes in operating assets and liabilities:                                       |   |                    |   |   |   |
| Accounts receivable                                                                |   | 6,520                   |   | 3,896 |   |
| Deposits and other assets                                                          |   | (1,204                  | )      | (393 | ) |
| Accounts payable                                                                   |   | 428                     |   | 35 |   |
| Accrued payroll and related benefits                                               |   | (240                    | )      | 497 |   |
| Other accrued expenses                                                             |   | 955                     |   | (98 | ) |
| Income taxes payable                                                               |   | 1,958                   |   | 2,757 |   |
| Net cash provided by operating activities                                          |   | 15,695                  |   | 11,270 |   |
|                                                                               |   |                    |   |   |   |
| **Investing activities:**                                                          |   |                    |   |   |   |
| Purchases of property and equipment                                                |   | (857                    | )      | (507 | ) |
| Purchases of marketable securities                                                 |   | (87,534                 | )      | (38,866 | ) |
| Maturities of marketable securities                                                |   | 64,097                  |   | 26,797 |   |
| Sales of marketable securities                                                     |   | 1,193                   |   | — |   |
| Net cash used in investing activities                                              |   | (23,101                 | )      | (12,576 | ) |
|                                                                               |   |                    |   |   |   |
| **Financing activities:**                                                          |   |                    |   |   |   |
| Proceeds from exercise of stock options                                            |   | 5,477                   |   | 128 |   |
| Purchases of treasury stock                                                        |   | (2,956                  | )      | — |   |
| Net cash provided by financing activities                                          |   | 2,521                   |   | 128 |   |
|                                                                               |   |                    |   |   |   |
| Decrease in cash and cash equivalents                                              |   | (4,885                  | )      | (1,178 | ) |
|                                                                               |   |                    |   |   |   |
| Cash and cash equivalents at beginning of period                                   |   | 35,324                  |   | 29,263 |   |
|                                                                               |   |                    |   |   |   |
| Cash and cash equivalents at end of period                                         |   | $                       | 30,439 |   | $ | 28,085 |   |

 

See accompanying notes.

 

4

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**Websense, Inc.**

 

**Notes To Consolidated FinancialStatements (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 March 31, 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 options, warrantsand restricted stock subject to vesting. During the first three months of 2004and 2003, the difference between the weighted average shares used indetermining basic EPS versus diluted EPS related to dilutive stock options andwarrants totaling 999,000 and 921,000, respectively. Potentially dilutive securitiestotaling 219,000 and 1,546,000 for the quarters ended March 31, 2004 and 2003,respectively, were excluded from historical basic and diluted earnings pershare because of their anti-dilutive effect as a result of stock options whichhave exercise prices greater than the average market price on the commonshares.

 

5

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The following is a reconciliation ofthe numerator and denominator used in calculating basic EPS to the numeratorand denominator 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:** |   |                                          |   |                      |   |                  |   |
| **March 31, 2004:**             |   |                                          |   |                      |   |                  |   |
| Basic EPS                       |   | $                                             | 5,127  |                      | 22,677 |                  | $      | 0.23 |   |
| Effect of options               |   | —                                        |   | 999                       |   | (0.01                 | )      |
| Diluted EPS                     |   | $                                             | 5,127  |                      | 23,676 |                  | $      | 0.22 |   |
|                            |   |                                          |   |                      |   |                  |   |
| **March 31, 2003:**             |   |                                          |   |                      |   |                  |   |
| Basic EPS                       |   | $                                             | 3,860  |                      | 21,795 |                  | $      | 0.18 |   |
| Effect of options               |   | —                                        |   | 921                       |   | (0.01                 | )      |
| Diluted EPS                     |   | $                                             | 3,860  |                      | 22,716 |                  | $      | 0.17 |   |

 

3. *Amortization of Stock-Based Compensation*

 

For the three months ended March 31, 2004,the Company recorded no amortization of stock-based compensation. Theallocation of the expense by operating expense category in the three monthsended in the prior year is as follows (in thousands):

 
|                                            |   | **Three  months ended  March 31, 2003** |   |
|-------------------------------------------------|--------|-----------------------------------------|--------|
| Selling and marketing                           |   | $                                       | 14     |   |
| Research and development                        |   | 8                                       |   |
| General and administrative                      |   | 21                                      |   |
| Total amortization of stock-based  compensation |   | $                                       | 43     |   |

 

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** |   |
|-----------------------------------------------------------------------------------|--------|-------------------------|--------|
|                                                                              |   | **March 31,  2004**     |   | **March 31,  2003** |   |
| Net income                                                                        |   | $                       | 5,127  |   | $ | 3,860 |   |
| Change in unrealized gain (loss) on  investments                                  |   | 3                       |   | (134 | ) |
| Change in unrealized loss on fair market  valuation of foreign exchange contracts |   | (200                    | )      | — |   |
| Comprehensive income                                                              |   | $                       | 4,930  |   | $ | 3,726 |   |

 

Accumulated other comprehensive income (loss)totaled $(182,000) and $15,000 at March 31, 2004 and December 31, 2003,respectively.

 

6

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5.* **Stock-Based Compensation*

 

Pro forma information regarding net income (loss) is required by SFASNo. 123, Accounting for Stock-Based Compensation, as amended by SFAS 148,Accounting for Stock-Based Compensation – Transition and Disclosure, and hasbeen determined as if the Company has accounted for its employee stock optionsand shares purchased under the employee stock purchase plan under the fair valuemethod of SFAS 123, as amended by SFAS 148. The pro forma effects ofstock-based compensation on net income and net income per share have beenestimated at the date of grant using the Black-Scholes option pricing modelbased on the following weighted average assumptions since the Company’s initialpublic offering in March of 2000: risk free interest rates of 2.36% to 6.0%,dividend yields of 0%, expected volatility of 62% to 132%, and life of 5 years.

 

TheCompany’s adjusted pro forma information is as follows (inthousands, except per share amounts):

 
|                                                                                             |   | **Three  months ended** |   |
|--------------------------------------------------------------------------------------------------|--------|-------------------------|--------|
|                                                                                             |   | **March 31,  2004**     |   | **March 31,  2003** |   |
| Net income as reported                                                                           |   | $                       | 5,127  |   | $ | 3,860 |   |
| Stock-based employee compensation cost  included in net income as  reported, net of tax (1), (2) |   | $                       | — |   | $ | 26 |   |
| Compensation expense under FAS 123, net of  tax (2)                                              |   | $                       | (2,598 | ) | $ | (2,052 | ) |
| Pro forma net income                                                                             |   | $                       | 2,529  |   | $ | 1,834 |   |
|                                                                                             |   |                    |   |   |   |
| Basic net income per share as reported                                                           |   | $                       | 0.23   |   | $ | 0.18 |   |
| Pro forma basic net income per share                                                             |   | $                       | 0.11   |   | $ | 0.08 |   |
|                                                                                             |   |                    |   |   |   |
| Diluted net income per share as reported                                                         |   | $                       | 0.22   |   | $ | 0.17 |   |
| Pro forma diluted net income per share                                                           |   | $                       | 0.11   |   | $ | 0.08 |   |

 

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(1)          The Company wasrecognizing deferred stock-based compensation expense on the deemed fair valueof options granted prior to the initial public offering in March 2000.  This expense was amortized on an acceleratedbasis, in accordance with FIN 28, over approximately a four-year period, whichbegan in March 2000 and ended in December 2003.

 

(2)          The Company had aneffective tax rate of 37% and 40% in the three months ended March 31, 2004 and2003, 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. *Reclassifications*

 

Certainreclassifications have been made for consistent presentation.

 

7

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

 

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

 

**Forward Looking Statements**

 

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

 

•                  anticipatedtrends in revenue;

•                  growthopportunities in domestic and international markets;

•                  customeracceptance and satisfaction with our products;

•                  expected trends in operating andother expenses;

•                  anticipated cash and intentionsregarding usage of cash;

•                  changes in effective tax rates; and

•                  anticipated product enhancements orreleases.

 

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

** **

**Overview**

** **

**Weprovide Employee Internet Management, or EIM, solutions that enableorganizations to analyze, report and manage how their employees use computingresources at work, including Internet access, instant messaging, peer-to-peerfile sharing, network bandwidth and desktop applications. Our primary product,Websense Enterprise®, gives organizations the ability to rapidly implement andconfigure Internet access policies in support of their efforts to improve employeeproductivity, conserve network bandwidth, mitigate potential legal liabilityand enhance network security. In 1996, we released our first software product,Websense Internet Screening System, and since that time, we have focused ourbusiness on developing and selling EIM solutions. In December 1999, we releasedWebsense Enterprise Version 4, which was sold through March 2003. We launchedthe next generation of Websense software - Websense Enterprise Version 5 - inMarch 2003, including enhanced EIM capabilities.  We have also introduced Premium GroupTM databases andadd-on modules featuring new network and application management technology suchas, Bandwidth OptimizerTM, Instant Messaging Attachment ManagerTM, and ClientPolicy ManagerTM. We currently derive nearly all of our revenue fromsubscriptions to the Websense Enterprise solution and expect this trend tocontinue in the future as more offerings are added to the Websense Enterpriseplatform.**

** **

 

8

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**Duringthe three months ended March 31, 2004, we derived 30% of revenue frominternational sales compared with 29% for the three months ended March 31,2003.  International revenue increased38% in the first quarter of 2004 over the first quarter of 2003, with theUnited Kingdom comprising approximately 9% of our total revenue. We believeinternational markets represent a significant growth opportunity and we arecontinuing to expand our international operations, particularly in selectedcountries in the European and Asia/Pacific markets.**

 

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

 

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

** **

**CriticalAccounting 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, customers enter into a subscription agreement, whichis generally 12, 24 or 36 months in duration and for a fixed number of users.We recognize revenue on a monthly straight-line basis over the term of thesubscription agreement. We promptly invoice customers for the full amount oftheir subscriptions at the time a subscription is activated. Payment is due forthe full term of the subscription, generally within 30 days of the invoice. 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 then current ratesto continue using Websense Enterprise. Our revenue is significantly influencedby subscription renewals, and a decrease in subscription renewals amounts couldnegatively impact our future revenue.

** **

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

** **

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

 

9

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# **Results of Operations**

 

***Three months endedMarch 31, 2004, compared with the three months ended March 31, 2003***

 

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

 

 
|                                      |   | **Three Months Ended**   |   |
|-------------------------------------------|--------|--------------------------|--------|
|                                      |   | **March 31,  2004** |   | **March 31,  2003** |   |
|                                      |   | **(Unaudited)**          |   |
|                                      |   |                     |   |   |   |
| Revenue                                   |   | 100                      | %      | 100 | % |
|                                      |   |                     |   |   |   |
| Cost of  revenue                          |   | 7                        |   | 7 |   |
|                                      |   |                     |   |   |   |
| Gross margin                              |   | 93                       |   | 93 |   |
|                                      |   |                     |   |   |   |
| Operating expenses:                       |   |                     |   |   |   |
| Selling and  marketing                    |   | 38                       |   | 36 |   |
| Research and  development                 |   | 15                       |   | 17 |   |
| General and  administrative               |   | 9                        |   | 8 |   |
| Amortization  of stock-based compensation |   | —                   |   | 1 |   |
| Total  operating expenses                 |   | 62                       |   | 62 |   |
|                                      |   |                     |   |   |   |
| Income from  operations                   |   | 31                       |   | 31 |   |
|                                      |   |                     |   |   |   |
| Other  income, net                        |   | 2                        |   | 4 |   |
|                                      |   |                     |   |   |   |
| Income  before income taxes               |   | 33                       |   | 35 |   |
|                                      |   |                     |   |   |   |
| Provision  for income taxes               |   | 12                       |   | 14 |   |
|                                      |   |                     |   |   |   |
| Net income                                |   | 21                       | %      | 21 | % |

 

10

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# **Revenue**

 

# **Revenue increased to $24.6 million in the first quarter of2004 from $18.5 million in the first quarter of 2003. This increase wasprimarily a result of the addition of new customers. Approximately 40% ofsubscription revenue recognized in the first quarter of 2004 was derived fromsales to first-time customers, who initially purchased one-, two-, orthree-year subscriptions to Websense Enterprise in 2004 or prior years. Theremaining 60% of subscription revenue was generated from existing customers. Weexpect total revenue growth in 2004 to exceed total revenue growth in 2003,although the percentage revenue growth rate may be lower in 2004 than in 2003as a result of the larger revenue base in 2004 as compared with 2003.**

# ** **

# **Cost of 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 $1.7 million in the first quarter of2004 from $1.3 million in the first quarter of 2003. The increase was primarilydue to the costs associated with additional personnel in our technical supportand database groups. We expect cost of revenue to increase in the future as wesupport the growth and maintenance of our databases as well as the technicalsupport needs of our customers. As a percentage of revenue, cost of revenueremained unchanged at 7% during the first quarters of 2004 and 2003. We expectthat cost of revenue, as a percentage of revenue, will remain below 10% ofrevenue for the foreseeable future.**

# ** **

# **Gross Margin**

 

# **Gross margin increased to $22.9 million in the firstquarter of 2004 from $17.2 million in the first quarter of 2003. The increasewas primarily due to increased revenue. As a percentage of revenue, grossmargin remained unchanged at 93% in the first quarters of 2004 and 2003.**We expect that gross margin, as a percentage of revenue, will remain inexcess of 90% of revenue for the foreseeable future.

 

# **Operating Expenses**

 

# ***Selling and marketing***. Selling and marketing expenses consist primarily of salaries,commissions and benefits related to personnel engaged in selling, marketing andcustomer support functions, along with costs related to public relations,investor relations, advertising, promotions and travel as well as allocatedfacilities costs and depreciation expenses. Selling and marketing expensesincreased to $9.4 million in the first quarter of 2004 from $6.6 million in thefirst quarter of 2003. The increase in selling and marketing expenses of $2.8million was primarily due to increased headcount costs and related travel andallocated costs as well as higher commission expenses related to higher saleslevels. We expect selling and marketing expenses to increase in the future asmore personnel 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 $3.6 million in the firstquarter of 2004 from $3.2 million in the first quarter of 2003. The increase of$400,000 in research and development expenses was primarily a result of personneladded to support our expanding list of technology partners, the enhancements ofWebsense Enterprise and additional products. We expect research and developmentexpenses to increase in the future, as more personnel are added to supportadditional technology partners, product enhancements, and expansion of ourproduct offerings.

 

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*General and administrative*.General and administrative expenses consist primarily of salaries, benefits andrelated expenses for our executive, finance, human resources and administrativepersonnel, third party professional service fees, allocated facilities costsand depreciation expenses. General and administrative expenses increased to$2.2 million in the first quarter of 2004 from $1.5 million in the firstquarter of 2003. The $700,000 increase in general and administrative expensesis primarily a result of an increase in state sales tax expenses and additionalpersonnel needed to support our growing operations, both domestically andinternationally. We expect general and administrative expenses to increase infuture periods, reflecting growth in operations, increasing expenses associatedwith being a public company and expansion of our international operations.

 

# **Other Income, Net**

 

# **Net other income decreased to $413,000 in the first quarterof 2004 from $675,000 in the first quarter of 2003. The decrease is dueprimarily to lower interest rates generated by our cash, cash equivalents andmarketable securities despite increased balances as of March 31, 2004 ascompared with March 31, 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 March 31, 2004, the majority of our total cash andcash equivalents and marketable securities were tax-exempt, compared to no suchinvestments at March 31, 2003. We expect the majority of our cash and cashequivalents and marketable securities will continue to be held in tax-exemptinvestments during the foreseeable future.**

 

# **Provision for Income Taxes**

 

# ** Provision forincome taxes consist primarily of federal and California income taxes as wellas taxes related to our wholly owned subsidiaries in the United Kingdom, Japan,Australia, France and Germany. Provision for income taxes increased to $3.0million in the first quarter of 2004 from $2.6 million in the first quarter of2003. The $400,000 increase in the provision for income taxes is primarily aresult of the increase in net income before income taxes partially offset bythe decreasing effective tax rate from 40% in the first quarter of 2003 to 37%in the first quarter of 2004.**Thedecrease in effective tax rate is primarily attributable to an increase intax-exempt investments. An increase in foreign income taxed at lower statutoryrates also contributed to the effective tax rate reduction. We expect aneffective tax rate of approximately 37% for 2004. Subsequent to 2004, oureffective tax rate may decrease over time due to benefits derived from lowertax rates associated with foreign income.

 

**Liquidity and Capital Resources**

 

As of March 31, 2004, we had cash and cash equivalents of $30.4million, investments in marketable securities of $169.8 million and accumulatedearnings of $20.9 million.

 

**Net cashprovided by operating activities was $15.7 million in the first three months of2004 compared with $11.3 million in the first three months of 2003. The $4.4million increase in cash provided by operating activities in the first threemonths of 2004 was primarily due to an increase in our net income, an increasein deferred revenue (our subscriptions are initially recorded as deferredrevenue) and a decrease in accounts receivable. Our operating cash flow andrevenue are significantly influenced by subscription renewals and a decrease insubscription renewals would negatively impact our operating cash flow andrevenue.**

 

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Net cash used in investing activities was $23.1 million in the firstthree months of 2004 compared with net cash used by investing activities of$12.6 million in the first three months of 2003. The $10.5 million increase incash used by investing activities in the first three months of 2004 wasprimarily due to less maturities and sales of marketable securities to offsetpurchases of marketable securities.

 

Net cash provided by financing activities was $2.5 million in the firstthree months of 2004 compared with net cash provided by financing activities of$128,000 in the first three months of 2003. The $2.4 million increase in netcash provided by financing activities in the first three months of 2004 isprimarily due to the proceeds from stock options exercised by employees,partially offset by the use of $3.0 million for the repurchase of 100,000shares of our common stock.

 

We have operating lease commitments of approximately $1.2 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 inApril 2002. The lease renewal incentives resulted in no rent payments inthe third and fourth quarters of 2002 and escalating rent payments from 2004 to2007. The rent expense related to our corporate headquarters lease renewal isrecorded monthly on a straight-line basis in accordance with generally acceptedaccounting principles.

 

Future minimum annual lease payments undernon-cancelable operating leases at March 31, 2004 are as follows (inthousands):

 

| 2004   |   | $     | 1,207  |   |
|--------|--------|-------|--------|--------|
| 2005   |   | 1,463 |   |
| 2006   |   | 1,501 |   |
| 2007   |   | 1,389 |   |
|   |   | $     | 5,560  |   |

 

As of March 31, 2004 and 2003, we did not have anyrelationships with unconsolidated entities or financial partners, such asentities often referred to as structured finance or special purpose entities,which would have been established for the purpose of facilitating off-balancesheet arrangements or other contractually narrow or limited purposes. As such,we are not materially exposed to any financing, liquidity, market or creditrisk that could arise if we had engaged in such relationships.

 

On April 3, 2003, we announced that our Board of Directorsauthorized a stock repurchase program of up to 2 million shares of our commonstock. The repurchases will be made from time to time on the open market atprevailing market prices or in privately negotiated transactions. Depending onmarket conditions and other factors, purchases under this program may becommenced or suspended at any time, or from time to time, without prior notice.As of March 31, 2004, we had repurchased 496,000 shares of our commonstock under this program, for an aggregate of $10.6 million at an average priceof $21.45 per share.

 

We believe that our cash and cash equivalents balances and investmentsin marketable securities will be sufficient to satisfy our cash requirementsfor the foreseeable future. We intend to continue to invest our cash in excessof current operating requirements in interest-bearing, investment-gradesecurities.

 

 

13

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**Risks and Uncertainties**

 

**Risks and uncertainties that could impact our business,consolidated financial position, results of operations and cash flows and causefuture results to differ from our expectations include the following: customeracceptance of our services, products and fee structures; the success of ourbrand development efforts; the volatile and competitive nature of the Internetindustry; changes in domestic and international market conditions and the entryinto and development of international markets for our products; risks relatingto intellectual property ownership; and the risks and uncertainties identifiedin our Annual Report on Form 10-K for the fiscal year ended December 31,2003 and other filings with the Securities and Exchange Commission.**

 

**Item3. Quantitative and Qualitative Disclosures About Market Risk**

 

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

** **

We are exposed to changes in interest ratesprimarily from our short-term available-for-sale investments. Under our currentpolicies, we do not use interest rate derivative instruments to manage exposureto interest rate changes. A hypothetical 100 basis point adverse move ininterest rates along the entire interest rate yield curve would not materiallyaffect the fair value of our interest sensitive financial instruments atMarch 31, 2004. Declines in interest rates over time will, however, reduceour interest income.

 

For the quarter ended March 31, 2004, all ofour billings, including those billed by our operations in Ireland, weredenominated in our functional currency, which is the U.S. dollar. Working fundsnecessary to facilitate the short-term operations of our subsidiaries are keptin the local currencies in which they do business.

 

Weutilize foreign exchange contracts to hedge foreign currency market exposuresof underlying 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 March 31, 2004, we had committed to 18 foreignexchange contracts to purchase Euro and British Pounds for $6.1 million. OurEuro commitment represents 1.7 million Euros at a weighted average forward rateof 1.2810. Our British Pound commitment represents 2.1 million British Poundsat a weighted average forward rate of 1.8714. The fair value of these foreignexchange contracts was $5.9 million at March 31, 2004. All of the foreignexchange contracts will be settled before December 31, 2004.

 

**Item 4.** Controls and Procedures

 

**Disclosure Controls and Procedures**

 

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

 

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**We alsomaintain a system of internal control over financial reporting (as defined inRules 13a – 15(f) and 15d – 15(f) of the Exchange Act) designed to providereasonable assurance that transactions are executed in accordance withmanagement’s general or specific authorization and that transactions arerecorded as necessary (1) to permit preparation of financial statements inconformity with generally accepted accounting principles, and (2) to maintainaccountability for assets. Access to assets is permitted only in accordancewith management’s general or specific authorization, and the recordedaccountability for assets is compared with the existing assets at reasonableintervals and appropriate action is taken with respect to any differences.**

** **

Since the date of the most recent evaluation of our internalcontrol over financial reporting by our Chief Executive and Chief FinancialOfficers, there have been no significant changes in our internal control overfinancial reporting or in other factors that could significantly affect ourinternal control over financial reporting, including any corrective actionswith regard to significant deficiencies and material weaknesses.

 

 

**Part II - Other Information**

 

**Item1****.****           Legal Proceedings**

 

None.

 

**Item2.****           Changes in Securities,Use of Proceeds and Issuer Purchases of Securities**

 

**(a) Not applicable.**

** **

**(b) Not applicable.**

** **

**(c) Not applicable.**

** **

**(d) On March 28, 2000, we completed our initial publicoffering for the sale of 4,000,000 shares of common stock at a price to thepublic of $18 per share, which resulted in net proceeds of $65.7 million afterpayment of the underwriters’ commissions and deductions of offeringexpenses.  The registration statement(No. 333-95619) relating to our initial public offering was declared effectiveon March 28, 2000.  Subsequent to ourinitial public offering, a portion of the offering proceeds were used to repaythe $1.5 million balance of our fixed term loan agreements with financialinstitutions. The remaining proceeds have conformed with our intended useoutlined in the prospectus related to such offering.  We currently have approximately $64.2 million remaining from theproceeds of our initial public offering.**

 

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**(e)  Purchases ofEquity Securities by the Issuer and Affiliated Purchasers**

** **
| **Month**              |   | **Number of  shares purchased   during month** |   | **Average  price paid per  share** |      | **Cumulative  number of  shares purchased  as part of publicly  announced plan(1**) |        | **Maximum  number  of shares that may  yet be purchased  under the plan** |
|------------------------|--------|------------------------------------------------|--------|------------------------------------|-----------|-------------------------------------------------------------------------------------|-------------|---------------------------------------------------------------------------|
| **January 2004**  |   | **—**                                     |   | **—**                         |      | **396,000**                                                                         |        | **1,604,000**                                                             |
| **February 2004** |   | **—**                                     |   | **—**                         |      | **396,000**                                                                         |        | **1,604,000**                                                             |
| **March 2004**    |   | **100,000**                                    |   | **$**                              | **29.57** |                                                                                | **496,000** |                                                                      | **1,504,000** |
|                        |        |                                                |        |                                    |           |                                                                                     |             |                                                                           |  |

 

**(1) 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 SeniorSecurities

 

**None.**

** **

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

** **

**None.**

** **

**Item 5**.           Other Information

** **

**None.**

** **

**Item 6**.           Exhibits and Reports on Form8-K

** **

**(a) Exhibits**

** **

**31.1Certification of Principal Executive Officer pursuant to Exchange Act Rules13a-14(a) and 15d-14(a).**

** **

**31.2Certification of Principal Financial Officer pursuant to Exchange Act Rules13a-14(a) and 15d-14(a).**

** **

**32.1Certification of Principal Executive Officer pursuant to Exchange Act Rules13a-14(b) and 15d-14(b).**

** **

**32.2**Certification of Principal Financial Officer pursuant to Exchange ActRules 13a-14(b) and 15d-14(b).

** **

**(b) Reports on Form 8-K**

** **

**On January 28, 2004, the Company filed a CurrentReport on Form 8-K reporting that financial results for its fourth quarter andyear-ended December 31, 2003 were available in a press release datedJanuary 28, 2004.**

** **

**16**

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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 7, 2004  | By:    |   /s/ JOHN B. CARRINGTON      |   |
|--------------------------|--------|-----------------------------------------|--------|
|                     |   |   John B. Carrington          |
|                     |   | *  Chairman of the Board and* |
|                     |   | *  Chief Executive Officer*   |
|                     |   |                                    |
| Date:   May 7, 2004 | By:    |   /s/ DOUGLAS C. WRIDE        |   |
|                     |   |   Douglas C. Wride            |
|                     |   | *  Chief Financial Officer*   |

 

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