**FORM 10-Q**

 

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

 

**(Mark One)**

 

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

 

**For the quarterly period ended June 30, 2005**

 

**OR**

 

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

 

**For the Transition Period from          to         **

 

**Commission File Number 000-30093**

 

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**Websense, Inc.**

(Exact name of registrant as specified in its charter)

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

 

**10240 Sorrento Valley Road**

**San Diego, California 92121**

**858-320-8000**

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

 

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

 

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

 

The number of shares outstanding of the registrant’s Common Stock, $.01 par value, as of July 29, 2005 was 23,890,690.

 

 

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**Websense, Inc.**

**Form 10-Q**

**For the Period Ended June 30, 2005**

 

**TABLE OF CONTENTS**

 
| ** **                         | ** ** | ** **                                                                                        | **Page** |
|------------------------------------|------------|---------------------------------------------------------------------------------------------------|----------|
|                               |       |                                                                                              |     |
| Part I. Financial Information |       |
|                               |       |                                                                                              |     |
|                               | Item 1.    | Consolidated Financial Statements (Unaudited)                                                     |     |
|                               |       | Consolidated Balance Sheets as of June 30, 2005 and December 31,  2004                  | 1        |
|                               |       | Consolidated Statements of Income for the three and six months ended June 30,  2005 and 2004 | 2        |
|                               |       | Consolidated Statement of Stockholders’ Equity for the six months  ended June 30, 2005  | 3        |
|                               |       | Consolidated Statements of Cash Flows for the six months ended June 30,  2005 and 2004       | 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                                                                          | 19       |
|                               |       |                                                                                              |     |
| Part II.  Other Information   |       |
|                               |       |                                                                                              |     |
|                               | Item 1.    | Legal Proceedings                                                                                 | 20       |
|                               | Item  2.   | Unregistered  Sales of Equity Securities and Use of Proceeds                                      | 20       |
|                               | Item  3.   | Defaults  upon Senior Securities                                                                  | 20       |
|                               | Item  4.   | Submission  of Matters to a Vote of Security Holders                                              | 20       |
|                               | Item 5.    | Other Information                                                                                 | 21       |
|                               | Item 6.    | Exhibits                                                                                          | 21       |
|                               |       |                                                                                              |     |
| Signatures                         |       |                                                                                              | 22       |

 

i

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**Part I – Financial Information**

** **

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

 

**Websense, Inc.**

**Consolidated Balance Sheets**

**(Unauditedand in thousands)**

 
| ** **                                                   | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                   | ** ** | ** **              | ** ** | **(See Note 1)**            | ** ** |
| **Assets**                                                   |       |                    |       |                        |       |
| Current  assets:                                             |       |                    |       |                        |       |
| Cash and  cash equivalents                                   |       | $                       | 33,150     |                        | $          | 38,878 |   |
| Marketable  securities                                       |       | 253,115                 |       | 204,910                     |       |
| Accounts  receivable, net of allowance for doubtful accounts |       | 32,666                  |       | 44,309                      |       |
| Prepaid  income taxes                                        |       | 3,378                   |       | 3,201                       |       |
| Current  portion of deferred income taxes                    |       | 8,530                   |       | 8,530                       |       |
| Other  current assets                                        |       | 3,271                   |       | 1,525                       |       |
| Total  current assets                                        |       | 334,110                 |       | 301,353                     |       |
|                                                         |       |                    |       |                        |       |
| Property and  equipment, net                                 |       | 4,154                   |       | 3,955                       |       |
| Deferred  income taxes, less current portion                 |       | 9,523                   |       | 9,523                       |       |
| Deposits and  other assets                                   |       | 512                     |       | 462                         |       |
| Total assets                                                 |       | $                       | 348,299    |                        | $          | 315,293 |   |
|                                                         |       |                    |       |                        |       |
| **Liabilities  and stockholders’ equity**               |       |                    |       |                        |       |
| Current  liabilities:                                        |       |                    |       |                        |       |
| Accounts  payable                                            |       | $                       | 1,592      |                        | $          | 1,100 |   |
| Accrued  payroll and related benefits                        |       | 7,017                   |       | 7,163                       |       |
| Other  accrued expenses                                      |       | 5,087                   |       | 5,011                       |       |
| Income taxes  payable                                        |       | 1,971                   |       | 1,758                       |       |
| Current  portion of deferred revenue                         |       | 97,597                  |       | 90,686                      |       |
| Total  current liabilities                                   |       | 113,264                 |       | 105,718                     |       |
|                                                         |       |                    |       |                        |       |
| Deferred  revenue, less current portion                      |       | 45,951                  |       | 41,631                      |       |
|                                                         |       |                    |       |                        |       |
| Stockholders’  equity:                                  |       |                    |       |                        |       |
| Common stock                                                 |       | 242                     |       | 235                         |       |
| Additional  paid-in capital                                  |       | 171,524                 |       | 150,447                     |       |
| Treasury  stock                                              |       | (17,335                 | )          | —                      |       |
| Retained  earnings                                           |       | 35,227                  |       | 17,681                      |       |
| Accumulated  other comprehensive loss                        |       | (574                    | )          | (419                        | )          |
| Total  stockholders’ equity                             |       | 189,084                 |       | 167,944                     |       |
| Total  liabilities and stockholders’ equity             |       | $                       | 348,299    |                        | $          | 315,293 |   |

 

See accompanying notes.

 

1

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**Websense, Inc.**

**ConsolidatedStatements of Income**

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

 
| ** **                              | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                              | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **                              | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                    |       |                   |       |                 |       |   |   |   |   |
| Revenue                                 |       | $                      | 36,026     |                 | $          | 26,643 |   | $ | 70,208 |   | $ | 51,254 |   |
|                                    |       |                   |       |                 |       |   |   |   |   |
| Cost of  revenue                        |       | 2,501                  |       | 1,774                |       | 5,001 |   | 3,465 |   |
|                                    |       |                   |       |                 |       |   |   |   |   |
| Gross margin                            |       | 33,525                 |       | 24,869               |       | 65,207 |   | 47,789 |   |
|                                    |       |                   |       |                 |       |   |   |   |   |
| Operating  expenses:                    |       |                   |       |                 |       |   |   |   |   |
| Selling and  marketing                  |       | 13,872                 |       | 10,449               |       | 26,200 |   | 19,865 |   |
| Research and  development               |       | 4,007                  |       | 3,534                |       | 8,031 |   | 7,101 |   |
| General and  administrative             |       | 2,938                  |       | 2,133                |       | 5,809 |   | 4,352 |   |
| Total  operating expenses               |       | 20,817                 |       | 16,116               |       | 40,040 |   | 31,318 |   |
|                                    |       |                   |       |                 |       |   |   |   |   |
| Income from  operations                 |       | 12,708                 |       | 8,753                |       | 25,167 |   | 16,471 |   |
|                                    |       |                   |       |                 |       |   |   |   |   |
| Other  income, net                      |       | 1,201                  |       | 456                  |       | 2,155 |   | 869 |   |
|                                    |       |                   |       |                 |       |   |   |   |   |
| Income  before income taxes             |       | 13,909                 |       | 9,209                |       | 27,322 |   | 17,340 |   |
|                                    |       |                   |       |                 |       |   |   |   |   |
| Provision  for income taxes             |       | 4,975                  |       | 3,402                |       | 9,776 |   | 6,406 |   |
|                                    |       |                   |       |                 |       |   |   |   |   |
| Net income                              |       | $                      | 8,934      |                 | $          | 5,807 |   | $ | 17,546 |   | $ | 10,934 |   |
|                                    |       |                   |       |                 |       |   |   |   |   |
| Net income  per share:                  |       |                   |       |                 |       |   |   |   |   |
|                                    |       |                   |       |                 |       |   |   |   |   |
| Basic net  income per share             |       | $                      | 0.37       |                 | $          | 0.25 |   | $ | 0.74 |   | $ | 0.48 |   |
| Diluted net  income per share           |       | $                      | 0.36       |                 | $          | 0.24 |   | $ | 0.71 |   | $ | 0.46 |   |
| Weighted  average shares – basic   |       | 23,835                 |       | 22,971               |       | 23,754 |   | 22,824 |   |
| Weighted  average shares – diluted |       | 24,749                 |       | 23,928               |       | 24,740 |   | 23,806 |   |

 

See accompanying notes.

 

2

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**Websense, Inc.**

**Consolidated Statement of Stockholders’ Equity**

**(Unauditedand in thousands)**

 
| ** **                                                                                           | ** ** | ** **       | ** ** | ** **     | ** ** | ** **          | ** ** | ** **   | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|------------------|------------|----------------|------------|---------------------|------------|--------------|------------|-------------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                           | ** ** | ** **       | ** ** | ** **     | ** ** | ** **          | ** ** | ** **   | ** ** | ** **        | ** ** | **other**              | ** ** | **Total**  | ** ** |
| ** **                                                                                           | ** ** | **Common stock** | ** ** | **Additional** | ** ** | **Treasury**        | ** ** | **Retained** | ** ** | **comprehensive** | ** ** | **stockholders’** | ** ** |
| ** **                                                                                           | ** ** | **Shares**       | ** ** | **Amount**     | ** ** | **paid-in capital** | ** ** | **stock**    | ** ** | **earnings**      | ** ** | **loss**               | ** ** | **equity** | ** ** |
|                                                                                                 |       |             |       |           |       |                |       |         |       |              |       |                   |       |       |       |
| Balance at December 31, 2004                                                                    |       | 23,526           |       | $              | 235        |                | $          | 150,447      |       | $                 | —     |                   | $          | 17,681     |       | $ | (419 | ) | $ | 167,944 |   |
| Issuance of common stock upon exercise of options                                                    |       | 579              |       | 6              |       | 10,656              |       | —       |       | —            |       | —                 |       | 10,662     |       |
| Issuance of common stock for purchase plan                                                           |       | 109              |       | 1              |       | 1,646               |       | —       |       | —            |       | —                 |       | 1,647      |       |
| Purchase of treasury stock                                                                           |       | (325             | )          | —         |       | —              |       | (17,335      | )          | —            |       | —                 |       | (17,335    | )          |
| Tax benefit of stock options                                                                         |       | —           |       | —         |       | 8,775               |       | —       |       | —            |       | —                 |       | 8,775      |       |
| Comprehensive income:                                                                                |       |             |       |           |       |                |       |         |       |              |       |                   |       |       |       |
|                                                                                                 |       |             |       |           |       |                |       |         |       |              |       |                   |       |       |       |
| Net income                                                                                           |       | —           |       | —         |       | —              |       | —       |       | 17,546            |       | —                 |       | 17,546     |       |
| Net change in unrealized gain (loss) on fair market  valuation of marketable securities              |       | —           |       | —         |       | —              |       | —       |       | —            |       | (37                    | )          | (37        | )          |
| Net change in unrealized gain (loss) on fair market  valuation of foreign currency forward contracts |       | —           |       | —         |       | —              |       | —       |       | —            |       | (118                   | )          | (118       | )          |
| Comprehensive income                                                                                 |       |             |       |           |       |                |       |         |       |              |       |                   |       | 17,391     |       |
| Balance at June 30, 2005                                                                        |       | 23,889           |       | $              | 242        |                | $          | 171,524      |       | $                 | (17,335    | )                      | $          | 35,227     |       | $ | (574 | ) | $ | 189,084 |   |

 

See accompanying notes.

 

3

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**Websense, Inc.**

**Consolidated Statements of Cash Flows**

**(Unauditedand in thousands)**

 
| ** **                                                                         | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                         | ** ** | **June 30,**    | ** ** | **June 30,** | ** ** |
| ** **                                                                         | ** ** | **2005**             | ** ** | **2004** | ** ** |
| **Operating  activities:**                                                         |       |                 |       |   |   |
| Net income                                                                         |       | $                    | 17,546     |   | $ | 10,934 |   |
|                                                                               |       |                 |       |   |   |
| Adjustments  to reconcile net income to net cash provided by operating activities: |       |                 |       |   |   |
| Depreciation                                                                       |       | 1,248                |       | 1,066 |   |
| Deferred  revenue                                                                  |       | 11,231               |       | 11,052 |   |
| Unrealized  loss on foreign exchange contracts                                     |       | (118                 | )          | (164 | ) |
| Tax benefit  from exercise of stock options                                        |       | 8,775                |       | 6,090 |   |
| Changes in  operating assets and liabilities:                                      |       |                 |       |   |   |
| Accounts  receivable                                                               |       | 11,643               |       | (559 | ) |
| Prepaid  income taxes                                                              |       | (177                 | )          | (2,457 | ) |
| Other  current assets                                                              |       | (1,746               | )          | (541 | ) |
| Deposits and  other assets                                                         |       | (50                  | )          | (35 | ) |
| Accounts  payable                                                                  |       | 492                  |       | 617 |   |
| Accrued  payroll and related benefits                                              |       | (146                 | )          | (206 | ) |
| Other  accrued expenses                                                            |       | 76                   |       | 773 |   |
| Income taxes  payable                                                              |       | 213                  |       | (429 | ) |
| Net cash  provided by operating activities                                         |       | 48,987               |       | 26,141 |   |
|                                                                               |       |                 |       |   |   |
| **Investing  activities:**                                                         |       |                 |       |   |   |
| Purchases of  property and equipment                                               |       | (1,447               | )          | (1,749 | ) |
| Purchases of  marketable securities                                                |       | (142,960             | )          | (147,553 | ) |
| Maturities  of marketable securities                                               |       | 76,746               |       | 109,329 |   |
| Sales of  marketable securities                                                    |       | 17,972               |       | 6,968 |   |
| Net cash  used in investing activities                                             |       | (49,689              | )          | (33,005 | ) |
|                                                                               |       |                 |       |   |   |
| **Financing  activities:**                                                         |       |                 |       |   |   |
| Proceeds  from exercise of stock options and warrants                              |       | 10,662               |       | 10,698 |   |
| Proceeds  from issuance of common stock for stock purchase plan                    |       | 1,647                |       | 1,251 |   |
| Purchases of  treasury stock                                                       |       | (17,335              | )          | (6,027 | ) |
| Net cash  provided by (used in) financing activities                               |       | (5,026               | )          | 5,922 |   |
|                                                                               |       |                 |       |   |   |
| Decrease in  cash and cash equivalents                                             |       | (5,728               | )          | (942 | ) |
|                                                                               |       |                 |       |   |   |
| Cash and  cash equivalents at beginning of period                                  |       | 38,878               |       | 35,324 |   |
|                                                                               |       |                 |       |   |   |
| Cash and  cash equivalents at end of period                                        |       | $                    | 33,150     |   | $ | 34,382 |   |

 

Seeaccompanying notes.

 

4

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**Websense, Inc.**

 

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

 

1.  *Basis of Presentation*

 

Theaccompanying unaudited consolidated financial statements have been prepared inconformity with accounting principles generally accepted in the United Statesfor interim financial statements and with the instructions to Form 10-Qand Article 10 of Regulation S-X. Accordingly, certain information orfootnote disclosures normally included in complete financial statementsprepared in accordance with accounting principles generally accepted in theUnited States have been condensed or omitted pursuant to the rules andregulations of the Securities and Exchange Commission. In the opinion of management,the statements include all adjustments necessary, which are of a normal andrecurring nature, for the fair presentation of our financial position and ofthe results for the interim periods presented.

 

Thesefinancial statements should be read in conjunction with the auditedconsolidated financial statements and notes thereto for the year ended December 31,2004, included in Websense, Inc.’s Annual Report on Form 10-K filedwith the Securities and Exchange Commission. Operating results for the three and six months ended June 30, 2005are not necessarily indicative of the results that may be expected for anyother interim period or for the year ending December 31, 2005.  The balance sheet at December 31, 2004 hasbeen derived from the audited financial statements at that date but does notinclude all of the information and footnotes required by accounting principlesgenerally accepted in the United States for complete financial statements.

 

2.  *Net Income Per Share*

 

Websensecomputes net income per share in accordance with Statement of FinancialAccounting Standards (SFAS) No. 128, Earnings Per Share (EPS). Under theprovisions of SFAS No. 128, basic net income per share is computed bydividing the net income for the period by the weighted average number of commonshares outstanding during the period. Diluted net income per share is computedby dividing the net income for the period by the weighted average number ofcommon and common equivalent shares outstanding during the period. Commonequivalent shares for all periods presented consist of dilutive stock options.

 

Dilutivesecurities include stock options, warrants, preferred stock on an as ifconverted to common stock basis and restricted stock subject to vesting. Duringthe quarters ended June 30, 2005 and 2004, the difference between theweighted average shares used in determining basic EPS versus diluted EPSrelated to dilutive stock options totaled 914,000 and 957,000, respectively.Potentially dilutive securities totaling 178,000 and 163,000 for the quartersended June 30, 2005 and 2004, respectively, were excluded from historicalbasic and diluted earnings per share because of their anti-dilutive effect as aresult of stock options which have exercise prices greater than the averagemarket price of the common shares.

 

During thefirst six months of 2005 and 2004, the difference between the weighted averageshares used in determining basic EPS versus diluted EPS related to dilutivestock options and warrants totaled 986,000 and 982,000, respectively.Potentially dilutive securities totaling 96,000 and 143,000 for the first sixmonths of 2005 and 2004, respectively, were excluded from historical basic anddiluted earnings per share because of their anti-dilutive effect as a result ofstock options which have exercise prices greater than the average market priceof the common shares.

 

5

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The followingis a reconciliation of the numerator and denominator used in calculating basicEPS to the numerator and denominator used in calculating diluted EPS for allperiods presented:

 
| ** **                       | ** ** | **Net Income**                                | ** ** | **Shares**        | ** ** | **Per Share** | ** ** |
|----------------------------------|------------|-----------------------------------------------|------------|-------------------|------------|---------------|------------|
| ** **                       | ** ** | **(Numerator)**                               | ** ** | **(Denominator)** | ** ** | **Amount**    | ** ** |
| ** **                       | ** ** | **(In thousands, except per share  amounts)** | ** ** |
| **For the  Three Months Ended:** | ** ** | ** **                                    | ** ** | ** **        | ** ** | ** **    | ** ** |
| **June 30,  2005:**         | ** ** | ** **                                    | ** ** | ** **        | ** ** | ** **    | ** ** |
| Basic EPS                        |       | $                                             | 8,934      |              | 23,835     |          | $          | 0.37 |   |
| Effect of  options               |       | —                                        |       | 914               |       | (0.01         | )          |
| Diluted EPS                      |       | $                                             | 8,934      |              | 24,749     |          | $          | 0.36 |   |
| ** **                       | ** ** | ** **                                    | ** ** | ** **        | ** ** | ** **    | ** ** |
| **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 |   |
| ** **                       | ** ** | ** **                                    | ** ** | ** **        | ** ** | ** **    | ** ** |
| **For the  Six Months Ended:**   | ** ** | ** **                                    | ** ** | ** **        | ** ** | ** **    | ** ** |
| **June 30,  2005:**         | ** ** | ** **                                    | ** ** | ** **        | ** ** | ** **    | ** ** |
| Basic EPS                        |       | $                                             | 17,546     |              | 23,754     |          | $          | 0.74 |   |
| Effect of  options               |       | —                                        |       | 986               |       | (0.03         | )          |
| Diluted EPS                      |       | $                                             | 17,546     |              | 24,740     |          | $          | 0.71 |   |
| ** **                       | ** ** | ** **                                    | ** ** | ** **        | ** ** | ** **    | ** ** |
| **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 |   |

 

3. *Comprehensive Income*

 

The componentsof comprehensive income, as required to be reported by SFAS No. 130,Reporting Comprehensive Income, were as follows (in thousands):

 
| ** **                                                                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended**   | ** ** |
|---------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                                        | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** |
|                                                                                              |       |                   |       |                   |       |   |   |   |   |   |   |   |   |
| Net income                                                                                        |       | $                      | 8,934      |                   | $          | 5,807 |   | $ | 17,546 |   | $ | 10,934 |   |
|                                                                                              |       |                   |       |                   |       |   |   |   |   |
| Change in  unrealized gain (loss) on fair market valuation of marketable securities               |       | 288                    |       | (348                   | )          | (37 | ) | (345 | ) |
|                                                                                              |       |                   |       |                   |       |   |   |   |   |
| Change in  unrealized gain (loss) on fair market valuation of foreign currency forward  contracts |       | (100                   | )          | 36                     |       | (118 | ) | (164 | ) |
|                                                                                              |       |                   |       |                   |       |   |   |   |   |
| Comprehensive  income                                                                             |       | $                      | 9,122      |                   | $          | 5,495 |   | $ | 17,391 |   | $ | 10,425 |   |

 

6

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Accumulatedother comprehensive loss totaled ($574,000) and ($419,000) at June 30,2005 and December 31, 2004, respectively.

 

4.* **Stock-Based Compensation*

 

Pro formainformation regarding net income is required by SFAS No. 123, Accountingfor Stock-Based Compensation, as amended by SFAS No. 148, Accounting forStock-Based Compensation – Transition and Disclosure, and has been determinedas if the Company has accounted for its employee stock options and employeestock purchase plan under the fair value method of SFAS No. 123, asamended by SFAS No. 148. The pro forma effects of stock-based compensationon net income and net income per share have been estimated at the date of grantusing the Black-Scholes option pricing model based on the following weightedaverage assumptions since the Company’s initial public offering in March of2000: risk free interest rates of 1.04% to 6.0%, dividend yields of 0%,expected volatility of 40% to 132%, and a life of 5 years for employee stockoptions and 6 months to 2 years for the employee stock purchase plan.

 

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

 
| ** **                                                    | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**    | ** ** |
|---------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                    | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** |
| Net income  as reported                                       |       | $                       | 8,934      |                    | $          | 5,807 |   | $ | 17,546 |   | $ | 10,934 |   |
| Compensation  expense under SFAS No. 123, net of tax (1) |       | (2,686                  | )          | (2,296                  | )          | (5,074 | ) | (4,673 | ) |
| Pro forma  net income                                         |       | $                       | 6,248      |                    | $          | 3,511 |   | $ | 12,472 |   | $ | 6,261 |   |
|                                                          |       |                    |       |                    |       |   |   |   |   |
| Basic net  income per share as reported                       |       | $                       | 0.37       |                    | $          | 0.25 |   | $ | 0.74 |   | $ | 0.48 |   |
| Pro forma  basic net income per share                         |       | $                       | 0.26       |                    | $          | 0.14 |   | $ | 0.53 |   | $ | 0.27 |   |
|                                                          |       |                    |       |                    |       |   |   |   |   |
| Diluted net  income per share as reported                     |       | $                       | 0.36       |                    | $          | 0.24 |   | $ | 0.71 |   | $ | 0.46 |   |
| Pro forma  diluted net income per share                       |       | $                       | 0.25       |                    | $          | 0.13 |   | $ | 0.50 |   | $ | 0.26 |   |

 

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(1)   TheCompany had an effective tax rate of 36% and 37% in the three months ended June 30,2005 and 2004, respectively.The Company had an effective tax rate of 36% and 37% in the six months ended June 30,2005 and 2004, respectively.

 

For purposes of pro forma disclosures, the estimated fair value isamortized to expense over the options vesting period.  The effect of applying SFAS No. 123, asamended by SFAS No. 148, for purposes of providing pro forma disclosuresmay not be representative of the effects on the Company’s operating results infuture years.

 

5.*Foreign Currency Cash Flow Hedges*

 

SFAS No. 133,Accounting for Derivative Instruments and Hedging Activities, as amended,established accounting and reporting standards requiring recognition of allderivatives as assets or liabilities in the consolidated balance sheets andmeasurement of those instruments at fair value. Gains and losses resulting fromchanges in the fair values of those derivative instruments will be recorded to

 

7

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earnings or other comprehensive incomedepending on the use of the derivative instrument and whether it qualifies forhedge accounting.  The Company usesderivatives to manage foreign currency risk and not for speculative or tradingpurposes.  The Company’s objective is toreduce the risk to earnings associated with changes in foreign currencyexchange rates.

 

During 2005, the Company continues to utilize foreign currency forward contracts. All such contracts entered into were designated as cash flow hedges and were considered effective as of June 30, 2005, as defined by SFAS No. 133, as amended.  None of the contracts were terminated prior to settlement. Net realized losses related to these contracts settled during the periods presented are included in other income, net in the accompanying consolidated income statements and amounted to $64,000 and $106,000 in the three months ended June 30, 2005 and 2004, respectively. Net realized losses amounted to $71,000 and $135,000 in the six months ended June 30, 2005 and 2004, respectively. As of June 30, 2005, the Company had committed to six foreign currency forward contracts to purchase British Pounds for $4.2 million.  The fair value of these contracts was $4.1 million at June 30, 2005 and all of the foreign exchange contracts will be settled before December 31, 2005. Realized gains or losses related to the settlements, if any, will be recorded in other income, net at the time of settlement.

 

6. *Tax Matters*

 

From time to time, the Company is audited byvarious state, federal and international authorities relating to taxmatters.  The Company fully cooperateswith all audits, but defends its positions vigorously.  The Company’s audits are in various stages ofcompletion; however, no outcome for a particular audit can be determined withcertainty prior to the conclusion of the audit and appeals process.  Adjustments, if any, are appropriatelyrecorded in the Company’s financial statements in the period determined.

 

7. *Recent Accounting Pronouncements*

 

In December 2004,the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS No. 123R),which will be effective in the Company’s first quarter of fiscal 2006.   As permitted by SFAS No. 123, theCompany currently accounts for share-based payments to employees using APB 25’sintrinsic value method and, as such, generally recognizes no compensation costfor employee stock option grants or the discounts the Company provides underits employee stock purchase plans. Accordingly, the adoption of SFAS No. 123R’s fair value method willsignificantly increase the Company’s recognized employee compensation expense,thereby reducing net income and earnings per share.  The impact of adoption of SFAS No. 123Rcannot be predicted at this time because it will depend on levels ofshare-based payments granted in the future. However, had the Company adopted SFAS No. 123R in prior periods,the impact of that standard would have approximated the impact of SFAS No. 123as described in Note 4 above, “Stock-Based Compensation.”  SFAS No. 123R also requires the benefitsof tax deductions in excess of recognized compensation cost to be reported as afinancing cash flow, rather than as an operating cash flow as required undercurrent guidance.  This requirement willreduce the Company’s net operating cash flows and increase net financing cashflows in periods after adoption.  TheCompany cannot estimate what those amounts will be in the future, however, theamount of operating cash flows recognized in the first six months of 2005 and2004 for such tax deductions were $8.8 million and $6.1 million, respectively.

 

8. *Reclassifications*

 

Certain reclassifications have been made forconsistent presentation.

 

8

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

** **

**Thefollowing discussion and analysis should be read in conjunction with thefinancial statements and related notes contained elsewhere in this report. See “Risksand Uncertainties” regarding certain factors known to us that could causereported financial information not to be necessarily indicative of futureresults.**

** **

**Forward Looking Statements**

** **

**Thisreport on Form 10-Q contains “forward-looking statements” within themeaning of the federal securities laws made pursuant to the safe harborprovisions of the Private Securities Litigation Reform Act of 1995. Thesestatements, which represent our expectations or beliefs concerning variousfuture events, may contain words such as “may,” “will,” “expects,” “anticipates,”“intends,” “plans,” “believes,” “estimates,” or other words indicating futureresults. Such statements may include but are not limited to statementsconcerning the following:**

** **

•                  anticipatedtrends in revenue;

•                  growthopportunities in domestic and international markets;

•                  customeracceptance and satisfaction with our products;

•                  expected trendsin operating and other expenses;

•                  anticipated cashand intentions regarding usage of cash;

•                  changes ineffective tax rates; and

•                  anticipatedproduct enhancements or releases.

 

**Theseforward-looking statements are subject to risks and uncertainties that couldcause our actual results to differ materially from those anticipated as of thedate of 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 (EIM) software products that enableorganizations to analyze, report and manage how their employees use computingresources, including internet access, instant messaging (IM), peer-to-peer filesharing, network bandwidth and desktop applications.  Our primary product offering is the WebsenseEnterprise® software application, our central policy engine and managementconsole.  Websense Enterprise givesorganizations the ability to enhance security, improve employee productivity,conserve network bandwidth and mitigate potential legal liability byidentifying potential risks and rapidly configuring and implementing policiesto manage their employees’ internet access and use of software applications. In1996, we released our first software product, Websense Internet ScreeningSystem. Since that time, we have focused our business on developing and sellingEIM solutions. Websense Enterprise now serves as a platform for relatedWebsense add-on modules, such as the Premium Groups**ä, Real Time Security UpdatesTM,Bandwidth OptimizerTM, Instant Messaging (IM) Attachment ManagerTM, and ClientPolicy ManagerTM. We have also created suites of some of our products to addressspecific customer needs, such as the Websense Web Security SuiteTM and WebsenseWeb Security Suite – Lockdown EditionTM. We currently derive all of our revenue from subscriptions to theWebsense Enterprise solution (including add-on modules), and expect this trendto continue in the future as more offerings are added to the WebsenseEnterprise platform.

** **

**Duringthe six months ended June 30, 2005, we derived 32% of revenue from internationalsales, compared with 32% for the six months ended June 30, 2004, with theUnited Kingdom comprising approximately 9% of our total revenue in both periods.We believe international markets continue to**

 

9

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**representa significant growth opportunity and we are continuing to expand ourinternational operations, particularly in selected countries in the European,Asia/Pacific and Latin American 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, including add-on modules, on a monthly straight-line basisover the term of the subscription. We recognize the operating expenses relatedto these sales as they are incurred. These operating expenses include salescommissions, which are based on the total amount of the subscription contractand are fully expensed in the period the product is delivered. Operatingexpenses have continued to increase as compared with prior periods due to expandedselling and marketing efforts, continued product research and development andinvestments in administrative infrastructure to support subscription sales thatwe will recognize as revenue in subsequent periods.**

** **

**Critical Accounting Policies**

** **

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

** **

***Revenue Recognition.***When apurchase decision is made for Websense Enterprise, customers enter into asubscription agreement, which is generally 12, 24 or 36 months in duration andfor a fixed number of users. Other services such as upgrades/enhancements andstandard post-contract technical support services are sold together withWebsense Enterprise and provided throughout the subscription term. We recognizerevenue on a monthly straight-line basis, commencing with the month thesubscription begins, over the term of the subscription agreement, providedcollectibility is reasonably assured. Upon entering into a subscriptionarrangement for a fixed or determinable fee, we electronically deliver accesscodes to users and then promptly invoice customers for the full amount of theirsubscriptions. Payment is due for the full term of the subscription, generallywithin 30 days of the invoice. We record amounts billed to customers in excessof recognizable revenue as deferred revenue on our balance sheet. Upon expirationof the subscription, customers who wish to re-subscribe typically must do so atthen current rates to continue using Websense Enterprise. Our revenue issignificantly influenced by new and renewal subscriptions, and a decrease insubscription amounts could negatively 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 pay theirinvoice(s). If the financial condition of our customers were to deteriorate,resulting in an impairment of their ability to make payments, additionalallowances may be required.

** **

*Deferred Tax Assets.* As required by Statement ofFinancial Accounting Standards No. 109, we recognize tax assets on thebalance sheet if it is “more likely than not” that they will be realized onfuture tax returns.  At December 31,2004, we had deferred tax assets of $18.1 million.  We believe that it is more likely than notthat our deferred tax assets will be realized. Factors considered by usincluded: our earnings history, projected earnings based on current operations,and projected future taxable income in excess of stock option deductions.However, should we determine that we would not be able to realize all or partof our deferred tax assets in thefuture, an adjustment to thedeferred tax assets would be charged against income in the period suchdetermination was made.

 

# ***Tax Contingency Reserve***.Significant judgment is required in determining our consolidated income taxprovision and evaluating our U.S. and foreign tax positions. It is our policyto maintain tax

 

# **contingency reserves for tax audit issues that are likelyto occur and can reasonably be estimated. We review the reserves ascircumstances warrant and adjust the reserves as events occur that affect ourpotential liability for additional taxes, such as lapsing of applicablestatutes of limitations, conclusion of tax audits, additional exposure based oncurrent calculations, identification of new issues or rendering of courtdecisions affecting a particular tax issue. Tax reserve contingencies andchanges to the reserves are evaluated and recorded in our tax provision in theperiod in which the above noted events occur.**

 

10

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**Results of Operations**

 

***Three months ended June 30,2005 compared with the three months ended June 30, 2004***

 

The following table summarizes our operatingresults as a percentage of total revenue for each of the periods shown.

 
| ** **                  | ** ** | **Three Months Ended** | ** ** |
|-----------------------------|------------|------------------------|------------|
| ** **                  | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** |
| ** **                  | ** ** | **(Unaudited)**        | ** ** |
|                        |       |                   |       |   |   |
| Revenue                     |       | 100                    | %          | 100 | % |
|                        |       |                   |       |   |   |
| Cost of  revenue            |       | 7                      |       | 7 |   |
|                        |       |                   |       |   |   |
| Gross margin                |       | 93                     |       | 93 |   |
|                        |       |                   |       |   |   |
| Operating  expenses:        |       |                   |       |   |   |
| Selling and  marketing      |       | 39                     |       | 39 |   |
| Research and  development   |       | 11                     |       | 13 |   |
| General and  administrative |       | 8                      |       | 8 |   |
| Total  operating expenses   |       | 58                     |       | 60 |   |
|                        |       |                   |       |   |   |
| Income from  operations     |       | 35                     |       | 33 |   |
|                        |       |                   |       |   |   |
| Other  income, net          |       | 3                      |       | 2 |   |
|                        |       |                   |       |   |   |
| Income  before income taxes |       | 38                     |       | 35 |   |
|                        |       |                   |       |   |   |
| Provision  for income taxes |       | 13                     |       | 13 |   |
|                        |       |                   |       |   |   |
| Net income                  |       | 25                     | %          | 22 | % |

 

# **Revenue**

# ** **

# **Revenueincreased to $36.0 million in the second quarter of 2005, from $26.6 million inthe second quarter of 2004. The increase was primarily a result of the additionof new, renewed and upgraded subscriptions from our customers. Approximately65% of subscription revenue recognized in the second quarter of 2005 wasderived from renewal business, consistent with the prior year. We expect totalrevenue growth amounts in 2005 to exceed total revenue growth in 2004, althoughthe percentage revenue growth rate may be lower in 2005 than in 2004 as aresult of the increasing overall revenue base.**

# ** **

# **Cost of Revenue**

# ** **

# **Cost ofrevenue consists of the costs of content review, technical support andinfrastructure costs associated with maintaining our databases. Cost of revenueincreased to $2.5 million in the second quarter of 2005, from $1.8 million inthe second quarter of 2004. The increase was primarily due to the costsassociated with additional personnel in our technical support and databasegroups, as well as allocated costs. We allocate the total costs for humanresources, employee benefits, payroll taxes, information technology,facilities, fixed asset depreciation and legal costs to each of our functionalareas based on salaries and headcount data. We expect cost of revenue toincrease in the future as we support the growth and maintenance of**

 

11

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# **ourdatabases as well as the technical support needs of our customers. As apercentage of revenue, cost of revenue remained unchanged at 7% during the secondquarters of 2005 and 2004. We expect that cost of revenue, as a percentage ofrevenue, will remain below 10% of revenue for the foreseeable future.**

 

# **Gross Margin**

# ** **

# **Grossmargin increased to $33.5 million in the second quarter of 2005, from $24.9million in the second quarter of 2004. The increase was due to increasedrevenue. As a percentage of revenue, gross margin remained unchanged at 93% inthe second quarters of 2005 and 2004.**Weexpect that gross margin, as a percentage of revenue, will remain in excess of90% of revenue for the foreseeable future.

# ** **

# **Operating Expenses**

# ** **

# ***Selling and marketing***. Sellingand marketing expenses consist primarily of salaries, commissions and benefitsrelated to personnel engaged in selling, marketing and customer supportfunctions, along with costs related to public relations, advertising,promotions and travel as well as allocated costs. Selling and marketingexpenses increased to $13.9 million in the second quarter of 2005, from $10.4million in the second quarter of 2004. The increase in selling and marketingexpenses of $3.5 million was primarily due to increased personnel 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 absolute dollars 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 anddevelopment.*****Researchand development expenses consist primarily of salaries and benefits forsoftware developers, contract programmers, and allocated costs. Research and developmentexpenses increased to $4.0 million in the second quarter of 2005, from $3.5 millionin the second quarter of 2004. The increase of $500,000 in research anddevelopment expenses was primarily a result of increased personnel needed tosupport our expanding list of technology partners, the enhancements of WebsenseEnterprise and additional products, as well as allocated costs. We expectresearch and development expenses to increase in absolute dollars in futureperiods as a result of our continued enhancements of Websense Enterprise andadditional products.

 

*General andadministrative*. General and administrative expensesconsist primarily of salaries, benefits and related expenses for our executive,finance, administrative personnel, third party professional service fees and allocatedcosts. General and administrative expenses increased to $2.9 million in the secondquarter of 2005, from $2.1 million in the second quarter of 2004. The $800,000increase in general and administrative expenses was primarily a result ofadditional personnel needed to support our growing operations, allocated costsand an increase in professional accounting fees driven by compliance with theSarbanes-Oxley Act of 2002. We expect general and administrative expenses toincrease in absolute dollars in future periods, reflecting growth inoperations, increasing expenses associated with being a public company andexpansion of our international operations. We may also incur increased general and administrative expense inconnection with our announced search for a successor to our current Chairmanand Chief Executive Officer, John Carrington, in his role as our Chief ExecutiveOfficer.

 

12

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# **Other Income, Net**

# ** **

# **Netother income increased to $1.2 million in the second quarter of 2005, from $456,000in the second quarter of 2004. The increase was due primarily to higherinterest rates realized on our increased balances of cash, cash equivalents andmarketable securities as of June 30, 2005 compared with June 30, 2004.The majority of our total cash and cash equivalents and marketable securities aretax-exempt. We expect that the majority of our cash and cash equivalents andmarketable securities will continue to be held in tax-exempt investments duringthe foreseeable future.**

# ** **

# **Provision for IncomeTaxes**

# ** **

# **In the secondquarter of 2005, United States and foreign income tax expense was $5.0 million,compared to $3.4 million for the second quarter of 2004. The annual effectiveincome tax rate for the second quarter 2005 was 36%, compared to 37% for the secondquarter of 2004. The effective tax rate for the second quarter 2005 was lowerthan the second quarter 2004 effective tax rate, primarily due to an increasein foreign earnings taxed at less than the United States federal income taxrate, an increase in tax exempt interest income and a decrease in our overallstate tax rate. We expect an effective tax rate of approximately 36% for 2005.  Subsequent to 2005, our effective tax ratemay change due to potential changes in the mix of income within variousdomestic and international tax jurisdictions, along with potential changes intax rules and legislation.**

 

13

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***Six months ended June 30,2005 compared with the six months ended June 30, 2004***

 

The following table summarizes our operatingresults as a percentage of total revenue for each of the periods shown.

 
| ** **                  | ** ** | **Six Months Ended**   | ** ** |
|-----------------------------|------------|------------------------|------------|
| ** **                  | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** |
| ** **                  | ** ** | **(Unaudited)**        | ** ** |
|                        |       |                   |       |   |   |
| Revenue                     |       | 100                    | %          | 100 | % |
|                        |       |                   |       |   |   |
| Cost of  revenue            |       | 7                      |       | 7 |   |
|                        |       |                   |       |   |   |
| Gross margin                |       | 93                     |       | 93 |   |
|                        |       |                   |       |   |   |
| Operating  expenses:        |       |                   |       |   |   |
| Selling and  marketing      |       | 37                     |       | 39 |   |
| Research and  development   |       | 12                     |       | 14 |   |
| General and  administrative |       | 8                      |       | 8 |   |
| Total  operating expenses   |       | 57                     |       | 61 |   |
|                        |       |                   |       |   |   |
| Income from  operations     |       | 36                     |       | 32 |   |
|                        |       |                   |       |   |   |
| Other  income, net          |       | 3                      |       | 2 |   |
|                        |       |                   |       |   |   |
| Income  before income taxes |       | 39                     |       | 34 |   |
|                        |       |                   |       |   |   |
| Provision  for income taxes |       | 14                     |       | 13 |   |
|                        |       |                   |       |   |   |
| Net income                  |       | 25                     | %          | 21 | % |

 

14

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# **Revenue**

 

# **Revenueincreased to $70.2 million in the first six months of 2005, from $51.3 millionin the first six months of 2004. The increase was primarily a result of theaddition of new, renewed and upgraded subscriptions from our customers. Approximately65% of subscription revenue recognized in the first six months of 2005 wasderived from renewal business, consistent with the prior year. We expect totalrevenue growth amounts in 2005 to exceed total revenue growth in 2004, althoughthe percentage revenue growth rate may be lower in 2005 than in 2004 as aresult of the increasing overall revenue base.**

 

# **Cost of Revenue**

 

# **Cost ofrevenue increased to $5.0 million in the first six months of 2005, from $3.5million in the first six months of 2004. The increase was primarily due to thecosts associated with additional personnel in our technical support anddatabase groups as well as allocated costs. We allocate the total costs forhuman resources, employee benefits, payroll taxes, information technology,facilities, fixed asset depreciation and legal costs to each of our functionalareas based on salaries and headcount data. We expect cost of revenue toincrease in the future as we support the growth and maintenance of ourdatabases as well as the technical support needs of our customers. As apercentage of revenue, cost of revenue remained unchanged at 7% during thefirst six months of 2005 and 2004. We expect that cost of revenue, as apercentage of revenue, will remain below 10% of revenue for the foreseeablefuture.**

# ** **

# **Gross Margin**

# ** **

# **Grossmargin increased to $65.2 million in the first six months of 2005, from $47.8million in the first six months of 2004. The increase was due to increasedrevenue. As a percentage of revenue, gross margin remained unchanged at 93% inthe first six months of 2005 and 2004.**Weexpect that gross margin, as a percentage of revenue, will remain in excess of90% of revenue for the foreseeable future.

# ** **

# **Operating Expenses**

# ** **

# ***Selling and marketing***.Selling and marketing expenses increased to $26.2 million in the first sixmonths of 2005, from $19.9 million in the first six months of 2004. Theincrease in selling and marketing expenses of $6.3 million was primarily due toincreased personnel costs and related travel and allocated costs as well ashigher commission and co-op marketing expenses related to higher sales levels.We expect selling and marketing expenses to increase in absolute dollars in thefuture as more personnel are added to support our expanding selling andmarketing efforts worldwide and as increased sales result in higher overallsales commission expenses.

# ** **

*Research anddevelopment.*****Researchand development expenses increased to $8.0 million in the first six months of2005, from $7.1 million in the first six months of 2004. The increase of$900,000 in research and development expenses was primarily a result ofincreased personnel needed to support our expanding list of technologypartners, the enhancements of Websense Enterprise and additional products aswell as allocated costs. We expect research and development expenses toincrease in absolute dollars in future periods as a result of our continuedenhancements of Websense Enterprise and additional products.

 

*General andadministrative*. General and administrative expensesincreased to $5.8 million in the first six months of 2005, from $4.4 million inthe first six months of 2004. The $1.4 million increase in general andadministrative expenses was primarily a result of additional personnel neededto support our growing operations, allocated costs and an increase inprofessional accounting fees driven by compliance with the Sarbanes-Oxley Actof 2002. We expect general and administrative expenses to increase in absolutedollars in future periods, reflecting growth in operations, increasing expensesassociated with being a public company and expansion of our internationaloperations.  We may also incur increased

 

15

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general and administrative expense in connection with our announcedsearch for a successor to our current Chairman and Chief Executive Officer,John Carrington, in his role as our Chief Executive Officer.

 

# **Other Income, Net**

 

# **Netother income increased to $2.2 million in the first six months of 2005, from$869,000 in the first six months of 2004. The increase was due primarily tohigher interest rates realized on our increased balances of cash, cashequivalents and marketable securities as of June 30, 2005 compared with June 30,2004. The majority of our total cash and cash equivalents and marketablesecurities are tax-exempt. We expect that the majority of our cash and cashequivalents and marketable securities will continue to be held in tax-exemptinvestments during the foreseeable future.**

 

# **Provision for IncomeTaxes**

 

# **In thefirst six months of 2005, United States and foreign income tax expense was $9.8million, compared to $6.4 million for the first six months of 2004. The annualeffective income tax rate for the first six months of 2005 was 36%, compared to37% for the first six months of 2004. The effective tax rate for the first sixmonths of 2005 was lower than the effective tax rate for the first six monthsof 2004 primarily due to an increase in foreign earnings taxed at less than theUnited States federal income tax rate, an increase in tax exempt interestincome and a decrease in our overall state tax rate. We expect an effective taxrate of approximately 36% for 2005. Subsequent to 2005, our effective tax rate may change due to potentialchanges in the mix of income within various domestic and international taxjurisdictions along with potential changes in tax rules and legislation.**

 

**Liquidity and Capital Resources**

 

As of June 30, 2005, we had cash andcash equivalents of $33.2 million, investments in marketable securities of$253.1 million and retained earnings of $35.2 million. As of December 31,2004, we had cash and cash equivalents of $38.9 million, investments inmarketable securities of $204.9 million and retained earnings of $17.7 million.

 

**Net cashprovided by operating activities was $49.0 million in the first six months of2005, compared with $26.1 million in the first six months of 2004. The $22.9million increase in cash provided by operating activities in the first sixmonths of 2005 was primarily due to an increase in our net income and adecrease in our accounts receivable balance. Our operating cash flow andrevenue are significantly influenced by subscription renewals, and a decreasein subscription renewals would negatively impact our operating cash flow andrevenue.**

** **

Net cash used in investing activities was$49.7 million in the first six months of 2005, compared with net cash used ininvesting activities of $33.0 million in the first six months of 2004. The$16.7 million increase of cash used in investing activities for the first sixmonths of 2005 was primarily due to fewer maturities and sales of marketablesecurities to offset purchases of marketable securities.

 

Net cash used by financing activities was$5.0 million in the first six months of 2005, compared with net cash providedby financing activities of $5.9 million in the first six months of 2004. The$10.9 million decrease in net cash provided by financing activities in thefirst six months of 2005 was primarily due to the use of $17.3 million torepurchase 325,000 shares of our common stock.

 

We have operating lease and software licensecommitments of approximately $1.1 million during the remainder of 2005, $2.2million in 2006, $2.0 million in 2007 and $0.3 million in 2008. A significantmajority of our operating lease commitments are related to our corporateheadquarters lease, which was 

 

16

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most recently amended in July 2004 to add additional space for ourcorporate headquarters and to extend the lease through 2008. The lease providesfor escalating rent payments from 2004 to 2008. The rent expense related to ourcorporate headquarters lease is recorded monthly on a straight-line basis inaccordance with generally accepted accounting principles.

 

Future minimumannual payments under non-cancelable operating leases and software licenses at June 30,2005 are as follows (in thousands):

 
| ** ** | ** ** | **Operating   Leases** | ** ** | **Software   Licenses** | ** ** | **Total** | ** ** |
|------------|------------|------------------------|------------|-------------------------|------------|-----------|------------|
| 2005       |       | $                      | 923        |                    | $          | 157       |       | $ | 1,080 |   |
| 2006       |       | 1,889                  |       | 314                     |       | 2,203     |       |
| 2007       |       | 1,937                  |       | 79                      |       | 2,016     |       |
| 2008       |       | 325                    |       | —                  |       | 325       |       |
|       |       | $                      | 5,074      |                    | $          | 550       |       | $ | 5,624 |   |

 

Asof June 30, 2005 and 2004, we did not have any relationships withunconsolidated entities or financial partners, such as entities often referredto as structured finance or special purpose entities, which would have beenestablished for the purpose of facilitating off-balance sheet arrangements orother contractually narrow or limited purposes. As such, we are not 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 ourBoard of Directors authorized a stock repurchase program of up to 2 millionshares of our common stock. The repurchases will be made from time to time onthe open market at prevailing market prices or in privately negotiatedtransactions. Depending on market conditions and other factors, purchases underthis program may be commenced or suspended at any time, or from time to time,without prior notice. As of June 30, 2005, we had repurchased 1,331,000shares of our common stock under this program, for an aggregate of $48.0million at an average price of $36.06 per share.

 

As of December 31, 2004, we retired all1,006,000 shares of our common stock that had been repurchased prior to thatdate.  In accordance with APB 6, Statusof Accounting Research Bulletins, the treasury stock retirement was effected byreducing the following on our Consolidated Balance Sheets:  treasury stock by $30.7 million, common stockby $0.1 million, additional paid-in capital by $6.4 million and retainedearnings by $24.2 million. There was no effect to our overall equity positionas a result of the retirement.

 

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

 

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**Risks and Uncertainties**

 

**Risks and uncertainties thatcould impact our business, consolidated financial position, results ofoperations and cash flows and cause future results to differ from our expectationsinclude the following: customer acceptance of our services, products and feestructures; the success of our brand development efforts; the volatile andcompetitive nature of the internet industry; changes in domestic andinternational 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 on Form 10-Kfor the fiscal year ended December 31, 2004 and other filings with theSecurities and Exchange Commission.**

** **

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

** **

**Our market risk exposures are related to our cash, cashequivalents and investments. We invest our excess cash in highly liquidshort-term investments, municipal securities, commercial paper and corporatebonds. 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 fromour short-term available-for-sale investments. Under our current policies, wedo not 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, 2005.Changes in interest rates over time will, however, affect our interest income.**

** **

For the quarter ended June 30,2005, the majority of our billings were denominated in our functional currency,which is the U.S. dollar. Beginning in the second quarter of 2005, we beganbilling certain international customers in Euros, however, we do not expectthese billings to represent more than 10% of our total billings during 2005. Workingfunds necessary to facilitate the short-term operations of our subsidiaries arekept in the local currencies in which they do business.

 

We utilize foreign currencyforward contracts to hedge foreign currency market exposures of underlyingassets and liabilities. Our objective is to reduce the risk to earnings andcash flows associated with changes in foreign currency exchange rates. We donot use foreign currency forward contracts for speculative or tradingpurposes. As of June 30, 2005, we had committed to six foreigncurrency forward contracts to purchase British Pounds for $4.2 million. OurBritish Pound commitment represents 2.3 million British Pounds at a weightedaverage forward rate of 1.8312. The fair value of these foreign currencyforward contracts was $4.1 million at June 30, 2005. All of the foreigncurrency forward contracts will be settled before December 31, 2005.

 

18

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**Item4. Controls and Procedures**

** **

**Disclosure Controls andProcedures**

** **

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

** **

**Internal Control OverFinancial Reporting**

** **

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

 

19

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**Part II - Other Information**

 

**Item 1.****           LegalProceedings**

 

None.

 

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

 

**(a) Not applicable.**

** **

**(b) Not applicable.**

** **

**(c)  Issuer Purchases of EquitySecurities**

 
| **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 2005 |       | —                                             |       | —                               |       | 1,131,000                                                                              |       | 869,000                                                                    |       |
| May 2005   |       | 185,000                                            |       | $                                    | 50.94      |                                                                                   | 1,316,000  |                                                                       | 684,000    |   |
| June 2005  |       | 15,000                                             |       | $                                    | 55.59      |                                                                                   | 1,331,000  |                                                                       | 669,000    |   |
| Total      |       | 200,000                                            |       | $                                    | 51.29      |                                                                                   | 1,331,000  |                                                                       | 669,000    |   |

 

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

 

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

 

**Item 3.**           Defaults uponSenior Securities

** **

**None.**

** **

**Item 4.  Submission of Matters toa Vote of Security Holders**

** **

**The Annual Meeting ofStockholders was held on Tuesday, June 7, 2005.  The following matters were voted upon at themeeting and were adopted by the margins indicated:**

** **

**1.**               Thestockholders elected two Directors to hold office for a term expiring upon the2008 Annual Meeting of Stockholders.

** **

**20**

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** **
| ** **                   | ** ** | **Number of Shares** | ** ** |
|------------------------------|------------|----------------------|------------|
| **Name of Director Elected** | ** ** | **For**              | ** ** | **Withheld** | ** ** |
|                         |       |                 |       |   |   |
| Mark S.  St.Clare            |       | 22,822,954           |       | 94,070 |   |
| Peter C.  Waller             |       | 22,028,378           |       | 888,646 |   |

 

**The followingindividuals are continuing directors with terms expiring upon the 2006 AnnualMeeting of Stockholders:  Bruce T. Colemanand John F. Schaefer**

** **

**Thefollowing individuals are continuing directors with terms expiring upon the2007 Annual Meeting of Stockholders: John B. Carrington and Gary E. Sutton.**

** **

**2.**               Thestockholders ratified the appointment of Ernst & Young LLP as ourindependent auditors for the fiscal year ending December 31, 2005.

** **

| For     |   | 22,642,976 |   |
|---------|--------|------------|--------|
| Against |   | 264,133    |   |
| Abstain |   | 9,915      |   |

** **

**Item 5.**           OtherInformation

** **

**None.**

** **

**Item 6.**           Exhibits

** **

**Exhibits**

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

 

----

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

 

21

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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 4, 2005 | By:                 |   /s/ JOHN B. CARRINGTON |   |
|                      |                |   John B. Carrington |
| * *                  | * *            |   *Chairman  of the Board and* |
| * *                  | * *            |   *Chief  Executive Officer* |
|                      |                |   |
| Date: August 4, 2005 | By:                 |   /s/ DOUGLAS C. WRIDE |   |
|                      |                |   Douglas C. Wride |
| * *                  | * *            |   *Chief  Financial Officer* |
|                           |                     |  |  |  |

 

22

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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).** |

 

----

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

 

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