**FORM 10-Q**

 

**UNITED STATES**

**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 September 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**

 

----

 

**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)

 

----

 

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

 

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

 

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

 

The number of shares outstanding of the registrant’s Common Stock, $.01 par value, as of October 31, 2005 was 23,799,276.

 

 

----

 

**Websense, Inc.**

**Form 10-Q**

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

 

**TABLE OF CONTENTS**

 
| Part I. Financial  Information |    |                                                                                                     |
|-------------------------------------|---------|----------------------------------------------------------------------------------------------------------|
|                                |    |                                                                                                     |   |   |
|                                | Item 1. | Consolidated  Financial Statements (Unaudited)                                                           |   |   |
|                                |    | Consolidated  Balance Sheets as of September 30, 2005 and December 31, 2004                    | 1 |   |
|                                |    | Consolidated  Statements of Income for the three and nine months ended September 30,  2005 and 2004 | 2 |   |
|                                |    | Consolidated  Statement of Stockholders’ Equity for the nine months ended September 30,  2005  | 3 |   |
|                                |    | Consolidated  Statements of Cash Flows for the nine months ended September 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              | 10 |   |
|                                | Item 3. | Quantitative and  Qualitative Disclosures About Market Risk                                              | 19 |   |
|                                | Item 4. | Controls and Procedures                                                                                  | 19 |   |
|                                |    |                                                                                                     |   |   |
| Part II. Other Information     |    |                                                                                                     |
|                                |    |                                                                                                     |   |   |
|                                | Item 1. | Legal Proceedings                                                                                        | 21 |   |
|                                | Item 2. | Unregistered  Sales of Equity Securities and Use of Proceeds                                             | 21 |   |
|                                | Item 3. | Defaults upon  Senior Securities                                                                         | 21 |   |
|                                | Item 4. | Submission of  Matters to a Vote of Security Holders                                                     | 21 |   |
|                                | Item 5. | Other Information                                                                                        | 21 |   |
|                                | Item 6. | Exhibits                                                                                                 | 22 |   |
|                                |    |                                                                                                     |   |   |
| Signatures                          | 23      |                                                                                                     |

 

i

----

 

**Part I – Financial Information**

 

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

 

**Websense, Inc.**

**ConsolidatedBalance Sheets**

**(Unauditedand in thousands)**

 
| ** **                                                   | ** ** | **September  30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------------|------------|-------------------------------|------------|-----------------------------|------------|
| ** **                                                   | ** ** | ** **                    | ** ** | **(See Note 1)**            | ** ** |
| **Assets**                                                   |       |                          |       |                        |       |
| Current assets:                                              |       |                          |       |                        |       |
| Cash and  cash equivalents                                   |       | $                             | 31,741     |                        | $          | 38,878 |   |
| Marketable  securities                                       |       | 255,575                       |       | 204,910                     |       |
| Accounts  receivable, net of allowance for doubtful accounts |       | 30,989                        |       | 44,309                      |       |
| Prepaid  income taxes                                        |       | 1,700                         |       | 3,201                       |       |
| Current  portion of deferred income taxes                    |       | 8,530                         |       | 8,530                       |       |
| Other  current assets                                        |       | 4,305                         |       | 1,525                       |       |
| Total  current assets                                        |       | 332,840                       |       | 301,353                     |       |
|                                                         |       |                          |       |                        |       |
| Property and equipment, net                                  |       | 4,475                         |       | 3,955                       |       |
| Deferred income taxes, less current portion                  |       | 9,523                         |       | 9,523                       |       |
| Deposits and other assets                                    |       | 541                           |       | 462                         |       |
| Total assets                                                 |       | $                             | 347,379    |                        | $          | 315,293 |   |
|                                                         |       |                          |       |                        |       |
| **Liabilities and stockholders’ equity**                |       |                          |       |                        |       |
| Current liabilities:                                         |       |                          |       |                        |       |
| Accounts  payable                                            |       | $                             | 1,305      |                        | $          | 1,100 |   |
| Accrued  payroll and related benefits                        |       | 7,059                         |       | 7,163                       |       |
| Other  accrued expenses                                      |       | 5,962                         |       | 5,011                       |       |
| Income taxes  payable                                        |       | 3,006                         |       | 1,758                       |       |
| Current  portion of deferred revenue                         |       | 102,842                       |       | 90,686                      |       |
| Total  current liabilities                                   |       | 120,174                       |       | 105,718                     |       |
|                                                         |       |                          |       |                        |       |
| Deferred revenue, less current portion                       |       | 49,647                        |       | 41,631                      |       |
|                                                         |       |                          |       |                        |       |
| Stockholders’ equity:                                   |       |                          |       |                        |       |
| Common stock                                                 |       | 243                           |       | 235                         |       |
| Additional  paid-in capital                                  |       | 174,388                       |       | 150,447                     |       |
| Treasury  stock                                              |       | (41,855                       | )          | —                      |       |
| Retained  earnings                                           |       | 45,338                        |       | 17,681                      |       |
| Accumulated  other comprehensive loss                        |       | (556                          | )          | (419                        | )          |
| Total  stockholders’ equity                             |       | 177,558                       |       | 167,944                     |       |
| Total  liabilities and stockholders’ equity             |       | $                             | 347,379    |                        | $          | 315,293 |   |

 

See accompanying notes.

 

1

----

 

**Websense, Inc.**

**Consolidated Statements of Income**

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

 
| ** **                              | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|-----------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                              | ** ** | **September 30,** | ** ** | **September 30,** | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                              | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                    |       |                   |       |                   |       |   |   |   |   |
| Revenue                                 |       | $                      | 38,300     |                   | 28,917     |   | $ | 108,508 |   | $ | 80,171 |   |
|                                    |       |                   |       |                   |       |   |   |   |   |
| Cost of revenue                         |       | 2,829                  |       | 2,003                  |       | 7,830 |   | 5,468 |   |
|                                    |       |                   |       |                   |       |   |   |   |   |
| Gross margin                            |       | 35,471                 |       | 26,914                 |       | 100,678 |   | 74,703 |   |
|                                    |       |                   |       |                   |       |   |   |   |   |
| Operating expenses:                     |       |                   |       |                   |       |   |   |   |   |
| Selling and  marketing                  |       | 13,770                 |       | 10,615                 |       | 39,970 |   | 30,480 |   |
| Research and  development               |       | 4,091                  |       | 3,576                  |       | 12,122 |   | 10,677 |   |
| General and  administrative             |       | 3,145                  |       | 2,045                  |       | 8,954 |   | 6,397 |   |
| Total  operating expenses               |       | 21,006                 |       | 16,236                 |       | 61,046 |   | 47,554 |   |
|                                    |       |                   |       |                   |       |   |   |   |   |
| Income from operations                  |       | 14,465                 |       | 10,678                 |       | 39,632 |   | 27,149 |   |
|                                    |       |                   |       |                   |       |   |   |   |   |
| Other income, net                       |       | 1,535                  |       | 598                    |       | 3,690 |   | 1,467 |   |
|                                    |       |                   |       |                   |       |   |   |   |   |
| Income before income taxes              |       | 16,000                 |       | 11,276                 |       | 43,322 |   | 28,616 |   |
|                                    |       |                   |       |                   |       |   |   |   |   |
| Provision for income taxes              |       | 5,889                  |       | 4,170                  |       | 15,665 |   | 10,576 |   |
|                                    |       |                   |       |                   |       |   |   |   |   |
| Net income                              |       | $                      | 10,111     |                   | $          | 7,106 |   | $ | 27,657 |   | $ | 18,040 |   |
|                                    |       |                   |       |                   |       |   |   |   |   |
| Net income per share:                   |       |                   |       |                   |       |   |   |   |   |
|                                    |       |                   |       |                   |       |   |   |   |   |
| Basic net  income per share             |       | $                      | 0.43       |                   | $          | 0.31 |   | $ | 1.17 |   | $ | 0.79 |   |
| Diluted net  income per share           |       | $                      | 0.41       |                   | $          | 0.29 |   | $ | 1.12 |   | $ | 0.75 |   |
| Weighted  average shares – basic   |       | 23,663                 |       | 23,250                 |       | 23,723 |   | 22,967 |   |
| Weighted  average shares – diluted |       | 24,452                 |       | 24,228                 |       | 24,647 |   | 23,960 |   |

 

See accompanying notes.

 

2

----

 

**Websense, Inc.**

**ConsolidatedStatement of Stockholders’ Equity**

**(Unauditedand in thousands)**

 
| ** **                                                                                    | ** ** | **Common stock** | ** ** | ** ** | ** ** | ** **                      | ** ** | ** **          | ** ** | ** **             | ** ** | ** **                                  | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------------|------------|------------|------------|---------------------------------|------------|---------------------|------------|------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                    | ** ** | **Shares**       | ** ** | **Amount** | ** ** | **Additional  paid-in capital** | ** ** | **Treasury  stock** | ** ** | **Retained  earnings** | ** ** | **Accumulated  other  comprehensive  loss** | ** ** | **Total  stockholders’  equity** | ** ** |
|                                                                                          |       |             |       |       |       |                            |       |                |       |                   |       |                                        |       |   |   |
| Balance at December 31, 2004                                                             |       | 23,526           |       | $          | 235        |                            | $          | 150,447             |       | $                      | —     |                                        | $          | 17,681 |   | $ | (419 | ) | $ | 167,944 |   |
| Issuance of common stock upon exercise of options                                             |       | 663              |       | 7          |       | 12,709                          |       | —              |       | —                 |       | —                                      |       | 12,716 |   |
| Issuance of common stock for purchase plan                                                    |       | 109              |       | 1          |       | 1,646                           |       | —              |       | —                 |       | —                                      |       | 1,647 |   |
| Purchase of treasury stock                                                                    |       | (829             | )          | —     |       | —                          |       | (41,855             | )          | —                 |       | —                                      |       | (41,855 | ) |
| Tax benefit of stock options                                                                  |       | —           |       | —     |       | 9,586                           |       | —              |       | —                 |       | —                                      |       | 9,586 |   |
| Comprehensive income:                                                                         |       |             |       |       |       |                            |       |                |       |                   |       |                                        |       |   |   |
| Net income                                                                                    |       | —           |       | —     |       | —                          |       | —              |       | 27,657                 |       | —                                      |       | 27,657 |   |
| Net change in unrealized loss on fair market  valuation of marketable securities              |       | —           |       | —     |       | —                          |       | —              |       | —                 |       | (53                                         | )          | (53 | ) |
| Net change in unrealized loss on fair market  valuation of foreign currency forward contracts |       | —           |       | —     |       | —                          |       | —              |       | —                 |       | (84                                         | )          | (84 | ) |
| Comprehensive income                                                                          |       |             |       |       |       |                            |       |                |       |                   |       |                                        |       | 27,520 |   |
| Balance at September 30, 2005                                                            |       | 23,469           |       | $          | 243        |                            | $          | 174,388             |       | $                      | (41,855    | )                                           | $          | 45,338 |   | $ | (556 | ) | $ | 177,558 |   |

 

See accompanying notes.

 

3

----

 

**Websense, Inc.**

**ConsolidatedStatements of Cash Flows**

**(Unauditedand in thousands)**

 
| ** **                                                                         | ** ** | **Nine Months Ended**  | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                         | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                                         | ** ** | **2005**               | ** ** | **2004** | ** ** |
| **Operating activities:**                                                          |       |                   |       |   |   |
| Net income                                                                         |       | $                      | 27,657     |   | $ | 18,040 |   |
|                                                                               |       |                   |       |   |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                   |       |   |   |
| Depreciation                                                                       |       | 1,924                  |       | 1,673 |   |
| Deferred  revenue                                                                  |       | 20,172                 |       | 18,226 |   |
| Unrealized  loss on foreign exchange contracts                                     |       | (84                    | )          | (60 | ) |
| Tax benefit  from exercise of stock options                                        |       | 9,586                  |       | 8,780 |   |
| Changes in  operating assets and liabilities:                                      |       |                   |       |   |   |
| Accounts  receivable                                                               |       | 13,320                 |       | 352 |   |
| Prepaid  income taxes                                                              |       | 1,501                  |       | (1,352 | ) |
| Other  current assets                                                              |       | (2,780                 | )          | (488 | ) |
| Deposits and  other assets                                                         |       | (79                    | )          | (39 | ) |
| Accounts  payable                                                                  |       | 205                    |       | 220 |   |
| Accrued  payroll and related benefits                                              |       | (104                   | )          | 232 |   |
| Other  accrued expenses                                                            |       | 951                    |       | 1,424 |   |
| Income taxes  payable                                                              |       | 1,248                  |       | (397 | ) |
| Net cash provided by operating activities                                          |       | 73,517                 |       | 46,611 |   |
|                                                                               |       |                   |       |   |   |
| **Investing activities:**                                                          |       |                   |       |   |   |
| Purchases of property and equipment                                                |       | (2,444                 | )          | (2,331 | ) |
| Purchases of marketable securities                                                 |       | (299,074               | )          | (226,046 | ) |
| Maturities of marketable securities                                                |       | 247,314                |       | 179,340 |   |
| Sales of marketable securities                                                     |       | 1,042                  |       | 1,193 |   |
| Net cash used in investing activities                                              |       | (53,162                | )          | (47,844 | ) |
|                                                                               |       |                   |       |   |   |
| **Financing activities:**                                                          |       |                   |       |   |   |
| Proceeds from exercise of stock options and  warrants                              |       | 12,716                 |       | 15,359 |   |
| Proceeds from issuance of common stock for  stock purchase plan                    |       | 1,647                  |       | 1,251 |   |
| Purchases of treasury stock                                                        |       | (41,855                | )          | (17,558 | ) |
| Net cash used in financing activities                                              |       | (27,492                | )          | (948 | ) |
|                                                                               |       |                   |       |   |   |
| Decrease in cash and cash equivalents                                              |       | (7,137                 | )          | (2,181 | ) |
|                                                                               |       |                   |       |   |   |
| Cash and cash equivalents at beginning of  period                                  |       | 38,878                 |       | 35,324 |   |
|                                                                               |       |                   |       |   |   |
| Cash and cash equivalents at end of period                                         |       | $                      | 31,741     |   | $ | 33,143 |   |

 

Seeaccompanying notes.

 

4

----

 

**Websense, Inc.**

 

**Notes ToConsolidated 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 nine months ended September 30,2005 are 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, 2004has been derived from the audited financial statements at that date but doesnot include all of the information and footnotes required by accountingprinciples generally accepted in the United States for complete financialstatements.

 

2.  *Net Income Per Share*

 

Websensecomputes net income per share in accordance with Statement of FinancialAccounting Standards (SFAS) No. 128, *Earnings Per Share*(EPS) (SFAS No. 128). Under the provisions of SFAS No. 128, basic netincome per share is computed by dividing the net income for the period by theweighted average number of common shares outstanding during the period. Dilutednet income per share is computed by dividing the net income for the period bythe weighted average number of common and common equivalent shares outstandingduring the period. Common equivalent shares for all periods presented consistof 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 September 30, 2005 and 2004, the difference between theweighted average shares used in determining basic EPS versus diluted EPSrelated to dilutive stock options totaled 789,000 and 978,000 shares,respectively. Potentially dilutive securities totaling 628,000 and 268,000shares for the quarters ended September 30, 2005 and 2004, respectively,were excluded from historical basic and diluted earnings per share because oftheir anti-dilutive effect as a result of stock options which have exerciseprices greater than the average market price of the common shares.

 

During thefirst nine 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 924,000 and 993,000 shares, respectively.Potentially dilutive securities totaling 152,000 and 104,000 shares for thefirst nine months of 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.

 

5

----

 

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:** | ** ** | ** **                                    | ** ** | ** **        | ** ** | ** **    | ** ** |
| **September 30, 2005:**    | ** ** | ** **                                    | ** ** | ** **        | ** ** | ** **    | ** ** |
| Basic EPS                       |       | $                                             | 10,111     |              | 23,663     |          | $          | 0.43 |   |
| Effect of  options              |       | —                                        |       | 789               |       | (0.02         | )          |
| Diluted EPS                     |       | $                                             | 10,111     |              | 24,452     |          | $          | 0.41 |   |
| ** **                      | ** ** | ** **                                    | ** ** | ** **        | ** ** | ** **    | ** ** |
| **September 30, 2004:**    | ** ** | ** **                                    | ** ** | ** **        | ** ** | ** **    | ** ** |
| Basic EPS                       |       | $                                             | 7,106      |              | 23,250     |          | $          | 0.31 |   |
| Effect of  options              |       | —                                        |       | 978               |       | (0.02         | )          |
| Diluted EPS                     |       | $                                             | 7,106      |              | 24,228     |          | $          | 0.29 |   |
|                            |       |                                          |       |              |       |          |       |
| **For the Nine Months Ended:**  | ** ** | ** **                                    | ** ** | ** **        | ** ** | ** **    | ** ** |
| **September 30, 2005:**    | ** ** | ** **                                    | ** ** | ** **        | ** ** | ** **    | ** ** |
| Basic EPS                       |       | $                                             | 27,657     |              | 23,723     |          | $          | 1.17 |   |
| Effect of  options              |       | —                                        |       | 924               |       | (0.05         | )          |
| Diluted EPS                     |       | $                                             | 27,657     |              | 24,647     |          | $          | 1.12 |   |
| ** **                      | ** ** | ** **                                    | ** ** | ** **        | ** ** | ** **    | ** ** |
| **September 30, 2004:**    | ** ** | ** **                                    | ** ** | ** **        | ** ** | ** **    | ** ** |
| Basic EPS                       |       | $                                             | 18,040     |              | 22,967     |          | $          | 0.79 |   |
| Effect of  options              |       | —                                        |       | 993               |       | (0.04         | )          |
| Diluted EPS                     |       | $                                             | 18,040     |              | 23,960     |          | $          | 0.75 |   |

 

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**       | ** ** | **Nine Months Ended**        | ** ** |
|---------------------------------------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                                                        | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
| ** **                                                                                        | ** ** | ** **                   | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                                        |       | $                            | 10,111     |                         | $          | 7,106 |   | $ | 27,657 |   | $ | 18,040 |   |
| Change in  unrealized gain (loss) on fair market valuation of marketable securities               |       | (16                          | )          | 88                           |       | (53 | ) | (257 | ) |
| Change in  unrealized gain (loss) on fair market valuation of foreign currency forward  contracts |       | 34                           |       | 104                          |       | (84 | ) | (60 | ) |
|                                                                                              |       |                         |       |                         |       |   |   |   |   |   |   |   |   |
| Comprehensive  income                                                                             |       | $                            | 10,129     |                         | $          | 7,298 |   | $ | 27,520 |   | $ | 17,723 |   |

 

6

----

 

Accumulatedother comprehensive loss totaled $556,000 and $419,000 at September 30,2005 and December 31, 2004, respectively.

 

4.* **Stock-Based Compensation*

 

Pro formainformation regarding net income is required by SFAS No. 123, *Accounting for Stock-Based Compensation*(SFAS No. 123), asamended by SFAS No. 148*, Accounting forStock-Based Compensation – Transition and Disclosure* (SFAS No. 148),and has been determined as if the Company has accounted for its employee stockoptions and employee stock purchase plan under the fair value method of SFAS No. 123,as amended by SFAS No. 148. The pro forma effects of stock-basedcompensation on net income and net income per share have been estimated at thedate of grant using the Black-Scholes option pricing model based on thefollowing weighted average assumptions since the Company’s initial publicoffering in March of 2000: risk free interest rates of 1.04% to 6.0%,dividend yields of 0%, expected volatility of 38% to 132%, and a life of 5years for employee stock options and 6 months to 2 years for the employee stockpurchase plan.

 

The Company’spro forma information is as follows (in thousands, except per share amounts):

 
| ** **                                                         | ** ** | **Three Months Ended**       | ** ** | **Nine Months Ended**        | ** ** |
|--------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                         | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
| Net income  as reported                                            |       | $                            | 10,111     |                         | $          | 7,106 |   | $ | 27,657 |   | $ | 18,040 |   |
| Compensation  expense under SFAS No. 123, net of tax (1) |       | (2,802                       | )          | (2,410                       | )          | (7,874 | ) | (7,083 | ) |
| Pro forma  net income                                              |       | $                            | 7,309      |                         | $          | 4,696 |   | $ | 19,783 |   | $ | 10,957 |   |
|                                                               |       |                         |       |                         |       |   |   |   |   |
| Basic net  income per share as reported                            |       | $                            | 0.43       |                         | $          | 0.31 |   | $ | 1.17 |   | $ | 0.79 |   |
| Pro forma  basic net income per share                              |       | $                            | 0.31       |                         | $          | 0.20 |   | $ | 0.83 |   | $ | 0.48 |   |
|                                                               |       |                         |       |                         |       |   |   |   |   |
| Diluted net  income per share as reported                          |       | $                            | 0.41       |                         | $          | 0.29 |   | $ | 1.12 |   | $ | 0.75 |   |
| Pro forma  diluted net income per share                            |       | $                            | 0.30       |                         | $          | 0.19 |   | $ | 0.80 |   | $ | 0.46 |   |

 

----

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

 

7

----

 

5.*Foreign Currency Cash Flow Hedges*

 

SFAS No. 133,*Accounting for Derivative Instruments and HedgingActivities* (SFAS No. 133), as amended, established accounting andreporting standards requiring recognition of all derivatives as assets orliabilities in the consolidated balance sheets and measurement of those instrumentsat fair value. Gains and losses resulting from changes in the fair values ofthose derivative instruments will be recorded to earnings or othercomprehensive income depending on the use of the derivative instrument andwhether it qualifies for hedge accounting. The Company uses derivatives to manage foreign currency risk and not forspeculative or trading purposes.  TheCompany’s objective is to reduce the risk to earnings and cash flows associatedwith changes in foreign currency exchange 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 September 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 $43,000 and $56,000 in the three months ended September 30, 2005 and 2004, respectively. Net realized losses amounted to $114,000 and $191,000 in the nine months ended September 30, 2005 and 2004, respectively. As of September 30, 2005, the Company had committed to three foreign currency forward contracts to purchase British Pounds for $2.1 million.  The fair value of these contracts was $2.0 million at September 30, 2005 and all of these 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-BasedPayment* (SFAS No. 123R), which will be effective in the Company’sfirst quarter of fiscal 2006.   Aspermitted by SFAS No. 123, the Company currently accounts for share-basedpayments to employees using the intrinsic value method in accordance with APB 25and, as such, generally recognizes no compensation cost for employee stockoption grants or the discounts the Company provides under its employee stockpurchase plans.  Accordingly, theadoption of the SFAS No. 123R fair value method will significantlyincrease the Company’s recognized employee compensation expense, therebyreducing net income and earnings per share. The impact of adoption of SFAS No. 123R cannot be predicted at thistime because it will depend on levels of share-based payments granted in thefuture.  However, had the Company adoptedSFAS No. 123R in prior periods, the impact of that standard would haveapproximated the impact of SFAS No. 123 as described in Note 4 above, “Stock-BasedCompensation.”  SFAS No. 123R alsorequires the benefits of tax deductions in excess of recognized compensationcost to be reported as a financing cash flow, rather than as an operating cashflow as required under current guidance. This requirement will reduce the Company’s net operating cash flows andincrease net financing cash flows in periods after adoption.  The Company cannot estimate what thoseamounts will be in the future, however, the amount of operating cash flowsrecognized in the first nine months of 2005 and 2004 for such tax deductions were$9.6 million and $8.8 million, respectively.

 

8

----

 

8. *Reclassifications*

 

Certain reclassifications have been made forconsistent presentation.

 

9

----

 

**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-looking statementsto reflect events or circumstances arising after the date of this report.**

** **

**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 and Websense Enterprise – Corporate Editionnow serve as platforms for related Websense add-on modules, such as the PremiumGroups**ä, Real Time Security UpdatesTM,Bandwidth OptimizerTM, Instant Messaging (IM) Attachment ManagerTM, Client PolicyManagerTM and Remote Filtering. We have also created suites of some of ourproducts to address specific customer needs, such as the Websense Web SecuritySuiteTM and Websense Web Security Suite – Lockdown EditionTM.  We currently derive all of our revenue fromsubscriptions to the Websense Enterprise solutions (including add-on modules),and expect this trend to continue in the future as more offerings are added tothe Websense Enterprise platforms.  In October 2005,we announced that we signed an agreement with Nortel Networks to develop a webcontent filtering solution to protect GSM/UMTS mobile handsets from receivingand accessing unwanted content.

** **

**Duringthe nine months ended September 30, 2005, we derived 33% of revenue frominternational sales, compared with 32% for the nine months ended September 30,2004, with the United Kingdom**

 

10

----

 

**comprisingapproximately 9% of our total revenue in both periods. We believe internationalmarkets continue to represent a significant growth opportunity and we arecontinuing to expand our international operations, particularly in selectedcountries in the European, Asia/Pacific and Latin American markets.**

** **

**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 subscription arrangementfor a fixed or determinable fee, we electronically deliver access codes tousers and then promptly invoice customers for the full amount of theirsubscriptions. Payment is due for the full term of the subscription, generallywithin 30 to 60 days of the invoice. We record amounts billed to customers inexcess of recognizable revenue as deferred revenue on our balance sheet. Uponexpiration of the subscription, customers who wish to re-subscribe typicallymust do so at then current rates to continue using Websense Enterprise. Ourrevenue is significantly influenced by new and renewal subscriptions, and adecrease in subscription 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, additional allowancesmay 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.

 

*Income Tax Provision and Tax Contingency Reserve*. Significant judgment is required in determining our consolidated incometax provision and evaluating our U.S. and foreign tax positions. It is 

 

11

----

 

ourpolicy to maintain tax contingency reserves for tax audit issues that arelikely to occur and can reasonably be estimated. Factors that impact our incometax provision include the actual versus forecasted mix of U.S. andinternational income, transfer pricing changes, earnings on tax-exemptinvestments, availability of credits, foreign tax withholding and changes inour income tax contingent reserves.  Wereview the reserves as circumstances warrant and adjust the reserves as eventsoccur that affect our potential liability for additional taxes, such as lapsingof applicable statutes of limitations, conclusion of tax audits, additionalexposure based on current calculations, identification of new issues orrendering of court decisions affecting a particular tax issue. Tax reservecontingencies and changes to the reserves are evaluated and recorded in our taxprovision in the period in which the above noted events occur.

 

**Results of Operations**

 

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

 

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

 
| ** **                  | ** ** | **Three Months Ended**       | ** ** |
|-----------------------------|------------|------------------------------|------------|
| ** **                  | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
| ** **                  | ** ** | **(Unaudited)**              | ** ** |
|                        |       |                         |       |   |   |
| Revenue                     |       | 100                          | %          |   | 100 | % |   |
|                        |       |                         |       |   |   |   |   |
| Cost of revenue             |       | 7                            |       |   | 7 |   |   |
|                        |       |                         |       |   |   |   |   |
| Gross margin                |       | 93                           |       |   | 93 |   |   |
|                        |       |                         |       |   |   |   |   |
| Operating expenses:         |       |                         |       |   |   |   |   |
| Selling and  marketing      |       | 36                           |       |   | 37 |   |   |
| Research and  development   |       | 11                           |       |   | 12 |   |   |
| General and  administrative |       | 8                            |       |   | 7 |   |   |
| Total  operating expenses   |       | 55                           |       |   | 56 |   |   |
|                        |       |                         |       |   |   |   |   |
| Income from operations      |       | 38                           |       |   | 37 |   |   |
|                        |       |                         |       |   |   |   |   |
| Other income, net           |       | 4                            |       |   | 2 |   |   |
|                        |       |                         |       |   |   |   |   |
| Income before income taxes  |       | 42                           |       |   | 39 |   |   |
|                        |       |                         |       |   |   |   |   |
| Provision for income taxes  |       | 16                           |       |   | 14 |   |   |
|                        |       |                         |       |   |   |   |   |
| Net income                  |       | 26                           | %          |   | 25 | % |   |

 

**Revenue**

 

Revenue increased to $38.3 million in thethird quarter of 2005, from $28.9 million in the third quarter of 2004. Theincrease was primarily a result of the addition of new, renewed and upgradedsubscriptions from our customers. Approximately 65% of subscription revenuerecognized in the third quarters of 2005 and 2004 was derived from renewalbusiness.  We expect total revenue growthamounts 

 

12

----

 

in 2005 to exceed total revenue growth in 2004, although the percentagerevenue growth rate may be lower in 2005 than in 2004 as a result of theincreasing overall revenue base.

 

**Cost of Revenue**

 

Cost of revenue consists of the costs ofcontent review, technical support and infrastructure costs associated withmaintaining our databases. Cost of revenue increased to $2.8 million in thethird quarter of 2005, from $2.0 in the third quarter of 2004. The increase wasprimarily due to the costs associated with additional personnel in ourtechnical support and database groups, as well as allocated costs. We allocatethe total costs for human resources, employee benefits, payroll taxes,information technology, facilities, fixed asset depreciation and legal costs toeach of our functional areas based on salaries and headcount data. We expectcost of revenue to increase in the future as we support the growth andmaintenance of our databases as well as the technical support needs of ourcustomers. As a percentage of revenue, cost of revenue remained unchanged at 7%during the third quarters of 2005 and 2004. We expect that cost of revenue, asa percentage of revenue, will remain below 10% of revenue for the foreseeablefuture.

 

**Gross Margin**

 

Gross margin increased to $35.5 million inthe third quarter of 2005, from $26.9 million in the third quarter of 2004. Theincrease was due to increased revenue. As a percentage of revenue, gross marginremained unchanged at 93% in the third quarters of 2005 and 2004. We expectthat gross margin, as a percentage of revenue, will remain in excess of 90% ofrevenue for the foreseeable future.

 

**Operating Expenses**

 

*Selling andmarketing*. Selling and marketing expenses consistprimarily of salaries, commissions and benefits related to personnel engaged inselling, marketing and customer support functions, along with costs related topublic relations, advertising, promotions and travel as well as allocatedcosts. Selling and marketing expenses increased to $13.8 million in the thirdquarter of 2005, from $10.6 million in the third quarter of 2004. The increasein selling and marketing expenses of $3.2 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 overall salescommission expenses.

 

*Research anddevelopment.*****Researchand development expenses consist primarily of salaries and benefits forsoftware developers, contract programmers, and allocated costs. Research anddevelopment expenses increased to $4.1 million in the third quarter of 2005,from $3.6 million in the third quarter of 2004. The increase of $0.5 million inresearch and development expenses was primarily a result of increased personnelneeded to support our expanding list of technology partners, the enhancementsof Websense Enterprise and additional products, as well as allocated costs. Weexpect research and development expenses to increase in absolute dollars infuture periods as a result of our continued enhancements of Websense Enterpriseand additional 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, andallocated costs. General and administrative expenses increased to $3.1 millionin the third quarter of 2005, from $2.0 million in the third quarter of 2004.The $1.1 million increase in general and administrative expenses was primarilya result of additional personnel needed to support our growing operations,allocated costs, an increase in professional accounting fees driven bycompliance with the Sarbanes-Oxley Act of 2002 and executive recruitment feesfor a successor to our Chairman, Chief 

 

13

----

 

Executive Officer and President, John Carrington, in his roles as ourChief Executive Officer and President. We expect general and administrativeexpenses to increase in absolute dollars in future periods, reflecting growthin operations, increasing expenses associated with being a public company andexpansion of our international operations. We have incurred, as discussed above, and will continue to incurincreased general and administrative expenses in connection with our announcedsearch for a successor to our current Chief Executive Officer and President.

 

**Other Income, Net**

 

Net other income increased to $1.5 million inthe third quarter of 2005, from $0.6 million in the third quarter of 2004. Theincrease was due primarily to higher interest rates realized on our increasedbalances of cash, cash equivalents and marketable securities as of September 30,2005 compared with September 30, 2004. The majority of our investments ofcash and cash equivalents and marketable securities are tax-exempt. We expectthat the majority of our cash and cash equivalents and marketable securitieswill continue to be held in tax-exempt investments during the foreseeablefuture.

 

**Provision for Income Taxes**

 

In the third quarter of 2005, United Statesand foreign income tax expense was $5.9 million, compared to $4.2 million forthe third quarter of 2004. The annual effective income tax rate for the thirdquarter 2005 was 37%, the same as the third quarter of 2004. We expect aneffective tax rate of approximately 36% for the full fiscal year 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.

 

14

----

 

***Nine Months Ended September 30,2005 compared with the Nine Months Ended September 30, 2004***

 

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

 
| ** **                  | ** ** | **Nine Months Ended**        | ** ** |
|-----------------------------|------------|------------------------------|------------|
| ** **                  | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
| ** **                  | ** ** | **(Unaudited)**              | ** ** |
|                        |       |                         |       |   |   |
| Revenue                     |       | 100                          | %          |   | 100 | % |   |
|                        |       |                         |       |   |   |   |   |
| Cost of revenue             |       | 7                            |       |   | 7 |   |   |
|                        |       |                         |       |   |   |   |   |
| Gross margin                |       | 93                           |       |   | 93 |   |   |
|                        |       |                         |       |   |   |   |   |
| Operating expenses:         |       |                         |       |   |   |   |   |
| Selling and  marketing      |       | 37                           |       |   | 38 |   |   |
| Research and  development   |       | 11                           |       |   | 13 |   |   |
| General and  administrative |       | 8                            |       |   | 8 |   |   |
| Total  operating expenses   |       | 56                           |       |   | 59 |   |   |
|                        |       |                         |       |   |   |   |   |
| Income from operations      |       | 37                           |       |   | 34 |   |   |
|                        |       |                         |       |   |   |   |   |
| Other income, net           |       | 3                            |       |   | 2 |   |   |
|                        |       |                         |       |   |   |   |   |
| Income before income taxes  |       | 40                           |       |   | 36 |   |   |
|                        |       |                         |       |   |   |   |   |
| Provision for income taxes  |       | 14                           |       |   | 13 |   |   |
|                        |       |                         |       |   |   |   |   |
| Net income                  |       | 26                           | %          |   | 23 | % |   |

 

15

----

 

**Revenue**

 

Revenue increased to $108.5 million in thefirst nine months of 2005, from $80.2 million in the first nine months of 2004.The increase was primarily a result of the addition of new, renewed andupgraded subscriptions from our customers. Approximately 65% of subscriptionrevenue recognized in the first nine months of 2005 and 2004 was derived fromrenewal business.

 

**Cost of Revenue**

 

Cost of revenue increased to $7.8 million inthe first nine months of 2005, from $5.5 million in the first nine months of2004. The increase was primarily due to the costs associated with additionalpersonnel in our technical support and database groups as well as allocatedcosts. We allocate the total costs for human resources, employee benefits,payroll taxes, information technology, facilities, fixed asset depreciation andlegal costs to each of our functional areas based on salaries and headcountdata. We expect cost of revenue to increase in the future as we support thegrowth and maintenance of our databases as well as the technical support needsof our customers. As a percentage of revenue, cost of revenue remainedunchanged at 7% during the first nine months of 2005 and 2004.

 

**Gross Margin**

 

Gross margin increased to $100.7 million inthe first nine months of 2005, from $74.7 million in the first nine months of2004. The increase was due to increased revenue. As a percentage of revenue,gross margin remained unchanged at 93% in the first nine months of 2005 and2004.

 

**Operating Expenses**

 

*Selling andmarketing*. Selling and marketing expenses increased to$40.0 million in the first nine months of 2005, from $30.5 million in the firstnine months of 2004. The increase in selling and marketing expenses of $9.5million was primarily due to increased personnel costs and related travel andallocated costs as well as higher commission and co-op marketing expensesrelated to higher sales levels.

 

*Research anddevelopment.*****Researchand development expenses increased to $12.1 million in the first nine months of2005, from $10.7 million in the first nine months of 2004. The increase of $1.4million 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.

 

*General andadministrative*. General and administrative expensesincreased to $9.0 million in the first nine months of 2005, from $6.4 millionin the first nine months of 2004. The $2.6 million increase in general andadministrative expenses was primarily a result of additional personnel neededto support our growing operations, allocated costs, an increase in professionalaccounting fees driven by compliance with the Sarbanes-Oxley Act of 2002 andexecutive recruitment fees for a successor to our Chairman, Chief ExecutiveOfficer and President, John Carrington, in his roles as our Chief ExecutiveOfficer and President.

 

**Other Income, Net**

 

Net other income increased to $3.7 million inthe first nine months of 2005, from $1.5 million in the first nine months of2004. The increase was due primarily to higher interest rates realized on ourincreased balances of cash, cash equivalents and marketable securities as of September 30,2005 

 

16

----

 

compared with September 30, 2004. The majority of our investmentsof cash and cash equivalents and marketable securities are tax-exempt.

 

**Provision for Income Taxes**

 

In the first nine months of 2005, UnitedStates and foreign income tax expense was $15.7 million, compared to $10.6million for the first nine months of 2004. The annual effective income tax ratefor the first nine months of 2005 was 36%, compared to 37% for the first ninemonths of 2004. The effective tax rate for the first nine months of 2005 waslower than the effective tax rate for the first nine months of 2004 primarilydue to an increase in foreign earnings taxed at less than the United Statesfederal income tax rate, an increase in tax exempt interest income and adecrease in our overall state tax rate. We expect an effective tax rate of approximately36% for 2005.

 

**Liquidity and Capital Resources**

 

As of September 30, 2005, we had cashand cash equivalents of $31.7 million, investments in marketable securities of$255.6 million and retained earnings of $45.3 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 $73.5 million in the first nine months of2005, compared with $46.6 million in the first nine months of 2004. The $26.9million increase in cash provided by operating activities in the first ninemonths of 2005 was primarily due to an increase in our net income and adecrease in our accounts receivable balance. Our operating cash flow issignificantly influenced by subscription renewals and accounts receivablecollections, and a decrease in subscription renewals or accounts receivablecollections would negatively impact our operating cash flow.**

** **

Net cash used in investing activities was$53.2 million in the first nine months of 2005, compared with net cash used ininvesting activities of $47.8 million in the first nine months of 2004. The$5.4 million increase of cash used in investing activities for the first ninemonths 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$27.5 million in the first nine months of 2005, compared with net cash used byfinancing activities of $0.9 million in the first nine months of 2004. The$26.6 million increase in net cash used by financing activities in the firstnine months of 2005 was primarily due to share repurchases of $41.9 million and829,000 shares of our common stock in the first nine months of 2005, comparedwith $17.6 million and 502,000 shares in the first nine months of 2004.

 

We have operating lease and software licensecommitments of approximately $0.5 million during the remainder of 2005, $2.2million in 2006, $2.0 million in 2007 and $0.3 million in 2008. A majority ofour operating lease commitments are related to our corporate headquarterslease, which was most recently amended in July 2004 to add additionalspace for our corporate headquarters and to extend the lease into 2008. Thelease provides for escalating rent payments from 2004 to 2008. The rent expenserelated to our corporate headquarters lease is recorded monthly on astraight-line basis in accordance with generally accepted accounting principles.

 

17

----

 

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

 
| ** ** | ** ** | **Operating  Leases** | ** ** | **Software  Licenses** | ** ** | **Total** | ** ** |
|------------|------------|-----------------------|------------|------------------------|------------|-----------|------------|
| 2005       |       | $                     | 465        |                   | $          | 79        |       | $ | 544 |   |
| 2006       |       | 1,889                 |       | 314                    |       | 2,203     |       |
| 2007       |       | 1,937                 |       | 79                     |       | 2,016     |       |
| 2008       |       | 325                   |       | —                 |       | 325       |       |
|       |       | $                     | 4,616      |                   | $          | 472       |       | $ | 5,088 |   |

 

Asof September 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 exposed toany financing, liquidity, market or credit risk that could arise if we hadengaged 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.  On August 15,2005, we announced that our Board of Directors increased the size of the stockrepurchase program by an additional 2 million shares, for a total program sizeof up to 4 million shares. 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 September 30, 2005, we had repurchased1,835,030 shares of our common stock under this program, for an aggregate of$72.5 million at an average price of $39.52 per share.

 

As of December 31, 2004, we retired all 1,006,000 shares of ourcommon stock that had been repurchased prior to that date.  In accordance with APB 6, Status ofAccounting 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 do notexpect to retire shares of our common stock that we repurchased during 2005 inthe foreseeable future.

 

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.

 

18

----

 

**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 ourexpectations include the following: customer acceptance of our services,products and fee structures; the success of our brand development efforts; thevolatile and competitive nature of the internet industry; changes in domesticand international market conditions and the entry into and development ofinternational markets for our products; risks relating to intellectual propertyownership; and the risks and uncertainties identified in our Annual Report on Form 10-Kfor the fiscal year ended December 31, 2004 and other filings with theSecurities and Exchange Commission.**

** **

**Item 3. 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 speculative purposes.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 September 30,2005. Changes in interest rates over time will, however, affect our interestincome.**

** **

For the quarter ended September 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 underlying assetsand liabilities. Our objective is to reduce the risk to earnings and cash flowsassociated with changes in foreign currency exchange rates. We do not useforeign currency forward contracts for speculative or trading purposes. Asof September 30, 2005, we had committed to three foreign currency forwardcontracts to purchase British Pounds for $2.1 million. Our British Poundcommitment represents 1.2 million British Pounds at a weighted average forwardrate of 1.8285. The fair value of these foreign currency forward contracts was$2.0 million at September 30, 2005. All of the foreign currency forwardcontracts outstanding at September 30, 2005 will be settled before December 31,2005.

 

**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 

 

19

----

 

**report. Based on theirevaluation, our Chief Executive Officer and Chief Financial Officer haveconcluded that these controls and procedures are effective.**

** **

**Changes In Internal ControlOver Financial Reporting**

** **

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

 

20

----

 

**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 ofEquity Securities**

** **
| **Month**           | ** ** | **Number of shares   purchased  during month(1)** | ** ** | **Average price paid per   share** | ** ** | **Cumulative number of shares   purchased as part of publicly   announced plan** | ** ** | **Maximum number of shares that may   yet be purchased  under the plan(2)** | ** ** |
|---------------------|------------|--------------------------------------------------------|------------|-----------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| July 2005      |       | —                                                 |       | —                                  |       | 1,331,000                                                                                  |       | 669,000                                                                          |       |
| August 2005    |       | 504,030                                                |       | $                                       | 48.65      |                                                                                       | 1,835,030  |                                                                             | 2,164,970  |   |
| September 2005 |       | —                                                 |       | —                                  |       | 1,835,030                                                                                  |       | 2,164,970                                                                        |       |
| Total               |       | 504,030                                                |       | $                                       | 48.65      |                                                                                       | 1,835,030  |                                                                             | 2,164,970  |   |

 

----

**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. On August 15, 2005, we announced that ourBoard of Directors increasedthe size of the stock repurchase program by an additional 2 million shares ofour common stock, for a total program size of up to 4 million shares of ourcommon stock.

** **

**Item3.**           Defaults uponSenior Securities

** **

**None.**

** **

**Item4.  Submission of Matters to a Vote ofSecurity Holders**

** **

**None.**

** **

**Item 5.**           OtherInformation

** **

**None.**

 

21

----

 

**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.** |
|------------|------------|---------|------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

22

----

 

##### **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: November 8, 2005 | By:                 |   /s/ JOHN B. CARRINGTON |   |
|                        |                |   John B. Carrington |
| * *                    | * *            | *  Chairman of the  Board and* |
| * *                    | * *            | *   Chief  Executive Officer* |
|                        |                |   |
| Date: November 8, 2005 | By:                 |   /s/ DOUGLAS C. WRIDE |   |
|                        |                |   Douglas C. Wride |
| * *                    | * *            | *  Chief Financial  Officer* |
|                             |                     |  |  |  |

 

23

----

 

**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.** |
|------------|---------|------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

----